Merger and Division Prop. Regs.

Until recently, the only available guidance on partnership mergers and divisions was a smattering of revenue and letter rulings. Earlier this year, Treasury released proposed regulations on such transactions; the rules are instructive, but leave many unanswered questions. This article's many examples point out the issues that need to be addressed in the final regulations.

Kenneth N.Orbach, Ph.D., CPA
Professor of Accounting
School of Accounting
Florida Atlantic University
Boca Raton, FL

Kenneth H. Heller, Ph.D., CPA
Professor of Accounting
School of Management
George Mason University
Fairfax, VA

Editor's note: Dr. Orbach is a member of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel. Dr. Heller is a member of the AICPA Tax Division's Tax Executive Committee. Authors' note: The authors wish to thank Monte Jackel, of Ernst & Young LLP's National Tax Office, and Alan Baseman, of Atlas Pearlman PA, for their helpful comments and insights on previous drafts of this article. For more information about this article, contact Dr. Orbach at orbach@fau.edu or Dr. Heller at kheller@som.gmu.edu .

Executive Summary

• The proposed regulations bring needed guidance and clarification to an area that has been beset by confusion and inconsistency.

• The form of a partnership merger or division will be respected for Federal income tax purposes if an assets-over or assets-up form is used.

• The Service has erred in accepting McCauslen as correct and should disavow the holding when finalizing the regulations.

Earlier this year, Treasury issued proposed regulations providing much-needed (and long-sought) guidance on the tax treatment of partnership mergers and divisions.¹ Although Sec. 708 and the current regulations provide rules for identifying, for Federal income tax purposes, whether the resulting partnership (1) of a merger is a continuation of one of the merging partnerships and (2) of a division is a continuation of the prior partnership, neither the statute nor the regulations prescribe a particular form of merger or division. This is a critical omission, because the form undertaken (or deemed undertaken) dictates the underlying transactions effecting the merger or division and the corresponding tax consequences. As a result, practitioners have had to rely on a relatively limited (and occasionally conflicting) number of published and private rulings in this area.

The proposed regulations provide clarification, by prescribing the form of partnership mergers and divisions and addressing some related tax issues. Specifically, the form of a partnership merger or division will be respected for Federal income tax purposes if an assets-over or assets-up form is used. The proposed regulations also address the tax treatment of Sec. 752 liability shifts and certain buyouts of exiting partners; they modify the Sec. 743 regulations when elective basis adjustments are available.² These regulations are proposed to be effective for partnership mergers and divisions occurring on or after the date final regulations are published in the Federal Register.³

Overview

Sec. 708

A threshold issue in partnership mergers and divisions is determining, in a merger, whether the resulting partnership is deemed a continuation of a merging partnership⁴ or, in the case of a division, whether any of the resulting partnerships are continuations of the prior partnership. This issue is important for a variety of tax compliance reasons; only a resulting partnership that is a continuing partnership retains certain tax elections of a predecessor partnership (such as tax year). It also has significant tax consequences for partnerships not deemed continuations. The noncontinuing merging partnerships in a merger are treated as terminated under Sec. 708; the noncontinuing resulting partnerships in a partnership division are treated as newly created partnerships.⁵

Under Sec. 708(b)(2), the determination of which partnerships are continuing is made by looking to the partners' interests in partnership capital and profits. For mergers, the statute looks to the partners who hold a majority interest in the resulting partnership; for divisions, the statute looks to the partners who held a majority interest in the prior partnership.⁶

Mergers

When two or more partnerships merge, Sec. 708(b)(2)(A) provides that the resulting partnership is a continuation of the merging partnership whose partners own aggregate interests of more than 50% in the resulting partnership's capital and profits; all other merging partnerships are deemed terminated. If more than one of the merging partnerships meets this ownership test, the continuing partnership is the merging partnership that contributed the greatest dollar value of assets (net of partnership liabilities) to the resulting partnership.⁷ If the partners of none of the merging partnerships own aggregate interests of more than 50% in the resulting partnership, all of the merging partnerships are deemed terminated; the resulting partnership is treated as a new partnership.

Example 1: AB Partnership is owned equally by A and B, BC Partnership is owned equally by B and C and CD Partnership is owned equally by C and D. The three partnerships merge to form ABCD Partnership, owned as follows: A, 20%, B, 30%, C, 30% and D, 20%. ABCD is deemed a continuation of BC, because B and C own more than 50% of ABCD; AB and CD are deemed terminated. If instead, ABCD is owned by A, 10%, B, 30%, C, 30% and D, 30%, ABCD is deemed a continuation of either BC or CD (depending on which partnership contributed the greater net dollar value of assets to ABCD). However, if each of the ABCD partners owned a 25% interest in ABCD, all of the merging partnerships would be considered terminated; ABCD would be treated as a new partnership.

If the resulting partnership is a continuation of one of the merging partnerships (the continuing partnership), the resulting partnership and the continuing partnership are considered one and the same for Federal income tax purposes. The continuing/resulting partnership files a return for the continuing partnership's tax year. This return must state that the resulting partnership is a continuation of the continuing partnership and include the merged partnerships' names and addresses. The respective distributive shares of the partners of the continuing/resulting partnership for periods before and after the date of merger must be broken out on the return. The tax years of the other merging partnerships (i.e., the terminated partnerships) are closed in accordance with Sec. 706(c); a final return must be filed for their tax years ending on the merger date.⁸

Divisions

When a partnership divides into two or more partnerships, Sec. 708(b)(2)(B) provides that any resulting partnership is deemed a continuation of the prior partnership, unless the resulting partnership's partners owned aggregate interests of 50% or less in the prior partnership's capital and profits. Under this ownership test, more than one resulting partnership may be deemed a continuation of the prior partnership.⁹ Any resulting partnership not deemed a continuation of the prior partnership is treated as a new partnership.

Example 2: ABCD Partnership is owned as follows: A, 20%, B, 30%, C, 30% and D, 20%. It divides into AB Partnership, BC Partnership and CD Partnership. AB is owned equally by A and B, BC is owned equally by B and C and CD is owned equally by C and D. BC is deemed a continuation of ABCD, because B and C owned more than 50% of ABCD; AB and CD are treated as new partnerships. If instead, ABCD was owned by A, 10%, B, 30%, C, 30% and D, 30%, both BC and CD would be deemed continuations of ABCD; AB would be treated as a new partnership. However, if each of the ABCD partners owned a 25% interest in ABCD, all of the resulting partnerships would be treated as new.¹⁰

Although the definition of a continuing partnership may seem straightforward, the following example demonstrates that the definition under the proposed (and current) regulations is inconsistent with the statute's provisions.

Example 3: ABC Partnership is owned by three partners. A, B and C have equal one-third interests in capital. A and B each have a 20% profits interest; C has a 60% profits interest. ABC divides into AB and BC Partnerships. Because the AB partners did not own aggregate interests of 50% or less in both the capital and profits of ABC (A and B had an aggregate 67% interest in ABC's capital), AB meets the statutory definition of a continuing partnership. However, Prop. Regs. Sec. 1.708-1(d)(1) requires that the members of a continuing/resulting partnership must have owned more than 50% of the prior partnership's capital and profits; thus, under the proposed regulations, AB would be treated as a new partnership (because A and B had an aggregate 40% interest in profits). On the other hand, under either definition, BC would be deemed a continuation of ABC, because the BC partners owned aggregate interests of 67% in ABC's capital and 80% in its profits.

Any resulting partnership deemed a continuation of the prior partnership must file a return for the latter's tax year. The return must contain a statement that the resulting partnership is a continuation of the prior partnership and disclose the partners' distributive shares in the resulting partnership for the periods before and after the division date. Partners of the prior partnership who do not become partners in a continuing/resulting partnership are treated as having their interests in the prior partnership liquidated at the division date. Because any resulting partnership not deemed a continuation of the prior partnership is treated as a new partnership, it must, among other things, adopt a tax year under Sec. 706(b).¹¹

Importance of Form

The Federal income tax consequences of a merger or division may differ, depending on the underlying transactions associated with its form; thus, taxpayers need to know whether the form selected will be respected for tax purposes.¹² (See Exhibit 1.) If the form selected is not respected, taxpayers need to know the form the IRS will impose.

IRS's Pre-Prop. Regs. Position

Prior to the proposed regulations, the Service had taken the position that, regardless of the merger form used by taxpayers, it would impose the assets-over form.¹³ On the other hand, its treatment of divisions before the proposed regulations was unclear, if not contradictory. For example, the IRS respected the assets-up form used in Letter Ruling 8945069¹⁴ and the assets-over form used in Letter Ruling 9015016.¹⁵ However, in Letter Ruling 8852004,¹⁶ the IRS rejected the assets-over form used and imposed the assets-up form. Likewise, in Letter Ruling 9350035,¹⁷ the Service imposed the assets-up form on taxpayers that had used the assets-over form.

Proposed Regulations

Under the proposed regulations, the form of a partnership merger or division will be respected for Federal income tax purposes if either the assets-over form or the assets-up form is used under local law. If any other form is adopted, or if the merger or division is effected under local law without undertaking a form, the proposed regulations impose the assets-over form for Federal income tax purposes.¹⁸ Consequently, if the interest-over form is used, the merger or division will be re-cast as the assets-over form.¹⁹

Mergers

For partnership mergers, Prop. Regs. Sec. 1.708-1(c)(2)(i) and (ii) describe the two accepted forms as follows:

Assets-over form: The noncontinuing merging partnerships contribute all of their assets and liabilities to the resulting partnership in exchange for resulting partnership interests. These interests are immediately distributed to the noncontinuing partnerships' partners in liquidation of their noncontinuing partnership interests.

Assets-up form: The noncontinuing merging partnerships distribute all of their assets and liabilities to their partners in liquidation of the partners' interests therein, followed immediately by those partners contributing the distributed assets and liabilities to the resulting partnership in exchange for interests therein.

Example 4:²⁰ AB Partnership is owned 40% by A and 60% by B. B and C own 60% and 40%, respectively, of BC Partnership. The fair market value (FMV) (net of liabilities) of AB assets is $100; BC's net FMV of assets is $200. AB and BC merge under state law; BC contributed its assets and liabilities to AB in exchange for AB interests; BC liquidates, distributing AB interests to B and C.

After the merger, A owns a 13¹/3% interest in the resulting partnership; B owns a 60% interest and C owns a 26²/3% interest. Thus, the owners of both old AB and old BC own a more-than-50% interest in the resulting partnership. Because old BC's assets had a greater net FMV than old AB's, BC is the continuing/resulting partnership; AB terminates.

The form of the merger clearly is not assets-up. Based on the form undertaken under state law, it also is not assets-over, because continuing/resulting BC transferred assets and liabilities. The proposed regulations impose the assets-over form for Federal income tax purposes. Contrary to the form undertaken, for tax purposes AB is deemed to have contributed its assets and liabilities to BC in exchange for BC interests; AB is then deemed to liquidate, distributing the BC interests to A and B.

Divisions

The proposed regulations introduce four new terms. A "divided partnership" exists under Prop. Regs. Sec. 1.708-1(d)(3)(i) only when there is at least one continuing/resulting partnership. In such case, the divided partnership is the (unique) continuing/resulting partnership treated for Federal income tax purposes as transferring the assets and liabilities to the recipient partnership(s), either directly (assets-over form) or indirectly (assets-up form). The prior partnership and the divided partnership are treated as one for Federal income tax purposes.

If there is only one continuing/ resulting partnership, it is the divided partnership. If a continuing/resulting partnership (in form) transfers the assets and liabilities in connection with a division, that partnership is the divided partnership. Generally, in all other cases in which there are continuing/resulting partnerships, the divided partnership is the continuing/resulting partnership with assets having the greatest FMV (net of liabilities).

Second, a "recipient partnership" is a partnership treated as receiving, for Federal income tax purposes, assets and liabilities from a divided partnership, either directly (assets-over form) or indirectly (assets-up form). Thus, recipient partnerships include any continuing/resulting partnerships other than the divided partnership, and all noncontinuing/resulting partnerships.²¹ Like "divided partnership," "recipient partnership" is a Federal tax concept. Finally, a "prior partnership" is the partnership that existed under local law before a division; a "resulting partnership" is a partnership that exists under local law after a division.

Assets-over form: As described in Prop. Regs. Sec. 1.708-1(d)(2)(i), when at least one resulting partnership is a continuation of the prior partnership, the divided partnership contributes certain assets and liabilities to the recipient partnerships in exchange for recipient partnership interests, which are immediately distributed to all or some of its partners in complete or partial liquidation of their interests in the divided partnership. If none of the resulting partnerships is a continuing partnership (i.e., there is no divided partnership), the prior partnership contributes (or is deemed to contribute) all of its assets and liabilities to new resulting partnerships in exchange for interests in the new partnerships; these interests are immediately distributed to all of the prior partnership's partners in complete liquidation of the prior partnership.

Assets-up form: As described in Prop. Regs. Sec. 1.708-1(d)(2)(ii), when at least one resulting partnership is a continuation of the prior partnership, the divided partnership distributes certain assets and liabilities to some or all of its partners in complete or partial liquidation of their interests in the divided partnership, followed immediately by the partners contributing the distributed assets and liabilities to the recipient partnerships in exchange for their recipient partnership interests. If none of the resulting partnerships is a continuing partnership (i.e., there is no divided partnership), the prior partnership distributes certain of its assets and liabilities to some or all of its partners in complete or partial liquidation of their interests in the prior partnership, followed immediately by the partners contributing the distributed assets and liabilities to the new resulting partnerships in exchange for interests therein.²²

Example 5:²³ ABCD Partnership owns three assets (and has no liabilities): property X with a $500 FMV, Y with a $300 FMV and Z with a $200 FMV. A and B each own a 40% interest in ABCD; C and D each own a 10% interest. ABCD divides into AB1, AB2 and CD Partnerships by operation of state law, without undertaking a form. A and B are equal owners of AB1, which owns X; A and B are equal owners of AB2, which owns Y. C and D are equal owners of CD, which owns Z.

Both AB1 and AB2 are continuing/ resulting partnerships; CD is treated as a new partnership. AB1 is the divided partnership (because no form was undertaken under state law and AB1 has property with the larger net FMV); AB2 and CD are the recipient partnerships. Thus, ABCD and AB1 are deemed one partnership for Federal income tax purposes. ABCD/AB1, following the assets-over form, is deemed to contribute Y to AB2 and Z to CD in exchange for interests in AB2 and CD, followed by its distribution of these interests to the designated partners.

 

Analysis and Related Tax Issues

McCauslen and the Interest-Over Form

Rev. Rul. 84-111²⁴ generally allows a taxpayer to choose one of three forms (assets-over, assets-up or interest-over) to incorporate a partnership and provides that that form will be respected for Federal income tax purposes. This ruling is the model for the proposed regulations' division and merger forms, except that the interest-over form will not be given effect. The interest-over proscription in the division and merger context is grounded essentially on McCauslen.²⁵

In that case, a transferor partner of a two-person partnership transferred his interest at death, via a buy-sell agreement, to the transferee partner. Less than six months later (the then long-term holding period), the transferee sold certain property formerly held by the partnership longer than six months. The transferee reported long-term capital gain on the sale, relying on the form of the transaction (i.e., purchase of interest/distribution of assets) and Sec. 735(b) tacking of holding periods.

Refusing to respect the form, the Tax Court treated the transaction as if the transferee had purchased a half-interest in partnership assets and acquired the other half via a partnership distribution. The "purchased" half-interest in assets did not qualify for Sec. 735(b) tacking; only the "distributed" half-interest did. The court concluded that, because the transferee's purchase of the decedent's partnership interest resulted in partnership termination under Sec. 708(b), the transferee acquired the partnership assets relating to such interest by purchase, rather than by partnership distribution; his holding period for such assets began on the purchase date. The IRS was quick to support McCauslen in Rev. Rul. 67-65.²⁶

Critical to the court's rationale is that the taxpayer's purchase resulted in a partnership termination under Sec. 708(b). That provision includes both Sec. 708(b)(1)(A) terminations (discontinuation of the partnership business) and Sec. 708(b)(1)(B) terminations (sale or exchange of at least 50% of a partnership's interests within a 12-month period). Essentially, the court refused to recognize the existence of a one-person partnership, even for an instant.

Contrary to McCauslen and Rev. Rul. 67-65, Regs. Sec. 1.708-1(b)(1)(iv) respects the purchase of a partnership interest that causes a Sec. 708(b)(1)(B) termination (i.e., the purchase of the interest is given effect).²⁷ In particular, the momentary ownership of all interests of the new partnership by the terminated partnership is respected.

The Service also concedes that the proposed regulations' partnership division rules may be contrary to McCauslen. The preamble states that, pursuant to the proposed regulations, under the assets-over form of a partnership division, the prior partnership's momentary ownership of all the interests in a resulting partnership will not prevent the resulting partnership from being classified as a partnership on formation.

Example 6: ABCD Partnership, an equal partnership, divides into AB and CD Partnerships (neither being a continuation of ABCD), by contributing all assets and liabilities to AB and CD, then distributing all AB and CD interests received to its partners in liquidation of ABCD. ABCD is a momentary owner of all interests in both AB and CD.

Even the Tax Court may have retreated from its McCauslen position; in Siller Bros. Inc.,²⁸ one 50% partner of a two-person partnership purchased the other partner's 50% interest. Although the issue was whether an investment tax credit is recaptured on partnership termination, the court observed that the transferee partner's purchase of the transferor partner's 50% partnership interest terminated the partnership; the transferee partner acquired each partnership asset in a liquidating distribution. When the partnership liquidated, the transferee partner's basis in the distributed partnership assets should have been determined with reference to both the transferee's basis in its original partnership interest and its basis in the partnership interest acquired from the transferor partner. Further, although the liquidation literally may have occurred under either Sec. 708(b)(1)(A) or (B), the court stated that it did not have to rule on which takes precedence, because both provisions have the same effect for Federal income tax purposes. In other words, the Siller Bros. court gave tax effect to the purchase/liquidation form of the transaction.

Observation: Neither the Tax Court nor the Service has proffered a clear reason why McCauslen's momentary ownership of all interests in his partnership could not be respected for Federal income tax purposes, while in other contexts such momentary ownership is respected. The Service should advance a clear and consistent theory that explains this apparent disparity.

Such a theory probably does not exist. Thus, a policy should be adopted that momentary ownership will be respected for all purposes of subchapter K (subject, as always, to anti-avoidance rules). Tax theory and policy are needlessly complicated by the government's position, which provides that McCauslen's partner "sees" a different transaction on the selling side than McCauslen "sees" on the purchasing side.

Example 7: CD Partnership merges into AB Partnership under the interest-over form; partners C and D contribute their CD interests to AB, the continuing partnership. Assume the use of the interest-over form is respected for tax purposes. Under McCauslen, C and D "see" a transfer of their partnership interests under the interest-over form; thus, under Regs. Sec. 1.704-3(a)(7), from their perspective, their Sec. 704(c) potential shifts to the transferee (AB). On the other hand, under McCauslen, AB probably "sees" its receipt of partnership assets under the assets-up form; from its viewpoint, it does not step into C's and D's Sec. 704(c) CD potential.

This anomaly is a direct result of McCauslen. Instead of rejecting the interest-over form, the Service should repudiate McCauslen.

Siller Bros. may provide the Service with the judicial cover to disavow McCauslen and revoke Rev. Rul 67-65. The purchaser/seller inconsistency of Rev. Rul 99-6²⁹ (as to the tax consequences when one person purchases all the interests of an LLC classified as a partnership) would also be avoided. Further, the IRS would be able to add the interest-over form to its merger/division menu, in line with Rev. Rul. 84-111.

Built-in Gain or Loss Issues

In general, Secs. 704(c)(1)(B) and 737 trigger the recognition of built-in gain (or loss, in the case of Sec. 704(c)(1)(B)) when, within a seven-year period, Sec. 704(c) property (or substituted Sec. 704(c) property) is distributed to noncontributing partners or other property is distributed to contributing partners. The interaction of the two acceptable forms of partnership mergers and divisions with Secs. 704(c)(1)(B) and 737 is addressed in the preamble to the proposed regulations.³⁰

Regs. Sec. 1.704-4(c)(4) provides that Sec. 704(c)(1)(B) does not apply to a Sec. 721 transfer of all of a transferor partnership's assets and liabilities to a transferee partnership, followed by a distribution of the transferee partnership interest in liquidation of the transferor partnership. Regs. Sec. 1.737-2(b) provides a similar rule in the Sec. 737 context. As a result, Secs. 704(c)(1)(B) and 737 do not apply to mergers under the assets-over form.

There are apparently no exceptions to Secs. 704(c)(1)(B) and 737 when a merger is effected under the assets-up form.³¹ Further, Secs. 704(c)(1)(B) and 737 generally apply to partnership divisions.

Example 8: ABCD Partnership is divided into AB and CD under the assets-over form; neither AB nor CD is a continuing partnership. The AB and CD interests that ABCD receives in exchange for the contribution of its Sec. 704(c) property are Sec. 704(c) property under Regs. Sec. 1.704-4(d)(1) and -3(a)(8).³² Thus, the distribution of such interests to an ABCD partner, other than the one who contributed the Sec. 704(c) property, apparently triggers Sec. 704(c)(1)(B) if the division takes place within seven years of the contribution of the Sec. 704(c) property.

Likewise, Sec. 737 may be triggered if an interest in AB or CD not attributable to Sec. 704(c) property is distributed to a contributor of Sec. 704(c) property within seven years of such property's contribution.³³ Regs. Secs. 1.704-4(c)(4) and 1.737-2(b)(1) should not apply, because ABCD assets and liabilities are transferred to more than one partnership.³⁴ On the other hand, Regs. Sec. 1.737-2(b)(2) (which provides that Sec. 737 does not apply to a partnership's transfer of all the Sec. 704(c) property contributed by a partner to a transferee partnership in a Sec. 721 exchange, followed by a distribution of a transferee partnership interest (and no other property) in complete liquidation of that partner's interest) could apply to an ABCD partner (e.g., A) if ABCD transferred all its Sec. 704(c) property contributed by A to AB and A received only an AB interest in liquidation of A's ABCD interest. Under Regs. Sec. 1.737-2(b)(3), Sec. 737 now applies in a step-into-the-shoes fashion to a subsequent distribution of property by AB to A within the original seven-year period.³⁵

Example 9:³⁶ A, B and C form ABC Partnership. A contributes property X (zero basis, $200 FMV), B contributes Y ($200 basis, $200 FMV) and C contributes $200. Within seven years, Y is contributed to a newly created partnership, Newco; Newco interests are distributed in accordance with each partner's pro rata interest in ABC. Under Sec. 708(b)(2)(B) and the proposed regulations, ABC has divided into two partnerships using the assets-over form; ABC and Newco are both continuing/resulting partnerships. ABC is the divided partnership; Newco is the recipient partnership. Sec. 737 applies to A's receipt of an interest in Newco. If, instead of Y, X were contributed to Newco, Sec. 704(c)(1)(B) would trigger gain to A as a result of B's and C's receipt of Newco interests.³⁷

Distribution of Interests

Example 10:³⁸ A and B each own a 50% interest in AB Partnership, which has $500 FMV of assets (net of liabilities). A and B each own 250 units of AB. B and C each own a 50% interest in BC Partnership, which has $400 FMV of assets (net of liabilities). D and E each own a 50% interest in DE Partnership, which has $100 FMV of assets (net of liabilities). BC and DE merge into AB, using the assets-over form. BC and DE receive 400 and 100 units, respectively, of AB, which are then distributed proportionately to the respective BC and DE partners in liquidation of BC and DE. Under Prop. Regs. Sec. 1.708-1(c)(1), AB is the continuing partnership. Because 50% of the AB interests are distributed by BC and DE, the issue arises whether Sec. 761(e), which provides that the distribution of a partnership interest is a sale or exchange for Secs. 708 and 743 purposes, causes a technical termination of AB under Sec. 708(b)(1)(B). The Service ruled in Rev. Rul. 90-17³⁹ that distributions of interests in a continuing partnership under a Sec. 708(b)(2)(A) merger do not cause a Sec. 708(b)(1)(B) termination. This ruling, promulgated prior to the current proposed regulations, should continue to apply to mergers undertaken (or deemed undertaken) in the assets-over form.

Liability Shifts

Absent a special provision, partnership mergers undertaken (or deemed undertaken) in the assets-over form could trigger gain recognition under Secs. 731 and 752 to partners of non-continuing (i.e., terminated) partnerships.

Example 11:⁴⁰ B owns a 70% interest in T Partnership, whose sole asset, X, has a $600 basis and a $1,000 FMV; X is encumbered by a $900 liability (i.e., net FMV is $100). B's outside basis in T is $420. B also owns a 20% interest in S Partnership, whose sole asset, Y, has a $200 basis and a $1,000 FMV; Y is encumbered by a $100 liability (i.e., net FMV is $900). B's outside basis in S is $40. T merges into S under the assets-over form; S is the continuing partnership. T is the momentary owner of 10% of S after the merger. An issue arises as to whether T, as a momentary partner of S, has to recognize gain under Secs. 752 and 731 (which would flow through to B and the other T partners), due to its contribution of X to S: T contributed X, with a $600 basis and encumbered by a $900 liability. After the contribution, T's momentary share of S liabilities is $100 (10% x ($900 + $100)); thus, there would be a deemed distribution of $800 to T under Sec. 752 ($900 – $100). T would then have a $200 Sec. 731(a)(1) gain ($800 deemed distribution – $600 X adjusted basis), which would have to be allocated among T's (former) partners, including B.

Fortunately, T's momentary ownership of an interest in S is disregarded for Sec. 752 purposes.⁴¹ The netting of partnership liabilities under Sec. 752 is applied at the partner level, under Prop. Regs. Sec. 1.752-1(f). B's share of liabilities before the merger is $650 ((70% x $900) + (20% x $100)); his share of liabilities after the merger is $250 (25%⁴² x ($900 + $100)). Thus, B is deemed to receive a $400 distribution ($650 + $250) from S under Sec. 752. B's adjusted basis in S after the merger, without regard to the deemed distribution, is $460 ($420⁴³ – $40). B's outside basis in S after the merger is $60 ($460 – $400); B recognizes no gain.

Example 12: The facts are the same as in Example 11. In addition, A owns the remaining 30% of T before the merger, C owns the remaining 80% of S before the merger and T's $900 liability is not a qualified liability for Sec. 707(a)(2)(B) purposes, under Regs. Sec. 1.707-5(a)(6). After the merger, A's, B's and C's ownership interests in S are 3%, 25% and 72%, respectively.

Query how applying Sec. 752 at the partner level (rather than at the partnership level) in assets-over mergers may be significant in terms of the Sec. 707(a)(2)(B) disguised-sale rules.

Although the matter is not free from doubt, consistent with a netting-at-the-partner-level approach, the proceeds of the Sec. 707(a)(2)(B) sale may be computed under Regs. Sec. 1.707-5(a)(1) by subtracting $252 ((3% + 25%) x $900) (A's and B's total share of the $900 nonqualified liability after the merger), from $900 (A's and B's share before the merger). The $648 difference, resulting from a shift of 72% of T's liability from A and B to C, is treated as the deemed sale proceeds. Thus, 64.8% ($648/$1,000) of the transfer from T to S is a sale; the remaining 35.2% of the transfer is part of an assets-over merger.⁴⁴

Example 13: D Partnership is owned equally by A and B. D owns two zero-basis assets, P and Q, each encumbered by $10 debt. P and Q have equal FMVs. D contributes Q, subject to its $10 liability, to new E Partnership, then distributes its E interest to A and B; thus, A's and B's ownership interests in D are 60% and 40%, respectively, and in E, are 40% and 60%, respectively.

Under Prop. Regs. Sec. 1.708-1(d), both D and E are continuing partnerships after the division, the assets-over form is used and D is the divided partnership. After the division, A's share of the two liabilities (now in D's and E's hands) is $10 ((60% x $10) 1 (40% x $10)), just as it was before the division. Query whether A's share of the two liabilities, now in two partnerships, can be combined for Sec. 752 purposes?⁴⁵

Partner Buyout

Example 14: A publicly traded umbrella partnership real estate investment trust (UPREIT) has an affiliated umbrella partnership, UP. UP seeks to acquire T Partnership's assets and liabilities. T has three partners, one of whom (the exiting partner) wishes to receive cash for his interest in the property (and recognize the tax consequences); the other two partners seek to defer tax. UP will pay the T partners cash and UP units.

If the assets-over form of merger is used (with UP as the continuing partnership) and cash is distributed to the exiting partner in liquidation of his interest, a disguised sale under Sec. 707(a)(2)(B) may cause T to recognize gain. T's partners want such gain to be allocated to the exiting partner; however, Sec. 704(b) and (c) problems may require a different result.⁴⁶

This result may be avoided if the T partners contribute their UP interests, provided the interest-over form is respected. However, the interest-over form is not given tax effect by the Sec. 708(b)(2) proposed regulations; instead, it is transmuted into the assets-over form.

Fortunately, Prop. Regs. Sec. 1.708-1(c)(3) provides that, under certain circumstances, the exiting partner's interest in T may be treated as sold to UP; the receipt of cash or other property by the exiting partner is not treated as proceeds of a disguised sale by T. Specifically, in an assets-over merger, a sale of an interest in the terminated partnership (T) to the resulting partnership (UP) is respected as a sale/purchase of the interest immediately before the merger, if the merger agreement (or similar document) specifies that the resulting partnership (UP) is purchasing the exiting partner's interest in the terminating partnership (T) and the amount paid therefor.⁴⁷

The preamble makes clear that this provision applies even if the resulting partnership transfers the consideration to the terminating partnership on the exiting partner's behalf, as long as the designated language is used in the merger agreement.

Because the sale of the exiting partner's interest is deemed to occur immediately before the assets-over merger, the resulting partnership (UP) and (ultimately) its pre-merger partners inherit the exiting partner's capital account (according to Regs. Sec. 1.704-1(b)(2)(iv)(I)) and his Sec. 704(c) potential (according to Regs. Sec. 1.704-3(a)(7)), if any. Further, if terminating T Partnership has a Sec. 754 election in effect, the continuing/ resulting UP Partnership, as the purchaser of an exiting partner's interest, will have a Sec. 743(b) adjustment in T's property. Prop. Regs. Sec. 1.743-1(h)(1) provides that that adjustment (now in UP's property) that UP had in the instant before the merger must be segregated and allocated solely to UP's pre-merger partners. This rule applies whether or not UP has a Sec. 754 election in effect.⁴⁸

Definition of "Divided Partnership"

Example 15: A and B are equal partners in AB Partnership, which has two assets, P and Q. AB divides into A1B1 and A2B2 Partnerships, by transferring P to A1B1 and Q to A2B2 in Sec. 721 transactions, then liquidates. A and B are the partners of both A1B1 and A2B2.

A1B1 and A2B2 are both continuations of AB. Query: under Prop. Regs. Sec. 1.708-1(d)(3)(i), which is the divided partnership? The definition of "divided partnership" does not provide an answer. Neither A1B1 nor A2B2 transferred, in form, any assets or liabilities in connection with the division; both are continuations of AB.

It appears that the division is accomplished using the assets-over form. However, Prop. Regs. Sec. 1.708-1(d)(2)(i)(A), in defining the assets-over form when at least one resulting partnership is a continuing partnership, provides that the divided partnership contributes certain assets and liabilities to the recipient partnerships. The problem in the above example is that it is not known whether A1B1 or A2B2 is the divided partnership. Prop. Regs. Sec. 1.708-1(d)(2)(i)(A) looks to -1(d)(3)(i), which looks to -1(d)(2) for the form of the division. The circularity does not help in deciding whether A1B1 or A2B2 is the divided partnership.

A1B1 should be the divided partnership if P's value (net of liabilities) exceeds Q's value (net of liabilities); A2B2 should be the divided partnership in the opposite case. The definition of "divided partnership" should be amended as follows:

• The divided partnership must be a resulting partnership that is a continuation of the prior partnership.
• If the resulting partnership that, in form, transferred the assets and liabilities in connection with the division is a continuation of the prior partnership, it will be treated as the divided partnership.
• In all other cases in which there is at least one continuing/resulting partnership, the divided partnership is that continuing/resulting partnership with assets having the greatest FMV (net of liabilities). Thus, for example, if there is only one continuing partnership, it is the divided partnership.

Form Combinations

The final regulations should clarify that, in the case of a merger or consolidation, each noncontinuing (terminating) merged partnership may undertake either the assets-over form or the assets-up form for Federal income tax purposes. For example, one terminated partnership may undertake the assets-over form, while another may use the assets-up form. A similar rule should apply to divisions (other than with respect to the divided partnership, if it exists).⁴⁹

Necessity of Titling in Assets-Up Form

Neither Prop. Regs. Sec. 1.708-1(c)(2)(ii) (defining the assets-up form for mergers) nor -1(d)(2)(ii) (defining the assets-up form for divisions) requires that title to assets actually pass to the distributee partners. On the other hand, Prop. Regs. Sec. 1.708-1(d)(4), Examples 2 and 6, assume title to the assets vests in the distributee partners.⁵⁰ The difference may be significant for state transfer tax purposes.⁵¹ It appears that the Service will adopt the examples' retitling rule when promulgating final regulations.⁵²

Capital Accounts

Example 16: A and B form AB Partnership, which they own equally. A contributes land with a $10 basis and $50 FMV to AB; B contributes $50. No more than seven years later, when the land is worth $55, AB merges into CD Partnership, using the assets-over form. CD is the continuing/ resulting partnership; thus, AB terminates. The proposed regulations do not address A's and B's capital account balances in CD after the merger and the land's Sec. 704(c) potential in CD's hands as to A after the merger. Arguably, in this example, A's and B's AB capital accounts carry over to CD; A's Sec. 704(c) potential as to the land remains at $40 ($50 – $10).

Because AB contributes all its assets and liabilities to CD in a Sec. 721 transaction, followed by AB's liquidation, Regs. Secs. 1.704-4(c)(4) and 1.737-2(b)(1) provide that there are no immediate Sec. 704(c)(1)(B) or 737 consequences, and that the Sec. 704(c) potential that A had as an AB partner carries over to A as a CD partner. But the Sec. 704(c)(1)(B) potential is the same as the Sec. 704(c) potential,⁵³ $40 ($50 – $10). Thus, the merger of AB into CD preserves the old Sec. 704(c) layer; no new layer is added. In other words, the $40 book/tax disparity at AB's formation carries over from AB to CD; because tax basis carries over as well, so too must the book value of the assets and capital accounts. Thus, A's and B's capital accounts in AB carry over to CD.⁵⁴

Variation 1—The conclusion in Example 16 above, that A's Sec. 704(c) potential remains at $40 and that A's and B's AB capital accounts carry over to CD, depends on the application of Regs. Secs. 1.704-4(c)(4) and 1.737-2(b)(1) to the facts.⁵⁵ Arguably, A and B "should be" responsible for the first $45 of gain ($55 FMV at the time of merger – $10 adjusted basis) on a post-merger sale of the land; this $45 built-in gain arose while the land was held by A ($40) or AB ($5). In this analysis, if the land were sold by CD for $55, $40 of the $45 gain would be allocated to A; $5 would be allocated equally between A and B. The analysis is set forth below:

Computing capital accounts: Under Regs. Sec. 1.704-1(b)(2)(iv)(b), the land is booked up to $55 on its contribution to CD. AB has a $105 CD capital account balance ($55 land + $50 cash). Under Regs. Sec. 1.704-1(b)(2)(iv)(l), this balance carries over to A and B ($52.50 to each) on the distribution to them of CD interests in liquidation of AB. In addition, CD may (and probably should) book up its own pre-merger assets; the capital accounts of CD's pre-merger partners should reflect the revaluation, under Regs. Sec. 1.704-1(b)(2)(iv)(f).

Built-in gain: First, a book-up by CD under Regs. Sec. 1.704-1(b)(2)(iv)(f) creates reverse Sec. 704(c) potential for CD's pre-merger partners. Second, on the distribution to A and B of CD interests, presumably A would not recognize gain under Sec. 704(c)(1)(B) or 737.⁵⁶ A and B share equally in the $5 ($55 – $50) second Sec. 704(c) layer.

Accounting Methods

The proposed regulations do not address whether a partnership resulting from a merger or division is bound by the accounting methods of a predecessor partnership.

Example 17: AB and BC Partnerships merge to form ABC Partnership; because AB had a greater net asset value, ABC is a continuation of AB. Thus, AB and ABC are deemed the same partnership for Federal income tax purposes; BC, the noncontinuing partnership, terminates.

It is unclear which accounting method AB/ABC must use after the merger. Perhaps Sec. 381(c)(4) and its regulations may serve as models, especially if the assets-over form is used to effect the merger.⁵⁷ If AB and BC used the same method, ABC generally must use that method.⁵⁸ If AB and BC used different methods, ABC continues to use both methods, provided the BC business is continued by ABC as a separate and distinct business from the AB business. If AB and BC used different methods and the old AB and old BC businesses are integrated, the principal method of accounting prevails; the other method must change, and Sec. 481 would apply.

A carryover accounting method rule (such as the above) probably should apply if the former BC partners, immediately after the merger, own a more-than-50% interest in ABC. However, given the explicit 50% continuity-of-interest statutory requirement for partnership continuation in a merger or division, arguably, no specific carryover rule should apply to merging partnerships that do not meet the 50% continuity rule.⁵⁹ In any event, the same accounting method rule that applies if the merger is effected under the assets-over form should generally apply if the assets-up form is used.

In the case of a division, the accounting method of the prior partnership should carry over to all continuing/resulting partnerships. No special rule should apply to the noncontinuing/resulting partnerships.

Example 18: DE and FG Partnerships merge to form DEFG Partnership. DEFG is not the continuation of DE. DE's only asset is depreciable property X, with a $100 basis. DE has no liabilities; D's and E's outside basis in DE is $60 each.

If the merger takes the assets-over form, DEFG will have a $100 basis in X under Sec. 723. Under Sec. 168(i)(7), DEFG also steps into DE's shoes as to the depreciation method and period used for X.

On the other hand, if the assets-up form is used, DEFG will have a $120 ($60 + $60) basis in X under Secs. 732 and 723. For purposes of depreciation method and period, DEFG will step into DE's shoes as to $100 of that basis. The other $20 of basis is treated as newly purchased property placed in service by DEFG immediately after the merger. DEFG may choose any applicable recovery period and method for the $20 of "new property"; DEFG need not use DE's recovery period or method, under Prop. Regs. Sec. 1.168-5(b)(7).

The same analysis applies to divisions.

Example 19: D Partnership divides into two continuing/resulting partnerships, D1 and D2; D1 is the divided partnership. Presumably, D1 retains D's tax or employer identification number. Final regulations should clarify this issue.⁶⁰

What Is a Merger or Division?

Although the proposed regulations provide guidance on the Federal income tax consequences of mergers and divisions, nowhere do they define "merger" or "division." The issue is a difficult one; guidelines, rather than rules, may be all that is possible (or even desirable).

For ease of discussion, assume partnerships M1, M2 and M3 "combine" into M, and D "separates" into D1, D2 and D3. Using this notation, a merger (or division) should not require that all the assets and liabilities of M1, M2 and M3 (D) end up in M (D1, D2 or D3); in particular, "substantially all operating assets and liabilities" should be the criterion. Also, M1–M3 (D), pursuant to a merger (division), generally should not acquire and retain assets not owned before the transaction.

Example 20: P1 sells all its operating assets to P2 for an installment note. The P2 partners owned more than 50% of the interests in P1. This transaction should not be a division, because P1 (the prior partnership) gets an installment note that it did not own immediately before the transaction.⁶¹

Example 21: BC Partnership contributes all its operating assets to AB Partnership, holding back some cash, in exchange for AB interests. BC liquidates, distributing the AB interests and the cash to B and C. But for the cash held back, the transaction would have been a merger of BC into AB, with the latter the continuing/resulting partnership.

This transaction should be treated as a merger of BC into AB. Because the form clearly is not assets-up, the deemed form is assets-over. Under this form, all of the assets (including the cash) and liabilities of BC are deemed contributed to AB for AB interests, which BC then distributes to B and C in complete liquidation. The (held- back) cash should then be deemed distributed by AB to B and C in partial liquidation of their AB interests.⁶²

Example 22: The facts are the same as in Example 21, except that BC distributes to B and C only its AB interests, and retains the cash. This transaction should also be a merger of BC into AB. The analysis of the Federal income tax consequences of this transaction is the same as in Example 21, except that the cash B and C are deemed distributed in Example 21 is instead deemed contributed by B and C to a new partnership, New BC, with a fresh tax history.⁶³

Example 23: D Partnership owns properties X and Y and cash. D contributes X to D1 for a D1 interest, which it distributes to certain D partners in partial or complete liquidation of their D interests. If D is the divided partnership, this is a division under the assets-over form.

Example 24: The facts are the same as in Example 23, except that D distributes the cash and the D1 interest to some of its partners. This should also be a division. Under the facts, the Federal income tax treatment should respect the form of the transaction—contribution of X in exchange for a D1 interest, followed by a distribution by D of the D1 interest and cash.⁶⁴

Example 25: A and B are equal partners in AB Partnership, which owns assets P1 and P2, with FMVs of $400 and $200, respectively. C and D are partners in CD Partnership; E and F are partners in EF Partnership. CD has one asset, Q, with a $300 FMV; EF has one asset, R, with a $700 FMV. None of the partnerships has liabilities.

AB contributes P1 to CD for a 4/7 interest in CD and contributes P2 to EF in exchange for a 2/9 interest in EF. AB then liquidates, by distributing proportionately its CD and EF interests to A and B.

Query whether the transaction is a division, a merger, a combination of the two or a liquidation of AB preceded by a contribution of its assets? If it is a division, then both CD and EF are continuing/resulting partnerships of AB, because A and B are partners of both post-transaction CD and EF. Query whether CD is the divided partnership, because the FMV of P1, the asset it received from AB, is greater than the FMV of P2, the asset EF received from AB? Or is EF the divided partnership, because the total FMV of its assets after the transaction is greater than that of CD?⁶⁵

Variation 1—The facts are the same as in Example 25, except that CD and EF are "much larger" than AB. If the transaction is deemed a division of AB, then CD and EF are continuing/resulting partnerships of AB, because A and B become partners of both post-transaction CD and EF, even though A and B receive minuscule interests therein. It is hard to imagine that CD and EF are continuations of AB or that the transaction is a division.

Variation 2—An alternative view is that the underlying transaction in Example 25 (i.e., AB contributes all of its assets and liabilities to CD and EF in exchange for interests therein, then liquidates) also resembles a merger. However, the transaction does not meet the literal definition of a merger under Sec. 708(b)(2)(A), which mandates a combination of two or more partnerships into one resulting partnership. Second, even if the Service could overcome this definitional problem in final regulations, it would still have to resolve a host of technical problems (e.g., which partnership or partnerships continue and which terminate). Third, even if all the problems could be resolved, query whether the concept of "division" would be superfluous and whether the new "merger" rule would be overly complex?

Variation 3—The Example in Prop. Regs. Sec. 1.708-1(c)(5)(ii) recasts a series of prearranged transactions structured as a merger followed by a division as, in substance, a taxable exchange of partnership interests.⁶⁶ Query whether a division followed by mergers can be the substance of a transaction? In particular, query whether the underlying current transaction may be recast as a division of AB, followed by mergers of the two deemed resulting partnerships into CD and EF, when both the division and the mergers are analyzed separately under Prop. Regs. Sec. 1.708-1(c) and (d)?

Variation 4—Should the form of the transaction (i.e., contributions followed by liquidation) control, so that the division and merger rules are not used at all?

   

Conclusion

The proposed regulations on partnership mergers and divisions bring needed guidance and clarification in an area that has been beset by confusion and inconsistency. The proposals are generally well conceived, although somewhat complex and incomplete. However, the Service has erred in accepting McCauslen as correct and should disavow the holding when finalizing the regulations.