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Final regs prevent corporate partners from avoiding gain in partnership transactions - Thomson Reuters Tax & Accounting
Final regs prevent corporate partners from avoiding gain in partnership transactions
By Thomson Reuters Tax & Accounting On June 8, 2018 · Add Comment - Checkpoint Daily Newsstand, Featured -
IRS has issued final regs under Code Sec. 337(d) and Code Sec. 732(f), which generally adopt with minor clarifications temporary and proposed regs issued in 2015, that prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving equity interests of the partner. IRS noted, however, that it is considering proposing substantive amendments to the final regs under Code Sec. 337(d), and described a number of the changes that it might make.
Statutory background.In General Utilities & Operating Co., (S Ct 1935) 16 AFTR 1126, 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). Congress repealed the General Utilities doctrine by enacting Code Sec. 336(a) to apply gain and loss recognition to liquidating distributions.
Under current law, Code Sec. 311(b) and Code Sec. 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. (FMV). IRS is also specifically authorized under Code Sec. 337(d) to prescribe regs that are necessary or appropriate to carry out the purposes of the General Utilities repeal.
In general, under Code Sec. 732(a)(1), the basis to a partner of property distributed to him by the partnership, in kind, other than in distribution of his partnership interest, is the same as the property’s adjusted basis to the partnership immediately before the distribution. A partner’s basis for property distributed in liquidation of his partnership interest is the same as the adjusted basis for his partnership interest reduced by any money distributed to him in the same transaction. (Code Sec. 732(b))
Code Sec. 732(f) was enacted to address concerns that a corporate partner could otherwise negate the effects of a basis “step-down” to distributed property required under Code Sec. 732(b) by applying the step-down against the basis of the stock of the distributed corporation. Under Code Sec. 732(f), if (1) a corporate partner receives a distribution from a partnership of stock in another corporation (distributed corporation); (2) the corporate partner has control of the distributed corporation, defined as ownership of stock meeting the requirements of Code Sec. 1504(a)(2), immediately after the distribution or at any time thereafter (control requirement); and (3) the partnership’s basis in the stock immediately before the distribution exceeded the corporate partner’s basis in the stock immediately after the distribution, then the basis of the distributed corporation’s property must be reduced by this excess. The amount of this reduction is limited to the amount by which the sum of the aggregate adjusted basis of property and the amount of money of the distributed corporation exceeds the corporate partner’s adjusted basis in the stock of the distributed corporation. The corporate partner must recognize gain to the extent that the basis of the distributed corporation’s property cannot be reduced.
Code Sec. 732(f)(8) authorizes IRS to prescribe such regs as may be necessary to carry out the purposes of Code Sec. 732(f), including regs to avoid double counting and to prevent the abuse of such purposes.
Prior regs. In ’92, IRS issued proposed regs (’92 proposed regs) under Code Sec. 337(d) that were designed to prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving stock of the corporate partner, stock of the partner’s affiliate, and other equity interests in the corporate partner or affiliate.
The ’92 proposed regs provided two rules that would protect the repeal of the General Utilities doctrine. The first, a “deemed redemption” rule, provided that a corporate partner would recognize gain at the time of, and to the extent that, any transaction (or series of transactions) has the economic effect of an exchange by the partner of its interest in appreciated property for an interest in its stock (or the stock of any member of the affiliated group of which such partner is a member) owned, acquired, or distributed by the partnership. The second, a “distribution rule,” provided that a partnership’s distribution to a corporate partner of stock in the corporation would be treated as a redemption or an exchange of that stock for a portion of the partner’s partnership interest with a value equal to the distributed stock.
Under the ’92 proposed regs, a corporation would be treated as an affiliate of a partner at the time of a deemed redemption or distribution by the partnership if, immediately thereafter, the partner and corporation were members of an affiliated group as defined in Code Sec. 1504(a) without regard to Code Sec. 1504(b) (“section 337(d) affiliation”). In subsequent guidance, IRS indicated that the ’92 proposed regs would be amended to limit their application to transactions in which section 337(d) affiliation existed immediately before the deemed redemption or distribution.
In June 2015, IRS issued temporary and proposed regs under Code Sec. 337(d) which retained the deemed redemption rule provided in the ’92 regs, with certain modifications, but which did not keep the separate distribution rule. The 2015 proposed regs also set forth de minimis and inadvertence exceptions to the deemed redemption rule. For more details, see “Temp regs prevent corporate partners from avoiding gain in partnership transactions” (06/18/2015).
Also in June 2015, IRS issued proposed regs under Code Sec. 732(f) that were intended to address the concern that the application of that provision was too broad in some circumstances (e.g., by requiring basis reduction of gain recognition even when such wouldn’t further the purposes of Code Sec. 732(f) but too narrow in others (in that corporate partners could avoid it by engaging in transactions that allow corporate partners to receive property held by a distributed corporation without reducing the basis of that property to account for basis reductions under Code Sec. 732(b) made when the partnership distributed stock of the distributed corporation to the corporate partner).
To address these concerns, the 2015 proposed regs under Code Sec. 732(f) set out specific rules that would govern the application of that provision in two specific sets of circumstances. The first rule would permit consolidated group members to aggregate the bases of their respective interests in the same partnership, in certain circumstances, for Code Sec. 732(f) purposes. The second rule would restrict corporate partners from entering into certain transactions or a series of transactions (gain elimination transactions) that might eliminate gain in the stock of a distributed corporation while avoiding the effects of a basis step-down under Code Sec. 732(f). In addition, the 2015 proposed regs under Code Sec. 732(f) would require taxpayers to apply those rules to tiered partnerships in a manner consistent with the purpose of that provision. For more details, see “Proposed regs on partnership distributions of stock to corporate partner” (06/18/2015).
The temporary and proposed regs under Code Sec. 337(d), and the proposed regs under Code Sec. 732(f), are collectively referred to throughout this article as “the 2015 regs.”
New final regs. The new final regs adopt as final the 2015 regs under Code Sec. 337(d) with only minor clarifications as explained below, and the 2015 regs under Code Sec. 732(f) without change. However, IRS noted that it is considering publishing new proposed regs that would make more substantive amendments to the final regs under Code Sec. 337(d).
Overview and purpose. The final regs are intended to prevent taxpayers from using a partnership to avoid gain recognition under Code Sec. 311(b) or Code Sec. 336(a). (Reg. § 1.337(d)-3(a)) In general, the final regs apply when a partnership, either directly or indirectly, owns, acquires, or distributes Stock of the Corporate Partner (see below). A Corporate Partner may be required to recognize gain when it is treated as acquiring or increasing its interest in Stock of the Corporate Partner held by a partnership in exchange for appreciated property in a manner that avoids gain recognition under Code Sec. 311(b) or Code Sec. 336(a). (Reg. § 1.337(d)-3(b))
Definitions. The final regs adopt the 2015 regs’ definition of a “Corporate Partner” as a person that holds or acquires an interest in a partnership and that is classified as a corporation for federal income tax purposes. (Reg. § 1.337(d)-3T(c)(1)) (Reg. § 1.337(d)-3(c)(1))
“Stock of a Corporate Partner” is defined by the final regs as including the Corporate Partner’s stock, or other equity interests, including options, warrants, and similar interests, in the Corporate Partner or a “Controlling Corporation.” A Controlling Corporation is one that controls the Corporate Partner (within the meaning of Code Sec. 304(c); generally, ownership of stock possessing at least 50% of (i) the total combined voting power of all classes of stock entitled to vote, or (ii) the total value of all classes of stock), except that the family attribution rules of Code Sec. 318(a)(1) and the downward attribution rules of Code Sec. 318(a)(3) do not apply. (Reg. § 1.337(d)-3(c)(2)(i)) Stock of the Corporate Partner also includes interests in any entity to the extent that the value of the interest is attributable to stock of the Corporate Partner (the “Value Rule”), as well as an equity interest issued by a third party on a Corporate Partner’s stock. (Reg. § 1.337(d)-3(c)(2)(i))
In TD 9833, IRS acknowledged that the Value Rule could potentially be overbroad in certain situations and stated that it is considering limiting its application to entities that are not Controlling Corporations but which own, directly or indirectly, 5% or more of the stock, by vote or value, of the Corporate Partner. IRS also noted in TD 9833 that it is considering modifying the definition of “Stock of a Corporate Partner” so that it would no longer include attribution under Code Sec. 318(a)(1) and Code Sec. 318(a)(3) when determining whether an interest in an entity is Stock of the Corporate Partner.
The final regs retain the “Affiliated Group Exception” provided in the 2015 regs under Code Sec. 337(d), which excludes from “Stock of the Corporate Partner” any stock or other equity interests held or acquired by a partnership if all interests in the partnership’s capital and profits are held by members of an affiliated group defined in Code Sec. 1504(a) that includes the Corporate Partner. (Reg. § 1.337(d)-3(c)(2)(ii)) However, IRS noted in TD 9833 that it was considering publishing new proposed regs to remove the Affiliated Group Exception because it can permit corporations to engage in transactions with partnerships to eliminate permanently the built-in gain on appreciated assets or otherwise to avoid the purposes of General Utilities repeal and these regs.
The final regs define a “Section 337(d) Transaction” as a transaction(or series of transactions) 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. (Reg. § 1.337(d)-3(c)(3)) IRS noted in TD 9833 that in certain situations, a partnership’s acquisition of Stock of the Corporate Partner does not have the effect of an exchange of appreciated property for that stock—but that taxpayers must maintain appropriate records or other documentation to affirmatively demonstrate that the acquisition doesn’t have the effect of an exchange of appreciated property for the stock.
Deemed redemption rule. The final regs adopt the “deemed redemption rule” as set out in the 2015 regs, which generally provides that if a transaction is a Section 337(d) Transaction, a Corporate Partner must recognize gain. (Reg. § 1.337(d)-3(d)) For more details on the deemed redemption rule, see “Temp regs prevent corporate partners from avoiding gain in partnership transactions.”
IRS clarified that the deemed redemption rule does apply in certain transactions involving related parties in which a first transaction does not constitute a Section 337(d) Transaction because the partnership does not own stock in either a Corporate Partner or in a Controlling Corporation, but the Corporate Partner in a later, separate transaction transfers its partnership interest to a related corporation whose stock the partnership owns. And, in situations where 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. (Reg. § 1.337(d)-3(h), Examples 5 – 7)
The final regs clarify that, when determining a Corporate Partner’s gain in a Section 337(d) transaction, basis adjustments, including those made pursuant to Code Sec. 743(b), are taken into account. (Reg. § 1.337(d)-3(d)(4)) The final regs also clarify that the character of the gain that the Corporate Partner recognizes in a Section 337(d) Transaction is the same character of the gain that the Corporate Partner would have recognized if, immediately before the Section 337(d) Transaction, the Corporate Partner had disposed of the appreciated property in a fully taxable transaction for cash in an amount equal to the FMV of such property (taking into account Code Sec. 7701(g)). (Reg. § 1.337(d)-3(d)(3)(ii))
The final regs adopt the rules in the 2015 regs related to the effect of the deemed redemption rule on partner and partnership basis, including the rule that a Corporate Partner must 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 in order to prevent the Corporate Partners from recognizing gain a second time when the partnership liquidates (or, if property is distributed to the Corporate Partner, when that property is sold). (Reg. § 1.337(d)-3(d)(4)(i)) The final regs also clarify that, for basis recovery purposes, this increase is treated as property that is placed in service by the partnership in the tax year of the Section 337(d) Transaction. (Reg. § 1.337(d)-3(d)(4)(ii))
Gain recognition rule. The final regs adopt the gain recognition rule in the 2015 regs, which provided that if a distribution is a Code Sec. 337(d) distribution, then in addition to any gain recognized under the deemed redemption rule upon the distribution of Stock of the Corporate Partner to the Corporate Partner, the Corporate Partner must 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 (as reduced by any cash distributed in the transaction) immediately before the distribution. (Reg. § 1.337(d)-3(e)(3)) The language in the final regs, however, is modified to conform to the Code Sec. 732(f) gain recognition provision.
Basis rules. The 2015 regs provided two rules under Code Sec. 337(d) and Code Sec. 732 to coordinate the effects of the rule requiring gain recognition when the basis of the Stock of the Corporate Partner is stepped down on a Code Sec. 337(d) distribution with existing rules for determining the basis of property upon partnership distributions. Under one of these rules, which was to apply 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 Code Sec. 732(b) would be allocated first to the Stock of the Corporate Partner before taking into account the distribution of any other property (other than cash). (Reg. § 1.337(d)-3(e)(2)) Therefore, under the proposed regs, before taking into account the distribution of other property, the Corporate Partner would 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).
In response to a commenter who noted that duplication of gain under Code Sec. 337(d) and Code Sec. 732(f) could occur under the 2015 regs, the final regs provide a basis rule under which, for purposes of determining the amount of the decrease to the basis of property held by a distributed corporation pursuant to Code Sec. 732(f), the amount of this decrease is reduced by the amount of gain that a Corporate Partner has recognized under this section in a Section 337(d) Transaction, both in cases where Code Sec. 732(f) applies at the time of the Section 337(d) Transaction and in cases where Code Sec. 732(f) is subsequently triggered. (Reg. § 1.337(d)-3(e)(2)(iii)) This rule prevents the Corporate Partner from recognizing the same gain twice.
Exceptions. The final regs adopt the “de minimis rule” set out in the 2015 regs. (Reg. § 1.337(d)-3(f)) Under this rule, the final regs don’t apply to a Corporate Partner if: (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 5% of the partnership; (2) the partnership holds Stock of the Corporate Partner worth less than 2% of the value of the partnership’s gross assets, including Stock of the Corporate Partner; and (3) the partnership has never, at any point in time, held more than $1 million in Stock of the Corporate Partner or more than 2% of any particular class of Stock of the Corporate Partner. (Reg. § 1.337(d)-3(f)(1)(i)) These conditions are to be tested upon the occurrence of a Section 337(d) Transaction and upon any subsequent revaluation event described in Reg. § 1.704-1(b)(2)(iv)(f), and a special gain recognition rule applies if the conditions were met 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.) (Reg. § 1.337(d)-3(f)(1))
Due to concerns that taxpayers could intentionally plan to combine entities, each meeting the de minimis limits, to avoid the purposes of these final regs, IRS added a clarifying provision to the de minimis exception in the final regs. (Reg. § 1.337(d)-3(f)(1)(i)) This clarifying provision states that the di minimis exception does not apply to Stock of the Corporate Partner that is acquired as part of a plan to circumvent the purpose of these final regs.
The final regs also generally adopted the so-called “inadvertence” exception set out in the 2015 regs under which the regs won’t apply to a Section 337(d) Transaction in which the partnership satisfies two requirements: (1) the partnership disposes of, by sale or distribution, the Stock of the Corporate Partner before the due date (including extensions) of its federal income 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 has not distributed the Stock of the Corporate Partner to the Corporate Partner or a person possessing Code Sec. 304(c) control of the Corporate Partner. (Reg. § 1.337(d)-3(f)(2)) However, the final regs renamed the exception so as to clarify that inadvertence is not actually a requirement.
Applicability date. The final regs apply to transactions occurring on or after June 12, 2015. (Reg. § 1.337(d)-3(i))
References: For exchange by corporate partner for its stock, see FTC 2d/FIN ¶ B-1411 et seq.; United States Tax Reporter ¶ 3374.03. For Code Sec. 732(f)‘s rules on distributions by partnerships to corporate partners, see FTC 2d/FIN ¶ B-3704; United States Tax Reporter ¶ 7324.03
TD 9833, 6/7/2018; Reg. § 1.337(d)-3, Reg. § 1.732-1