Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Partnership Exit Strategies and the Failure of the Substantiality Test
Thomas W. Henning*
Subchapter K is intended to provide flexibility so that tax rules do not impede partnership formations, allocation of income and loss among the partners, or the transfer of property into and out of a partnership. The allocation rules, as reflected in the current section 704 regulations, are so flexible as to allow highly tax-motivated transactions. At the same time as these rules allow tax avoidance allocations, they disallow nontax avoidance allocations.
What is missing from the regulations is the explicit tax avoidance standard that the Treasury excised from the prior section 704 regulations when the current regulations were issued in 1985. What the Treasury substituted in place of the tax avoidance standard in the prior section 704 regulations is the largely unworkable substantiality test. The substantiality test represents a valiant but failed attempt to reduce tax avoidance to a quasi-mathematical test. Unfortunately, it did not work.
This Article approaches substantiality at the end of a partnership’s life cycle when the partners’ exit strategies diverge. This is common in an era when partnerships are increasingly formed between capital sources, such as investment funds, and operating partners. The investment fund typically wants the partnership to sell its property within a certain time frame—and receive cash to return to its investors and pay its managers—while the operating partner may want to continue to own its interest in the partnership’s property or to exchange it for other property.
This Article models the case of a two-person partnership owning real estate, where one partner—an investment fund—wants the partnership to sell its property, while the other partner—a local real estate company—wants to continue to own its interest in the partnership’s real property. The Article considers different ways a buyer can take the place of the partner who wants to sell. The primary focus is on a part sale-part contribution by the partnership of its property to a new partnership between the buyer and the continuing partner. To set the stage for the discussion of the part sale-part contribution, the Article first considers the simple alternative of a sale of a partnership interest by the partner who wants to sell. The Article also considers a distribution of an undivided interest in the partnership’s property followed by a sale and contribution.
The principal discussion centers on the partnership’s part sale-part contribution of its property. The part sale is for cash, and the part contribution is for an interest in a new partnership with the buyer. This transaction is coupled with a special allocation of the recognized gain on the sale portion to the retiring partner, and the deferred gain on the contributed portion to the continuing partner. The special allocation of recognized and deferred gain leads into the thicket of the substantiality part of the substantial economic effect test for partnership allocations. The substantiality analysis shows that this special allocation may or may not satisfy the regulations’ substantiality tests, depending on what factual assumptions are made.
The final Part of the Article considers whether the substantiality rule should prohibit or allow a special allocation of this type. The Article explores the history and purpose of the substantial economic effect rule from its origins in the 1954 Code to the current regulations. In determining whether the allocations should be allowed, the discussion considers how the objectives of the parties could be reached, not only through the alternative transaction structures previously considered, but also through a change in the transaction structure that takes advantage of the value-equals-basis presumption in the substantiality regulations. The partner buyout rule in the merger regulations points to another avenue for effecting the transaction.
This review of the history and purpose of the substantial economic effect test shows that a special allocation of the type involved here, motivated by business concerns and congruent with the economic results, would have been permitted under the 1954 Code and was intended to be permitted by Congress when it amended section 704 in 1976. By contrast, other much less benign allocations that have a tax avoidance objective are permitted under the current regulations. It is submitted that the Treasury needs to rewrite the substantiality
provisions of the section 704 regulations to bring back an explicit tax avoidance standard that should incorporate parts of the substantiality tests in the current regulations.
*Adjunct Professor, Loyola Law School, Los Angeles; Partner, Allen Matkins Leck Gamble Mallory & Natsis LLP, Los Angeles, California.