Tax Planning Using Partnership Divisions

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editors note: This case study has been adapted from PPC Tax Planning GuidePartnerships, 17th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2003 ((800) 323-8724; www.ppcnet.com).

Facts: Bruce and Harrison formed the Jackson Hole Development Partnership (JHD) in 1996 to develop resort properties in Wyoming. The partnership currently owns a hotel in Jackson Hole with a $1 million basis and a $2 million fair market value (FMV), and two undeveloped parcels of land, each with a $500,000 basis and a $1 million FMV. JHD needs an additional $1 million of capital to continue development activities.

The partners have asked Kevin to invest in their business. Kevin wants to invest in the hotel, but does not want to own land or participate in any ongoing development activities. He would like to invest in the hotel through an interest in a new entity that would not be subject to any of JHDs known or unknown liabilities. Bruce and Harrison do not want to recognize the gain that would result from selling an interest in JHD to Kevin. Issue: Can JHD structure a transaction using the partnership division rules to transfer a portion of the ownership?

Analysis

Under the partnership division rules, a transaction generally will be respected for tax purposes if the division is an assets-up or assets-over transaction. Generally, an assets-over transaction is one in which the dividing partnership transfers its assets to the resulting partnerships for interests in the latter. The divided partnership immediately distributes to its partners the interests in the resulting partnerships. An assets-up transaction is one in which the dividing partnership distributes its assets to its partners, who then contribute the assets to the resulting partnerships for interests in the latter. (For background on the partnership division final regulations, see MacNeil, Tax Clinic, Partnership Mergers and Divisions, TTA, April 2001.)

Under JHDs facts, it seems logical to transfer the hotel to a new partnership (or a limited liability company (LLC) classified as a partnership), then have Kevin make a $1 million contribution of capital to the new entity. This would be an assets-over transaction, because the old JHD would transfer assets to a new entity (e.g., JHDK), then transfer ownership interests in it to its existing partners (Bruce and Harrison). The transactions form would be respected for Federal tax purposes; the property contribution to JHDK would be nontaxable under Sec. 721 and the distribution of JHDK interests to old JHDs partners would be nontaxable under Sec. 731.

Because old JHDs partners would own more than 50% of both new JHD and JHDK, both JHD and JHDK would be deemed continuations of old JHD, under Regs. Sec. 1.708-1(d)(1). As new JHD is a continuing partnership and, in form, is the partnership that transferred the assets and liabilities to the recipient partnership, it is deemed the divided partnership, under Regs. Sec. 1.708-1(d)(4). This transaction would accomplish Bruces, Harrisons and Kevins goals, because the property would be owned by a new legal entity (providing Kevin with protection from JHDs liabilities); Bruce and Harrison would get an influx of capital, while recognizing no gain.

However, Bruce and Harrison might face a problem were they to try to take funds out of JHDK or receive a property distribution from JHDK in the future. A distribution of cash or property within two years of the transaction might run afoul of the disguised-sale rules, causing Bruce and/or Harrison to recognize gain on the transfer of the property as if they had sold it at the time of the transfer.

Additionally, the contribution of appreciated property from JHD to JHDK would invoke the special rules that apply to contributors of appreciated property if distributions are made to Bruce or Harrison within seven years of the transfer. If such distributions occur, Sec. 704(c)(1)(B) (for distributions of contributed appreciated property to partners other than the contributing partner) or 737 (for distributions to contributors of appreciated property) might apply.

Another type of division that might accomplish their goals would be for JHD to distribute the hotel to Bruce and Harrison and have them contribute it to a new partnership or LLC (JHDK). This type of transaction is also respected for tax purposes under the partnership division regulations (as an assets-up transaction). In this kind of transaction, the dividing partnership distributes its assets to its partners, who then contribute them to the resulting partnerships in exchange for partnership interests. Under the facts, the tax ramifications to Bruce, Harrison and Kevin would be the same under an assets-up transaction as for an assets-over transaction.

Conclusion

Bruce, Harrison and Kevin can achieve their goals by using a partnership division. Using either the assets-over or assets-up form, Bruce and Harrison can transfer the hotel to a new entity and recognize no gain. Kevin can make a capital contribution to the new entity in exchange for an interest in ownership of the hotel, while not investing in the undeveloped properties and shielding himself from JHDs liabilities. However, distributions from JHDK should be monitored closely, to make sure the disguised sale rules and Secs. 704(c)(1)(B) and 737 do not result in gain recognition by Bruce and Harrison.