I. Introduction: On January 11, 2000, the Treasury Department issued proposed regulations under §708, relating to the tax consequences of partnership mergers and divisions. Prop. Reg. §1.708-1(c), (d) (January 10, 1999). These proposed regulations are generally consistent with prior administrative advice, see Rev. Rul. 68-289, 1968-1 C.B. 314, but provide substantially more detail and have considerably greater reach.
A. Asset Transfers
1. "Assets-Over": An "assets-over" transaction is the transfer of assets from one partnership to another in exchange for one or more interests in the transferee partnership followed by a distribution of the interests received to partners of the transferor partnership. This distribution can, but need not, be in complete liquidation of the distributee partners' interests in the partnership. This is the preferred form of transfer in the proposed regulations and defines the taxation of a merger or division that occurs by operation of statute without any actual asset transfer or if any unapproved form of asset transfer is adopted.
2. "Assets-Up": An "assets-up" transaction is the distribution of assets from a partnership to a partner and then the contribution of those assets by the distributee to a new partnership. The initial distribution can, but need not, be in complete liquidation of the distributee partner's interest in the distributing partnership. The proposed regulations specify that such an "assets-up" transaction will be treated as occurring only if the distributed assets are first titled to the distributee and then retitled to the resulting partnership. This requirement likely will make the "assets-up" transaction impractical in many circumstances. In addition, adoption of the "assets-up" form may result in taxation to partners of the distributing partnership under §§704(c)(1)(B), 707(a)(2)(B), and 737.
B. Effective Date: The proposed regulations are effective as to mergers and divisions occurring on or after the date final regulations are published in the Federal Register. Prop. Reg. §§1.708-3(c)(6), -3(d)(6).
II. The Proposed Merger Regulations
A. Overview: Most partnership mergers can be accomplished without significant adverse tax consequences, although possible disguised sale issues can arise postmerger. The principle planning opportunities should include using a partnership merger to accomplish a tax-free exchange of dissimilar assets and avoiding the merger regulations to preserve favorable tax incidents of the combining entities.
B. Technical Details
1. Continuing and Terminating Partnerships
b. At Most One Continuing Partnership: At most only one of the merging partnerships will be treated as continuing (in the form of the resulting partnership) with the remaining partnerships treated as terminating. Prop. Reg. §1.708-1(c)(1). As to the terminating partnerships, prior elections and methods of accounting will not continue and, depending on changes in the law, may not be available postmerger. In addition, if the transaction is structured as a distribution from one of the merging partnerships to its partners and then over to the resulting partnership (that is, as an "assets-up" transaction), gain could be triggered to the distributee partners. See paragraph II.C.1.a.(1) below.
c. Overlapping Ownership: If there is overlapping ownership of the merging partnerships, it may be the case that the partners of more than one of the merging partnerships end up owning greater than 50% of the capital and profits in the resulting partnership. In such circumstances the resulting partnership is treated as the continuation of that merging partnership whose partners own more than 50% of the capital and profits in the resulting partnership and that transferred the greatest value of assets (net of liabilities) to the resulting partnership. Prop. Reg. §1.708-1(c)(1); see Prop. Reg. §1.708-1(c)(4)(example 2).
d. No Continuing Partnership: It may also be the case that the partners of no merging partnership end up owning more than 50% of the capital and profits in the resulting partnership. This is especially likely if more than 2 partnerships merge or consolidate. In this circumstance the resulting partnership is not treated as the continuation of any of the merging partnerships. Prop. Reg. §1.708- 1(c)(1). Rather, for tax purposes the resulting partnership is treated as newly-formed. Any book/tax disparities in transferred assets must be allocated to partners of the transferor partnership. See Prop. Reg. §1.708-1(c)(4) (example 4(iii)).
e. Non-Continuing Partnerships Deemed Liquidating: All of the merging partnerships not treated as continuing under the rules described above are treated as terminating and must file returns for the short taxable year ending on the date of merger or consolidation. Prop. Reg. §1.708-1(c)(1). If the resulting partnership is treated as the continuation of one of the merging partnerships, it will file a return for its full taxable year and must indicate on its return for the year of merger or consolidation that it is the continuation of the partnership treated as continuing. Prop. Reg. §1.708-1(c)(1).
2. Ignored Transfers, Deemed Transfers and Recast Transfers
b. Deemed Transfers
(1) The Transferor Partnership Terminates
(b) Example 2: Consider the merger of equal value partnerships X and Y into Z such that the former partners of X, of Y and of Z each end up owning onethird of the capital and profits of the merger partnership. While there is no actual transfer of the assets of Z, because Z is not a continuation, it is treated as terminating. Prop. Reg. §1.708-1(c)(1). Accordingly, the assets actually owned by Z prior to the merger are treated as transferred to a new partnership, new-Z, in an assets-over transfer. This new partnership is also treated as the recipient of the assets transferred by X and Y (whether transferred by an assets-over transfer or an assets-up transfer).
(b) Example 4: Reconsider the example above but assume that the resulting partnership (B) is treated asa continuation of partnership A. In this case, the assets held by A prior to the merger are not treated as transferred in any manner and the assets held by B are treated as transferred to A (which is then renamed B) in an assets-over transaction.
(c) Recast Transfers
(2) Part Assets-Over, Part Assets-Up
(b) Example 6: Partnership ABC owns Blackacre with adjusted basis of $20 and fair market value of $100 as well as Whiteacre with adjusted basis and fair market value of $100. A and B each have an outside basis of $10 in their 25% partnership interests while C has an outside basis in its 50% partnership interest. To effectuate a merger of ABC into partnership D, ABC distributes Blackacre to partner C who then immediately contributes Blackacre to D. As part of the same transaction, ABC transfers Whiteacre to D in exchange for interests in D, interests which are then distributed to A and B in liquidation of ABC. Assuming ABC is not the continuing partnership, the transaction will be recast as if Blackacre had been transferred directly from ABC to D. This recharacterization preserves the low asset basis of Whiteacre and prevents a net basis step-up.
(1) Example 7: A and B form the AB partnership, with each partner contributing appreciated property. Suppose, prior to the disposition of the property contributed by A and B and within 7 years of the formation of AB, that the AB partnership merges into CD in an assets-up transaction. If partnership AB distributes its assets pro rata to A and to B, distribution to B of property contributed by A will trigger gain recognition to B under §737 as well as to A under §704(c)(1)(B). In an assets-up transaction, the partnership should try to ensure that property contributed by a partner is distributed exclusively to that contributing partner. See §§704(c)(1)(B) (second parenthetical), 737(d)(1). These taxing provisions would be avoided if the merger were effected via an assets-over transfer.
(2) Excess Outside Basis—Example 8: If the partners have an aggregate outside basis in excess of the partnership's aggregate inside basis, merging in an "assets-up" transaction will permit the excess outside basis to move into inside basis. For example, suppose X and Y each have an outside basis of $100 in their 50% partnership interests while the XY partnership owns two capital assets, each with adjusted basis of $40 and fair market value of $50. If none of the appreciation in the partnership's assets is subject to §704(c), then merging XY into some other partnership in an assets-up transfer will increase asset basis to $100 apiece because the distribution of the assets out of XY steps-up asset basis under §732(b).
(3) Distribution of Marketable Securities and Cash: Distributions of cash or of marketable securities can be taxable to the extent such distributions exceed the distributee partner's outside basis. See §§731(a), (c). These provisions can apply to distributions forming an assets-up transfer as part of a partnership merger.
b. Assets-Over Transfers: An assets-over transfer as part of a merger should be tax-free to all parties.
(1) Section 704(c)(1)(B): If §704(c) property is transferred from a merging partnership, then the partnership interest received in exchange will be substitute §704(c) property. Reg. §1.704- 3(a)(8). Thus, distribution of that interest in the resulting partnership by the terminating partnership potentially could trigger taxation under §704(c)(1)(B). However, the regulations provide an explicit exception under §704(c)(1)(B) for this precise transaction. See Reg. §1.704-4(c)(4). The transferred §704(c) assets will continue to be subject to §704(c) when held by the transferee partnership to the same extent as they were when held by the transferor partnership. Id.
(2) Section 737: Because the interest in the resulting partnership received by the merging partnership takes a carryover basis under §722, the distribution of that partnership interest could potentially could trigger taxation under §737. However, like the regulations under §704(c)(1)(B), the regulations under §737 provide an explicit exception for this transaction. See Reg. §1.737-2(b)(1).
(3) Section 707(a)(2)(B): A distribution within two years of a merger can trigger gain recognition under the disguised sale rules of §7079a)(2)(B) if the distribution is made to a former partner of a terminating partnership. Unlike the other antimixing bowl provisions described above, the regulations do not provide an explicit exception to the application of §707(a)(2)(B) for partnership mergers. Note: after a partnership merger the former partners of the terminating partnership have not technically made any transfers to the surviving partnership; rather, it was their (now terminated) partnerships that made the transfers. The regulations promulgated under §707(a)(2)(B) do not address the possibility that a §707 taint can continue in the hands of a transferee of a partnership interest. Thus, application of §707(a)(2)(B) in this context is unclear.
(4) Section 752: Conforming amendments have been proposed to the regulations promulgated under §752, providing that when two or more partnerships merge using the "assetsover" form, increases and decreases in shares of partnership liabilities will be netted by the partners in the merging and resulting partnerships prior to determining any liability shift under §752. Prop. Reg. §1.752-(f); §1.752-(g) (example 2). Absent this rule the merger of a highly-leveraged partnership could cause a taxable distribution under §752(b) as a result of the deemed asset transfer. As a result of this rule, a partner in a merging partnership will recognize gain on the transaction under §752(b) only if the net §752 distribution exceeds the partner's outside basis in the resulting partnership immediately after the "assets-over" transaction.
(1) Election to Treat Exit as Prior to Merger: It may be the case that not all of the partners in the merging partnerships continue to have an interest in the enterprise after the merger or consolidation. In a transaction characterized as an "assetsover" transaction (that is, any transaction other than a respected "assets-up" transaction), the partners may elect to treat one or more of the partners as selling their partnership interests to the resulting partnership immediately prior to the merger or consolidation. This characterization will be respected even if the consideration actually distributed to the partner was held by the merging partnership prior to the transaction. Prop. Reg. §1.708-3.
(2) Consequences of the Election: If such an election is made in the merger or consolidation documents, the exiting partner will be taxed pursuant to §741 (applicable to transfers of partnership interests) rather than pursuant to §731 (applicable to partnership distributions). In such circumstances the deemed purchase of the partnership interest or interests by the resulting partnership may generate an optional basis adjustment under §743(b). This optional basis adjustment must be allocated solely to partners who were partners in the resulting partnership immediately prior to the transaction. Note that this treatment of the transaction ensures that the disguised sale provision of §707(a)(2)(B) is not implicated by the transaction.
1. Mixing Bowls
(1) If the partners merge X into Y using the assets-over method, none of the transferred assets are treated as newly contributed for purposes of §704(c). As a result, distribution of those assets will not trigger gain to the contributing partners under §704(c)(1)(B), Reg. §1.704-4(c)(4), or to the distributee under §737, Reg. §1.737-2(b)(1).
(2) Note: No exception applies with respect to the disguised sales rules of §707(a)(2)(B), although the application of §707(a)(2)(B) to partnership mergers is uncertain. See paragraph II.C.1.b above. Accordingly, assets distributed to partners of a terminating partnership within two years of the merger may triggering gain recognition under §707(a)(2)(B). Note also that if neither of the partnerships is treated as continuing, then all of the assets are treated as transferred and so all asset distributions should be deferred for two years.
(3) Assume that X is treated as continuing and that Y is treated as terminating. The assets initially held by Y can be distributed to the former partners of X anytime after the merger without implicating the disguised sale rules or the anti-mixing bowl rules. (Of course, assets formerly held by X can also be distributed to the former partners of X without tax, but that does not accomplish any mixing bowl.)
(4) However, if former assets of X are distributed to former partners of Y within two years of the merger, the distribution may trigger gain to the distributee partners under §707(a)(2)(B).
(1) The Hokey-Pokey: To reverse the direction or a merger in anticipation of a tax-free mixing bowl distribution within two years of the merger, the partners of the partnership who want to receive the post-merger distribution can contribute cash to their partnership prior to the merger. While it will not suffice for those partners to have their partnership borrow additional funds, then can borrow the funds themselves and then contribute the loan proceeds to the partnership. If this contribution is coupled with a preferred return or guaranteed payment obligation sufficient to service the debt, the direction of the merger can be reversed at little cost. Once the merger is completed and the transaction is old and cold, the cash can be distributed and the loan repaid.
(2) The Morris Trust Two-Step: Rather than stuff one partnership with additional funds prior to the merger, the other partnership could divide and then merger only one of the divided partnerships. See the discussion of partnership division planning opportunities below.
b. The Downside of Stop-Short Mergers
(1) Deliberately avoiding the merger rules by keeping the transferor partnerships alive has the negative effect of implicating the anti-mixing bowl provisions of §§704(c)(1)(B), 707(a)(2)(B), and §737. As discussed more fully above, see paragraph II.C.1.b, the regulations provide specific exceptions under §§704(c)(1)(B) and 737 for partnership mergers. These exceptions will not apply if the transferor partnerships remain alive. Further, the application of §707(a)(2)(B) in such transactions that stop-short of a complete merger is clear.
(2) Example 11: Partnerships X and Y combined their business by transferring all of their assets to new partnership XY in exchange for interests in XY; thus, X and Y become holding partnerships. All of the assets transferred to XT are subject to §704(c), so that cross-distributions of those assets within 7 years will trigger gain recognition under §704(c)(1)(B), and distributions by XY of appreciated property within 7 years can trigger gain recognition under §737. Further, any distributions by XY within two years will be subject to the reporting requirements of §707 as well as possible recharacterization as disguised sales.
A. Overview: Partnership divisions present considerable hazard, with adverse tax consequences possible under §§704(c), 707, and 737. Planning opportunities include avoiding or minimizing these hazards as well as avoiding the division regulations entirely to prevent an unwanted partnership termination.
B. Basic Terms
1. The "Prior" and "Resulting"Partnerships
b. The "Resulting" Partnerships: The partnerships that survive the division are called "resulting" partnerships in the proposed regulations, see Prop. Reg. §1.708-1(d)(3)(iv); if the prior partnership continues in existence after the division, then it is one of the resulting partnerships as well.
3. The "Divided" Partnership
b. No Continuing Partnership: If none of the resulting partnerships is a continuation of the prior partnership, then the regulations do not define the "divided" partnership. However, they do provide that the "prior" partnership is treated as the transferor partnership and they further provide that all assets-over transfers and all assets-up transfers will be taxed in accordance with their forms. Prop. Reg. §§1.708-1(d)(2)(i)(B), -1(d)(2)(ii)(B). If in such circumstances the prior partnership does not liquidate as part of the transaction, it will be treated as transferring its assets to a new resulting partnership in an assets-over transaction. Prop. Reg. §1.708-1(d)(2)(ii)(B).
c. One Continuing Partnership: If the owners of only one resulting partnership owned more than 50% of the capital and profits in the prior partnership, then that single continuing partnership is the "divided" partnership.
d. Multiple Continuing Partnerships: If more than one of the resulting partnerships is a continuation of the prior partnership, then under Prop. Reg. §1.708-1(d)(3)(i) the divided partnership –
(2) is that resulting partnership that is a continuation of the prior partnership which receives the greatest value of assets (net of liabilities) in the division.
1. Multiple Forms in a Single Division: The proposed regulations seem to contemplate the possibility that some of the assets may be transferred in an assets-up transfer and other assets may be transferred in an assets-over transfer in the same, single division. See the reference to "certain" assets in Prop. Reg. §1.708-1(d)(2)(ii)(A). However, no example in the proposed regulations uses both an assets-up transfer and an assets-over transfer. This likely will be clarified in the final regulations.
2. Assets-Up Form
b. Example 13: Suppose partnership PQRS distributes some of its assets to partners R and S in complete liquidation of their interests in PQRS (renamed PQ). R and S then contribute the distributed assets to newly-formed partnership RS. The form of this "assets-up" transfer will be respected if neither PQ nor RS is a continuation of PQRS. The form of the transaction also will be respected if PQ rather than RS is a continuation of PQRS. But the transaction will be recharacterized as an assets-over transfer from PQRS to PQ if RS is the continuation of PQRS. (Note: on these facts it cannot be the case that both PQ and RS are continuations of PQRS.)
b. Example 14: Partnership A distributes some of its assets in liquidation of the partnership interests of some but not all of its partners. These partners then contribute the distributed assets to partnerships B and C. As part of the same transaction, partnership A transfers some of its assets to partnership D and other assets to partnership E, receiving in exchange interests in partnership D and E which are then immediately distributed to partners of partnership A. That is, prior partnership A has divided into resulting partnerships A, B, C, D and E, using assets-up transfers to form B and C and assets-over transfers to form D and E.
(1) If none of the resulting partnerships is treated as a continuation of A, then all of the transfers will be taxed in accordance with their forms. In addition, A is treated as transferring the assets it retains to New-A in exchange for interests in New-A which are then distributed to the partners of A in complete liquidation of A.
(2) If A is treated as a continuation of A, then all transfers are taxed in accordance with their forms.
(3) If B is the only resulting partnership treated as a continuation of A, then the assets retained by A are treated as having been transferred from B in an assets-over transaction. The assets received by C are treated as having been transferred from B in an assets-up transfer. The assets received by D and E are treated as having been transferred from B in assets-over transactions. B is not treated as having received any assets in any form of transaction. (If C is the only continuing partnership, simply reverse B and C in all transfers in this paragraph.)
(4) If D is the only resulting partnership treated as a continuation of A, then the assets retained by A are treated as having been transferred from D in an assets-over transaction. The assets received by B and C are treated as having been transferred from D in an assets-up transaction. The assets received by E are treated as having been transferred in an assets-over transfer from D. Partnership D is not treated as receiving any assets in any form of transaction. (If E is the only continuing partnership, simply reverse D and E in all transfers in this paragraph.)
(5) If A is not treated as a continuation of A but two or more of B, C, D and E are treated as continuations of A, then the divided partnership is that resulting partnership, among those that are treated as continuations of A, which received the greatest value of assets (net of liabilities) in the division. All parts of the division are then recharacterized as transfers from the divided partnership to the resulting partnerships as described in the two immediately preceding paragraphs.
1. Assets-up Transfers:
b. Example 15: A contributes property with adjusted basis of $0 and fair market value of $1,000 to the ABCD partnership in exchange for a 25% interest in profits and losses. B, C, D and E each contribute cash of $1,000 for a 25% interest. Subsequently, when the partnership continues to hold the property contributed by A (adjusted basis of $0, fair market value of $2,000) as well as three assets with adjusted basis and fair market value of $2,000 each, the partnership divides in an assets-up transfer with A's property distributed to A and one of the unappreciated assets distributed to B in liquidation of their interests. A and B then contribute the property and cash to new partnership AB for 50% interests in the new partnership. At the time of the division, A had an outside basis of $750 and B had an outside basis of $1,750. The division is tax-free to A and B, and the partnership takes an adjusted basis in A's property of $750 and an adjusted basis of $1,750 in the other asset (not a net asset increase of $500). Note that if the property contributed by A had been distributed to partner C rather than to partner A, partner A would have been taxed on $1,000 under §704(c)(1)(B).
(1) General Rule of Taxability: If §704(c) property is transferred to a resulting partnership in an assets-over transaction as part of a partnership division, the partnership interest of the resulting partnership received in return is treated as §704(c) property under the substitute §704(c) property rule of Reg. §1.704-3(a)(8) to the extent of the transferred §704(c) property. As a result, distribution of that interest in the resulting partnership will be taxable to the partner who contributed the §704(c) property to the extent this partnership interest is distributed to other partners.
(2) Example 16: A contributes nondepreciable property with adjusted basis of $30 and fair market value of $120 to the AB partnership while B contributes cash of $120. Five years later, AB transfers the property, still worth $120, to the NewP partnership in exchange for two 50% interests in NewP, and then those interests in NewP are distributed to A and to B. A will be taxable on a gain of $45 under §704(c)(1)(B) because the interest in NewP distributed to B is treated as substitute §704(c) property. That partnership interest has a basis immediately prior to the distribution of $15, a fair market value of $60, and the entire unrealized appreciation of $45 is §704(c) gain allocable to A's contribution.
(b) If NewP files an election under §754, then the basis increase under §704(c)(1)(B) made to the NewP partnership interest distributed to B should produce an equivalent basis increase in the actual property initially contributed by A and now held by NewP. See Reg. §1.743-1(g)(4).
(1) Section 737 does not apply if all of the §704(c) property contributed by the distributee partner is transferred to a single resulting partnership and the contributing partner receives an interest in that resulting partnership as part of the exchange in liquidation of its interest in the prior partnership. Prop. Reg. §1.737-2(b)(2).
(2) Example 17: A, B, C and D form the ABCD partnership. A contributes appreciated property X with adjusted basis of $0 and fair market value of $200. B contributes property Y with adjusted basis of and fair market value of $200. C and D each contribute $200 of cash. The partnership subsequently divides into two partnerships using the assets-over form, distributing interests in the new partnership pro rata to A, B, C and D in nonliquidating distributions. Property X remains in the prior partnership, and property Y is transferred to the new partnership. The preamble to the proposed regulations concludes that taxation under §737 as to A is appropriate because §737 could be avoided otherwise: "[i]f, subsequent to the division, half of property Y is distributed to A, §737 would not be triggered because property X (the §704(c) property) is no longer in the same partnership as property Y."
(b) If in this example asset X rather asset Y had been transferred to the new partnership, §737 would not apply to A on the division. The transfer of §704(c) property to the new partnership is tax-free and the partnership interest received by ABCD on the exchange becomes substitute §704(c) property. Reg. §1.704-3(a)(8); Reg. §1.737-2(d)(3). Distribution of substitute §704(c) property is not subject to §737 when it is distributed back to the contributing partner. Reg. §1.737-2(d)(1). However, to the extent that the substitute §704(c) property is distributed to a partner other than the contributing partner (here, 25% each to B, C and D), the transaction will be taxable to A under §704(c)(1)(B). The one-quarter of the §704(c) built-in gain that escapes taxation under §704(c)(1)(B) should retain its §704(c) taint in the hands of the new partnership.
1. Using a Dummy Partnership to Change the Divided Partnership:
b. Example 19: Suppose in the example above that the assets retained by ABC are transferred to new-ABC, and old ABC liquidates as part of the transaction. AB and new-ABC remain continuations of old ABC but now the divided partnership is AB. Thus, the only consequence of replacing old-ABC with new-ABC is to change the divided partnership from ABC to AB.
3. Using a Partnership Division to Avoid §751(b)—Example 21: Individuals P, Q and R each own a one-third interest in the profits, losses and capital of the PQR partnership. PQR owns a capital asset with adjusted basis of $45 and fair market value of $105, an unrealized receivable with adjusted basis of $0 and fair market value of $60, and cash $45. PQR transfers the capital asset and cash of $35 to new partnership T and the unrealized receivable plus the remaining cash of $10 to new partnership T. PQR liquidates, with P owning 50% of S and no interest in T while Q and R each own 25% of S and 50% of T. P can sell its interest in the venture by selling its interest in S, and that sale will produce only capital gain.
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