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In-Depth: Temp Regs Block Corporations from Using Partnerships to Avoid Recognizing Gains.

(Parker Tax Publishing June 26, 2015)

The IRS has issued temporary regulations intended to prevent corporate taxpayers from using a partnership to avoid gain required to be recognized under Code Sec. 311(b) or Code Sec 336(a). The regulations are intended to prevent circumvention of the General Utilities doctrine repeal. The text of the temporary regulations serves as the text of the proposed regulations. T.D. 9722.

Background

In General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), the Supreme Court held that corporations generally could distribute appreciated property to their shareholders without the recognition of any corporate level gain (the General Utilities doctrine). Beginning in 1969 and ending with the Tax Reform Act of 1986, Congress enacted Code Sec. 311(b) and Code Sec. 336(a) to limit and ultimately repeal the General Utilities doctrine. Under current law, Code Sec. 311(b) and 336(a) require a corporation that distributes appreciated property to its shareholders to recognize gain determined as if the property were sold to the shareholders for its fair market value.

After the enactment of Code Sec. 311(b), the IRS became aware of transactions in which taxpayers used a partnership to postpone or avoid completely gain generally required to be recognized under Code Sec. 311(b). In one example of this type of transaction, a corporation entered into a partnership and contributed appreciated property. The partnership then acquired stock of that corporate partner, and later made a liquidating distribution of this stock to the corporate partner. Under Code Sec. 731(a), the corporate partner did not recognize gain on the partnership's distribution of its stock. By using such a transaction, the corporation had disposed of the appreciated property it formerly held and had acquired its own stock, permanently avoiding gain on the appreciated property. If the corporation had directly exchanged the appreciated property for its own stock, Code Sec. 311(b) would have required the corporation to recognize gain upon the exchange.

In 1992, the IRS issued proposed regulations that adopted two rules to protect the repeal of the General Utilities doctrine. The "1992 deemed redemption rule" provided that a corporate partner recognizes gain if transaction has the economic effect of an exchange by the partner of its interest in appreciated property for an interest in its stock owned, acquired, or distributed by the partnership. The "1992 distribution rule" provided that a partnership's distribution to a partner of the partner's stock is treated as a redemption or an exchange of the stock of the partner for a portion of the partner's partnership interest with a value equal to the distributed stock.

After considering comments and taking into account subsequent changes in relevant law, the IRS has withdrawn the 1992 proposed regulations and issued temporary regulations under T.D. 9722. The purpose of the regulations issued in T.D. 9722 is to prevent corporate taxpayers from using a partnership to circumvent gain required to be recognized under Code Sec. 311(b) or Code Sec. 336(a).

The regulations apply to transactions occurring on or after June 12, 2015.

Key Definitions

The temporary regulations apply when a partnership, either directly or indirectly, owns, acquires, or distributes "Stock of the Corporate Partner." Under the regulations, a "Corporate Partner" is defined as a person that holds or acquires an interest in a partnership and that is classified as a corporation for federal income tax purposes. The regulations define "Stock of the Corporate Partner" expansively to include the Corporate Partner's stock, or other equity interests, including options, warrants, and similar interests, in the Corporate Partner or a corporation that controls (within the meaning of Code Sec. 304(c)) the Corporate Partner, and also includes interests in any entity to the extent that the value of the interest is attributable to Stock of the Corporate Partner. Stock of a Corporate Partner excludes stock of any corporation that does not possess control of the Corporate Partner under Code Sec. 304(c), even if the corporation is a Code Sec. 337(d) affiliate or a member of the same consolidated group as the Corporate Partner.

OBSERVATION: Under Code Sec. 304(c), control generally exists when there is ownership of stock of a corporation possessing at least 50 percent of the total combined voting power of all classes of the corporation's stock that is entitled to vote or at least 50 percent of the value of the shares of all classes of stock of the corporation.

For partnerships that hold Stock of the Corporate Partner, the regulations apply to a transaction (or series of transactions) that is a "Section 337(d) Transaction." The regulations define a Section 337(d) Transaction as a transaction that has the effect of an exchange by a Corporate Partner of its interest in appreciated property for an interest in Stock of the Corporate Partner owned, acquired, or distributed by a partnership.

Deemed Redemption Rule in T.D. 9722

The regulations in T.D. 9722 largely retain the 1992 deemed redemption rule: if a transaction is a Section 337(d) Transaction, a Corporate Partner must recognize gain. To determine the amount of gain, the Corporate Partner must first determine the amount of appreciated property (other than Stock of the Corporate Partner) effectively exchanged for Stock of the Corporate Partner (by value) and then calculate the amount of taxable gain recognized.

A Corporate Partner must recognize gain under the regulations even if the Section 337(d) Transaction would not otherwise change the Corporate Partner's allocable share of gain under Code Sec. 704(c).

Example: A Corporate Partner contributes appreciated property to a newly-formed partnership and an individual contributes cash that the partnership subsequently uses to purchase Stock of the Corporate Partner. The purchase of the stock is a Section 337(d) Transaction even though the Corporate Partner's allocable share of gain in the appreciated property under Code Sec. 704(c) is the same before and after the purchase.

If the Corporate Partner has an existing interest in the partnership's Stock of the Corporate Partner prior to the Section 337(d) Transaction, the deemed redemption rule applies only with respect to the Corporate Partner's incremental increase in the Stock of the Corporate Partner. For example, changing allocations to increase a Corporate Partner's interest in the Stock of the Corporate Partner from 50 percent to 80 percent and to decrease the Corporate Partner's interest in other appreciated property from 80 percent to 50 percent would have the effect of an exchange by the Corporate Partner of the 30-percent incremental decrease in its interest in the appreciated property for the 30-percent incremental increase in the Stock of the Corporate Partner.

OBSERVATION: The regulations do not apply to stock purchases or other transactions that do not have the effect of an exchange of appreciated property for Stock of the Corporate Partner.

Calculating Gain under the Deemed Redemption Rule and Effect on Basis

If a transaction is a Section 337(d) Transaction, the deemed redemption rule requires the Corporate Partner to recognize a percentage of its total gain in partnership appreciated property equal to the Corporate Partner's interest (by value) in the appreciated property, divided by the Corporate Partner's interest (by value) in the appreciated property immediately before the Section 337(d) Transaction. This fraction is defined as the "Gain Percentage."

The Corporate Partner's gain under the deemed redemption rule equals the product of (1) the Corporate Partner's Gain Percentage and (2) the gain from the appreciated property that the Corporate Partner would recognize if, immediately before the Section 337(d) Transaction, all assets of the partnership and any assets contributed to the partnership in the transaction were sold at fair market value (taking into account Code Sec. 7701(g)), reduced, but not below zero, by any gain the Corporate Partner is required to recognize with respect to the appreciated property under any other section of the Code.

Example: A Corporate Partner is allocated $100,000 of tax gain on a sale of appreciated partnership property (other than Stock of the Corporate Partner). The Corporate Partner's interest in that property is $500,000. The partnership engages in a Section 337(d) Transaction that reduces the Corporate Partner's interest in appreciated partnership property by $200,000 and increases the Corporate Partner's interest in Stock of the Corporate Partner by $200,000. The Corporate Partner's Gain Percentage equals 40% (200,000/500,000), and the Corporate Partner's gain under the deemed redemption rule is $40,000 (40% of $100,000).

The regulations require the Corporate Partner to increase its basis in its partnership interest by an amount equal to the gain that the Corporate Partner recognizes in a Section 337(d) Transaction.

The regulations also require the partnership to increase its adjusted tax basis in the appreciated property by the amount of gain that the Corporate Partner recognized with respect to that property as a result of the Section 337(d) Transaction. This basis increase applies regardless of whether the partnership has elected under Code Sec. 754 to adjust the basis of partnership property.

Partnership Distributions of Stock of the Corporate Partner

The 1992 distribution rule required a Corporate Partner to recognize gain when the partnership distributed Stock of the Corporate Partner to the Corporate Partner. Some practitioners commenting on the proposed regs contended the rule was overly broad because it could cause the Corporate Partner to recognize gain in an amount that exceeded the appreciation in property effectively exchanged for the stock. The IRS agreed, and instead of adopting the 1992 distribution rule, the regulations extend the deemed redemption rule to certain distributions to the Corporate Partner of Stock of the Corporate Partner.

The new rules governing distributions apply only if the distributed stock had previously been the subject of a Section 337(d) Transaction, or becomes the subject of a Section 337(d) Transaction as a result of the distribution (a Section 337(d) Distribution). Additionally, the regulations do not apply to a distribution to the Corporate Partner of the Stock of the Corporate Partner to which Code Sec. 732(f) applies at the time of the distribution.

If a distribution is a Section 337(d) Distribution, then in addition to any gain recognized under the deemed redemption rule, the Corporate Partner is required to recognize gain to the extent that the partnership's basis in the distributed Stock of the Corporate Partner exceeds the Corporate Partner's basis in its partnership interest immediately before the distribution. The regulations provide an exception to this additional gain recognition rule if the gain recognition or basis reduction rules of Code Sec. 732(f) apply at the time of the distribution.

To regulations provide that the basis of Stock of the Corporate Partner distributed to the Corporate Partner equals the greater of:

(1) the partnership's basis of that distributed Stock of the Corporate Partner immediately before the distribution, or

(2) the fair market value of that distributed stock immediately before the distribution, less the Corporate Partner's allocable share of gain from all of the stock if the partnership sold all of its assets in a fully taxable transaction for cash in an amount equal to the fair market value of such property (taking into account Code Sec. 7701(g)) immediately before the distribution.

When a Corporate Partner receives both Stock of the Corporate Partner and other property in a Code Sec. 337(d) distribution, the basis to be allocated to the properties distributed under Code Sec. 732(a) or (b) is allocated first to the Stock of the Corporate Partner before taking into account the distribution of any other property (other than cash). Therefore, before taking into account the distribution of other property, the Corporate Partner will reduce its basis in its partnership interest by the Corporate Partner's basis in the distributed Stock of the Corporate Partner (but not below zero). The Corporate Partner will determine its basis in other distributed partnership property and in its remaining partnership interest after giving effect to this reduction.

OBSERVATION: Because the distribution to a Corporate Partner of its own stock affects the Corporate Partner's basis in other distributed property and any retained partnership interest, these regulations require the partnership and the Corporate Partner to determine the basis of other distributed property and any retained partnership interest by reference to the partnership's basis in the distributed Stock of the Corporate Partner.

De Minimis and Inadvertence Exceptions

The regulations include a de minimis rule that provides that the regulations do not apply to a Corporate Partner if three conditions are satisfied:

(1) Both the Corporate Partner and any persons related to the Corporate Partner under Code Sec. 267(b) or Code Sec. 707(b) own, in the aggregate, less than five percent of the partnership;

(2) The partnership holds Stock of the Corporate Partner worth less than two percent of the value of the partnership's gross assets, inclusive; and

(3) The partnership has never, at any point in time, held more than $1,000,000 in Stock of the Corporate Partner or more than two percent of any particular class of Stock of the Corporate Partner.

The regulations also provide a special rule that applies if the conditions of the de minimis rule are satisfied at the time of a Section 337(d) Transaction, but are not satisfied at the time of a subsequent Section 337(d) Transaction or revaluation event described in Reg. Sec. 1.704-1(b)(2)(iv)(f). This rule provides that, solely for purposes of the deemed redemption rule, a Corporate Partner may determine its gain on the subsequent acquisition or revaluation event as if it had already recognized gain at the previous event.

The regulations also contain an inadvertence exception, which provides that the regulations do not apply to Section 337(d) Transactions in which the partnership satisfies two requirements:

(1) The partnership must dispose of, by sale or distribution, the Stock of the Corporate Partner before the due date (including extensions) of its tax return for the tax year in which the partnership acquired the stock (or in which the Corporate Partner joined the partnership, if applicable); and

(2) The partnership must not have distributed the Stock of the Corporate Partner to the Corporate Partner or a person possessing control of the Corporate Partner under Code Sec. 304(c). (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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