Grecian Magnesite case in US partly clarifies LLC taxation

Israelis and other non-US investors often use LLCs (limited liability companies) without being sure about the consequences. They are likened to a partnership. The US federal tax treatment of partnerships as pass-through entities has elements of both “aggregate” (look through to assets and intra-entity activity) and “entity” (opaque) treatment. On disposition, the US tax code specifies aggregate treatment only for specified assets, namely, depreciated assets to the extent of depreciation taken, certain inventory and unrecognized receivables. All other gain on disposition is eligible for US capital-gains treatment as entity based.

Where nonresidents sell partnership interests (either US partnership interests or foreign partnerships that are engaged in US activity) the Internal Revenue Service Code is less clear, essentially stating in general terms that where income is “attributable to” a US office or “fixed place of business,” the income should be sourced to the US. Otherwise, the general rules is that gain on sale or disposition of capital assets is sourced based on residency.

In 1991, the IRS issued a critical Revenue Ruling that took an aggregate view of the entire disposition of partnership interests, sourcing it to the US where and to the extent the partnership had an office or fixed place of business in the US. Given that the underlying sourcing statutes do not expressly state that gain on disposition of partnership interests is US-sourced, but reference only income attributable to the office or fixed place of business, the ruling has been hotly debated ever since. A number of practitioners took filing positions directly contra to the ruling on the basis that they felt it lacked sufficient statutory support. Oddly, the matter was not litigated until this year.

In a detailed opinion, the US Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner) declined to follow the Revenue Ruling, citing incorrect construction of the Tax Code by the IRS in the ruling. In this case, a Greek corporation held a 12.6% partnership interest in Premier Chemicals LLC, a US partnership involved in extracting, producing and distributing magnesite in the US. The US partnership was headquartered in Pennsylvania and owned mines and industrial properties in Pennsylvania, Nevada and Florida.

On July 21, 2008, Premier Chemicals redeemed Grecian Magnesite’s interests for $10.6 million. The tax return filed by Grecian Magnesite did not report any tax for gain on disposition. Upon audit, IRS assessed taxes, interest and penalty on all the gain.

As to the component of gain that represented real-estate (mining) interests, the Tax Court agreed with the IRS assessment finding income sourced to the US based on the specific provisions of the Foreign Investment in Real Property Tax Act. This Code provision applies a “look through” rule for both corporations and partnerships that hold US real-property (mines) sourcing allocable gain to the US.

However, as to the remaining gain on disposition, the Tax Court turned to the Code sections addressing disposition. It specifically provides that gain on sale of partnership interests is capital save for the overriding provisions, including separate ordinary income for only specified assets.

In Grecian Magnesite, the partnership did not hold any such specified assets, and hence the gain was capital. The Tax Court then held that the gain on disposition is not gain from an office or fixed place of business, since a different element for triggering gain exists. In short, in the opinion of the Tax Court, gain on disposition of an outside interest in a partnership is separate from its operations, per the entity view promulgated in the Code. Therefore, the court ruled that Premier Chemicals was exempt from US federal capital-gains tax on selling the LLC interest.

What about US estate and gifts tax?

Moving to estate and gift taxes, the US Tax Code lacks dispositive provision regarding the treatment of partnerships. Also, there is little guidance from the IRS on the issue of either gifting partnership interests or holding US partnership interests at death.

In 2016, the IRS added to its list of “no rulings” the gifting of partnership interests. Hence many practitioners default to using opaque entities for inbound US tax planning.

Given that Grecian Magnesite involved income and not transfer-tax statutes, its use of entity analysis may be limited. So it is unwise to assume the case provides an exemption from estate and gift tax. The IRS has until mid-December to appeal the Grecian Magnetite decision.

Implications for Israelis

The case for capital-gains tax exemption for non-US investors on a sale of an interest US non-real-estate LLC is bolstered but still unsettled. The same goes for US estate and gifts tax.

Israeli residents should also consider Israeli taxes. Flowthrough treatment can be elected for an LLC (not S corporation) in Israel, in the first relevant tax year only, for foreign tax-credit purposes only – not loss offsets against other income.

As always, consult experienced tax advisers in each country at an early stage in specific cases.

magda.szabo@janoverllc.com leon@hcat.co

Magda Szabo is a tax partner in Janover LLC. Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax.