The Department of the Treasury ("Treasury") and the Internal Revenue Service (the "Service") issued proposed regulations (the "Proposed Regulations") providing guidance on certain provisions of the American Jobs Creation Act of 2004 (the "AJCA"), conforming the existing regulations under sections 704(c)(1)(B) and 73 1 to statutory changes made by the Taxpayer Relief Act of 1997, modifying the existing basis allocation rules under sections 743(b) and 755 for substituted basis transactions, and providing additional guidance regarding allocations resulting from revaluations of partnership property. 2
In the preamble to the Proposed Regulations, Treasury and the Service requested comments regarding specific issues. We appreciate the opportunity to provide comments both in response to these specific requests from Treasury and the Service and on other aspects of the Proposed Regulations.
2. Contributions of Built-in Loss Property
2.1. We recommend that Proposed Regulation section 1.704-3(f) specifically adopt the rule of Proposed Regulation section 1.704-3(a)(6)(iii). If the government intends to require a LIFO ordering rule in this situation, as is implied in an example in the Proposed Regulations, we recommend that the text of the final regulation be clarified to expressly so state.
2.2. Proposed Regulation section 1.704-3(f)(3)(iii)(A) provides special rules under which a section 704(c)(1)(C) basis adjustment is not eliminated if the pertinent section 704(c)(1)(C) partner transfers its partnership interest in a "nonrecognition transaction." Neither the Proposed Regulations nor their preamble defines the term "nonrecognition transaction." We believe that additional clarity could be achieved if the Proposed Regulations were modified to provide that the term "nonrecognition transaction" has the meaning set forth in section 7701(a)(45).
2.3. We recommend that the use of a section 704(c)(1)(C) basis adjustment to cure a ceiling rule limitation with respect to other property contributed by the section 704(c)(1)(C) partner be considered a reasonable method for purposes of section 704(c).
2.4. We recommend that Regulation section 1.704-3(a)(8) be amended to provide that when a partnership transfers section 704(c) property and other property to a corporation under section 351, the partnership should take a basis in a separate block of stock that preserves the aggregate built-in gain or loss that would be allocated to the relevant section 704(c) partner had the partnership disposed of the contributed property immediately before the transfer.
2.5. We recommend modifying the final regulations to allow the aggregation rules in Regulation section 1.704-3(e)(2) to be used in connection with the determination of a section 704(c)(1)(C) basis adjustment.
2.6. We recommend that the final regulations provide guidance illustrating that "attributable to" under Proposed Regulation section 1.704-3(f)(3)(iii)(B) means an amount of built-in loss that would have been allocated to a distributee-partner if an upper tier partnership had sold its built-in loss asset in an arm's length transaction immediately prior to the distribution that occurs in a partnership merger or division (the "Tracing Approach").
2.7. We recommend that the final regulations provide that, with respect to section 704(c)(1)(C) partners in a merged partnership, section 704(c)(1)(C) will continue to apply by reference to the resulting partnership in the same manner as section 704(c)(1)(C) applied with respect to the merged partnership prior to the merger.
2.8. We recommend that the final regulations provide a de minimis exception regarding the application of section 704(c)(1)(C) to partnership mergers and divisions similar to those in the 2007 proposed regulations relating to the anti-mixing bowl rules and assets-over partnership mergers.
2.9. We recommend that, in determining a distributee-partner's basis in a distributed lower-tier partnership interest, the final regulations provide guidance that would allow the term "equitably apportioned" under Regulation section 1.61-6(a) to be defined as taking into account the partner's share of gains or losses in the distributed lower-tier partnership's interest (the "Tracking Approach").
2.10. We recommend that the final regulations provide an elective rule that, in the context of the distribution transaction in a division, would permit the reallocation of any section 704(c)(1)(C) basis adjustment created in connection with the contribution of assets to the lower-tier partnership in the same way as if the assets were being distributed directly to the partners in the divided partnership.
2.11. If the immediately prior suggestion is not adopted, we recommend that the final regulations provide a rule confirming that in a situation where the "conforming reductions" rule in Proposed Regulation section 1.704-3(f)(3)(iv)(B)(2) overlaps with the Deemed Section 754 Election rule, the "conforming adjustment" would be made first, and the Deemed Section 754 Election rule would be applied after the application of the "conforming reduction." We believe that the final regulations should also provide an example illustrating the application of the "conforming reduction" rule in the context of a partnership division.
2.12. We agree with the rule of the Proposed Regulations that the non-contributing partner should not take section 704(c)(1)(C) basis adjustments into account under section 732. If a non-contributing partner took section 704(c)(1)(C) basis adjustments into account in applying section 732(f), losses might be inappropriately eliminated and additional gain might be inappropriately created. Accordingly, we recommend that the rule set forth in Proposed Regulations section 1.704-3(f)(3)(v)(B), (i.e., that a section 704(c)(1)(C) basis adjustment is not taken into account in applying section 732(f) upon a distribution of stock to a partner other than a contributing partner, be retained).
2.13. We recommend that existing Regulation section 1.743-1(g)(2)(ii) be amended, and that the Proposed Regulations be revised to allow taxpayers to reallocate sections 704(c)(1)(C) and 743(b) basis adjustments to remaining partnership property of a character similar to that of the distributed property with respect to which the adjustments arose under the principles of Regulation section 1.755-1(b)(5)(iii).
2.14. We recommend that a section 704(c)(1)(C) basis adjustment attributable to section 704(c)(1)(C) property hypothetically distributed to a non-section 704(c)(1)(C) partner under the existing section 751(b) regulations that is hypothetically reacquired by the distributing partnership in an exchange transaction with the distributee-partner should remain embedded with the section 704(c)(1)(C) property hypothetically distributed and reacquired by the distributing partnership under the current section 751(b) regulations.
2.15. We recommend that the Proposed Regulations or the Proposed Section 751(b) Regulations be clarified with respect to the interaction of sections 704(c)(1)(C) and 751(b) with respect to the Hypothetical Exchange Approach described in those Proposed Section 751(b) Regulations is adopted in final regulations for section 751(b).
3. Mandatory Basis Adjustment Provisions
3.1. We agree with the Proposed Regulations' clarification as to the timing for a partnership's determination of whether it has a substantial built-in loss being immediately after a transfer.
3.2. Subject to our comments herein as to certain subsidiary partnerships in a tiered partnership structure, we agree that the appropriate consequence of a partnership having a substantial built-in loss immediately after an interest transfer is to treat the partnership as having a section 754 election in effect only with respect to such transfer.
3.3. We agree that the determination of a substantial built-in loss for a partnership should be made without regard to any section 743(b) and 704(c)(1)(C) adjustments other than those of any relevant transferee-partner.
3.4. We agree with the Proposed Regulations' gross up approach for purposes of determining an upper-tier partnership's fair market value in a lower-tier partnership, but recommend that an example be provided to clarify the manner in which contingent liabilities of the lower-tier partnership are taken into account in determining the gross up amount.
3.5. Although we agree with the stated purpose of the Proposed Regulations' section 743 substantial built-in loss anti-abuse rule, due to the multiple purposes that exist with the implementation of most commercial transactions, we recommend that any such section 743 anti-abuse rule be applicable only in a situation in which "the" principal purpose (as opposed to "a" principal purpose) of a transaction, or series of transactions, is to circumvent or avoid the purposes of the substantial built-in loss rules. We also recommend that final regulations provide specific examples of such principal purpose transactions, as well as clarification as to whether the results of the application of such an anti-abuse rule would be limited to the application of the section 743 substantial built-in loss rules.
3.6. We recommend that final regulations clarify whether an anti-abuse rule similar to that proposed for purposes of the section 743(b) substantial built-in loss rule would be applicable with respect to a section 734(b) substantial basis reduction and, if so, the situations in which such a rule would be applicable.
3.7. Proposed Regulation section 1.743-1(n)(7)(ii) provides than an upper-tier partnership is not considered engaged in a trade or business, and thus as not disqualified from being an EIP, if the upper-tier partnership owns an interest in a lower-tier partnership and, at all times, the adjusted basis of the upper-tier partnership's interest in the lower-tier partnership is less than 25% of the total capital that is required to be contributed to the upper-tier partnership (defined herein as the 25% Requirement). We recommend that debt allocations under section 752 by a lower-tier partnership to an upper-tier partnership be disregarded when determining whether the adjusted basis of an upper-tier partnership's interest in a lower-tier partnership is less than 25% of the total capital that is required to be contributed to the upper-tier partnership by the partners of the upper-tier. This recommended rule should apply without regard to where in the tiered structure a borrowing partnership is located.
3.8. We recommend that Proposed Regulation section 1.743-1(n)(8) be modified to include, as an exception to the Substantive Restriction Rule of Proposed Regulation Section 1.743-1(n)(6)(viii), an investor's holding an interest in an electing partnership that constitutes a prohibited transaction under ERISA.
3.9. We recommend that a partnership that has properly elected to be an EIP be permitted to cure a transitory failure to satisfy the terms set forth in section 743(e) and Proposed Regulation section 1.743-1(n). We also believe that any such transitory failure should be disregarded following the electing partnership's return to compliance if no interests in the electing partnership were transferred during the period that the electing partnership was out of compliance with the EIP rules.
3.10. We request that final regulations provide additional guidance regarding interest transfers in an EIP at a time that the EIP is not in compliance with section 743(e) and Proposed Regulation section 1.743-1(n). We recommend that the guidance require the non-compliant EIP to adjust the basis of its property as otherwise required by sections 743(b) and (d) with respect to each of its partners that acquired an interest in such partnership during the period that the EIP is out of compliance with sections 743(e) and finalized Proposed Regulation section 1.743-1(n).
3.11. We recommend that an EIP be permitted to disregard its transitory non-compliance with section 743(e) and Proposed Regulation section 1.743-1(n) and to compute and allocate its taxable income and loss as if it had been continuously in compliance with these provisions provided it cures its non-compliance by the time for filing its return for the year in which its non-compliance arose, including extensions.
3.12. We recommend that final regulations provide, as a general rule, that a re-electing EIP, i.e., an EIP that revoked its election with the consent of the Treasury but that subsequently re-elects to become an EIP, would be required to maintain and apply any basis adjustments under sections 743(b) and (d) that arose following its revocation of its EIP election and before its re-election of EIP status.
3.13. We recommend that final regulations clarify that a re-electing EIP can treat itself as having continuously been in compliance with an EIP election if either (i) there were no transfers with respect to which a basis adjustment under section 743(b) or (d) would have been required during the period between the partnership's revocation and its re-election of EIP status or (ii) the partnership properly re-elected EIP status with its timely filed return (including extensions) for the year in which the Treasury's consent for its revocation became effective.
3.14. We believe that requiring a lower-tier partnership to adjust the inside basis of its partnership assets when such partnership does not have a section 754 election in effect will be highly burdensome for many partnerships and that requiring a lower-tier partnership to make adjustments when it does not have a substantial built-in loss is beyond the intent of section 743(d) and is contrary to Rev. Rul. 87-115. Moreover, we believe that the proposal might create a fungibility concern for many publicly traded partnerships, which generally have to ensure that each partnership interest within a class of interests is fungible with any other interest in such class. If adopted, the proposal might require certain publicly traded partnerships to alter their current structures in a manner that would create administrative burdens as noted herein without promoting the purposes of the enactment of the mandatory basis adjustment rules.
3.15. We believe that it is beyond the plain meaning and purpose of section 743(d)(1) to require a lower-tier partnership to make an adjustment to the basis of its assets when it does not have a substantial built-in loss and has not had an actual interest transfer while a section 754 election is in effect.
3.16. If the final regulations require basis adjustments of properties held by a lower-tier partnership as a result of an event at an upper-tier partnership, we recommend that final regulations include guidance requiring the upper-tier partnership to provide the computational information that would be available only at the upper-tier partnership level but is needed at the lower-tier partnership level in order for such lower-tier partnership to make its required adjustments.
4. The Section 755 Basis Allocation Rules
4.1. Existing section 755(c)(1) implies that a basis adjustment might be prohibited from being made to the basis of certain equity interests in a non-corporate person. Because we believe that section 755(c) was intended to prevent basis reductions only to stock, we recommend that Treasury and the Service pursue a legislative technical correction to adjust section 755(c)(1) to state that no allocation may be made to a corporation's stock directly or indirectly owned by a partnership in which such corporation is a partner or to stock of a corporation that is directly or indirectly owned by such partnership and that is related (within the meaning of section 267(b)(1)) to a corporation that is a partner in such partnership.
4.2. Proposed Regulation section 1.755-1(e)'s disjunctive approach might be read to prevent an upper-tier partnership from making a negative basis adjustment to a lower-tier partnership interest in a situation in which the upper-tier partnership and the lower-tier partnership are related within the meaning of section 707(b)(1). Because we do not believe this is consistent with the purpose of section 755(c), to the extent that the above recommendation is not accepted and the existing section 755(c)(1) language is retained, we believe that the Proposed Regulations should confirm that the provision is only intended to prohibit basis reductions in stock of a corporate partner or a corporation that is related to such partner.
4.3. We recommend that the Proposed Regulations clarify that where a negative basis adjustment is allocable to "other partnership property" under Proposed Regulation section 1.755-1(e)(1)(B), the rules set forth in Regulation section 1.755-1(c) apply such that a negative adjustment must be allocated to partnership property of a character similar to that of the distributed property to which the negative adjustment arose.
4.4. We recommend that the Proposed Regulations clarify that the gain recognized under Proposed Regulation section 1.755-1(e)(2) should be allocated to the partners in the partnership in accordance with the general rules of section 704(b).
4.5. We request that the final regulations provide examples as to the interaction of sections 337(d), 755(c), and 732(f).
4.6. We agree with the changes proposed that would provide that if there is an increase in the basis to be allocated to partnership assets under Regulation section 1.755-1(b)(5), the increase must be allocated to capital gain property and ordinary income property in proportion to, and to the extent of, gross gain or gross income that would be allocated to the transferee from a hypothetical sale of all property in each class, while a decrease must be allocated between capital gain and ordinary income property in proportion to, and to the extent of, the gross loss that would be allocated to the transferee from a similar hypothetical sale of all property in each class.
4.7. We recommend that the finalized Proposed Regulations include an example of the proposed modification to Regulation section 1.755-1(b)(5)(iii)(C) and clarify that, to the extent a transferee's negative basis adjustment is made, the applicable partnership is responsible for tracking any excess adjustment under Regulation section 1.743-1(k).
5. Succeeding to a Transferor's Basis Adjustment – Proposed Regulation Section 1.743-1(f)(2) Substituted Basis Transactions
5.1. The flush language of section 743(b) states that a basis adjustment under section 743 is an adjustment to the basis of partnership property with respect to the transferee partner only. Regulation section 1.743-1(j)(1) confirms that. The effect of Proposed Regulation section 1.743-1(f)(2) will often be that a transferee partner steps into the shoes of the section 743 basis adjustment of a transferor. We believe this result is inconsistent with both the statutory language and the existing section 743 regulations.
5.2. We believe that the Proposed Regulations prevent a basis shift only in situations where two factors are present: (i) the transferee's basis in its interest is equal to the transferor's basis in its interest and (ii) the transferor's outside basis in its interest is equal to the sum of the transferor's share of the inside basis of partnership assets and the transferor's section 743 adjustment. There are several common situations in which one or both of these factors will not apply and a substituted basis transaction will often result in a basis shift. As a result, instances remain in which a partner might effectively elect out of the basis adjustment rules of Regulation section 1.755-1(b)(2) through (4) and into the substituted basis adjustment rules of Regulation section 1.755-1(b)(5).
5.3. The Proposed Regulations indicate that a positive basis adjustment for a transferee-partner is recovered as if it were newly placed in service property. This restart of the depreciable life appears inconsistent with the underlying theory of the Proposed Regulations in that the Proposed Regulations effectively treat a transferor's section 743(b) basis adjustment as common inside basis for both the transferor and the transferee. If final regulations retain the rule set forth in Proposed Regulation section 1.743-1(f)(2), we believe the substantive language of the Proposed Regulations should be amended to make it clear that the transferee does not succeed to the remaining depreciable life associated with the basis adjustment.
5.4. The application of Proposed Regulation section 1.743-1(f)(2) should be clarified with respect to tiered partnerships. Specifically, the Proposed Regulations should clarify as to whether an interest in a lower-tier partnership is also treated as having been transferred in a substituted basis transaction when an interest in the upper-tier partnership is transferred in a substituted basis transaction.
5.5. In light of the questions raised herein regarding the authority for Proposed Regulation section 1.7431(f)(2) and the continued ability to avoid the electivity that Proposed Regulation section 1.743-1(f)(2) appears to target, we recommend that Treasury and the Service consider withdrawing Proposed Regulation 1.743-1(f)(2). If Proposed Regulation section 1.743-1(f)(2) is finalized, we recommend that Proposed Regulation section 1.743-1(f)(2) be modified so as to address the comments herein.
6. Section 704(c): Layering Versus Netting
6.1. We recommend that a partnership be permitted to use the netting approach where the parties agree to do so and the adoption of netting does not violate Regulation section 1.704-3(a)(10).
6.2. If the immediately prior recommendation is not adopted, we recommend that a partnership be permitted to use the netting approach where the gross value of the partnership's assets is less than $20 million, adjusted for inflation, as of the date of any revaluation event.
6.3. We recommend that final regulations provide a grandfather rule that allows an existing partnership to continue using the netting approach if it has adopted a netting approach prior to the adoption of final regulations.
6.4. We request that final regulations provide guidance on how to determine when a method is a "reasonable method" in addressing the existence of multiple layers for a single asset.
6.5. We recommend that final regulations provide that the disparity offset method, described below, is a permissible and reasonable section 704(c) method to account for revaluation layers. ■
1 References to a "section" are to a section of the Internal Revenue Code of 1986, as amended (the "Code"), unless otherwise indicated.
2 REG-144468-05, 79 Fed. Reg. 3042 (2014), revised by 79 Fed. Reg. 21163 (2014).