Tax Flotsam of Partnership Mergers and Divisions

On the left side of the table, “book” refers to the partnership’s “book basis” in its assets and “tax” refers to the partnership’s inside tax basis in such assets. On the right side of the table, “book” refers to the partner’s section 704(b) book capital account and “tax” refers to the partner’s tax capital account.

B. Roosevelt LLC

Theodore and Franklin are equal one-half partners in Roosevelt LLC, a tax partnership that operates an ongoing business. Roosevelt LLC has the following financial situation:

III. Federal Income Tax Forms of Partnership Mergers and Divisions

A. Merger

1. In General

Neither the Code nor the regulations define a partnership merger. The statutory law on partnership mergers is limited to the language of section 708(b)(2)(A)—providing that if two or more partnerships merge or consolidate into a single partnership, the resulting partnership is treated as a continuation of any merging partnership whose members own more than 50% of the capital and profits of the resulting partnership. The Treasury issued final regulations on the tax consequences of mergers under section 708 in 2001, but the Service and Treasury did not include a comprehensive definition of a partnership merger in those regulations. In rulings, however, the Service has treated the partnership merger rules as widely applicable to any transaction in which two or more tax partnerships combine into one tax partnership.

Partnership mergers may take many forms for state law purposes, but only two forms of merger exist for federal tax purposes: the assets-up form and the assets-over form. In general, any form of transaction not following the assets-up form will be characterized as an assets-over merger for federal income tax purposes. Thus, a state law merger structured as an interests-over transaction will be re-characterized for federal income tax purposes as an assets-over merger. The tax law will also control which of the merging state law partnerships will continue for federal income tax purposes. Thus, the entity that remains for state law purposes may not be the surviving entity for federal income tax purposes. In short, the two forms recognized for federal income tax purposes may achieve identical non-tax goals, but nevertheless result in very different federal tax consequences.

2. Assets-Up Merger

In an assets-up merger of partnerships, the terminating partnership distributes all its assets to its partners in liquidation of their interests. The partners in the terminating partnership must become the owners of the distributed assets under state law, but this ownership is merely transitory. Immediately after the distribution, the partners contribute the assets to the resulting partnership in exchange for interests in the resulting partnership.

When the assets are distributed to the partners of the terminating partnership, the partners take an aggregate basis in the assets equal to their respective “outside basis,” which is each partner’s basis in their partnership interest. When the partners contribute the assets to the resulting partnership, the resulting partnership takes a carry-over basis in each asset equal to the basis of each asset in the hands of the partner at the time of the contribution. The following diagrams provide a visual presentation of the assets-up merger.

3. Assets-Over Merger

As discussed above, any partnership merger that does not follow an assets-up form will be treated as an assets-over merger. Since the assets-over form is the default form, the assets-up form must be executed in exactly the correct fashion to be respected. In the assets-over form, the terminating partnership contributes all its assets and liabilities to the resulting partnership in exchange for an interest in the resulting partnership. The terminating partnership then liquidates and distributes its interest in the resulting partnership to its partners.

When the terminating partnership contributes its assets to the resulting partnership, the resulting partnership takes a basis in the assets equal to the terminating partnership’s “inside basis” in each asset. When the terminating partnership distributes its interest in the resulting partnership to its partners, the partners’ bases in the interest will generally be the same as their respective bases in their interests in the terminating partnership. Simply put, the partners’ bases in the terminating partnership interests will carry over to their bases in the resulting partnership interests. The following diagrams provide a visual presentation of the assets-over merger.

4. Interests-Over Merger (Re-Characterized as Assets-Over)

In an interests-over merger, the terminating partnership’s partners contribute their interests in the terminating partnership to the resulting partnership in exchange for interests in the resulting partnership. Regardless of whether the terminating partnership dissolves for state-law purposes, it will be deemed to terminate for tax purposes (because it is wholly owned by the resulting partnership), causing its assets to be reflected on the resulting partnership’s tax return.

The merger regulations do not recognize this form and will instead re-characterize it for tax purposes as an assets-over merger. Despite the lack of federal tax recognition for this form, it may result in tax and other benefits at the state level. For instance, the parties may prefer this form to obviate the need to re-title ownership of the terminating partnership’s property and file new deeds. In some jurisdictions, transferring LLC interests instead of deeds could also avoid or mitigate real property transfer tax liabilities. The following diagrams provide a visual presentation of the interests-over merger.

B. Division

1. In General

Like partnership mergers, neither the Code nor the regulations define a partnership division for tax purposes. But most commentators and practitioners conclude that a partnership division occurs when a transaction causes one partnership to split into two or more resulting partnerships. Section 708(b)(2)(B) provides that, in the case of a division of a partnership into two or more partnerships, any resulting partnership whose members had an interest of more than 50% in the capital and profits of the original partnership is deemed to be a continuation of the resulting partnership. Any other resulting partnership is a new partnership for federal income tax purposes.

Partnership divisions generally take the same forms as partnership mergers for state law purposes, and like mergers, there are only two forms of partnership divisions for federal income tax purposes. The variations depend on whether the prior partnership continues or terminates. Outside of the application of special anti-abuse rules, partnership divisions follow the same rules as partnership mergers and give rise to the same general tax consequences. Therefore, as with partnership mergers, the assets-up form must be executed in precise accordance with the Treasury Regulations to be respected. Otherwise, the default assets-over form prevails.

Understanding partnership divisions requires an understanding of the special vocabulary used in the Regulations. Under the Regulations, the “prior partnership” is the state law entity that exists before the division. The “resulting partnership” is any state law entity that results from, and exists after, the division and that has at least two partners who were partners in the prior partnership. The “divided partnership” is the partnership that is treated as transferring its assets and liabilities to the recipient partnership for federal income tax purposes. Finally, the “recipient partnership” is any partnership that is treated as receiving assets or liabilities or both from the divided partnership for federal income tax purposes.

2. Assets-Up Division

In an assets-up division, an existing partnership distributes some or all assets—and possibly liabilities—to some or all its partners, who then contribute the assets and liabilities to a new partnership. The partners receiving distributed assets must be the owners of the distributed assets for state law purposes once the distribution is made. Immediately after the distribution is made, the partners contribute the assets to one or more other partnerships in exchange for partnership interests.

If the prior partnership continues pursuant to section 708(b)(2)(B) (i.e., if at least one of the resulting partnerships is a continuation of the prior partnership), then it will be treated as a “divided partnership,” and one or more resulting partnerships will be treated as “recipient partnerships” which are “continuations” of the prior partnership. If no resulting partnership is treated as a continuation of the prior partnership, then all of the resulting partnerships will be treated as newly formed partnerships, and for federal income tax purposes, the prior partnership will liquidate and distribute its assets and liabilities to its partners in complete liquidation of the partners’ interests.

The assets-up form must be executed in exactly the correct fashion to be respected. If so, the partners’ outside bases in their prior partnership interests will be preserved, and the prior partnership’s inside basis will be lost. The following diagrams provide a visual presentation of the assets-up division.

3. Assets-Over Division

As with assets-over partnership mergers, assets-over partnership divisions are the default form. If the division does not follow the assets-up form, the assets-over form will control.

In an assets-over division, the prior partnership is treated as contributing assets and liabilities to two or more new resulting partnerships in exchange for interests in those resulting partnerships. Immediately thereafter, the prior partnership liquidates and distributes its interests in the resulting partnerships to its partners.

If the prior partnership continues pursuant to section 708(b)(2)(B) (i.e., if at least one of the resulting partnerships is a continuation of the prior partnership), then it will be treated as a “divided partnership,” and one or more resulting partnerships will be treated as “recipient partnerships” which are “continuations” of the prior partnership. If no resulting partnership is treated as a continuation of the prior partnership, then all the resulting partnerships will be treated as newly formed partnerships, and for federal income tax purposes the prior partnership will liquidate and distribute its assets and liabilities to its partners in complete liquidation of the partners’ interests.

In general, an assets-over division preserves the prior partnership’s inside basis, and therefore, the partners’ outside basis is lost. The following diagrams provide a visual presentation of the assets-over division.

4. Interests-Over Division (Re-Characterized as Assets-Over)

In an interests-over division, the prior partnership’s partners would contribute their interests in the prior partnership to one or more resulting partnerships in exchange for interests in the resulting partnership(s). Similar to interests-over mergers, the Regulations do not recognize this form and will instead re-characterize the transaction for tax purposes as an assets-over division. Taxpayers generally do not elect to use the interest-over form for divisions because, unlike the interest-over merger, the prior partnership generally does not become disregarded, and thus its assets must be re-titled before they can be reflected on the resulting partnership’s tax return. Thus, with an interest-over division, taxpayers may not be able to avoid transaction costs at the state and local level, thereby eliminating the common reason for using the interests-over form in merger transactions. The following diagrams provide a visual presentation of the interests-over division.

IV. General Rules of Partnership Mergers

A. Continuation and Termination

To determine the tax consequences of a partnership merger, practitioners must first undertake an analysis to determine which partnership is deemed to continue and which partnerships are deemed terminated. Under section 708(b)(2)(A), if two or more partnerships merge or consolidate into a single partnership, the resulting partnership is treated as a continuation of the partnership whose members own more than 50% of the capital and profits of the resulting partnership. All other partnerships terminate. If the partners of more than one partnership own more than 50% of the capital and profits of the resulting partnership, the partnership contributing the assets with the highest net value will be deemed the continuing partnership, and all other partnerships terminate. If no merging partnership’s partners own more than 50% of the capital and profits of the resulting partnership, then all of the merging partnerships terminate and a new partnership results.

To illustrate, assume Kennedy LLC and Roosevelt LLC merge to form a single resulting partnership. The resulting partnership will be treated as a continuation of Kennedy LLC because its members will own two-thirds of the capital interests in the resulting partnership. Roosevelt LLC, in turn, will terminate as of the date of the merger and will file a final tax return for the taxable year ending on the termination date.

B. Impact of Boot

Generally, mergers are treated as a series of contributions to, and distributions from, the merging partnerships, so the rules of sections 721 and 731 apply, and the merger transaction is generally tax-free. But if the partners receive both partnership interests and other consideration in the merger transactions, the other consideration is treated as taxable “boot.” For example, if an acquiring partnership includes boot as part of the consideration furnished to a target partnership, the boot will generally be taxable and the precise tax consequences will depend on the nature of the boot.

Boot in a partnership reorganization generally arises in one of three forms: cash, “hot assets,” or a net reduction in share of liabilities. In each case, the target partnership’s receipt of boot will generally result in gain recognition for the target partners, although a partner’s outside basis may be sufficient to offset the tax consequences in some cases, such as reduction of liability shares. Moreover, in certain instances, the receipt of boot may give rise to a disguised sale under section 707 if a target partner had made a transfer described in section 707(a)(2)(B)(i) within the previous two years. In this scenario, the boot could end up being taxed twice.

C. “Sale-Within-a-Merger” Rule

In partnership merger transactions, it is common for one or more partners to want to “cash-out,” while other partners desire to continue their investment in the resulting merged partnership. To this end, Regulation section 1.708-1(c)(4) (the “sale-within-a-merger rule”) provides a special rule applicable to partners in terminating partnerships who want to sell their partnership interests to the resulting partnership as part of the merger transaction. The selling partners treat the receipt of boot consideration as a sale of their partnership interests, while the remainder of the transaction is treated as a non-recognition transaction pursuant to the general merger rules.

The sale-within-a-merger rule has several special requirements pursuant to the section 708 regulations. First, the sale-within-a-merger rule is only available when the merger is structured as an assets-over merger. This is presumably because of both the administrative inconvenience and the potential for abuse that could arise if the sale-within-a-merger rule were used in an assets-up merger. Second, the transaction must be referenced in the merger agreement or another document as a sale of a partnership interests, and the reference must quantify the consideration exchanged for the partnership interests sold. Finally, the selling partner or partners must consent to treat the transaction as a sale of partnership interests for tax purposes. Provided the requirements of the sale-within-a-merger rule are met, the tax treatment for the selling partners is governed by section 741 and the corresponding regulations. The remainder of the transaction will be treated as an assets-over merger.

D. State Law Issues and Impact on Tax Elections

Partnership mergers and divisions have a unique potential for both advantageous structuring and outright abuse because the tax law and state law forms of the merger may be mixed and matched in several combinations. For example, if the Kennedy Partnership and Roosevelt Partnership merge, the transaction may take any one of three possible state law forms: (1) a state law merger or consolidation; (2) a sale of all or substantially all of one partnership’s assets to the other (an “asset sale”), or (3) the contribution by one partnership’s partners of all of their interests in the partnership to the second partnership in exchange for interests in the latter (an “interests-over merger”). In all three state law forms, either partnership can survive for state law purposes, creating six possible state law structures.

If the partnership tax rules followed the state law form of merger, taxpayers could use different state law transactional structures to manipulate the tax outcomes of the merger. These tax outcomes would include the fate of tax attributes, tax elections, tax years, and tax identification numbers. For instance, either partnership could artificially end its tax year, “undo” an irrevocable election, shop its tax attributes, or change its tax identification number by merging into the other partnership and stipulating that the other partnership will survive for state law purposes.

The federal tax rules prevent this type of abuse by separating the concept of the tax partnership from the state law partnership. For state law purposes, the regulations describe two “merging or consolidating” partnerships combining to form a “resulting partnership.” For tax law purposes, the regulations describe one or more “terminating partnerships” combining to form a “continuing partnership,” although the regulations acknowledge the possibility that no partnership continues for tax purposes. Regardless of state law form, the terminating partnerships (as determined under section 708) cannot continue their tax years or their tax identification numbers, and the rules of section 706 will apply for winding up the terminating partnerships’ affairs. Thus, the elections of the partnership treated as continuing remain in place, whereas the terminating partnerships’ elections do not.

E. Tax Reporting

In both partnership mergers and divisions, the regulations mandate all resulting partnerships attach statements to IRS Form 1065. For a merger, the continuing partnership reports the details of the transaction, the identifying information of the partnerships involved, and the status of distributive shares of each involved partner both before and after the merger. For a division, the divided partnership reports the most extensive details of the transaction, including identifying information for all the resulting partnerships and the distributive shares of each partner prior to and immediately after the division. Continuing partnerships that are not the divided partnership must list the prior partnership’s identifying information, and non-continuing partnerships do not have to list specific division information at all.

The regulations’ approach to division reporting is probably too scant to allow reviewers enough information to select a return for audit. The basis and fair market value of assets, the nature and amount of liabilities, the details about partnership activities, and governance information are not included in the reporting requirements, leaving Service personnel to guess whether some of the issues we identify in this article are worth examination. The Service should consider revising the regulations to make reporting more robust, as it does with corporate reorganizations.

V. General Rules of Partnership Divisions

A. Continuation and Termination

In a partnership division, continuation and termination become more nuanced issues, and a new partnership could result from the divided partnership. Under the regulations, any resulting partnership whose members had an interest of more than 50% in the capital and profits of the original partnership is deemed to be a continuation of the original partnership. Any other resulting partnership is treated as a new partnership. If none of the resulting partnerships’ partners owned an aggregate of at least 50% of the prior partnership, then the prior partnership is deemed terminated.

Even though multiple resulting partnerships can be a continuation of the divided partnership, there can only be one divided partnership. Notably, the divided partnership may not be the prior partnership and may not even exist for state law purposes prior to the division transaction. This result could happen if, as a result of the division, the members of the prior partnership had less than a 50% interest in the prior partnership before the division. In that situation, the divided partnership may be a newly formed state law entity that is deemed, for federal income tax purposes, to contribute assets to the prior partnership and then distribute the interests in the prior partnership to the members of the prior partnership. Thus, the state-law treatment and federal income tax treatment of a division can diverge with counterintuitive results, making visual aids such as transaction diagrams essential in understanding the full scope of consequences arising from reorganizations.

B. State Law Issues and Impact on Tax Elections

Partnership divisions can take on multiple state law forms. For example, assume Kennedy LLC plans to divide into three resulting partnerships (JTR, JR, and RT). John, Ted, and Robert will each own an interest in the resulting JTR partnership, while John and Robert will own all the interests in the JR partnership and Robert and Ted will own all the interests in the RT partnership. In this scenario, the division could take on the following state law forms:

• Form 1: Kennedy LLC (1) retains the JTR assets, (2) transfers the JR assets to the JR partnership in exchange for interests therein and then transfers those interests to John and Robert, and (3) transfers the RT assets to the RT partnership in exchange for interests therein and then transfers those interests to Robert and Ted.
• Form 2: Kennedy LLC (1) retains the JR assets, (2) transfers the JTR assets to the JTR partnership in exchange for interests therein and then transfers those interests to John, Ted, and Robert, and (3) transfers the RT assets to the RT partnership in exchange for interests therein and then transfers those interests to Robert and Ted.
• Form 3: Kennedy LLC (1) retains the RT assets, (2) transfers the JTR assets to the JTR partnership in exchange for interests therein and then transfers those interests to John, Ted, and Robert, and (3) transfers the JR assets to the JR partnership in exchange for interests therein and then transfers those interests to John and Robert.

Absent special rules, Kennedy LLC could use the division transaction to artificially manipulate its tax year and end irrevocable elections. To prevent this, the regulations are designed to ensure that regardless of the state law form of a division, there is limited opportunity for abuse. Recall that the partnership division regulations use defined terms to describe how the state law form interacts with the federal tax law form. Under the regulations, the partnership that exists prior to the division for state law purposes—referred to as the “prior partnership”—divides into “resulting partnerships” (i.e., the partnerships that exist after the division) for state law purposes. As noted above, for federal income tax purposes, there is a single “divided partnership,” which is treated for tax purposes as transferring assets and liabilities to the “recipient partnerships.” The recipient partnerships, in turn, are treated for tax purposes as receiving assets and liabilities from the divided partnership.

The divided partnership is determined pursuant to the following rules:

• If the resulting partnership that, in form, transferred assets and/or liabilities in the division is a continuation of the prior partnership, then that partnership is the divided partnership.
• If the resulting partnership that, in form, transferred assets and/or liabilities in the division is not a continuation of the prior partnership, and only one resulting partnership is a continuation of the prior partnership, then that resulting partnership is the divided partnership.
• If the division does not take the assets-up form or the assets-over form, or if the resulting partnership that, in form, transferred assets and/or liabilities in the division is not a continuation of the prior partnership, and more than one resulting partnership is a continuation of the prior partnership, then the resulting partnership with the greatest net asset value is treated as the divided partnership.

The divided partnership—as determined under the rules above—succeeds to the prior partnership’s EIN and continues the prior partnership’s taxable year. The other resulting partnerships start new taxable years as of the day after the division and acquire new EINs. The goal of the “divided partnership” designation is to ensure that the partnership most closely resembling the prior partnership succeeds to the prior partnership’s taxable year and EIN, thus mitigating the potential for abuse. The resulting partnerships that are continuing partnerships succeed to the prior partnership’s tax elections. Any subsequent elections made by one of the resulting partnerships will not affect the other resulting partnerships.

VI. Tax Flotsam

A. Section 1223: Holding Periods

An asset’s holding period determines whether the sale of that asset results in long-term or short-term gain or loss. If the holding period is one year or more, gain or loss is considered long-term. Long-term capital gains receive favorable treatment under the tax law in the form of lower marginal tax rates. With respect to gains only, an individual taxpayer and a pass-through entity will generally always prefer long-term capital gain treatment over ordinary gain treatment.

In general, nonrecognition transactions that result in a transferred or exchanged tax basis will correspondingly result in a “tacked,” or continued, holding period. For example, if a partner contributes long-term capital gain property to a partnership in a section 721 transaction, the contributing partner tacks the holding period of the contributed property to the holding period of partnership interest received. Likewise, the partnership is entitled to tack the contributing partner’s holding period to its own. On the other hand, transactions in which gain or loss are recognized will result in a corresponding change in tax basis and will restart the holding period in the hands of the transferee. Finally, when a partnership distributes an asset to a partner, the partner succeeds to the partnership’s holding period in the asset itself, although there is some question as to the effect of the partner’s holding period in the partnership interest.

If a contributing partner in a section 721 transaction contributes assets with both short-term and long-term holding periods, the partner’s holding period in the partnership interest received is split accordingly. The same principles apply when portions of a partnership interest are acquired at different times. The holding period ratio is determined by the aggregate proportions of the fair market value of each type of asset to the total fair market value of the assets contributed.

In a partnership merger, the partners of the terminating partnership will succeed to the aggregate holding period of each of the terminating partnership’s assets and lose the holding period of their respective partnership interests. In an assets-over merger, the terminating partnership’s contribution of its assets to the continuing partnership will result in a holding period that corresponds to the aggregate holding period of the terminating partnership’s assets in accordance with sections 721(a) and 1223. In an assets-up merger, the terminating partnership’s distribution of assets to its partners will be governed by section 735(b). For example, if the Roosevelt Partnership merges with the Kennedy Partnership by following the assets-up form, Theodore and Franklin’s subsequent contribution of the distributed Roosevelt assets to the Kennedy Partnership will be governed by sections 721(a) and 1223.

As a result, the holding period consequences of both forms of merger are identical. The holding period of Theodore’s and Franklin’s interests in the resulting Kennedy LLC partnership will be determined by reference to Roosevelt LLC’s aggregate holding period in its assets immediately before the merger. In short, Theodore and Franklin’s “outside” holding periods in their Roosevelt LLC interests may change upon the merger with Kennedy LLC to reflect Roosevelt LLC’s “inside” holding period in its assets.

Partnership divisions, on the other hand, enjoy some level of flexibility in planning that can affect a partner’s or partnership’s holding period. Assume that Kennedy LLC has a long-term holding period in Ranch and Riverside, and a short-term holding period in Pasture and Valley. Assume John and Ted have long-term holding periods in their Kennedy LLC interests, while Robert has a short-term holding period. Finally, assume that the members of Kennedy LLC wish to divide the partnership into two resulting partnerships, one owning Ranch and Riverside (“RR LLC”) and the other owning Pasture and Valley (“PV LLC”). Because John, Robert, and Ted will hold interests in each resulting partnership, each resulting partnerships will be deemed a continuation of Kennedy LLC. As a result, the divided partnership under the division rules will be the partnership transferring assets under the assets-over form.

Thus, if Kennedy LLC in form transfers Ranch and Riverside to RR LLC, then PV LLC will be treated as the divided partnership. The partners’ interests in RR LLC will have a long-term holding period in accordance with the long-term holding period of the Ranch and Riverside properties, and the partners’ interests in PV LLC will have the same holding periods as their original interests in Kennedy LLC.

On the other hand, if Kennedy LLC in form transfers Pasture and Valley to PV LLC, then RR LLC will be treated as the divided partnership. The partners’ interests in PV LLC will have short-term holding periods in accordance with the short-term holding period of the Pasture and Valley properties, and the partners’ interest in RR LLC will have the same holding periods as their original interests in Kennedy LLC. For John and Ted, this distinction is important because they would lose, in part, the long-term holding periods they had in their partnership interests before the division transaction. The distinction is important for Robert as well. Under the first alternative, in which Ranch and Riverside are transferred to RR LLC, Robert’s partnership interest in PV LLC is short-term, and his interest in RR LLC will be long-term. Thus, under the first alternative, Robert would effectively have more long-term interests than before the division and more long-term interests than he would have under the second alternative.

The holding period consequences of partnership divisions are analogous to the basis consequences of both partnership mergers and partnership divisions. Without proper planning, partnership divisions can be structured such that partners may change long-term holding periods to short-term holding periods or vice versa, which may prove a significant issue depending on subsequent events.

B. Section 704(c) and the Mixing-Bowl Rules

1. In General

The section 704 regulations require partnerships to “book” contributed property into the contributing partner’s capital account at current fair market value. On the other hand, the contributor’s tax basis in the property at the time of contribution is generally transferred to the partnership and reflected in the contributor’s basis in its partnership interest. This creates a disparity between the book value and tax basis of the property for both the partnership and the partner, and occurs because the capital account rules effectively allocate the book gain or loss in the property before the partnership recognizes the tax gain or loss. Consequently, there is a “built-in” gain or loss in the contributed property, and section 704(c) prescribes the rules for the partnership’s allocation of tax items derived from this so-called “704(c) property.”

The section 704(c) rules are designed to prevent partners from shifting the tax consequences of section 704(c) property among the partners. In effect, the rules attempt to mandate that the allocation of tax items attributable to the property follow the allocation of book items that occurred upon contribution, albeit on a deferred basis. The regulations under section 704(c) permit partnerships to use any “reasonable method” for allocating tax items to prevent the shifting of tax consequences among the partners for property with a built-in gain or loss. The regulations also mandate two foundational section 704(c) principles. First, the partnership must allocate cost recovery deductions from section 704(c) property to a noncontributing partner equal to the book basis derivative items to avoid creating a book-tax disparity in the noncontributing partner’s capital account. Second, when the partnership recognizes the built-in gain or loss with respect to section 704(c) property, such built-in gain or loss must be allocated to the contributing partner because the contributing partner was allocated the corresponding book items at the time of contribution.

Absent these special rules, partners could use the partnership as a conduit to manipulate tax outcomes in their favor. Using Kennedy LLC as an example, assume that instead of purchasing Ranch for $600,000—resulting in the $600,000 book and tax basis shown in the balance sheet above—John had instead contributed Ranch when its tax basis was $200,000 and its fair market value was $600,000. Kennedy LLC would have “booked” the Ranch property into John’s capital account at $600,000. John’s “built-in” (or section 704(c)) gain would be $400,000, and all of the partnership’s tax items with respect to Ranch will need to consider John’s section 704(c) gain. This means that if the partnership were to sell Ranch for $600,000, all $400,000 of recognized tax gain would be allocated to John and would follow the book allocation in his capital account. Otherwise, an effective tax shift would occur in which a portion of the gain accruing under John’s ownership would be taxed to Robert and Ted. Subchapter K rightfully considers such a shift abusive, and section 704(c) is designed to prevent these types of shifts.

Even when a partnership does not recognize any tax items related to section 704(c) property, the contributing partner may nevertheless recognize section 704(c) gain under the so-called “mixing bowl” rules. Under section 704(c)(1)(B), if section 704(c) property is distributed to a non-contributing partner within seven years of contribution, the contributing partner must recognize section 704(c) gain or loss in the amount and character that would have been allocated to the contributing partner if the property had been sold for FMV on the date of distribution. Otherwise, the contributing partner would have effectively transferred the built-in gain or loss to the distributee partner without a corresponding adverse tax consequence, which potentially gives rise to an abusive outcome. Section 737 functions in a similar manner to section 704(c)(1)(B), but instead triggers gain (but not loss) to a contributing partner if, within seven years of a contribution, the contributing partner receives a distribution of property other than the property the partner contributed, which is treated as exchanging one asset for the other using the partnership as a go-between.

2. Repairing Mismatches of Book and Tax Consequences Upon Applying Section 704(c)

Allocations of book items for certain contributed property can distort tax consequences upon a subsequent disposition of the property. The distortion typically occurs when changes in the fair market value of the contributed property have erased the built-in gain or loss allocable to the contributing partner. As a result of the distortion, the non-contributing partners do not enjoy the benefit of tax items to reflect the economic realities associated with the contributed property.

Reconsider the example from above wherein John had contributed Ranch to Kennedy LLC when its tax basis was $200,000 and its fair market value was $600,000. Assume Ranch decreases in fair market value from $600,000 to $420,000 before Kennedy LLC sells the property. How the partnership accounts for the tax consequences to all three partners is a matter of choice. The regulations provide three methods: the traditional method, the traditional method with curative allocations, and the remedial method. While all three methods prescribed by the regulations are available to account for tax items arising from section 704(c) property, the choice of method may result in different tax treatment for the contributing and non-contributing partners, so the choice of section 704(c) method is often a subject of negotiation when crafting governing agreements for tax partnerships.

a. The Traditional Method. If the partnership elects to use the traditional method, the book-tax disparity for the contributed asset will generally remain until disposition. Returning to the example above, upon the sale of Ranch for $420,000, John is allocated all $220,000 of tax gain in accordance with section 704(c). Ted and Robert, however, are each allocated a book loss of $60,000 for which they receive no corresponding tax item. The discrepancy between Ted and Robert’s book consequences and tax consequences illustrates an example of the “ceiling rule,” which provides that the tax items allocated to the partners cannot exceed the partnership’s tax items with respect to the property. The ceiling rule applies to all tax items derived from the property, not just gain and loss. Depreciation and amortization will be allocated only to the extent the partnership takes those items into account.

The result is that the distortions arising from the application of the ceiling rule and the use of the traditional method generally disfavor the non-contributing partners, and tax advisors representing non-contributing partners typically negotiate to use an alternative method for determining section 704(c) consequences.

b. The Traditional Method with Curative Allocations. If the partnership elects to use the traditional method with curative allocations to account for section 704(c) items, the partnership may cure ceiling rule distortions by reallocating tax items of a similar character that arise from partnership assets other than the contributed property. Continuing with the Kennedy LLC example, assume that after Ranch is sold for $420,000, Kennedy LLC sells Pasture when the property’s FMV has decreased to $840,000. The sale of Pasture results in a $360,000 book and tax loss. Generally, such book and tax loss would be allocated evenly among each of Kennedy LLC’s three partners. Under the traditional method with curative allocations, however, the $360,000 book loss is allocated equally among the partners, but the tax loss is disproportionately allocated to Ted and Robert to “cure” their book/tax mismatch that arose from the sale of Ranch. That is, since Ted and Robert are “owed” $60,000 each in tax losses on the sale of Ranch to match their book loss, the partnership would allocate its $360,000 of tax losses on Pasture equally to Ted and Robert to cure the ceiling rule disparity caused by the sale of Ranch. As with allocations under the traditional method, curative allocations are not limited merely to gains and losses; partnerships may also make curative allocations of items of deduction and credit, including depreciation.

The traditional method with curative allocations is designed to resolve the book/tax mismatch caused by the ceiling rule organically, but the non-contributing partners cannot be assured of when (or even if) the curative tax items may arise. By contrast, because the remedial method (discussed below) arguably favors the noncontributing partner and disfavors the contributing partner, in such situations the traditional method with curative allocations may represent a compromise between the contributing partner and the non-contributing partner(s) when negotiating a tax partnership’s governing agreement. The partners should, however, carefully consider which method will be most favorable to them in any partnership they consider joining. For instance, if curative allocations are available, the noncontributing partners may be able to obtain greater allocations related to depreciation under the traditional method with curative allocations than they would under the remedial method. For this reason, some partners prefer to consider the appropriate method on a case-by-case basis.

c. The Remedial Method. If the partnership elects to use the remedial method to account for section 704(c) items, the partnership creates remedial (or notional) tax items to avoid ceiling rule distortions. Revisiting the example of Kennedy LLC’s sale of Ranch for $420,000, Kennedy LLC would resolve the resulting book-tax disparity by allocating notional tax loss of $60,000 to Ted and Robert to match their book loss. Because the partnership has created a $120,000 tax loss that does not correspond to any actual economic event, the partnership must also create a $120,000 tax gain to ensure the remedial allocations are tax-neutral to the entire partnership. Thus, John (the partner who contributed Ranch) is allocated $120,000 of tax gain.

The remedial method favors the non-contributing partners because the method immediately resolves the book/tax disparities caused by the ceiling rule. The non-contributing partners do not experience the uncertainty of waiting for curative allocations that may never come, and they do not suffer the time-value of money consequences when curative items arrive in a different taxable year. On the other hand, the remedial method disfavors the contributing partner because it often results in more allocated taxable income to the contributing partner than the other methods. Accordingly, attorneys representing contributing partners typically negotiate against choosing the remedial method in a partnership’s governing agreement.

3. The Anti-Circumvention Rules Under Section 737

The section 704(c) rules left room for taxpayer circumvention, even when combined with the rules under section 707 governing disguised sales. Reconsider the example from above wherein John had contributed Ranch to Kennedy LLC when its tax basis was $200,000 and its fair market value was $600,000. Three years after John contributed Ranch to Kennedy LLC, the partnership distributes nonmarketable stock to John. The nonmarketable stock has a FMV of $600,000 and a tax basis of $400,000. Assume John’s outside basis in his partnership interest is $450,000 at the time of the distribution. Under section 731, John does not recognize gain upon distribution of the property, and John succeeds to the partnership’s basis in the stock pursuant to section 732(a)(1). Under section 707, John is presumed not to have made a sale or exchange of Ranch. Under section 704(c), John does not recognize his pre-contribution gain because Ranch has had no items of income, gain, loss, or deduction from the distribution of the nonmarketable stock. Instead, John has effectively exchanged a low-basis asset for higher-basis assets without any recognition of gain.

Section 737 is designed to prevent the type of circumvention described above. It triggers gain (but not loss) to a contributing partner if, within seven years of a contribution, the contributing partner receives a distribution of property other than the contributed property. When applicable, the contributing partner must recognize gain equal to the lesser of (1) the excess distribution (i.e., the excess of the property’s fair market value over the partner’s outside basis), or (2) the partner’s net pre-contribution gain. Upon the application of section 737 to John’s effective exchange of property, John will recognize gain equal to the lesser of: (1) the excess distribution of $150,000, or (2) his net pre-contribution gain of $400,000.

4. “Reverse” Section 704(c) Consequences

The principles of section 704(c) also apply when property is revalued under Regulation section 1.704-1(b)(2)(iv)(f)—commonly referred to as partnership revaluation or “book-up.” Under Regulation section 1.704-1(b)(2)(iv)(f), partnerships may, upon the occurrence of certain events, increase or decrease the capital accounts of the partners to reflect a revaluation of the partnership’s assets. The result is a book-up of appreciated assets and a book-down of depreciated assets. The most common events where a partnerships may complete elective revaluations are (1) a contribution to the partnership in exchange for an interest in the partnership, or (2) a distribution of money or other property to a partner as consideration for an interest in the partnership (i.e., a partial or complete redemption). Partnerships are required to revalue or book-up distributed property pursuant to Regulation section 1.704-1(b)(2)(iv)(e)(1). Whether elective or mandatory, the adjustments to the partnership capital accounts are allocations of book income or loss and those allocations must reflect the manner in which the partners would have shared those items in a taxable disposition and the principles of section 704(c) should apply any time a partnership completes a book-up or book-down.

5. Section 704(c)(1)(C)—Treatment of Built-in Losses

Section 704(c)(1)(C) applies specifically to property contributed with a built-in loss. The additional rules under section 704(c)(1)(C) apply because, unlike the section 704(c) allocations attributable to pre-contribution gains, the section 704(c) allocations attributable to pre-contribution losses may change over time; furthermore, built-in loss property provides a unique opportunity for tax item trafficking.

Treasury promulgated Proposed Regulations to govern the mechanics of section 704(c)(1)(C). The general theme of the Proposed Regulations is to carry out this section’s intent of isolating all tax items of built-in loss property to the contributing partner. This is a more difficult endeavor than accomplishing the same goal with built-in gain property because, by default, property contributed to a partnership has a carry-over basis equal to its basis in the hands of the contributing partner. Therefore, even though section 704(c)(1)(B) and section 737 will allocate pre-contribution loss to the contributing partner when a distribution or disposition occurs, those provisions will not cure the discrepancies arising while the partnership holds the contributed property. Unlike property with pre-contribution gain, built-in loss property may distort tax consequences even without a distribution or disposition ever occurring.

Section 704(c)(1)(C) is designed to deter this kind of abuse. Section 704(c)(1)(C) and the Proposed Regulations provide that built-in loss property will have a special basis in the hands of the contributing partner. The special basis will initially be equal to the basis in the hands of the contributing partner before contribution, but the special basis will be adjusted depending on subsequent events. The events that may change the special basis are depreciation, amortization, or the transfer of the contributing partner’s partnership interest in a non-recognition transaction. Each of these events will change the basis of the built-in loss property in the hands of the partnership. To the extent the basis “wipes out” the pre-contribution loss, the contributing partner’s special basis will decrease accordingly. This rule makes sense because any adjustments to basis occurring while the partnership owns the property should result in attendant consequences to all of the partners and not just one.

6. Section 704(c)(2) and the Exception for Like-Kind Distributions

An exception to the mixing-bowl rules exists when a partnership makes companion distributions of like-kind property in a similar fashion to a section 1031 exchange. Under section 704(c)(2), if a partnership makes a distribution of section 704(c) property to a non-contributing partner but follows such a distribution with a second distribution of like-kind property to the contributing partner within a specified time frame, then the normal consequences prescribed by section 704(c) and section 737 will be ignored. When planning such distributions, one must still be wary of how the transactions will be treated under the remainder of subchapter K, with particular regard for consequences under section 707.

7. Section 704(c) in the Partnership Merger and Division Context

Section 704(c) is well known for its complexity. Its application becomes even more complex when applied to partnership mergers and divisions. Depending on the form of the merger or division, section 704(c) affects the transaction in varying ways. For example, if a practitioner is planning an assets-up merger or division, the practitioner must consider section 704(c) gain or loss in the partnership’s assets when planning the distributions to the partners—properly structuring which assets are distributed to which partners can make the difference between triggering gain recognition pursuant to section 704(c), section 707, or section 737, and avoiding application of these principles altogether. In an assets-over merger or division, the transaction structure results in contributions of assets to a new partnership, which may result in multiple layers of section 704(c) gain and loss.

8. Assets-Up Transactions

When structuring an assets-up merger or division, practitioners must consider the section 704(c) gain or loss attached to the assets of the distributing partnership. In an assets-up merger, the terminating partnership or partnerships make distributions in complete liquidation of the partners’ interests. Because the distributed assets may have forward or reverse section 704(c) layers, practitioners must weigh the section 704(c) consequences of the distribution alongside the general distribution consequences under sections 731(a)(2) and section 732(b). In most instances, the partnership should attempt to distribute assets with forward or reverse section 704(c) layers to the partners to whom the underlying tax gain or loss is attributable, therefore avoiding immediate recognition of the tax consequences.

Employing the same strategy in a partnership division may be complicated by the partners’ non-tax motivations for dividing. If the division represents a shift in asset ownership (sometimes referred to as a “non-pro rata division”), wherein one or more partners effectively reduce or sever their proportionate indirect ownership in property they originally contributed, section 704(c) will apply to track pre-contribution gain or loss back to the contributing partners. In some cases, taxpayers may wish to avoid structuring an assets-up division if the preferred distribution of assets in liquidation of the partners’ interests cannot be reconciled with optimal section 704(c) consequences.

9. Assets-Over Mergers

Assets-over mergers will not trigger section 704(c) gain or loss because the Treasury Regulations carve out an exception to recognition. Nonetheless, because any assets-over transaction involves one partnership contributing its assets to another partnership, section 704(c) gain and loss must be recalibrated to reflect the “new layer” of pre-contribution gain and loss.

Using Roosevelt LLC as an example, assume that instead of purchasing the Building for $800,000—resulting in the $800,000 book and tax basis shown in the balance sheet above—Theodore had instead contributed the Building when its tax basis was $400,000 and its fair market value was $800,000. Thus, the Building has $400,000 of “original” section 704(c) gain. Three years later, Roosevelt LLC merges with Kennedy LLC in an assets-over merger in which Roosevelt LLC terminates for federal income tax purposes. Thus, Roosevelt LLC is deemed to contribute its assets to Kennedy LLC in exchange for interests in Kennedy LLC. At the time of the merger, the Building has a basis of $400,000 and a FMV of $2,400,000, thus resulting in $1,600,000 of “new” section 704(c) gain.

The total amount of section 704(c) gain is thus $2,000,000 and includes both the original and new section 704(c) gain. Hence, the section 704(c) gain allocable to the Building will be divided into two “layers.” The “original layer” of $400,000 should be recognized only by Theodore, and the remaining $1,600,000 will be recognized by Theodore and Franklin as successors-in-interest to the Roosevelt Partnership in accordance with their proportional ownership of partnership interests (in this case, 50% each).

The time limit to recognize the original layer is unchanged by the merger. Since Theodore contributed the Building to Roosevelt LLC three years before the merger, there are four years remaining on the section 704(c) “clock” for the original layer. On the other hand, the new layer created as a result of the merger will have its own seven-year clock beginning from the date of the merger. To illustrate, if the merged Kennedy-Roosevelt Partnership distributed the Building to Robert immediately after the merger, Theodore would recognize $1,200,000 of section 704(c) gain (the entire $400,000 from the original layer and half of the $1,600,000 new layer), and Franklin would recognize $800,000 of section 704(c) gain. On the other hand, if the Kennedy-Roosevelt Partnership distributed the Building to Robert five years after the merger, each of Theodore and Franklin would only recognize $800,000 of section 704(c) gain from the new layer because the seven-year clock on the original layer would have expired, and section 704(c)(1)(B) would no longer apply to the original layer.

10. Assets-Over Divisions

As opposed to assets-over mergers, the distribution of partnership interests made pursuant to assets-over divisions will trigger the application of section 704(c)(1)(B) unless the distribution falls within the exceptions under Regulation section 1.704-4(c). The partnership interests will be successor property to any section 704(c) property contributed to the recipient partnership(s), so distribution of the partnership interests will be tantamount to distributing the section 704(c) property itself. Because assets-over divisions do not permit taxpayers to customize the manner in which individual partnership assets are distributed, they present less flexibility when planning for the avoidance of triggering section 704(c) consequences.

11. Special Concerns for Tiered Partnerships

Outside the merger and division context, the regulatory guidance for tracking section 704(c) consequences in tiered partnerships is limited to the mandate that the upper-tier partnership must “allocate its distributive share of lower-tier partnership items with respect to [such] property in a manner that takes into account [an upper-tier] contributing partner’s remaining built-in gain or loss.” The regulation leaves open the choice of method for allocating section 704(c) items, which led to myriad interpretations by practitioners. The Service conceded the existence of multiple valid interpretations in Notice 2009-70. The Service’s motivation behind issuing Notice 2009-70 was to solicit commentary about the application of section 704(c) and section 737 in tiered partnerships, including partnership mergers and divisions.

The New York State Bar Association Tax Section (“NYSBA”) submitted comprehensive comments in response to Notice 2009-70. These comments highlighted several remaining ambiguities in the law and offered several recommendations for the Service’s consideration. One of the recommendations was using the aggregate theory (wherein the partnership is treated as an aggregate of its owners) instead of the entity theory (wherein the partnership is treated as a separate entity) when evaluating the impact of sections 704(c) and 737 on tiered partnership mergers and divisions. Under the aggregate theory, the tiered partnership would be treated as a single partnership, with the upper-tier partnership “looking through” to its partners when prescribing section 704(c) consequences. Under the entity theory, the upper-tier partnership is considered separate from the lower-tier partnership, in which case the upper- and lower-tier partnerships could each use a different section 704(c) method to cure book/tax disparities arising from a merger or division. The different methods used by the upper-tier and lower-tier partnerships could result in a distortion of gain and loss recognition to achieve improper tax benefits.

The NYSBA comments to Notice 2009-70 also point out that under the aggregate theory, mergers and divisions of tiered partnerships would be treated like mergers and divisions of single partnerships. That is, the look-through treatment described above would effectively make tiered partnerships the same as single partnerships for purposes of determining section 704(c) consequences. On the other hand, determining the section 704(c) consequences of mergers and divisions under the entity theory would presumably require separate evaluation of the section 704(c) consequences at each tier. This assessment may be considerably more complex if each tier uses a different method to cure book/tax disparities.

The Service and Treasury have not yet issued followed up guidance with respect to the application of Notice 2009-70 to section 704(c) layers—despite public requests to do so. While practitioners have some flexibility in dealing with tiered partnerships under Regulation section 1.704-3(a)(9), they should pay heed to the potential tax and administrative complexities of the chosen path to do so.

C. Section 707: Disguised Sales

Section 707 and the corresponding Treasury Regulations set forth rules designed to prevent taxpayers from using a partnership as a conduit to avoid taxes. Perhaps the most common scenario implicating section 707 is a disguised sale. To illustrate, assume again that Theodore had contributed the Building to Roosevelt LLC when its tax basis was $400,000 and its fair market value was $800,000 One week following the contribution, Roosevelt LLC distributes the $200,000 of cash on its balance sheet to Theodore. Although the transactions are a contribution and distribution in form, the arrangement is a partial sale in substance. If the transaction was respected as a contribution and distribution, Theodore would not recognize gain under section 731 because the cash (and deemed cash) distributed would not exceed his outside basis.

Under section 707(a)(2)(B), a disguised sale involves a “direct or indirect transfer of money or other property by a partner to a partnership” and “a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner).” If “the [two] transfers, when viewed together, are properly characterized as a sale or exchange of property,” then the partnership conduit is ignored and the transaction is deemed to occur outside of the partnership. Accordingly, applying section 707(a)(2)(B) generally recasts contributions and related distributions as sales between the partners.

The Treasury promulgated Regulations to clarify when and how the rules governing section 707(a)(2)(B) should be applied. The Regulations specify that if any two transfers fitting the description in section 707(a)(2)(B) occur within two years of each other, the transfers are presumed to be a disguised sale unless the taxpayer can establish that the facts and circumstances clearly show that the transfers were not a disguised sale. The Regulations provide a non-exclusive list of ten factors that “may tend to prove the existence of a sale.” On the other hand, if the transfers take place more than two years apart, the transfers are presumed not to be a sale unless the facts and circumstances clearly establish otherwise. The Regulations also reverse the two-year presumption or create an outright exception when transfers are made for a legitimate non-tax business purposes, such as reasonable guaranteed payments, payments of reasonable preferred returns, distributions of cash flow resulting from the partnership’s business operations, reimbursements of preformation capital expenditures, and deemed distributions related to certain “qualified liabilities.”

When applied to mergers and divisions, section 707(a)(2)(B) and the corresponding Regulations produce interesting results. Because all mergers and divisions involve a “direct or indirect transfer of money or other property by a partner to a partnership,” the disguised sale rules would apparently trigger a mandatory disclosure whenever a distribution of money or property is made to the contributing partner(s). The Regulations do, however, provide an exception for transfers resulting from a technical termination under former section 708(b)(1)(B). Therefore, under the old law, any transfers that are part of a partnership merger or division would not be considered when evaluating whether a contribution or distribution has occurred for section 707 purposes. The rules do not clarify if the principle of that section would still apply. The plain language of the regulation applies to terminations under section 708(b)(1)(B), but such terminations cannot occur under current law, so the exception may be lost now.

The presence of the exception does not imply that practitioners may neglect the disguised sale rules entirely when planning a merger or division. If a contribution or distribution occurs in close proximity to a merger or division (but is not actually a part of the merger or division itself), a companion contribution or distribution may trigger disguised sale treatment depending on the facts and circumstances at hand.

For instance, if Kennedy LLC and Roosevelt LLC were to merge, a pre-merger contribution and a post-merger distribution could be re-characterized as a sale. Assume Theodore contributed the Building (unencumbered by a mortgage) to Roosevelt LLC one week before the merger. One week after the merger, the resulting partnership distributes $800,000 cash to Theodore. The disguised sale rules would presume these two transfers constituted a sale in substance, and the exception in Regulation section 1.707-3(a)(4)—related to transfers resulting from a termination—would not apply to either transfer because neither was part of the merger.

The Regulations are silent about the application of the disguised sale rules when a partnership involved in a transfer terminates as part of a merger or division. Interpreted strictly, the use of the term “the partnership” in section 707(a)(2)(B)(ii) implies that both transfers described in section 707(a)(2)(B) must involve the same partnership. This strict interpretation, however, leaves some potential for abuse—the example in the preceding paragraph would not be a disguised sale. A more reasonable approach would be to assume the disguised sale rules may be applied to successor entities after a merger or division has occurred, regardless of whether the partnership described in section 707(a)(2)(B)(i) continues or terminates. Accordingly, practitioners should evaluate the contributions and distributions made in the two-year period before a merger or division and advise clients accordingly about the effect of a subsequent contribution or distribution on disguised sale treatment.

D. Recapture of Accelerated Depreciation and Section 197 Amortization

1. In General

When a taxpayer depreciates property in accordance with an accelerated schedule, the Code provides for recapture of the accelerated depreciation deductions in the form of ordinary income when the taxpayer disposes of such property. Before the Tax Reform Act of 1986, taxpayers could choose to depreciate real estate on an accelerated schedule. Section 168, which was not revoked by the Tax Reform Act of 1986 and remains effective today, allows taxpayers to use an accelerated depreciation schedule for certain tangible business property. Section 197 allows taxpayers to amortize certain intangible property ratably over a 15-year period. While the corresponding deductions are not attributable to depreciation and are not taken on an accelerated schedule, a special rule requires such deductions to be recaptured under section 1245.

When a partnership sells section 1245 or section 1250 property, the Regulations dictate that recapture income be allocated to the partners in accordance with the manner in which the partners received the benefit of the corresponding depreciation deductions. This principle is directly analogous to the partnership minimum gain rules under the section 704 Regulations, which dictate that partners generally must be “charged back” their respective deductions allocable to property secured by a non-recourse liability. This “chargeback” comes in the form of an allocation of taxable income incurred when the partnership sells the property in question.

2. Mergers and Divisions

While practitioners must be wary of recapture income as part of the disposition of property subject to section 1245 and section 1250, both statutes nevertheless carve out exceptions for non-recognition transactions. In general, if section 1245 or section 1250 property is distributed by a partnership in a non-recognition transaction under section 731, the depreciation recapture potential is preserved for later recognition by the distributee partner upon a subsequent disposition of the property in a recognition event. In performing the following analysis, recall that section 1250 gain arises from sales of section 1250 property that qualifies for accelerated depreciation, so most real estate, which is subject to straight-line depreciation, does not have section 1250 gain.

To accomplish this objective, the property’s basis is adjusted upon distribution based on two factors: (1) gain that would have been recognized had the partnership sold the property for its fair market value immediately before distribution, and (2) gain actually recognized under the section 751 rules. The Regulations prescribe a complex system for taxpayers to calculate recapture in the event of a subsequent sale by the distributee partner. The principle supporting these Regulations mirrors the principle behind the Regulations corresponding to sections 704, 737, and 751: a property’s built-in section 1245 or section 1250 gain must “track back” to the parties under whose ownership the section 1245 or section 1250 gain actually arose. The rule does not, however, apply to unrecaptured section 1250 that is long-term capital gain taxed at a higher tax rate than regular long-term capital gain.

While the special basis and holding period rules prescribed in the Regulations are cumbersome, their application is easier when one keeps in mind the philosophy behind them. Again using Roosevelt LLC as an example, assume the Building is not and has never been encumbered by a mortgage. Further assume that before forming Roosevelt LLC, Theodore owned the Building and accrued built-in section 1250 gain of $10,000 during his period of ownership on real property that qualified for accelerated depreciation. Theodore then contributes the Building to Roosevelt LLC. Under the Roosevelt LLC’s period of ownership, the Building accrues additional built-in section 1250 gain of $5,000. Roosevelt LLC then completes an assets-over merger with Kennedy LLC. During the resulting partnership’s period of ownership, the Building accrues additional built-in section 1250 gain of $7,500. The resulting partnership then sells the Building, resulting in section 1250 gain of $22,500. Assuming the transfer occurs within the seven-year periods under section 704(c) and section 737, the section 1250 gain must be allocated upon sale as follows:

• $7,500 to the resulting partnership, to be allocated according to the agreement among the partners of the resulting partnership
• $5,000 to Roosevelt LLC, to be allocated evenly among Theodore and Franklin as partners
• $10,000 to Theodore, individually

The chosen form of a merger or division will make a substantial impact with respect to recapture because the assets-up form implicates the basis adjustment prescribed in the Code and Regulations, whereas the assets-over form will not require a basis adjustment because neither the section 1245 or section 1250 property itself is ever actually distributed out of a partnership. Furthermore, the administrative burden should prove manageable so long as practitioners carefully track the accrual of section 1245 and section 1250 gain through changes in ownership.

E. Section 50: Recapture of Investment Tax Credits

Section 38(b)(1) provides for an investment tax credit if a taxpayer spends money rehabilitating certain old or historic real property. In the case of an “early disposition,” however, section 50(a)(1) requires the recapture of investment tax credits (ITCs). The recapture percentage depends upon how soon the taxpayer disposes of the rehabilitated property after such property has been placed in service. In a partnership merger or division, practitioners must resolve whether an early disposition has occurred requiring recapture of ITCs.

Congress gave Treasury the authority to promulgate regulations defining an “early disposition” of ITC property. The Service did so in the Regulations under section 47. Under Regulation section 1.47-3, the Service set forth exceptions to the recapture requirement in which it described situations not qualifying as an early disposition. One such exception is a “mere change in form of conducting a trade or business.” To qualify for this mere change in form exception (the “MCFE”), a transaction must meet all of the following conditions (the “MCFE conditions”):

1. The section 38 property in question is retained as section 38 property in the same trade or business;
2. The transferor of the section 38 property retains a substantial interest in such trade or business;
3. Substantially all the assets (whether or not section 38 property) necessary to operate such trade or business are transferred to the transferee to whom such section 38 property is transferred; and
4. The basis of such section 38 property in the hands of the transferee is determined, in whole in part, by reference to the basis of such section 38 property in the hands of the transferor.

In the partnership reorganization context, failure to fulfill one or more of the MCFE conditions may cause recapture depending on the facts and circumstances of the transaction at issue.

1. Assets-Over Mergers

Since a straightforward assets-over merger will preserve the basis of section 38 property in the hands of the previously existing partnerships, no recapture should occur. Any assets-over merger must fulfill the other three MCFE conditions to qualify for non-recognition. If the parties structure the transaction as a “boot merger,” recapture may occur for the departing partner(s) under Regulation section 1.47-6.

An assets-over merger was the subject of the only published guidance regarding ITC recapture consequences of partnership reorganizations. In Rev. Rul. 77-458, a merger occurred between ten general partnerships with the same two equal owners and the same equal pro rata allocation of all tax items. The partners chose the assets-over form for the merger. The Service considered whether the provisions of section 43(b) and Regulation section 1.47-3(f) required ITC recapture. The Service ruled that the transaction fulfilled the MCFE exception and therefore did not require ITC recapture.

2. Assets-Up Mergers

In an assets-up merger, basis in the hands of the resulting partnership is not determined by reference to basis in the hands of the terminating partnership. Therefore, any ITC property held by the terminating partnership will be subject to ITC recapture because the transaction fails the fourth MCFE condition per se.

In Long v. United States, a taxpayer has challenged the validity of the conditions to qualify for the “mere change in form” exception, although the transaction at issue was not a partnership reorganization; rather, the taxpayers liquidated a subchapter S corporation. The taxpayer’s facts and circumstances in the Long case resembled an assets-up merger; the section 38 property was removed from a pass-thru entity in a non-recognition transaction. The lower court held the regulation was inconsistent with the statute and awarded the taxpayer summary judgment. The Sixth Circuit reversed and held the regulation was valid, thus upholding the imposition of ITC recapture. Any taxpayer attempting to fight the application of ITC recapture to an assets-up merger would face a significant hurdle in the Long decision, although the difficulty level of overcoming Long may be lower outside the Sixth Circuit (where Long is binding precedent).

3. Assets-Over Divisions

Unlike an assets-over merger, the only MCFE condition an assets-over division fulfills per se is the fourth condition. Depending on facts and circumstances, an assets-over division may fail any of the other three MCFE conditions with respect to one or more resulting partnerships.

Ordinarily, the first condition will not pose an issue because distributing ITC property to a resulting partnership engaged in a different trade or business will call into question whether the anti-abuse regulations should apply to the reorganization.

When a division changes a partner’s proportionate interest in ITC property, the division may fail the second MCFE condition and therefore give rise to ITC recapture with respect to any partner whose proportionate interest has shifted. The mechanics of this rule are analogous to shifts in section 724 or section 751 “hot assets” or section 752 shares of partnership liabilities.

4. Assets-Up Divisions

Any assets-up division will fail the fourth MCFE condition per se for the same reasons as an assets-up merger. An assets-up division may also fail any or all of the other three MCFE conditions for the same reasons as an assets-over division; generally, if a given resulting partnership does not continue the same trade or business and retain sufficient assets from the prior partnership, such resulting partnership will inure ITC recapture.

Because an assets-up division is not guaranteed to satisfy any of the four MCFE conditions and fails one of the conditions automatically, an assets-up division is least likely to qualify for the MCFE. Therefore, any taxpayer contemplating a division of a partnership with ITC property must weigh the substantial certainty of ITC recapture against the benefits and burdens of the assets-up form.

F. Section 752: Partners’ Share of Liabilities

Section 752 governs how partnerships and partners treat liabilities. In general, each partner is allocated a share of the partnership’s overall liabilities. An increase in a partner’s share of liabilities is treated as a contribution of money from the partner to the partnership, and a decrease in a partner’s share of liabilities is treated as a distribution of money from the partnership to the partner.

The corresponding Treasury Regulations contain intricate rules for determining partners’ shares of recourse and non-recourse liabilities. In a straightforward situation with a pro rata allocation of all tax attributes and exclusively non-recourse debt without any guarantees, determining a partner’s share of liabilities is as simple as dividing the partnership’s outstanding debt in accordance with percentage ownership of partnership profits interests. Using Roosevelt LLC as an example, Theodore and Franklin each have an equal one-half share of the partnership’s total liabilities; therefore, each of their section 752 shares is $400,000.

If Theodore were to personally guarantee the mortgage on the Building, his share of liabilities would be all $600,000 of the mortgage and half of the $200,000 business loan for a total of $700,000. Theodore’s $300,000 increase in his share of partnership liabilities would be considered a contribution of $300,000 of cash from Theodore to the partnership and Franklin’s $300,000 decrease in his share of partnership liabilities would be considered a distribution of $300,000 from the partnership to Franklin.

In the context of partnership mergers and divisions, changes in section 752 shares may occur without any actual change in outstanding debt balances or the nature of guarantees. Assume Roosevelt LLC and Kennedy LLC merge in an assets-over merger (disregard the above scenario in which Theodore personally guarantees the mortgage). Since Kennedy LLC has no debt and Roosevelt LLC’s debts are non-recourse obligations, all of the resulting partnership’s partners will experience changes in their section 752 shares as follows:

*Note the fraction of ownership has been determined with respect to capital contributed and not with respect to assets contributed.

Simply by virtue of the merger, section 752 shares change and result in deemed contributions and distributions of money. For Theodore and Franklin, the deemed distributions of money will not result in recognition of gain, provided their respective outside bases exceed the deemed distribution. On the other hand, if either Theodore or Franklin has an outside basis of less than $266,666.67 at the time of the transaction, gain will be recognized to the extent that the deemed distribution exceeds basis.

When a partner’s share of liabilities exceeds the partner’s outside basis, the partner is likely to have a negative capital account under Regulation section 1.704-1(b)(2)(iv). In real estate tax partnerships, negative tax capital accounts often arise when the partners refinance appreciated property in order to “cash out” the additional equity via partnership distributions. When a negative tax capital account is present, a merger or division has a risk of triggering gain recognition under section 752. Before regulations first proposed in 2014, made temporary in 2016, and finalized in 2019, partners would make “bottom dollar guarantees” to create an economic risk of loss, but the final regulations put significant guardrails around them. Those regulations generally define a bottom dollar guarantee as either an obligation to satisfy a partnership liability only if the lender does not otherwise collect, or a less-than-full obligation to restore a partner’s deficit capital account. The definition also includes indemnity arrangements with the same effect and attempts to circumvent the definition through tactics such as tiered partnerships, use of intermediaries, or splicing a single obligation into many. After these regulations, the conventional options available to taxpayers wishing to increase section 752 shares are (1) “first dollar” guarantees, in which the partner assumes an unconditional obligation to contribute to the partnership if a liability comes due; (2) “vertical slice” guarantees, in which the partner assumes a fixed percentage of every dollar of partnership liability; or complete deficit restoration obligations.

The analogous concept for non-recourse loans is the minimum gain chargeback. In essence, the minimum gain chargeback calls for allocations of income and gain to recapture partners’ non-recourse deductions. For deductions (e.g., depreciation) attributable to property acquired through non-recourse financing, the partnership tax rules require this recapture to prevent abuse. Otherwise, partners could use the deductions as a tax shelter without any attendant economic risk.

While not a concept found under section 752 or the corresponding regulations, minimum gain chargebacks will have a similar effect as shifts in section 752 liabilities when partnership mergers and divisions occur. Like section 752 liabilities, each individual partner has a share of the partnership’s overall minimum gain. When a partner’s share decreases, a minimum gain chargeback occurs, and the partner in question receives corresponding amounts of income and gain. Shares can shift when capital accounts are revalued.

Two main differences exist between the concepts. First, section 752 consequences will always manifest immediately, whereas the minimum gain chargeback will only manifest if and when the partnership either (1) has sufficient items of income and gain to allocate accordingly or (2) pays back the principal of non-recourse debts financing deductions. Second, shifts in section 752 liabilities can result in either a favorable or unfavorable tax result upon a merger or division, whereas minimum gain chargebacks will always give rise to unfavorable tax results for all affected partners.

When a merger or division occurs and several liabilities are involved, the Treasury Regulations allow taxpayers to net the section 752 consequences and make only a single deemed contribution or distribution after the transaction is complete. Tax consequences will follow from this single net result.

The tax consequences arising from shifts in section 752 shares may have a dramatic effect on a merger or division. Even if gain is not recognized right away, changes in outside basis will affect future recognition of gain or loss. Practitioners should tabulate the section 752 consequences of a proposed transaction and consider negotiating recompense or changing the nature of guarantees and indemnities (i.e., the economic risk of loss) if they represent adversely affected partners.

G. Section 751 “Hot Assets:” Inventory and Unrealized Receivables

1. In General

Section 751 prescribes sale or exchange treatment whenever a partner’s share of unrealized receivables and inventory (collectively, “hot assets”) shifts as a result of a distribution or a sale of all or part of the partner’s partnership interest. Although partnership mergers and divisions are generally non-recognition transactions, section 751 assets represent an important exception.

Section 751 is an anti-abuse provision designed to prevent the use of partnerships as a conduit to convert ordinary gain into capital gain and to prevent shifting of ordinary income among partners. Using Roosevelt LLC as an example, assume Theodore sells his one-half interest to Millard Fillmore for $1,500,000 plus Millard’s assumption of Theodore’s share of the partnership’s liabilities. Since the partnership interest is a capital asset, Theodore realizes $800,000 of long-term capital gain on the interest. If he had, however, retained ownership of the partnership interest long enough for the partnership to sell its entire inventory, then he would have realized $50,000 of ordinary income. By selling his interest instead, Theodore has escaped $50,000 of ordinary income and effectively converted it to long-term capital gain. Section 751 prevents this avoidance by forcing Theodore to recognize $50,000 of ordinary income attributable to the appreciated inventory.

The same ordinary income treatment would apply if Theodore’s share of section 751 property changed as a result of a deemed “section 751 exchange.” Under section 751(b), a section 751 exchange occurs when section 751 property is exchanged for money or other property using the partnership as a conduit.

In recognition of the outdated and unclear nature of the current Regulations, the Treasury proposed new Regulations in 2014 designed to ease the administration of section 751. The Proposed Regulations present an easier and cleaner way of applying section 751. The Proposed Regulations have taxpayers take the following steps to identify and administer section 751(b):

1. Each partner calculates its respective “net section 751 unrealized gain or loss,” which is equal to how much gain or loss attributable to section 751 property would be allocated to each partner in a hypothetical sale of all of the partnership’s assets for fair market value. The “net section 751 unrealized gain or loss” is calculated both before and after the distribution in question. For purposes of the distributee partner, the amount is calculated as if the distributee partner sold the section 751 property for fair market value immediately after the distribution.
2. The “section 751(b) amount” for each partner is the change in “net section 751 unrealized gain or loss” caused by the distribution.
3. The “section 751(b) amount” is taxed as ordinary income, with narrow exceptions.

The Proposed Regulations provide a simpler illustration than their predecessors of the concept behind section 751. Effectively, section 751 tracks each partner’s share of unrealized receivables and appreciated inventory, and the rules disallow partners from escaping their respective shares of ordinary income allocable to such items.

2. Mergers and Divisions

In the context of mergers and divisions, section 751 could prove problematic. In both the assets-up and assets-over forms, a distribution will be made that may trigger ordinary income under section 751(b).

3. Section 724: Counterpart to Section 751

a. In General. Section 751 applies to prevent abuse in only two scenarios: a partner selling or exchanging a partnership interest or a deemed section 751 exchange. Falling outside the scope of section 751 is a contribution to a partnership of certain property followed by a sale of such property by the partnership in quick succession. A taxpayer’s goal in doing so would be to convert the character of the contributed property and achieve either a capital gain or an ordinary loss.

This conversion could occur with respect to two different types of property: hot assets (inventory and unrealized receivables) or property with a built-in capital loss. Upon contributing the former to a partnership, the taxpayer could wait for the partnership to establish the character of the contributed property as capital, then sell the property to incur a capital gain that would have otherwise been ordinary if sold by the contributing partner instead. Upon contributing the latter, the taxpayer could wait for the partnership to establish the character of the contributed property as ordinary, then sell the property to incur an ordinary loss that would have otherwise been capital if sold by the contributing partner instead.

Section 724 puts a “taint” on the two types of property when contributed to the partnership that prevents conversion of character. For contributed inventory, any subsequent sale by the partnership within five years will result in ordinary income or loss, regardless of the character in the hands of the partnership. For contributed unrealized receivables, the taint of ordinary character is permanent. The discrepancy between the two time periods is likely due to the notion that a partnership may legitimately hold the contributed inventory as non-inventory, whereas a partnership will likely have no legitimate alternative use for an unrealized receivable.

For capital loss property, the taint of capital character lasts five years, but only in the event the partnership sells the property at a loss, and only to the extent of the built-in loss. This treatment synchronizes well with section 704 to ensure a taxpayer will incur a built-in capital loss upon disposition, regardless of whether the sale occurs inside or outside of a partnership. The five-year expiration of the taint allows for situations in which a partnership has truly converted the character of the contributed property to ordinary and ensures the contributing partner cannot use the partnership as a device.

b. Mergers and Divisions. Section 724 has potential relevance in all mergers and divisions because each type of transaction involves contribution of property by at least one party to a partnership. Particularly relevant in the merger and division context is the exception under section 724(d)(3)(A), which provides that substituted basis property received in exchange for section 724 property in a non-recognition transaction will carry the same taint as the original section 724 property. For instance, if a partner contributes unrealized receivables to a partnership as part of an assets-up merger, the merged partnership interests received in exchange for the unrealized receivables will carry a permanent taint under section 724(a) by virtue of section 724(d)(3)(A).

Therefore, whenever any partnership involved in a merger or division transaction contains section 724 assets, the practitioner must track the section 724 taint accordingly. For partners receiving partnership interests tainted by section 724(d)(3)(A), practitioners must take into account section 724 consequences when such partners dispose of their partnership interests. When the taint arises from inventory or capital loss property, the tracking will last five years. The interplay between section 724 and section 704 will ensure that the same tax consequences will arise with respect to these two types of property regardless of (1) whether the property itself is sold or the contributing partner’s interest is sold and (2) when the sale occurs. When the taint arises from unrealized receivables, the taint will last forever. This means that a mismatch in tax consequences could arise after seven years, in which case section 704 would not ensure that a sale by the partnership of the unrealized receivables would inure exclusively to the detriment of the contributing partner. Rather, the sale of the unrealized receivables more than seven years after contribution would result in tax consequences as allocated by the partnership’s governing agreement.

For the partnerships themselves, practitioners must track section 724 consequences of contributed property. This is not as simple a task in the merger and division context as in other contexts because section 724 does not address the potential issues in detail.

Likewise, in partnership divisions, the preservation of the original five-year taint or the start of a new five-year taint should depend on termination or continuation of the prior partnership.

H. Qualified Opportunity Zone Issues

1. In General

Congress passed Public Law 115-97, colloquially referred to as the Tax Cuts and Jobs Act (TCJA), in late December of 2017, and President Donald Trump signed it into law on December 22 of that year. As part of the Tax Cuts and Jobs Act, the Qualified Opportunity Zone (OZ) program was born; even though the TCJA passed exclusively with Republican support, the OZ program traces its roots to the time Barack Obama was President. The TCJA created sections 1400Z-1 and 1400Z-2 to govern the OZ program; the former governs the designation of the zones themselves, which occurred in 2018, and the latter governs the administration of the program. Conceptually, Congress intended for the OZ program to stimulate economic activity both generally (when selling capital assets) and specifically (when investing in Qualified Opportunity Funds) in exchange for conferring three tax benefits on taxpayer-investors: (1) the deferral of federal capital gains taxes; (2) the partial reduction of the deferred capital gains taxes via one type of basis adjustment, as long as the investment was made prior to certain dates; and (3) the elimination of federal income taxes upon exiting an investment held for ten or more years via a second type of basis adjustment.

Treasury proposed regulations appurtenant to section 1400Z-2 twice. The initial guidance, issued on October 29, 2018, did not address divisions or mergers. In response, one author of this article submitted comments seeking clarification. The second guidance, issued on May 1, 2019, remained silent on mergers and remained silent on mergers and divisions of Qualified Opportunity Funds (QOFs) and Qualified Opportunity Zone Businesses (QOZBs), inspiring further comment from this author. As explained below, the final regulations only address mergers (but not divisions) of QOF partnerships and QOZB partnerships.

This portion of the article will describe how Congress’s sloppy drafting of the TCJA restricted Treasury’s ability to accommodate reorganizations of QOF partnerships driven by legitimate business objectives, leaving those QOFs and their investors hamstrung when structuring adjustments to their deals in response to changing circumstances.

2. Section 1400Z-2: General Statutory Mechanics

Section 1400Z-2 sets forth how a taxpayer invests in a OZ and what the tax benefits will be for deploying capital consistently with the program. The first step in the process of making a qualifying investment is selling a capital asset to an unrelated person. If that sale results in gain, the taxpayer may make an investment of equivalent value into a QOF, defined as any electing entity taxed as a partnership or corporation that follows the compliance regime outlined in section 1400Z and its Regulations. A taxpayer’s investment into a QOF may be made with either cash or property, but since investments of property are likely to come with suboptimal tax treatment, taxpayers make investments in cash much more frequently.

One key part of the QOF compliance regime mandates that the QOF hold at least 90% of its assets in Qualified Opportunity Zone Property (QOZP), as measured during two semiannual testing dates. The most common type of QOZP into which a QOF invests is an interest in a QOZB, which is a trade or business that can be conducted by the QOF directly, but is most often held through Qualified Opportunity Zone Stock (i.e., a corporation) or Qualified Opportunity Zone Partnership Interests. A QOZB taxed as a partnership must issue its interests solely in exchange for cash to qualify as QOZP. In other words, if a QOZB conducted through a partnership issues any interests in exchange for property other than cash, those interests are non-qualified property for purposes of the QOF’s semi-annual QOZP compliance testing, which could put a taxpayer’s entire QOF in jeopardy of complete non-compliance and concomitant loss of eligibility for the statute’s tax benefits.

On top of the QOF compliance regime, any QOZB in which the QOF holds an interest has its own separate compliance regime as well. If a QOZB’s partnership interests make up more than 10% of a QOF’s assets under the regulations’ valuation methods, a QOZB’s compliance failure under its own regime could have a domino effect and result in a QOF’s non-compliance as well. Section 1400Z provides that substantially all of a QOZB’s tangible property, which can be either owned or leased, must be Qualified Opportunity Zone Business Property (QOZBP). The QOZB must purchase or lease QOZBP after December 31, 2017.

Although the OZ program provides for three tax benefits, the first two – deferral of the capital gain until, at latest, December 31, 2026, and a basis adjustment for certain investments made before December 31, 2021 and held at least five years – are generally not as important to taxpayers as the third: if a taxpayer holds a QOF investment for at least ten years before sale, the basis upon sale is immediately adjusted to the QOF interest’s fair market value. But if the taxpayer experienced an “inclusion event” with respect to a QOF interest before the ten-year holding period elapsing, this generous basis adjustment is no longer available to that part of the QOF interest experiencing the inclusion event. Accordingly, taxpayers seek to avoid inclusion events, although the rules governing when an inclusion event occurs are labyrinthine and counterintuitive.

3. QOFs and QOZBs in Mergers and Divisions

a. Mergers. The Treasury Regulations contemplate mergers of QOF partnerships, the partners of those QOF partnerships, and QOZB partnerships.

When one or more QOF partnerships merge, the deemed transactions occurring as part of the merger will not be inclusion events as long as the continuing partnership is a QOF and the deferred capital gains still get allocated to the partners who originally realized them. The regulatory provision governing these mergers overrides the portion of the regulations that could make the deemed transactions inclusion events, except to the extent the transaction is treated as a sale or exchange for inclusion event purposes. For example, if a boot merger of QOF partnerships occurs, the boot seller would experience an inclusion event.

If a partnership holding a QOF interest merges with another partnership, the section 1400Z-2(a)(1) election will stay in place for the continuing partnership, regardless of whether the resulting partnership is a continuation of the partnership that originally held the QOF interest. This special rule uses the authority Treasury reserved for the Commissioner under Regulation section 1.708-1(c)(1), which seems to be the only occasion on which the Service exercised this discretion. But this provision of the regulations comes with the same caveats as a merger of two QOF partnerships: the partners must be allocated their respective shares of deferred capital gain within the continuing partnership, and the favorable treatment does not apply to the extent any part of the transaction is treated as a sale of exchange.

When a QOZB partnership merges or consolidates, the “solely in exchange for cash” rule under section 1400Z-2(d)(2)(C)(i) would normally invalidate QOZB status for a terminating partnership because that partnership or its partners will necessarily be deemed to make a section 721 contribution to the continuing partnership in exchange for partnership interests. To the extent any assets that a terminating partnership contributes in exchange for an interest in the continuing partnership are not cash, the QOF partners of a terminating QOZB partnership would receive non-qualifying partnership interests, jeopardizing the QOF partners’ ongoing compliance with the requirement to be at least 90% invested in QOZP. But the Treasury Regulations adopt the same special treatment for mergers of QOZBs that they do for mergers of QOFs: that is, they override the normal application of section 1400Z and suspend the “solely in exchange for cash” rule, so both the terminating and continuing QOZBs will be deemed to continue their compliance status with all the other applicable rules.

b. Divisions. The Regulations’ permissive stance on mergers of OZ-related partnerships lies in stark contrast to its equally restrictive stance on divisions. Although the preamble to the final Regulations states that Treasury did not adopt a general rule that divisions of OZ-related partnerships would be permitted, Treasury did not instead make specific rules or even leave a path for practitioners to confidently assert that these divisions would steer clear of inclusion events.

Despite Treasury’s mention of divisions in the preamble to its final regulations, the text of the regulations themselves reveals that Treasury did not closely consider divisions when crafting its special rules for QOF partnerships. For instance, the general rule for distributions out of a QOF partnership provides that an actual or deemed distribution is only an inclusion event if the property (or cash) distributed has a fair market value in excess of the QOF’s basis in its qualifying investment. This provision prevents many divisions of QOFs before December 31, 2026 (before which, contributions do not give rise to outside basis), unless there is sufficient basis attributable to debt or to a five-, seven-, or ten-year holding period. Even if the continuing partnerships’ self-certifications as QOFs will continue under the general division rules governing the preservation of elections, this does not avoid the inclusion event.

By contrast, the general rule for contributions of QOF stock or partnership interests to a different partnership is more permissive. It excepts contributions from inclusion event treatment if section 721 applies and the transferee partnership both (i) continues the QOF’s historical activities (i.e., the QOF does not terminate under section 708(b)(1)) and (ii) the transferee partnership allocates all Section 1400Z-2 items with respect to the contributed QOF ownership interests back to the contributing partner. This rule seems to accommodate the possible division of partnerships owning QOF stock or partnership interests, but it would not apply to divisions of QOF partnerships themselves.

The regulations that would apply to divisions of QOF partnerships seem to accommodate the slim possibility of avoiding an inclusion event if the facts and circumstances align just right, but the technical hurdles for divisions of QOZB partnerships might be even worse. QOZB partnership interests must be received solely in exchange for cash to be treated as QOZP. Although the final rules waive this requirement for QOZB mergers, there is no similar rule for divisions. Regardless of whether a QOZB partnership divides assets-up or assets-over, the deemed contribution of assets in exchange for interests in a recipient QOZB partnership contravenes the TCJA per se if even a single QOZB asset is not cash, which is guaranteed if the QOZB partnership has undertaken any substantial business or investment activity since formation. Even continuation status of a recipient partnership would not override the “solely in exchange for cash” rule when evaluating the deemed transactions prescribed in the division regulations, so while a divided QOZB partnership could maintain its compliance, recipient QOZB partnerships no longer issue interests eligible for QOZP treatment, which all but assures the QOF owners of those QOZB partnerships that they will fail to maintain the required 90% standard for investment in QOZP after the division.

The OZ regime’s unfriendliness to divisions of QOF and QOZB partnerships was a curious but intentional choice. Congress began the path to this unfortunate reality when it drafted and passed a sloppy statute without deep thought, consultation with Treasury, or collaboration with the private sector. Treasury then continued by perceiving potential abuses in divisions of these partnerships, although reasonable minds may differ about that potential, and declining to accommodate partnership divisions the way it accommodated corporate divisions and partnership mergers. Practitioners are now left with a thorny, confusing environment to navigate if clients want to split their QOFs or QOZBs into multiple entities for legitimate business reasons.

I. Income Tax Audit Issues

1. Before the Bipartisan Budget Act of 2015

When the Service first started auditing items stemming from the activities of tax partnerships, the Service did not audit the returns of the partnerships themselves; instead, the Service audited individual partners and examined the partnership return through the lens of the partner’s reporting of items passing through from the partnership’s return to its own. As tax partnerships became more numerous and complex, especially in the tax shelter era that precipitated reform legislation in the 1980s, this approach to audits became unwieldy and hindered effective enforcement. The first attempt at overhauling the tax partnership audit procedures came with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which set forth a more centralized procedure in which the Service audited the partnership as a whole. But TEFRA still required the Service to make concomitant adjustments to partner returns when the partnership’s return experienced an adjustment of its own, and the administrative burden of tracking the series of changes to all affected returns became overwhelming for both taxpayers and the government, especially as tax partnerships grew in both popularity and complexity. Between the implications of making adjustments under TEFRA audits, the difficulty of applying and enforcing Subchapter K, and the vicious cuts to the Service budget in response to a scandal that occurred under the Obama Administration, audits of tax partnerships—particularly large and complex ones—reached an all-time low in the mid-2010s.

2. The BBA Changes the Game

Rather than restore funding to the Service and recruit a larger staff of partnership tax experts to assist with these audits, Congress chose instead to make a second attempt at completely changing the partnership audit landscape to shift the administrative burden of a partnership audit away from the Service and toward the taxpayer. The Bipartisan Budget Act of 2015 (BBA) introduced a centralized partnership audit regime for all taxable years beginning after December 31, 2017. The BBA repealed the TEFRA audit regime and made a radical conceptual change to partnership audits: instead of adjustments at the partnership level passing through to the partners and changing the partners’ returns accordingly, partnership adjustments would now be the responsibility of the partnership itself, effectively adopting an entity theory of partnership taxation for these purposes. The BBA also changed partners’ default rights to receive notice of audit proceedings directly from the Service and participate in the audit process; the partners no longer have any rights, and the audit is conducted through a “partnership representative” who, by default, has unlimited rights to bind the partnership by its actions with respect to all matters before the Service. Under the BBA’s centralized audit regime, the Service no longer concerns itself at all with the partnership representative’s duties to, and agreements with, the individual partners; federal law intentionally confers no guidance regarding the relationship between those parties and leaves the matter to be negotiated amongst them or, in default of any agreement, the provisions of state law.

The application of the entity theory of partnership taxation to the centralized audit regime produced puzzling and counterintuitive results beyond the statutes governing the administration of the audit: strange rules also apply when an adverse adjustment to the partnership return occurs, whether by a final adjudication in court, or the Service’s acceptance of an Administrative Adjustment Request (AAR), or a Final Partnership Adjustment (FPA). The general rule states that the partnership itself may make a payment to satisfy the obligation arising from the FPA. But the partnership makes that payment in the “Adjustment Year,” which is defined as the taxable year in which a final adjudication occurs, an AAR is made, or notice of the FPA is mailed. Yet the adjustment corresponds to tax items arising in the “Reviewed Year,” which is the taxable year during which the items leading to the adverse adjustment actually arose. As with the designation of partnership representatives, the Service does not concern itself at all with how the partnership deals with changes in beneficial ownership between the Reviewed Year and the Adjustment Year; instead, the partnership is left to address that issue on its own. The partnership could foist the adjustment onto the Reviewed Year partners by electing to “push out” the adjustment under section 6226(a), but this comes at the cost of a higher imputed underpayment rate.

a. Mergers and Divisions in the BBA Context. The statutes and regulations do not address how the BBA audit rules will work when a partnership merges or divides, regardless of whether that partnership continues or terminates. Instead, practitioners are left to apply non-specific law when mergers and divisions occur. For instance, these statutes and regulations address exhaustively the concept of a partnership “ceasing to exist.” Section 6241(7) delegates legislative-grade rulemaking authority to Treasury regarding how to treat situations when a partnership “ceases to exist.” Regulation section 301.6241-3 sets forth at considerable length the way that “ceases to exist” is defined and how the BBA regime applies when the situation occurs. But the entire regulation omits mergers and divisions, choosing instead to define “ceasing to exist” only as (i) termination under section 708(b)(1)—which does not include the merger and division rules under section 708(b)(2)—and (ii) the partnership’s inability to pay its amounts due to the federal government in full. When a partnership ceases to exist, the regulations basically prescribe a type of push-out election, insofar as the partnership’s most recent “former partners” receive statements with their respective shares of the partnership adjustments and bear individual responsibility for those shares.

One may easily envision scenarios arising in mergers and divisions where the regulations are silent, and practitioners must make judgment calls about how the rules apply. The examples below illustrate some of the issues mergers and divisions will pose under the BBA regime. The common theme between them is that the regulations can be reasonably interpreted in different ways, and the Service should issue guidance to clarify what the default outcome would be if the parties to a division have not negotiated treatment themselves that the Service considers acceptable. Moreover, practitioners should be careful to navigate non-substantive concerns when negotiating these issues.

Example 1: Merger

The Kennedy LLC and the Roosevelt LLC merge in an assets-over transaction on July 1, 2022, to form Rushmore LLC. The Kennedy LLC continues, and the Roosevelt LLC terminates under the section 708(b)(2) rules and Regulation section 1.708-1(c)(1), which means the Roosevelt LLC’s final 2022 taxable year ends on the closing date. In 2024, the Service initiates a BBA audit of the Roosevelt LLC’s 2022 IRS Form 1065.

Despite the Roosevelt LLC terminating as a result of the merger, the “cease to exist” rules only reference section 708(b)(1) terminations, so the Roosevelt LLC would need a complete discontinuation of its historical activities to qualify as ceasing to exist. If the Roosevelt LLC’s historical activities continue, the “cease to exist” regulations would no longer apply, and the Rushmore LLC would need to account for future audits in the transaction documents, because the Adjustment Year partners under the rules would be all members of Rushmore LLC, including the members of Kennedy LLC. Accordingly, an adjustment arising from an audit of the Roosevelt LLC’s 2022 IRS Form 1065 would affect all members of Rushmore LLC absent a section 6226 election.

The transactional documents could account for this possibility in several ways, including (i) mandating a section 6226 election for any Roosevelt LLC Reviewed Year, (ii) mandating indemnification of Rushmore LLC’s payment of Adjustment Year items from the Roosevelt LLC members only, or (iii) acknowledging the Kennedy LLC members’ assumption of this risk and compensating them with a different transactional item during negotiations. Practitioners can hatch creative solutions to the issue, but missing it entirely could be painful for all parties, especially the Kennedy LLC members.

Example 2: Division with No Continuations

Suppose Oval Office LLC boasts John, Robert, Ted, Theodore, and Franklin as equal 20% members. Oval Office LLC enacts an assets-over division into three resulting partnerships. Bull Moose LLC consists only of Theodore and Ted. Works Progress LLC consists only of Franklin and Robert. Moon Landing LLC consists of John and Ted. Therefore, no resulting partnership from the Oval Office LLC division continues the prior partnership’s existence, and every resulting partnership is a novation.

The “cease to exist” regulations only mention section 708(b)(1) termination, so if an audit of Oval Office LLC’s IRS Form 1065 from a pre-division year concludes in a post-division year, a question arises regarding responsibility for a final adjustment. When interpreting the “cease to exist” regulations, several outcomes are possible.

• Only those resulting partnerships continuing Oval Office LLC’s historical activities should be responsible for a final adjustment, and any resulting partnerships not conducting those historical activities should apply the section 708(b)(1) termination concept to avoid responsibility for the final adjustment.
• Oval Office LLC should be treated as ceasing to exist, because its section 708(b)(2) termination means that Oval Office LLC has no “ability to pay” the adjustment under the second criterion in Regulation section 301.6241-3(b)(1)(ii).
• As long as any partnership continues Oval Office LLC’s historical activities, all resulting partnerships should be responsible for the final adjustment. This outcome seems both unjust and unwieldy: as we will explore in Example 4, apportionment among continuing partnerships is an open question unto itself, and the administrative burden of apportioning among non-continuing partnerships would be cumbersome.
• If the adjustment stems from specific assets of Oval Office LLC, the specific partnership receiving those assets in the division should bear the entirety of the adjustment. This outcome is intuitive but does not find any specific support in the regulations.

Without complete clarity from the Service, query whether practitioners can negotiate any of these four outcomes (or others of their own creation) as a reasonable interpretation of the statute and regulations.

Example 3: Division with One Continuation and Novations

Assume the same facts as Example 2, except Moon Landing LLC includes all three of John, Ted, and Franklin, making Moon Landing LLC the only continuation of Oval Office LLC. If one resulting partnership continues the existence of the prior partnership, and all other partnerships are considered new, how would responsibility work for an adjustment after a post-division BBA audit of the prior partnership? Like Example 2, this Example 3 presents several possible outcomes.

• Since Moon Landing LLC is the only continuation of Oval Office LLC, the Adjustment Year partners are only the partners of Moon Landing LLC and none of the partners of the other resulting partnerships. This outcome is intuitive but potentially unfair, especially if the other resulting partnerships continue Oval Office LLC’s historical activities.
• The final adjustment should affect Moon Landing LLC and only those resulting partnerships continuing Oval Office LLC’s historical activities, excluding the resulting partnerships not continuing Oval Office LLC’s historical activities. This outcome seems technically in line with the section 6241 regulations but potentially unfair to the partnerships considered new: only one resulting partnership continues the prior partnership’s tax existence, and if the others are considered new, why should they be responsible for the tax items of the prior partnership? With the existence of a continuing partnership in this example, the notion of saddling the non-continuing partnerships with pre-division adjustments seems even more unjust than it would be in Example 2. But if the adjustment arose from specific activities of Oval Office LLC, and certain resulting partnerships continued those activities and others did not, this approach seems just. Query, however, fairness to Moon Landing LLC if it continues the tax existence of Oval Office LLC under section 708(b)(2) but does not conduct the historical activities of Oval Office LLC.
• If the adjustment stems from specific assets of Oval Office LLC, the specific partnership receiving those assets in the division should bear the entirety of the adjustment. This result seemed more equitable in Example 2 than it would here: with a single partnership continuing the existence of Oval Office LLC, allowing that partnership to escape responsibility for an adjustment on these grounds appears contrary to the statutory and regulatory framework of the BBA regime.

This example is perhaps the clearest thus far in illustrating potential ethical pitfalls for the practitioners orchestrating the transaction. A common situation would involve Oval Office LLC working with only one law firm and only one accounting firm until the division occurs. But including a single continuing partnership in the hypothetical division highlights the conflicts of interest that might arise between the three resulting partnerships when negotiating the issues posed by a potential BBA audit. Ideally, each of Oval Office LLC and the three resulting partnerships would have separate counsel to represent their respective interests on this issue, but this approach could be impractical because of the added costs, complexity, and time required to complete the transaction.

Example 4: Division with Multiple Continuations

Assume the facts as Example 2, except each resulting partnership features an additional member of Oval Office LLC, making all resulting partnerships continuations. In this scenario, the default outcome appears clear: since all the resulting partnerships are continuations, all of them should bear any adjustment from a BBA audit of the prior partnership. The equitable concerns about which partnerships receive corresponding assets or continue historical activities remain, but the technical support for absolving a continuing partnership of a final adjustment does not appear to exist. Therefore, the chief issue to resolve should be the method of allocating a final adjustment among multiple continuing partnerships.

Present Service guidance should tacitly allow the continuing partnerships to resolve the allocation among themselves by any reasonable method, because the theme of the BBA regime is to shift the burden for collateral issues to the taxpaying partnership and its partners; by default, the partnership under audit bears responsibility for the adjustment, and any obligation for current or past partners to contribute to the partnership to satisfy the adjustment is the sole domain of those parties. But in the absence of an agreement between continuing partnerships, whether by inability to agree or simple neglect, the Service should set forth a default rule. At least three possibilities exist:

• The adjustment gets allocated among the continuing partnerships pro rata. This approach is simplest but less than equitable: if one resulting partnership in this example receives 60% of Oval Office LLC’s net assets, leaving it with only one-third of the obligation to pay the net adjustment is a potential windfall.
• The adjustment gets allocated among the continuing partnerships according to net asset value. This approach could measure net asset value on the date of the division itself or the date of the final adjustment. The former already determines retention of the prior partnership’s TIN in this example, so the prior partnership’s advisors will already need to measure relative net asset value during the compliance process. Although the administrative burden of this approach is greater, it appears more equitable than the others.
• A single resulting partnership bears responsibility for the adjustment. This partnership could be the one retaining the prior partnership’s TIN or the one succeeding to the activities or assets giving rise to the adjustment. This approach presents too many practical and fairness issues to work as a default rule; foisting the adjustment onto the partnership retaining the prior partnership’s TIN is arbitrary, and determining responsibility for the adjustment could be unduly complicated when assets or activities are split between multiple partnerships, or the adjustment nets from multiple items.

The discussion about how the BBA audit rules will work in mergers and divisions illustrates the headaches taxpayers and practitioners can avoid when the issues manifest while remaining unaddressed in transaction documents. From the Service perspective, the absence of specific guidance about how the government will treat the parties might serve to create a greater administrative burden than it would prefer when these unaddressed scenarios arise during tax controversies. Practitioners will be left to jump into the breach until the Service acts, but the Service would be well served to contemplate how it wants to dispense with these problems before the number of taxpayers affected brings the ambiguity from a nuisance to a scourge.

J. Chapter 14: Gift Tax Consequences

1. In General

As part of the Omnibus Budget Reconciliation Act of 1990, Congress created Chapter 14 of Subtitle B of the Code (hereinafter “Chapter 14”) to address taxpayer abuses of family entity structuring to achieve wealth transfer without the corresponding estate or gift tax consequences. The four new statutes designed as part of Chapter 14 prescribed special valuation rules for federal transfer tax (i.e., estate, gift, and generation-skipping transfer (GST) tax) purposes. These special valuation rules were invented to curb taxpayer abuses in four distinct areas: (1) multiple classes of ownership interests in family-controlled entities with differing distribution, liquidation, or conversion rights; (2) family split-interest trusts; (3) rights to, or restrictions on the right to, acquire or use property, and (4) restrictions on the ability to compel liquidation of an entity, especially if these restrictions lapse upon certain intra-family transfers.

Because Chapter 14 was designed to exclusively target intra-family transfers, Chapter 14 will only become relevant in the merger and division context when multiple entities owned by the same family unit are involved. Spotting Chapter 14 issues may be particularly difficult when the income tax practitioners involved with a transaction do not have strong knowledge of transfer tax topics and vice-versa; however, spotting and addressing Chapter 14 issues may be vitally important because of the harsh gift tax consequences that would result from failing to do so.

2. Section 2701: The Anti-Freeze Rules

a. In General. Before the passage of Chapter 14, practitioners would use aggressive techniques to achieve outsize transfer tax benefits. Using Roosevelt LLC as an example, assume Theodore is concerned about the potential size of his taxable estate. Theodore approaches his estate planning attorney, who presents Theodore with several options to transfer his interest in Roosevelt LLC for the benefit of his heirs. Three such options are (1) an outright gift, (2) a sale to a grantor trust, or (3) using a grantor retained annuity trust (GRAT). Theodore is, however, unsatisfied with the prospect of losing some of the income derived from his interest and any potential loss of personal control over Roosevelt LLC’s affairs.

To provide Theodore with a compromise solution, his estate planning attorney instead suggests recapitalizing Roosevelt LLC. Theodore will retain a 50% interest (the “Senior Equity Interest”) in the current capital of Roosevelt LLC ($1,500,000). Theodore will transfer to a trust for the benefit of his heirs a 50% profits interest (the “Junior Equity Interest”) in Roosevelt LLC. The Senior Equity Interest will retain all voting rights and income derived from the 50% overall interest. The Junior Equity Interest will only be entitled to the future capital appreciation from the interest. For instance, if the capital value of Theodore’s share of the Roosevelt LLC’s assets appreciates to $2,500,000, Theodore’s Senior Equity Interest will retain the rights to the first $1,500,000 of capital value while the trust’s Junior Equity Interest will enjoy the rights to the next $1,000,000 of capital value. Therefore, when Roosevelt LLC liquidates, proceeds will be distributed accordingly.

Because the Junior Equity Interest has no voting rights and no rights to the income produced by Roosevelt LLC’s assets, the Junior Equity Interest’s fair market value is entirely predicated on the speculative prospect of Roosevelt LLC’s assets appreciating in value. For these reasons, practitioners would take the position that the fair market value of the Junior Equity Interest for transfer tax purposes is very small. Therefore, Theodore could effectively “freeze” the value of the Roosevelt LLC interest in his taxable estate at a relatively tiny cost and without comparable trade-offs.

Section 2701 outlawed the transaction described above by essentially requiring that either the Senior Equity Interest or Junior Equity Interest have a right to a “qualified payment,” defined as a fixed-rate dividend payable on a periodic basis. The Junior Equity Interest must be worth ten percent of the overall fair market value of all interests in Roosevelt LLC. Through this “minimum valuation” rule and the dividend requirement, Congress assured that taxpayers seeking to “freeze” the value of an entity interest for transfer tax purposes would need to make acceptable trade-offs. If the Senior Equity Interest retains the right to the dividend, the dividend must be paid or else the owner’s taxable estate would be increased by the amount of the unpaid dividend at death. If the Junior Equity Interest retains the right to the dividend, the senior generation runs the risk that all of the entity’s earnings will be paid over to the junior generation, thereby leaving no retained earnings for the entity’s operations.

b. Mergers and Divisions. If practitioners do not recognize the potential application of section 2701, the statute will treat the senior generation as transferring its entire partnership interest, regardless of whether a portion of the interest was actually retained in the transaction. If the junior generation paid consideration to the senior generation, such consideration would be subtracted from the value of the senior generation’s entire partnership interest before the transaction when determining transfer tax consequences. Therefore, if (1) a partnership features more than one class of partnership interest, and (2) the classes differ in distribution, liquidation, or certain other rights, then a partnership merger or division could potentially be treated for transfer tax purposes as a gift of up to the senior generation’s entire interest.

Section 2701 may apply in the merger context when two or more family partnerships merge to form a new capital structure. To illustrate this concept, consider an example in which Roosevelt LLC merges with another partnership controlled by the same family: The New Deal Partnership, the partners of which are Theodore, Franklin, and Kermit (Theodore’s son). The capital and profits interests of the New Deal Partnership are divided as follows:

• 25% of both the capital and profits to Franklin;
• 25% of both the capital and profits to Theodore;
• 50% of the profits only to Theodore, for a total of 75% in the profits only; and
• 50% of the capital only to Kermit.

Roosevelt LLC and the New Deal Partnership merge in an assets-over merger in which Roosevelt LLC survives. The New Deal Partnership’s net asset value represents 40% of the net asset value of the merged partnership. The capital and profits interests of the merged partnership are divided as follows: 40% to Theodore, 40% to Franklin, and 20% to Kermit. To the unwary observer, the transaction may appear a rather innocuous simplification of the family portfolio’s overall capital structure. By virtue of the merger, however, Theodore effectively relinquished two-thirds of his profits interest in the assets of the New Deal Partnership to Kermit as a gift. Therefore, the punitive valuation rules under section 2701 would apply to create a “phantom gift” of Theodore’s entire 25% capital interest and 75% profits interest in the New Deal Partnership to Kermit. Depending on the fair market value of Theodore’s interest in the New Deal Partnership, the adverse gift tax consequences of the merger could be significant.

Section 2701 will probably apply in the division context when the transaction is not a perfect “vertical-slice” division. In a vertical-slice division, every feature of a partnership interest is divided such that the retained interest and transferred interest have the exact same rights (except for differences in voting rights). Other divisions, known as “horizontal-slice” divisions, will effectively split a partnership interest into different classes based on distribution or liquidation rights. When the resulting partnerships from a horizontal-slice division represent a shift in distribution or liquidation rights between family members, section 2701 would deem the senior family member(s) to make a “phantom gift” to the junior family member(s) of up to the former’s entire interest in the prior partnership.

Using the New Deal Partnership above as an example, presume the New Deal Partnership divides into two partnerships in an assets-over division. The two resulting partnerships are the No Fear Partnership and the Works Progress Partnership. Theodore owns a 25% interest in the capital and profits of both resulting partnerships. Franklin owns a 75% interest in the capital and profits of the Works Progress Partnership. Kermit owns a 75% interest in the capital and profits of the No Fear Partnership. The No Fear Partnership is a continuation of the New Deal Partnership, whereas the Works Progress Partnership is considered a new partnership.

To the unwary observer, the transaction may appear to be a way for Kermit and Franklin to resolve an impasse preventing them from being part of the same enterprise. By virtue of the division, however, Theodore effectively relinquished two-thirds of his profits interest in the assets of the New Deal Partnership to Kermit as a gift. The punitive valuation rules under section 2701 would apply once again to create a “phantom gift” of Theodore’s entire interest in the New Deal Partnership to Kermit, despite the actual transfer of only a 50% profits interest. Again, depending on the fair market value of Theodore’s interest in the New Deal Partnership, the adverse gift tax consequences of the division could be significant.

3. Section 2704: The Anti-Lapse Rules

a. In General. Before the passage of Chapter 14, practitioners could install artificial and ultimately meaningless provisions into the governing agreements of family entities to manufacture valuation discounts that would not reflect economic reality. The result of installing such provisions would be a substantially lower transfer tax value for an ownership interest in the entity, but since the owners did not make any economic trade-offs, the lower transfer tax value comes at a comparatively tiny cost.

Using Roosevelt LLC as an example, assume the partnership’s governing agreement specifies that liquidation requires unanimous consent of the partners, but if either Theodore or Franklin transfers all or part of his partnership interest, the successor-in-interest may not vote on any material partnership matter (with material partnership matters including the decision to liquidate and wind up). If Theodore gifts his entire partnership interest to his son, Kermit, the valuation of Theodore’s gift will be made without regard to the lapsing voting rights (i.e., as if Kermit succeeded to a voting partnership interest despite the provisions of the partnership agreement). Therefore, Theodore will not enjoy the benefit of a valuation discount to that effect for gift tax purposes.

b. Mergers and Divisions. While not as punitive as the adverse tax consequences under section 2701, the results of overlooking section 2704 can either result in a phantom gift or an increase in the value of an actual gift. When no actual transfer has occurred but a voting or liquidation right lapses as the result of a merger or division, section 2704(a)(1) will apply to create a phantom gift. When an actual transfer occurs resulting in a lapse of a voting or liquidation right, section 2704(b)(2)(A) will apply to increase the value of the gift.

Consider an example in which Roosevelt LLC has the same governing agreement described in the previous section and divides into two partnerships in an assets-over division. The proportionate ownership of the two resulting partnerships is the same. The first resulting partnership, the Roosevelt Real Estate Partnership, owns only the building and no other assets. The second resulting partnership, the Roosevelt Operating Partnership, has all of the prior partnership’s other assets. The Roosevelt Trucking Partnership is a continuation of the Roosevelt Partnership, but the Pine Street Partnership is a new partnership for tax purposes.

Because Franklin is the partner who performs substantially all real estate management duties, the governing agreement of the Pine Street Partnership specifies that Theodore will have no voting rights. Because Theodore had voting rights under the governing agreement of the Roosevelt Partnership, his voting rights have lapsed with respect to the real property held by the Pine Street Partnership as a result of the division. Therefore, Theodore made a deemed (or “phantom”) gift to Franklin despite no actual transfer occurring. The value of the gift would be calculated pursuant to section 2704(a)(2).

Consider a different example in which the Roosevelt Partnership, with the same governing agreement in place, merges with another partnership controlled by the same family: The Court Packing Partnership, in which Franklin’s children Anna and Elliott each own 50% of the capital and profits interests. The two partnerships merge in an assets-over merger, with the Court Packing Partnership surviving. The Roosevelt Partnership’s net asset value represents 40% of the net asset value of the merged partnership. The capital and profits interests of the merged partnership are divided as follows: 20% Theodore, 40% Anna, and 40% Elliott. As part of the merged partnership’s governing agreement, Theodore’s interest has no voting control over the partnership’s affairs, while Anna and Elliott split voting control evenly. To the unwary observer, Franklin’s gift should be valued as the transfer of non-voting interests in the merged partnership, and Theodore has made no gift to Anna and Elliott. The merger resulted in two lapses: (1) the lapse of Theodore’s voting rights in the Roosevelt Partnership, which is a deemed gift from Theodore to Anna and Elliott; and (2) the lapse of Franklin’s voting rights in the Roosevelt Partnership, which inflates the value of his actual gift. Theodore’s deemed gift will be valued using the subtraction method prescribed in section 2704(a)(2). Franklin’s gift will be valued by measuring the fair market value of his voting interest in the Roosevelt Partnership rather than the non-voting interests in the merged partnership actually received by Anna and Elliott.

K. Anti-Abuse Regulations

In addition to the specific anti-abuse rules under the statutes and regulations throughout the remainder of Subchapter K, partnership mergers and divisions are also subject to macroscopic anti-abuse regulations designed to prevent mergers and divisions from being used as a device.

The Treasury Regulations effectively provide that all partnership mergers and divisions must have economic substance to be respected. In general, all transactions will be judged for tax purposes on their substance, and their form will only be respected in the event that (1) a legitimate non-tax purpose exists and (2) such purpose or purposes are of about equal or greater importance than tax benefits. The two chief arguments to attack the substance of a given transaction are (a) the step transaction doctrine, in which several transactions are collapsed into a single transaction that more sensibly reflects what the taxpayer has truly done; and (b) that the transaction was a device to achieve tax objectives rather than to accomplish the goals for which Congress originally afforded the transaction non-recognition treatment. The Treasury Regulations highlight both arguments with respect to partnership mergers and divisions.

In the Treasury Regulations’ example, two partnerships combine an assets-up merger and an assets-over division to effectively achieve a tax-free exchange of partnership interests. The example specifies that both the merger and division are pursuant to a “pre-arranged transaction.” In practice, ascertaining the substance of a transaction can prove difficult, and the issue has been litigated a great many times throughout the history of tax law.

The Treasury Regulations for partnership mergers and divisions do not have the same ancillary requirements for non-recognition as the Regulations governing corporate reorganizations. Although continuity of business enterprise and continuity of proprietary interest are not explicitly required by the merger and division Regulations, they are probably implicitly included under the general umbrella of substance-over-form; the merger and division Regulations simply decline to provide specific percentage thresholds under which non-recognition treatment would be denied per se. The difference in Regulations is also attributable to the differing tax treatment of entities under Subchapter C and Subchapter K.

VII. Conclusion

Business happens, transactions happen, tax partnerships combine, and tax partnerships split up. These things are inevitable, and the corresponding transactions also have tax consequences. The tax treatment of the transactions is not inevitable. The evolution of tax law as it relates to partnership mergers and divisions has become form-driven. The form of the transaction can determine tax consequences; business owners and their advisors, through careful planning, can choose a form that results in the most favorable outcomes for the parties to the transaction. By controlling the transaction and considering the numerous tax rules that apply, the parties and their advisors can reduce the potential negative effects—and maximize the positive effects—of the technical tax flotsam that inevitably comes with partnership mergers and divisions.