IRS Seeks Comments On Treatment Of Layers In Partnership Mergers, Divisions, And Tiered Partnerships.

SECTION 1. PURPOSE

The Internal Revenue Service invites public comments on the proper application of the rules relating to the creation and maintenance of multiple layers of forward and reverse section 704(c) gain and loss to partnerships and tiered partnerships, including in the context of partnership mergers and divisions.

SECTION 2. BACKGROUND

As discussed in greater detail below, the IRS and Treasury Department issued proposed regulations in 2007 addressing the consequences under sections 704(c)(1)(B) and 737 of certain partnership mergers. The IRS and the Treasury Department received a number of comments in response to these proposed regulations expressing concern about the proposed treatment of section 704(c) layers in connection with a partnership merger. In addition, the IRS and the Treasury Department have become aware that practitioners are taking positions based upon different interpretations of the current tiered partnership rules (Treas. Reg. § 1.704-3(a)(9)). A number of practitioners suggest that the tiered partnerships rules may need to be clarified and similar rules be provided with respect to partnership mergers. The IRS and Treasury believe that further study of certain aspects of the application of section 704(c) is necessary before finalizing the Proposed Merger Regulations.

Section 704(c), in relevant part, provides:

(c) CONTRIBUTED PROPERTY. --

Section 704(c)(1)(B) was enacted as part of the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239). It was Congress's view that the prior law made it "possible for partners to circumvent the rule requiring pre-contribution gain on contributed property to be allocated to the contributing partner." S. Finance Comm. 101^st Cong., Revenue Reconciliation Act of 1989, Explanation of Provisions Approved by the Committee on Oct. 3, 1989, 196 (Comm. Print 1989).

While section 704(c)(1)(B) addresses the recognition of gain by the contributing partner if property contributed by the partner is distributed to another partner, section 737 addresses the tax consequences when a partner who contributed built-in gain or loss property receives a distribution of other property.

Sections 737(a) and (b), in relevant part, provide:

(a) GENERAL RULE. In the case of any distribution by a partnership to a partner, such partner shall be treated as recognizing gain in an amount equal to the lesser of --

(b)NET PRECONTRIBUTION GAIN. For purposes of this section, the term "net precontribution gain" means the net gain (if any) which would have been recognized by the distributee partner under section 704(c)(1)(B) if all property which --

On August 22, 2007, the IRS and the Treasury Department published in the Federal Register (2007-41 I.R.B. 790 [72 FR 46932]) a notice of proposed rulemaking (REG-143397-05) (the Proposed Merger Regulations), consistent with Notice 2005-15 (2005-1 C.B. 527), providing that (1) section 704(c)(1)(B) applies to newly created section 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over merger, but does not apply to newly created reverse section 704(c) gain or loss resulting from a revaluation of property in the continuing partnership, and (2) for purposes of section 737(b), net precontribution gain includes newly created section 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over merger, but does not include newly created reverse section 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. On November 6, 2007, corrections to the proposed regulations were published in the Federal Register (72 FR 62608).

The proposed regulations include several examples. Example (3) of the proposed regulations (see Treas. Proposed Reg. § 1.704-4(c)(4)(ii)(F), Example (3)) involves a situation where built-in gain property contributed to the transferor partnership has both a revaluation loss in the transferor partnership and additional gain upon merger with the transferee partnership. The example concludes that the section 704(c) layers are collapsed in the merger and that upon contribution to the transferee partnership the property had only built-in gain and no built-in loss.

Example 3 is as follows.

Treas. Reg. § 1.704-3(a)(7) provides rules when a partner transfers his partnership interest and provides a "step in the shoes" approach:

While no requests for a hearing were received in response to the proposed regulations issued on August 22, 2007, the IRS and the Treasury Department did receive comments relating to the proposed regulations and took notice of a number of articles published in response to the proposed regulations.

Most of the comments and articles address Example (3) which provides that property either has a built-in gain or built-in loss upon merger, not both, and that original section 704(c) gain is reduced by subsequent revaluation losses. Several comments discussed not only the specifics of Example (3), but also the broader implications of the example. In particular, the commentators questioned whether the example implies that a subsequent revaluation loss would reduce prior section 704(c) gains rather than create a new section 704(c) loss layer where there has been no partnership merger. Another comment suggested that the section 704(c) allocations in the example could be different if, for example, the transferor partnership used the remedial method instead of the traditional method. Other commentators expressed concerns that the application of the proposed regulations would result in tax allocations after the merger that are not consistent with the economic arrangement of the partners of the transferor partnership. For example, if layers of reverse section 704(c) built-in gain or built-in loss are collapsed in the merger, then a partner who prior to the merger was allocated a net loss for book purposes with respect to the property would not recognize a corresponding tax loss until liquidation of its interest. They contend that if the transferor partnership had continued in existence instead of liquidating, the section 704(c) layers would have been preserved under the tiered partnership rules of Treas. Reg. § 1.704-3(a)(9). Some practitioners believe the results should be the same in a merger.

The IRS and the Treasury Department have also become aware that there are conflicting views among practitioners about how section 704(c) layers should be maintained with respect to tiered partnerships. One view is that an aggregate approach should apply or be permitted such that a tiered partnership arrangement can be "looked through" and section 704(c) applied as if the partners of the upper-tier partnership directly own a portion of the assets of the lower-tier partnership (the Aggregate Approach). Another view is the entity approach under which the upper-tier partnership is treated as owning an interest in the lower-tier partnership but is not treated as owning any interest in the section 704(c) property of the lower-tier partnership (the Entity Approach). Each approach raises different issues and has unique consequences.

After extensive consideration of the concerns raised, the IRS and the Treasury Department believe that comments would be helpful to the development of guidance concerning section 704(c) layers in tiered partnerships and in mergers and divisions. The IRS and Treasury Department believe that it is appropriate to consider the issues regarding section 704(c) layers in general before finalizing the Proposed Merger Regulations.

SECTION 4. REQUEST FOR COMMENTS

The IRS and Treasury Department are seeking comments relating to section 704(c) layers, as well as other section 704(c) issues, with respect to tiered partnerships, mergers and divisions. The IRS and the Treasury Department plan to address these issues as part of a future guidance project. However, the IRS and Treasury Department are not requesting comments on the principles described in Notice 2005-15, 2005-1 C.B. 527.

The IRS and Treasury Department include examples below of the types of comments requested, but comments are requested on all aspect of these issues, not only those matters listed.

Single Partnership with Layers -- No Tiers

SECTION 5. DRAFTING INFORMATION

The principal author of this notice is Laura Fields of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this notice, contact Ms. Fields at (202) 622-3050 (not a toll-free call).