AICPA Asks IRS to Apply "Anti-Mixing Bowl" Changes Prospectively Only  


    September 3, 2004

    The Honorable Gregory F. Jenner
    Acting Assistant Secretary (Tax Policy)
    U.S. Department of Treasury
    1500 Pennsylvania Avenue, N.W.
    Washington, D.C. 20220

    The Honorable Mark W. Everson
    Commissioner
    Internal Revenue Service
    1111 Constitution Avenue, N.W.
    Washington, D.C. 20224

    Re: Comments on Rev. Rul. 200443

    Gentlemen:

    The American Institute of Certified Public Accountants (AICPA) offers the following comments on Revenue Ruling 2004–43. These comments have been approved by the Partnership Taxation Technical Resource Panel and the Tax Executive Committee.

    Executive Summary

    Sections 704(c) and 737 were enacted to prevent the shifting of built-in gains and losses among partners. Regulations under sections 704(c) and 737 were issued in 1995 (the "anti-mixing bowl regulations") which provide, in general, that sections 704(c)(1)(B) and 737 do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership. A subsequent distribution of section 704(c) property by the transferee partnership is subject to sections 704(c)(1)(B) or 737 only to the same extent that a distribution by the transferor partnership would have been subject to sections 704(c)(1)(B) or 737 (emphasis added). 1

    On April 12, 2004, the Internal Revenue Service (IRS) published Rev. Rul. 2004-43, 2004-18 I.R.B. 842. Rev. Rul. 2004–43 specifically addresses the application of sections 704(c)(1)(B) and 737 to the distribution of property by a partnership following an assets-over partnership merger. The holding in the revenue ruling may result in the recognition of gain to one or more partners on a distribution of partnership property to a greater extent than that which would have been required prior to the merger (emphasis added).

    The holdings in Rev. Rul. 2004–43 appear to be inconsistent with the plain language of the anti-mixing bowl regulations. Nevertheless, Rev. Rul. 2004–43 applies retroactively to the effective date of the anti-mixing bowl regulations. Therefore, we suggest that the IRS and Treasury withdraw Rev. Rul. 2004–43 as changes to an IRS position of this significance are more appropriately made by promulgating a proposed regulation to give practitioners an opportunity to comment. In lieu of a regulation, this change should be made effective without retroactive effect as the IRS and Treasury are empowered to do under section 7805(b)(8).

    Background

    Section 704(c)(1)(A) and the regulations thereunder provide that income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value ("book value" as determined under reg. section 1.704-1(b)) at the time of contribution.   Section 704(c) generally applies on a property-by-property basis. Section 704(c) principles also apply to book-tax disparities created by revaluations of partnership property.

    Section 704(c)(1)(B) provides that if any property contributed to the partnership by a partner is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within seven years of being contributed: (i) the contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of the property in an amount equal to the gain or loss which would have been allocated to the partner under section 704(c)(1)(A) by reason of the variation described in section 704(c)(1)(A) if the property had been sold at its fair market value at the time of the distribution; (ii) the character of the gain or loss shall be determined by reference to the character of the gain or loss which would have resulted if the property had been sold by the partnership to the distributee; and (iii) appropriate adjustments shall be made to the adjusted basis of the contributing partner's interest in the partnership and to the adjusted basis of the property distributed to reflect any gain or loss recognized under section 704(c)(1)(B). 2

    Regulation section 1.704–4 addresses the application of section 704(c)(1)(B). Regulation section 1.704–4(c)(4) provides that section 704(c)(1)(B) and reg. section 1.704–4 do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement. An "assets-over" partnership merger under reg. section 1.708–1(c)(3)(i) falls within this section. Regulation section 1.704–4(c)(4) also provides that a subsequent distribution of section 704(c) property by the transferee partnership to a partner of the transferee partnership is subject to section 704(c)(1)(B) to the same extent that a distribution by the transferor partnership would have been subject to section 704(c)(1)(B) (emphasis added).

    Section 737(a) provides that, in the case of any distribution by a partnership to a partner, the partner shall be treated as recognizing gain in an amount equal to the lesser of (1) the excess (if any) of (A) the fair market value of property (other than money) received in the distribution over (B) the adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by the amount of money received in the distribution, or (2) the net pre-contribution gain of the partner. Gain recognized under the preceding sentence shall be in addition to any gain recognized under section 731. The character of the gain shall be determined by reference to the proportionate character of the net pre-contribution gain.

    Section 737(b) provides that for purposes of section 737, the term "net pre-contribution gain" means the net gain (if any) which would have been recognized by the distributee partner under section 704(c)(1)(B) if all property which (1) had been contributed to the partnership by the distributee partner within seven years of the distribution, 3  and (2) is held by the partnership immediately before the distribution, had been distributed by the partnership to another partner.

    Regulation section 1.737–2 provides certain exceptions and special rules for the application of section 737. Regulation section 1.737–2(b)(1) provides that section 737 and reg. section 1.737–2 do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement. Regulation section 1.737–2(b)(3) provides that a subsequent distribution of property by the transferee partnership to a partner of the transferee partnership that was formerly a partner of the transferor partnership is subject to section 737 to the same extent that a distribution from the transferor partnership would have been subject to section 737 (emphasis added).

    Rev. Rul. 2004–43 holds that a new layer of section 704(c) gain is created in an assets-over partnership merger if the fair market value of an asset at the time of the merger exceeds its "book" value as determined under the section 704(b) regulations. This layer of gain is in addition to any section 704(c) gain inherent in the asset at the time of the merger. If the transferor partnership had distributed section 704(c) property prior to the merger, only the original section 704(c) gain layer would have been subject to recognition under sections 704(c)(1)(B) or 737. By creating the new layer of section 704(c) gain, Rev. Rul. 2004–43 may require the recognition of gain on the distribution by the transferee partnership of section 704(c) property acquired in an assets-over merger to a greater extent than would have been required upon the distribution of such asset by the transferor partnership prior to the merger. Although issued on April 12, 2004, the revenue ruling applies retroactively to the effective date of the anti-mixing bowl regulations—January 9, 1995.

    General Comments

    The holding in Rev. Rul. 2004–43 contradicts the plain language of Treas. Reg. §§ 1.704–4(c)(4) and 1.737–2(b)(3). Many taxpayers and tax practitioners have understood the anti-mixing bowl regulations as treating the partners of the transferee partnership in an assets-over merger as stepping into the shoes of the partners of the transferor partnership for purposes of sections 704(c)(1)(B) and 737. 4  Although Rev. Rul. 2004 –43 may be a reasonable application of section 704(c) principles, it is inconsistent with the plain language of the regulations. Because many taxpayers have relied on the common interpretation and plain language of the anti-mixing bowl regulations for more than nine years, any changes to these rules should be made prospectively. Furthermore, given that revenue rulings are intended to merely set forth the IRS' interpretation of the law, 5 applying Rev. Rul. 2004 –43 retroactively is likely to generate considerable litigation and uncertainty until such litigation is resolved.

    Principal Recommendations

    The AICPA recommends two alternatives to addressing the retroactivity problem: (1) withdraw Rev. Rul. 2004–43 and promulgate the changes in proposed regulations; or (2) clarify that Rev. Rul. 2004–43 will apply prospectively to mergers occurring on or after April 12, 2004.

    Rev. Rul. 2004–43 significantly alters the anti-mixing bowl regulations in reg. sections 1.704–4(c)(4) and 1.737–2(b)(3). Issuing a proposed regulation will enable the IRS and Treasury to consider taxpayer and practitioner comments on how best to accomplish the result contemplated by the new rule and resolve the unforeseen, adverse tax consequences created by retroactively imposing a significant change on taxpayers who have reasonably relied on the long-standing, common interpretation of the mixing-bowl regulations in planning partnership transactions.

    A proposed regulation project would enable the IRS and Treasury to address several technical issues that arise in the context of distributions subsequent to an assets-over partnership merger and would remove some of the uncertainty that currently exists in this area. For example, the approach taken in Rev. Rul. 2004–43 creates "layers" of 704(c) gain. It is unclear under the section 704(c) regulations whether a taxpayer must use the same allocation method for each layer. Also, the merger and division regulations under section 708 fail to define what constitutes a "merger." A definition would be helpful to provide taxpayers with more certainty in determining which transactions create additional layers subject to sections 704(c)(1)(B) and 737. The comment period would be of particular help in creating a workable definition.

    In lieu of withdrawal and reissuance as a proposed regulation, the IRS and Treasury could issue additional guidance clarifying that Rev. Rul. 2004–43 will apply prospectively to mergers occurring on or after April 12, 2004. Under section 7805(b), taxpayers are generally protected from retroactive regulatory changes in the law, and section 7805(b)(8) grants the IRS and Treasury the authority to also apply rulings and other administrative guidance prospectively. Ample precedent exists for allowing prospective compliance with newly issued IRS interpretations that conflict with common taxpayer interpretations that developed in the absence of prior guidance from the Service. 6

    Conclusion

    By applying Rev. Rul. 2004–43 retroactively, the IRS and Treasury have created uncertainty and unanticipated tax consequences for taxpayers that have reasonably relied on the plain language of the anti-mixing bowl regulations in structuring partnership mergers. This change should apply prospectively only. 

    If you or your staff have any questions, please contact me at (202) 414-1407; or Elizabeth Case, Chair of the AICPA Partnership Taxation Technical Resource Panel at (202) 414-1628; or Marc Hyman, AICPA Technical Manager at (202) 434-9231.

    Sincerely,

     

    Robert A. Zarzar, Chair
    AICPA Tax Executive Committee

    cc: Mr. Eric Solomon, Deputy Assistant Secretary (Regulatory Affairs), U.S. Department of Treasury
    Ms. Helen Hubbard, Tax Legislative Counsel, U.S. Department of Treasury
    Ms. Deborah A. Harrington, Attorney-Advisor, Office of Tax Legislative Counsel, U.S. Department of Treasury
    The Honorable Donald Korb, Chief Counsel, Internal Revenue Service
    Mr. Nicholas DeNovio, Deputy Chief Counsel (Technical), Internal Revenue Service
    Ms. Heather Maloy, Associate Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service
    Mr. Matthew Lay, Special Counsel to the Associate Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service
    Mr. Monte Jackel, Special Counsel to the Associate Chief Counsel (Passthroughs   and Special Industries), Internal Revenue Service
    Ms. Heather Faught, Attorney-Advisor, Office of the Associate Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service


     

     

     

    1. See reg. sections 1.704-4(c)(4) and 1.737-2(b)(3).

    2. Section 704(c)(1)(B) provides for a five-year holding period for property contributed to a partnership on or before June 8, 1997.

    3. Section 737(b) provides for a five-year holding period for property contributed to a partnership on or before June 8, 1997. 

    4. See, e.g., McKee, Nelson & Whitmire: Federal Taxation of Partnerships & Partners, Ch. 10.04(4)(b); Blake D. Rubin, Andrea Macintosh Whiteway, "Creative Transactional Planning Using the Partnership Merger and Division Regulations," 95 J. Tax'n 133 (2001); Richard M. Lipton, Stefan F. Tucker and Phillip M. Brunson, Real Estate Tax Planning When You Strike It Rich, SD31 ALI-ABA 245 (1998).

    5. Rev. Proc. 89-14, 1989-1 C.B. 814, § 3.01.

    6. See, e.g., Rev. Rul. 2003-97, 2003-34 I.R.B. 380; Rev. Rul. 2003-22, 2003-8 I.R.B. 494; Rev. Rul. 2003-12, 2003-3 I.R.B. 283; Rev. Rul. 2002-85, 2002-2 C.B. 986; Rev. Rul. 2002-50, 2002-2 C.B. 292; Rev. Rul. 2002-35, 2002-1 C.B. 1067; Rev. Rul. 2002-27, 2002-1 C.B. 925; Rev. Rul. 2002-22, 2002-1 C.B. 849; Rev. Rul. 2001-46, 2001-2 C.B. 321; Rev. Rul. 2001-8, 2001-1 C.B. 726.




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