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Partnership Exchange Issues, Including Mergers and Divisions
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Handling Cash-Out Partners. If relinquished property is held by a tax
partnership, how can some of the partners receive cash while other partners
receive replacement property? Advisors usually examine four alternatives:
(1) Special allocations to the partners receiving cash, but such allocations
may lack substantial economic effect (further, if there is depreciation
recapture, the cash-out partners may not offset ordinary income with capital
losses);
(2) Distribute undivided interests and then the cash-out partners sell
their interests and the other partners exchange (this is the most frequently
used methodology, although there are “holding” and “continuing
partnership” issues);
(3) A partnership-level exchange with a buyer’s installment note (the
installment note is subsequently distributed to the cash-out partners),
which works but may not be practical unless the buyer is very creditworthy;
and
(4) Partnership mergers and divisions.
“
Drop and Swap” and “Swap and Drop” Transactions. Can a
taxpayer exchange property received in a distribution from a partnership
(a “drop and swap” transaction)? Can a taxpayer who receives
replacement property in an exchange immediately transfer the property to
a partnership (a “swap and drop” transaction)?” Many leading
tax commentators believe that these transactions “should be” allowed.
The weight of the law and Congressional intent appear to support such transactions.
Many practitioners simply caution their clients and try to put some time
in between the steps of the transactions and develop other favorable facts.
But they neither attempt to prevent such transactions nor disclose them
on tax returns. Authorities in support of such transactions include Bolker
v. Commissioner, 81 TC 782, aff’d 760 F.2d 1039 (9th Cir. 1985); Mason
v. Commissioner, TC Memo 1988-273, aff’d without pub. opin. 880 F.2d
420 (11th Cir. 1989); Magneson v. Commissioner, 81 TC 767 (1983), aff’d
753 F.2d 1490 (9th Cir. 1985); Maloney v. Commisssioner, 93 TC 89 (1989).
But see Chase v. Commissioner, 92 TC 874 (1989); Rev. Rul. 75-291, 1975-2
C.B. 332; Rev. Rul. 77-297, 1977-2 C.B. 304.
Partnership Mergers and Divisions. In the Section 708 regulations on
partnership mergers and divisions, the Service has adopted theories (referred
to as "assets up" and "assets over") in connection with
the treatment of partnership terminations, mergers and divisions. These
rules provide that partnership mergers and divisions operate differently
than corporate mergers and divisions as a result of the aggregate principle
underlying much of partnership taxation. For example, Reg. Section 1.708-1(d)
provides that, upon the division of a partnership into two or more partnerships,
any resulting partnership or partnerships shall be considered a continuation
of the prior partnership if the members of the resulting partnership or
partnerships had an interest of more than 50 percent in the capital and
profits of the prior partnership. Any other resulting partnership will not
be considered a continuation of the prior partnership but will be considered
a new partnership. If the members of none of the resulting partnerships
owned an interest of more than 50 percent in the capital and profits of
the prior partnership, none of the resulting partnerships will be considered
a continuation of the prior partnership, and the prior partnership will
be considered to have terminated. Where members of a partnership which has
been divided into two or more partnerships do not become members of a resulting
partnership which is considered a continuation of the prior partnership,
such members' interests shall be considered liquidated as of the date of
the division.
Example of Division: Partnership AB is owned 50% by A and 50% by B. Partnership
AB transfers relinquished property in a deferred exchange with a QI and
then divides into Partnership AB owned 99% by A and 1 % by B and Partnership
BA owned 99% by B and 1 % by A. Assume that Partnership AB has a 50.0001%
interest in the QI’s exchange account and Partnership BA has a 49.9999%
interest. Separate QI accounts could be established in these amounts. Partnership
AB completes the exchange into replacement property, and Partnership BA
does not and cashes out. This results in almost complete tax deferral for
A and gain recognition for B. Partnership AB is not considered to be terminated
under the Section 708 regulations since A and B, the members of the resulting
partnership or partnerships, had an interest of more than 50 percent in
the capital and profits of the prior partnership AB.
Example of Merger: Partnership ABC (equally owned by A, B and C) owns
relinquished property but the replacement property will be owned by Partnership
BCD (equally owned by B, C and D). Partnership ABC transfers the relinquished
property but later merges into Partnership BCD before completion of the
exchange. Partnership BCD receives the replacement property. A is redeemed
out of Partnership ABC during the exchange period without using the exchange
proceeds or otherwise creating boot on the exchange. Section 708(b)(2)(A)
provides that in a partnership merger the survivor is a partnership with
more than 50% common ownership with the prior partnership. Accordingly,
Partnership BCD is the successor to Partnership ABC since the common
owners, B and C, owned more than 50% of both partnerships.
Example of Continuation: A, B, C and D hold title to relinquished property
as equal tenants in common but have a long-standing partnership agreement,
maintain a partnership bank account and filed partnership returns for
many years. A, B, C and D transfer their undivided interests to a QI
in a deferred
exchange. The QI sets up a separate exchange account for each owner.
A, B and D identify and receive a common replacement property. C does
not identify
property and receives his share of the proceeds after 45 days and before
A, B and D receive their common replacement property. The facts are the
same as TAM 199907029. The IRS ruled that: (1) a tax partnership existed
and continued to exist among A, B, C and D at the time of the exchange;
(2) the exchange of relinquished property by the ABCD deemed partnership
for replacement property received by the ABD deemed partnership qualified
under Section 1031; (3) the ABCD partnership had to recognize gain equal
to the boot paid to partner C; (4) although the (g)(6) limitations were
violated, the entire exchange was not disqualified because actual or
constructive receipt occurred only as to the separate exchange account
held for C and
not as to the money held in the other exchange accounts; and (5) the
ABD partnership was a continuation of the ABCD partnership because A,
B and
D had more than 50% common ownership of the partnerships and the ABCD
partnership was not otherwise terminated under Section 708(b). A, B and
D could have
faced disaster based on their deemed status as a tax partnership but
were saved by their more than 50% ownership in both partnerships, their
common
acquisition of the replacement property, and the fact that the ABD partnership
was treated as a continuation of the ABCD partnership.
Section 704(c) Issues. In Rev. Rul. 2004-43, the IRS addressed the application
of Section 704(c) to partnership mergers. The IRS concluded that the
deemed contribution of property by a disappearing pre-merger partnership
to the
surviving post-merger partnership created a new level of Section 704(c)
gain which was subject to a new seven-year holding period under the mixing
bowl rules of Sections 704(c)(1)(B) and 737. Thus, the partnership merger
did not result in a complete carryover of attributes.
Use of Special Allocations to Create Asset Separation Within a Partnership.
Example: A and B are equal partners in Partnership AB and want to separate.
Partnership AB does a Section 1031 exchange at the partnership level
and receives two replacement properties, RPA and RPB. Partnership AB’s
partnership agreement is amended to allocate 90% of all profit, loss, credit
and deduction items attributable to RPA to A and 10% to B and 90% of all
profit, loss, credit and deduction items attributable to RPB to B and 5%
to A. All other items continue to be allocated 50/50. There is no formal
agreement, but the parties expect that, after a reasonable time, Partnership
AB will dissolve by distributing RPA to A and RPB to B. This example raises
issues as to whether the special allocations satisfy the requirements of
Section 704(b) and, if so, how close to 100/0 could the differential allocations
be taken. The IRS could argue that the transaction is in substance been
a disguised sale of partnership interests under Section 707. The IRS could
also claim that Partnership AB actually terminated and divided into Partnerships
AB and BA, with each owning one of the two replacement properties.
Special Allocations of Boot to Cash-Out Partner.
Example: A, B and C are equal partners of Partnership ABC. ABC holds
Property X which has FMV of $150 and adjusted basis of $30. Each partner's
outside basis is $10. Partners A and B want to exchange X for Property
Y and Partner C wants to sell. Partnership ABC enters into exchange agreement
with QI with respect to 2/3 of the value of X. At closing, QI receives
$100
and Partnership ABC receives $50. This results in $50 of recognized gain
to Partnership ABC. Partnership ABC then redeems the interest of C with
a distribution of $50. Partnership ABC (now AB) completes the deferred
exchange by acquiring replacement property costing $100. The question
is whether
Partnership ABC can specially allocate all of the $50 gain to C. C may
not care since on the complete termination of C's partnership interest
for $50,
C would have an offsetting $10 loss due to C’s outside basis of $10.
However, the liquidation of C’s interest would not be in accordance
with capital accounts and the special allocation of all $50 of the gain
to C may not have substantial economic effect. Partnership ABC might use
a "fill-up" allocation of $40 gain to C, reaching the right basis
and capital account result but creating $10 gain allocable to A and B.
Installment Note Distribution.
Example: Partnership engages in a Section 1031 exchange but receives
boot in the form of an installment note. The Partnership then liquidates
one of the partner's interests by distributing the installment obligation
to the partner. Distribution of the installment note is treated as
a distribution of property in a liquidating distribution to the partner.
The partner receives
the installment note with a basis equal to his basis in his partnership
interest under Section 732(b) and recognizes gain as payments are received
on the installment note under Section 453 outside of the partnership.
No gain is recognized by the partnership or by the distributee partner
on the
exchange itself. Reg. Section 1.453-9(c)(2) provides that, except as
provided in Sections 736 and 751, the disposition of an installment
obligation
in
a Section 731 distribution from a partnership to a partner will not
result in gain or loss under Section 453B.
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