Consolidated group ownership of partnership.

It is not uncommon for members of a consolidated group to own all of the interests in a partnership. If one of the partners later becomes the partnership's sole owner, unanticipated tax consequences may result under Rev. Rul. 99-6.

Matching and Acceleration Rules

Under the consolidated return intercompany transaction rules of Regs. Sec. 1.1502-13, when one member of a consolidated group (S) sells an asset to another member (B) for an amount in excess of S's adjusted basis in the property, taxation of S's intercompany gain ordinarily is deferred under complex matching and acceleration rules intended to treat S and B as if they were divisions of a single entity for certain purposes (including the timing of income inclusion). Under the matching rule of Regs. Sec. 1.1502-13(c), S's intercompany gain will be taken into account based on B's subsequent treatment (such as depreciation or disposition gain) of the transferred property. Under the acceleration rule of Regs. Sec. 1.1502-13(d), S's intercompany gain must be taken into account when it becomes impossible to treat S and B as divisions of a single entity, such as when either member leaves the consolidated group.

If the asset that S sells to B is a partnership interest and the partnership remains in existence (i.e., another partner owns an interest in the partnership, so that the partnership does not terminate under Sec. 708(b)(1)(A)), S's gain on the sale of the partnership interest is deferred under Kegs. Sec. 1.1502-13 and B's basis in its partnership interest acquired from S is its cost under Sec. 1012. If the partnership subsequently liquidates, distributing its assets to B and the other partners, B's basis in the distributed assets will be determined by reference to its basis in the partnership interest under Sec. 732. As a result, under the Regs. Sec. 1.1502-13(j)(1) "successor asset" rule, S's intercompany gain would not be included in income immediately, but instead would attach to the distributed assets for future inclusion in income under the matching and acceleration rules.

The results are not changed if S's sale of the partnership interest to B results in a technical termination of the partnership under Sec. 708(b)(1)(B). Under Regs. Sec. 1.708-1 (b)(1)(iv), the terminated partnership is deemed to contribute all of its assets to a new partnership and, immediately thereafter, the terminated partnership distributes interests in the new partnership to the partners. S's gain would continue to be deferred; B would be deemed to receive interests in a new partnership with a basis determined by reference to its basis in its interest in the terminated partnership. In this scenario, the new partnership interest would qualify as the successor asset under Kegs. Sec. 1.1502-13(j)(1).

Impact of Rev. Rul. 99-6

These seemingly reasonable rules may not apply to an intercompany sale of a partnership interest if the partnership terminates because it no longer has more than one partner (i.e., a Sec. 708(b)(1)(A) termination). Under Rev. Rul. 99-6, when one member in a two-member limited liability company (LLC) sells its interest to the other member (resulting in a termination of the partnership as such), the selling member is considered to have sold a partnership interest, while the purchaser is considered to have purchased assets following a liquidation of the partnership.

Although this ruling involves an LLC, the IRS analysis is applicable to acquisitions involving any state law partnership that is taxed as a partnership for Federal tax purposes (i.e., general and limited partnerships). Rev. Rul. 99-6 provides that, for purposes of determining the tax treatment of B, the SB partnership is deemed to make a liquidating distribution of all its assets to S and B. Thus, a dissolution of the partnership apparently occurs during the instant after the selling partner sells its interest and before the buying partner acquires it.

Rev. Rul. 99-6 considers the Federal income tax consequences associated with the termination of a partnership under Sec. 708(b)(1)(A) when the termination is caused by one partner's acquiring all the partnership interests. The ruling is based on the Tax Court's decision in McCaulsen, 45 TC 588 (1966), holding that tacking of holding periods was not permissible for assets related to the acquired partnership interest. The Tax Court reasoned that the assets attributable to the purchased partnership interest were acquired by purchase, not by distribution from the partnership.

Terminating Sale within Consolidated Group

When a Sec. 708(b)(1)(A) terminating sale occurs within a consolidated group, S's gain on the sale of the partnership interest should be deferred under the intercompany transaction rules, as no partnership assets have been transferred outside the consolidated group. However, because B's basis in the terminated partnership's assets is determined by reference to its cost under Sec. 1012 (rather than by reference to B's basis in the partnership interest itself), the assets do not qualify as successor assets under Regs. Sec. 1.1502-13(j)(1). Thus, neither the partnership interest to which the intercompany gain relates nor a successor asset is owned by a member of the consolidated group; it therefore appears that S's gain must be taken into account.

The group may assert that the nature of the asset sold by S (a partnership interest) and the identity of the asset purchased by B (the assets) are attributes that must be redetermined on a single-entity basis under the intercompany transaction regulations. Under this approach, S's gain should continue to be deferred by redetermining its gain as relating to partnership assets themselves. This approach appears consistent with the general principle that S and B are to be treated as divisions of a single entity under the intercompany transaction rules (i.e., if S and B truly were divisions, there would have been no partnership interest for S to sell and, therefore, no partnership interest to which S's gain could relate). However, whether this approach would be accepted by the Service is uncertain; the identity of the transferred property (i.e., partnership interest vs. partnership assets) may be considered a "characteristic" of the property not subject to redetermination on a single-entity basis under the matching rule.

To escape the harsh results that may occur under Rev. Rul. 99-6, the intercompany sale transaction described above could be modified. For example, instead of selling its entire partnership interest to B, S could sell all but a small portion. There is no definitive guidance on how much of an interest must be retained to avoid termination. (Under the letter ruling guidelines in effect prior to the check-the-box rules, a 1% overall interest was required, but this did not constitute a substantive rule of law.) If an adequate interest is retained, a Sec. 708(b)(1)(A) termination does not occur (because two members remain in the LLC) and, therefore, Rev. Rul. 99-6 should not control. S's gain would be deferred under the matching rule and would not be taken into account under the matching or acceleration rule, even if a technical termination of the partnership were deemed to occur. The partnership subsequently could redeem S's remaining small partnership interest, terminating the partnership in that fashion. S and B each would take partnership assets, with a basis determined by reference to their respective bases in their partnership interests. Thus, the partnership assets received by B would be considered successor assets, and S's gain from the sale of its partnership interest would remain deferred.

FROM PATRICIA W. PELLERVO, J.D., AND KAREN T. GARRE, J.D., WASHINGTON, DC