Impact of Off-Code Amendment to Consolidated Return Rules

Late last year, Congress enacted an off-Code technical change that deals directly with partnerships and consolidated groups. The provision, which applies retroactively, will likely affect a limited number of taxpayers; however, those affected should pay close attention, as the tax ramifications are important.

Background

Under general partnership rules, partners can receive distributions of property tax-free. Further, when a partner receives a property distribution in complete redemption of his interest, the property takes a substituted basis equal to the recipient's basis in his partnership interest.

These rules previously presented planning opportunities for corporate partners with a low basis in their partnership interests. If the partnership were to distribute "hard assets" in a complete redemption, the corporate partner would take a stepped-down basis in those assets. However, if the partnership first contributed these same assets to a corporation (Newco) and then distributed the Newco stock in redemption of the corporate partner's interest, the partner would suffer a basis step-down only in the Newco stock, preserving a high basis in the assets within Newco. The partner then could liquidate Newco tax-free, making the step-down in the basis of the stock inconsequential.

Congressional Response

In response, Congress enacted Sec. 732(f), which applies to distributions of stock to corporate partners made by a partnership after July 14, 1999. Basically, that provision mandates a further reduction to the basis of a corporation's assets if the stock of that corporation is distributed by a partnership to a corporate partner. As originally enacted, the reduction only applied if, after the distribution, the corporate partner controlled the distributed corporation, with control measured at the time of the distribution or at any time after the distribution.

Concerns arose over operation of the new statute. The term "control" generally meant direct, actual ownership of stock reflecting 80% vote and value. Since neither the Code nor the consolidated return rules contained an attribution rule, indirect stock ownership through an affiliated corporation would not result in control for Sec. 732(f) purposes. As a result, partnerships sought to circumvent Sec. 732(f) and avoid reducing the basis of the assets inside a distributed corporation.

Example: Partners A and B are members of the same consolidated group. A owns 40% of Partnership X, and B owns 40% of X. (The remaining 20% is owned by unrelated parties in varying percentages.) The 40% interests owned by A and B each are worth $100, and their adjusted bases in those interests is $20 each. X holds two assets, each worth $100 and having an adjusted basis of $100. X forms Newco and drops the assets into Newco. Subsequently, X distributes half the Newco stock to A and the other half to B in complete redemption of their partnership interests. A and B each take a substituted basis of $20 in the Newco stock. Since neither A nor B is in "control" of Newco for Sec. 732(f) purposes, as originally enacted, Newco is not required to reduce the assets' bases.

Off-Code Amendment

Congress addressed this situation in a somewhat surprising way. P.L. 106-554 enacted language specifying that Regs. Sec. 1.1502-34, which aggregates stock ownership when a subsidiary member of a consolidated group is liquidated, will also apply for Sec. 732(f) purposes. This off-Code amendment is effective retroactively to the enactment of Sec. 732(f) (i.e., for distributions after July 14, 1999).

Basically, the amendment means that the stock owned by all members of a consolidated group is aggregated for purposes of the control requirement of Sec. 732(f). Thus, if a consolidated group member is a partner and receives a corporate stock distribution from the partnership, the consolidated return regulations aggregate all the stock in that corporation owned by the consolidated group members to determine whether the corporation is subject to the Sec. 732(f) basis-reduction rules. Using Example 1, Newco would be required to reduce the basis of the assets inside Newco, as both A and B are members of the same consolidated group and collectively own 80% of the vote and value of Newco's stock.

Issues and Concerns

A major concern is that the new provision is practically invisible; the rule deeming a reference to Sec. 332 to include a reference to Sec. 732(f) was included in last year's legislation with little fanfare. On June 18, 2001, the IRS issued final regulations (TD 8949) amending Regs. Sec. 1.1502-34, expressly to reference Sec. 732(f), with a special effective date rule for certain distributions before July 1, 2001.

Difficult issues could arise under the new rule:

• Control for purposes of Sec. 732(f) is measured at the time of distribution or at any time after the distribution. How could the IRS enforce application of Sec. 732(f) months or years after a distribution has occurred?
• If stock is distributed to two corporate partners that do not control the distributed corporation at the time of the distribution, but later become members of the same consolidated group, Sec. 732(f) would seem to apply. If so, how would a taxpayer know the amount of the adjustment at this later time? How could the Service track these post-distribution events?
• What if the two corporate partners become members of the same consolidated group 20 years after the transaction took place?
• If the original assets no longer were in the distributed corporation, which assets would be adjusted at this point in time? Obviously, there could be significant differences in potential gain if the adjustment were allocated, for example, to a depreciable asset rather than to a capital asset.

Apart from these concerns, it is unclear whether the new rule presents any useful planning opportunities. A simple redemption distribution of "hard assets" to the corporate partner would have produced a basis step-down under the normal Sec. 732 rules. It is difficult to envision situations in which a corporation benefits from a sudden loss of asset basis.

Summary

By enacting this off-Code amendment, Congress has addressed what it perceived as a defect in Sec. 732(f); however, it appears that a number of issues could arise from the correction itself. Taxpayers should structure transactions carefully to avoid the administrative burdens, as well as the potential adjustments concerning the control factor arising from this amendment.

From Jennifer Long, CPA, and David Friedel, J.D., LL.M., Washington, DC