SECTION 2. BACKGROUND

A partnership may be used to create the economic equivalent of a variable-rate taxexempt bond. To create this instrument, a sponsor purchases a tax-exempt obligation and transfers the tax-exempt obligation to an entity that qualifies as a partnership for federal tax purposes (tax-exempt-bond partnership). The tax-exempt-bond partnership issues two classes of equity interests: interests that are entitled to a preferred variable return on its capital (variable-rate interests) and interests that are entitled to all of the remaining income of the partnership (inverse interest). The variable return on the variable-rate interests tracks current short-term exempt yields. Under § 702(b), tax-exempt interest income received by a partnership retains its character when the partnership allocates the income to a partner.

Under § 706(a), a partner generally includes in income for a taxable year the partner’s allocable share of items of partnership income, gain, loss, deduction, and credit for the partnership’s taxable year ending within or with the partner’s taxable year. A partner must also include in income for a taxable year guaranteed payments under § 707(c) that are taken into account by the partnership under its method of accounting in the partnership’s taxable year ending within or with the partner’s taxable year. Moreover, for each taxable year in which a partnership has income, deductions, or credits, § 6031(a) and (b) requires the partnership to file a Form 1065, U.S. Return of Partnership Income, and to issue Schedules K–1 (Form 1065) to each partner.

Annual inclusion of income under § 706(a) can be incompatible with the needs of money market funds and of medium- and long-term bond funds that invest in obligations that produce interest that is exempt from tax. For example, if a regulated investment company’s (RIC’s) taxable year does not correspond to the taxable year of a tax-exempt-bond partnership in which it holds an interest, the RIC

2003-48 I.R.B. 1159 December 1, 2003