IRS: Corporations cannot circumvent gain on appreciated property using partnerships

By Sally P. Schreiber, J.D.

The IRS issued more regulations on Thursday that take aim at transactions that attempt to avoid the repeal of the General Utilities doctrine. T.D. 9722 contains new rules designed to prevent “a corporate partner from avoiding corporate-level gain through transactions with a partnership involving equity interests of the partner.”

The General Utilities doctrine was repealed by the Tax Reform Act of 1986, P.L. 99-514. The doctrine grew out of General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), a Supreme Court case permitting tax-free liquidations to allow taxpayers to avoid potential multiple taxation of the same economic gain.

After the repeal, the IRS became aware that taxpayers were using partnerships to postpone or avoid gain generally required to be recognized under Sec. 311(b). For example, a corporation would enter into a partnership and contribute appreciated property. The partnership would then acquire that corporate partner’s stock and make a liquidating distribution of this stock to the corporate partner. Because of Sec. 731(a), the corporate partner would not recognize gain on the partnership’s distribution of its stock. The corporation had thus disposed of the appreciated property it formerly held and had acquired its own stock, permanently avoiding recognizing gain on the appreciated property. If the corporation had directly exchanged the appreciated property for its own stock, under Sec. 311(b) the corporation would have been required to recognize gain on the exchange.

As part of its efforts to curb these transactions, the IRS issued proposed regulations in 1992. The proposed regulations (REG-208989-90), in particular, had two rules designed to curb these transactions: (1) the deemed redemption rule and (2) the distribution rule. The deemed redemption rule required a corporate partner to recognize gain at the time of, and to the extent that, any transaction (or series of transactions) that has the economic effect of the partner’s exchange of its interest in appreciated property for an interest in its stock (or the stock of any member of the affiliated group of which such partner is a member) owned, acquired, or distributed by the partnership. The distribution rule required a partnership’s distribution to a partner of the partner’s stock be treated as a redemption or an exchange of the partner’s stock for a portion of the partner’s partnership interest with a value equal to the distributed stock.

The temporary regulations issued Thursday (which also withdraw the 1992 proposed regulations) apply to certain partnerships that hold stock of a corporate partner, which is defined as a person that holds or acquires an interest in a partnership and that is classified as a corporation for federal income tax purposes. Under the regulations, a corporate partner may recognize gain when it is treated as acquiring or increasing its interest in stock of the corporate partner held by a partnership in exchange for appreciated property in a manner that avoids gain recognition under Sec. 311(b) or Sec. 336(a).

The deemed redemption rule from the 1992 proposed regulations is retained in the temporary regulations, with some changes. The deemed distribution rule from the 1992 regulations has been removed, and instead the temporary regulations apply the deemed redemption rule to partnership distributions of a corporate partner’s stock to the corporate partner as though the partnership amended its agreement, immediately before the distribution, to allocate 100% of the distributed stock to the partner.

The temporary regulations retain two exceptions that were included in the 1992 proposed regulations. First, a de minimis exception applies if the corporate partner and any related persons own less than 5% of the partnership; the partnership holds stock of the corporate partner worth less than 2% of the value of the partnership’s gross assets, including stock of the corporate partner; and the partnership has never, at any time, held more than $1 million in stock of the corporate partner or more than 2% of any particular class of stock of the corporate partner. The 1992 proposed regulations contained similar conditions, but with a $250,000 cap on value of the partnership’s stock of the corporate partner.

The second exception is for inadvertence, which requires the partnership to, in effect, undo the transaction. This rule requires the partnership to dispose of, by sale or distribution, the corporate partner’s stock before the due date (including extensions) of its federal income tax return for the tax year in which the partnership acquired the stock (or in which the corporate partner joined the partnership). In addition, the partnership must not have distributed the corporate partner’s stock to the corporate partner or a person possessing control of the corporate partner under Sec. 304(c).          

Finally, the IRS explains that the regulations must be applied to tiered partnerships in a manner that is consistent with their purposes.

The temporary regulations apply to transactions occurring on or after June 12, 2015, the date they are being published in the Federal Register.

The IRS also issued proposed regulations (REG-138759-14) under Secs. 337(d) and 732(f) that would allow consolidated group members that are partners in the same partnership to aggregate their bases in stock distributed by the partnership for the purpose of limiting the application of rules that might otherwise cause basis reduction or gain recognition. The proposed regulations would also require certain corporations that engage in gain elimination transactions to reduce the basis of corporate assets or to recognize gain.

Sally P. Schreiber ( ) is a JofA senior editor.


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