I. Mergers and Divisions
A. 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.
1. Asset Transfers
a. "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.
b. "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) and 737.
2. 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).
B. The Proposed Merger Regulations
1. Continuing and Terminating Partnerships
a. Statutory Mergers and Consolidations: When two or more partnerships merge or consolidate, the resulting partnership is treated as a continuation of that merging partnership whose partners own more than 50% of the capital and profits in the resulting partnership. Prop. Reg. §1.708-1(c)(1). In the context of a merger, this resulting partnership will be, under state law, one of the merging partnerships. In the context of a consolidation, this resulting partnership will be, under state law, a newly-formed partnership.
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 partnership 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 post-merger. 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, gain could be triggered to the distributee partners. See paragraph I(B)(3)(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
a. Actual Transfers from the Continuing Partnership: Actual transfers from the continuing partnership are ignored. For example, suppose A and B each own 50% of the AB partnership which itself owns Blackacre with current fair market value of $60,000. Partnership AB transfers Blackacre to partnership CD which owns Whiteacre with current fair market value of $40,000. In exchange, AB receives two 30% interests in the capital and profits of CD, and those interests are distributed to A and B in complete liquidation of their interests in AB. While this is structured as an "assets-over" merger of AB into CD, the "continuing" partnership is AB. Accordingly, the transaction is recast as a merger of CD into AB (which is then renamed CD), so that no asset transfer of any kind is made of Blackacre. Thus, the actual assets-over transfer from AB to CD is ignored.
b. Deemed Transfers
(1) The Transferor Partnership Terminates
(a) In the AB/CD merger above, no actual asset transfer is made by partnership CD. However, because partnership CD is deemed to terminate, its assets are taxed as if they were transferred to the continuing partnership (that is, to AB) in an assets-over transfer. See Prop. Reg. §1.708-1(c)(2)(i).
(b) 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 one-third 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).
(2) Statutory Mergers and Consolidations: When two or more partnerships merge or consolidate, the resulting partnership is treated as a continuation of that merging partnership whose partners own more than 50% of the capital and profits in the resulting partnership. Prop. Reg. §1.708- 1(c)(1). In the context of a merger, this resulting partnership will be, under state law, one of the merging partnerships. In the context of a consolidation, this resulting partnership will be under state law, a newly-formed partnership. However, if the former members of one of the consolidating partnerships own more than 50% of the capital and profits of the resulting partnership, the consolidating partnership will be treated as a continuation of the partnership formerly owned by the new majority owners. Prop. Reg. §1.708-1(c)(1). If a merger or consolidation is effected by operation of law without any actual asset transfer, all assets received by the resulting partnership are treated as having been transferred in assets-over transfers.
(a) Example 1: Partnership A merges into partnership B under Delaware state law without an actual transfer of assets. If neither the former partners of A nor the former partners of own more than 50% of the capital and profits of post-merger B, then A and B are each treated as if they transferred their assets to newly-formed New-B in an assets-over transfer, followed by the liquidation of A and B.
(b) Example 2: Reconsider the example above but assume that the resulting partnership (B) is treated as a 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 in an assets-over transaction.
c. Recast Transfers
(1) "Interests-Over" Transfers: A partnership merger might be effected by means of a transfer of partnership interests in a transaction similar to a corporate "B" reorganization. For example, A and B might transfer their interests in the AB partnership to partnership CD in exchange for interests in CD. Because this would leave partnership with only a single partner, it would terminate by operation of law. Thus, the assets of AB would be owned by CD, and the former partners of AB have become partners in CD. This is called an "interests over" transfer, and the proposed regulations provide that such a transaction will be recast in the form of an assets-over transaction. See Prop. Reg. §1.708-1(c)(2)(i). If AB is not treated as the continuing partnership, then the transaction will be taxed as if partnership AB transferred its assets to CD in exchange for interests in CD, interests that were then distributed to CD in a liquidating distribution. If, though, AB is treated as the continuation, then the transaction is treated as if the assets of AB remained in AB and the assets of CD were transferred from CD to AB in an assets-over transfer.
Part Assets Over, Part Assets Up
(a) The proposed regulations seem to contemplate that a partnership which transfers its assets as part of a merger will use either the assets-over or the assets-up form of transfer for all of its assets. See Prop. Reg. §1.708-1(c)(2). Thus, if a partnership transfers part of its assets in an assets-over transfer and the remainder of its assets in an assets-up transfer, those assets actually transferred in the assets- up transfer will be taxed as if they were transferred in an assets-over transfer. See Prop. Reg. §1.708-1(c)(2)(i).
(b) Example 3: 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 b recast as if Blackacre had been transferred directly from ABC to D. As a result, this preserves the low asset basis of Whiteacre and prevents a net basis step-up.
3. Taxation of Mergers Under the Proposed Regulations
a. Assets-Up Transfers
(1) Example 4: 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 of B of property contributed by A will trigger gain recognition to B under §737 as well as to A under §704(c)(1)(B). The partnership should try to ensure that property contributed by a partner is distributed exclusively to that contributing partner in an assets- up transaction. 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: 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 $50 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 §§732(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. §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 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 "assetsover" transaction.
c. Exiting Partners:
(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 "assets-over" 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 on 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.
C. The Proposed Division Regulations
1. Basic Terms
a. The "Prior" and "Resulting" Partnerships
(1) The "Prior" Partnership: The "prior" partnership is the actual transferor of assets in the division. Prop. Reg. §1.708-1(d)(3)(ii). Note that the "prior" partnership may not be treated as the transferor of assets under the proposed regulations; that partnership is called the "divided" partnership. See paragraph I(C)(1)(c) below.
(2) 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.
b. The "Continued" Partnerships: any resulting partnership whose members owned more than 50% of the capital and profits of the prior partnership will be treated as a continuation of the prior partnership. Prop. Reg. §1.708-1(d)(1). For example, suppose partnership PQRST has 5 equal partners. If PQRST distributes some of its assets pro rate to its partners who then contribute those assets to newly-formed partnership PQRST-Prime, then PQRST is the "prior" partnership, both PQRST and PQRST-Prime are "resulting" partnerships, and both PQRST and PQRST-Prime are continuations of PQRST.
c. The "Divided" Partnership (deemed transferor)
(1) General Rule: The proposed regulations call the partnership that is treated as transferring assets in the division the "divided" partnership. Prop. Reg. §1.708- 1(d)(3)(i). Thus, for tax purposes the "divided" partnership is treated as the transferor partnership in the transaction.
(2) 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).
(3) 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.
(4) 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 -
(a) Is the prior partnership (that is, the "divided" partnership is the partnership that actually transferred its assets in the division) if the prior partnership continues in existence after the merger and is treated as a continuation of itself; otherwise
(b) 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.
2. The Form of the Division:
a. 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.
b. Assets-Up Form
(1) General Rule: If one or more of the resulting partnerships is a continuation of the prior partnership, then the assets-up form of transfer will be respected only if the assets are distributed from the divided partnership and then contributed to a resulting partnership. Prop. Reg. §1.708- 1(d)(2)(ii). If the form is not respected, then the transfer will be recharacterized as an assets-over transfer from the divided partnership to the resulting partnership. Prop. Re g. §1.708-1(d)(2)(i).
(2) Example 5: 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 is RS is the continuation of PQRS. (Note: on these facts it cannot be the case that both PQ and RS are continuations of PQRS.)
c. Assets-Over Form
(1) General Rule: In all other asset transfers, the transaction will be recast as an assets-over transfer from the divided partnership to the resulting partnership. Prop. Reg. §1.708- 1(c)(1). This general rule will therefore apply to the following circumstances: (1) transfers that are accomplished under applicable jurisdictional law without an actual asset transfer; (2) actual assets-over transfers from the divided partnership to a resulting partnership (in this case form is respected); and (3) assets-over transfers when the post-division prior partnership is not a continuation of the pre-division prior partnership but some other resulting partnership is a continuation (in which case the deemed transferor will be changed).
(2) Example 6: 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.
(a) 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.
(b) If A is treated as a continuation of A, then all transfers are taxed in accordance with their forms.
(c) 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.)
(d) 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.)
(e) 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.
3. Taxation of the Division:
a. Assets-up Transfers:
(1) A distribution of assets to partners of the prior partnership as part of a partnership division potentially implicates taxation under the following provisions: §§731(a)(1) (distributions of cash), 732(c) (distributions of marketable securities), 704(c)(1)(B) (distributions of contributed property), 707(a)(2)(B) (disguised sales), and 737 (distributions of appreciated property to contributors of appreciated property). However, an assets-up transfer offers the potential of pushing a high outside basis into an otherwise low basis asset.
(2) Example 7: 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).
b. Assets-Over Transfers: In the context of partnership mergers, asset-over transfers are generally free of taxation under the mixing bowl provisions of §§704(c)(1)(B) and 737. The same is not true in the context of partnership divisions, however, because §737 has only a limited exception for partnership divisions and §704(c)(1)(B) has no exception at all.
(1) Application of §704(c)(1)(B)
(a) 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) 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.
(b) Example 8: 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.
i) Note: As a result of the taxation to A, both A’s outside basis in AB, see Reg. §1-704- 4(e)(1), and the partnership’s basis in the interest in NewP distributed to B, see Reg. §1.704-4(e)(2), are increased by the gain recognized by A; that is, by $45.
ii) 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).
(2) Application of §737: Section 737 generally applies to a partnership distribution of property to a partner who contributed appreciated property, still held by the partnership, when the distribution occurs within 7 years of the initial contribution. When a partnership division is accomplished using an assets-over transfer, distribution by the prior partnership of interests in the resulting partnership could trigger taxation under §737 if the distributee partner contributed appreciated property within 7 years. However, §737 will not apply if all of the §703(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).
(a) Note: this exception apparently is intended to apply only to the partner who contributed the §704(c) property. Nothing in the regulations limits its application in this way, but the preamble to the proposed regulations under §708 contains an example premised on this reading. The Service has announced that it seeks guidance in defining the precise circumstances in which §737 should or should not apply to distributions incident to partnership divisions.
(b) Example 9: 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."
i) Note: the facts of this example fail to satisfy the requirements of Reg. §1.737-2(b)(2) in two ways: first, A does not exit ABCD as part of the transaction; and (2) the partnership does not transfer the §704(c) property contributed by A but rather transfers the non-§704(c) property contributed by B.
ii) 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.
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