Corporate contributions to partnerships owned by shareholders.

When the General Utilities doctrine was repealed by the Tax Reform Act of 1986, corporate liquidations and redemptions became subject to double taxation. Certain taxpayers attempted to avoid this by using partnerships in a tiered ownership structure. Shareholders would form a partnership and contribute their stock to the new partnership. The corporation would then acquire an interest through the contribution of appreciated property and later receive a distribution of its own stock. Barring the possible application of the disguised sale roles, the contributions by the shareholders and the corporation, and the distribution of stock to the corporation, are nontaxable. However, the substance of the transaction is that the corporation has redeemed stock through a tax-free distribution of appreciated property; see Notice 89-37.

Anti-Abuse Rules

The IRS issued proposed regulations in December 1992 to address this perceived abuse. These rules apply when a partnership (either directly or indirectly) owns, acquires or distributes a partner's stock. The regulations provide that a partner may be required to recognize gain under the deemed redemption rule or the distribution rule.

Deemed redemption rule: Under this rule, a partner recognizes gain whenever a transaction effectively results in the exchange of his or her interest in appreciated property for an interest in stock of the partner owned, acquired or distributed by the partnership. According to Prop. Regs. Sec. 1.337(d)-3(d), this may occur if?

1. A partner contributes property to a partnership when the partnership owns stock in the contributing partner;

2. A partnership acquires stock in one of its partners;

3. A partnership makes a disproportionate distribution;

4. A partnership agreement is amended to provide different sharing ratios; or

5. De minimis rules (discussed below) cease to apply.

If a partner recognizes gain under this provision, the bases of the partner's and partnership's property are increased accordingly.

Distribution rule: Under this rule, a partnership's distribution to a partner of partner stock is treated as a redemption or exchange for a portion of the partner's partnership interest; the Sec. 732 nonrecognition rules do not apply. A portion of the partner's partnership interest is deemed exchanged for stock equal to the fair market value (FMV) of the stock distributed. Sec. 311 (governing corporate taxation of a distribution of its stock or other property) or 1001 (governing the calculation of gain or loss on sale) applies to the deemed redemption or sale transaction, according to Prop. Regs. Sec. 1.337(d)-3(e)(l).

De minimis rule: A de minimis rule under Prop. Regs. Sec. 1.337(d)-3(f)(1) excludes the following transactions from the proposed regulations:

* Any transaction involving a partner who has never owned more than 5% of the partnership.

* Any transaction involving a partnership that, as of the end of the tax year and while the partner involved in the transaction is a partner, has not held, in the aggregate, the lesser of (1) $250,000 of the partner's stock or (2) 2% of the value of any class of the partner's stock.

A partner's stock is not included in the de minimis calculation if the partnership disposes of it before the due date (including extensions) of its Federal income tax return for the tax year in which the stock is acquired or during which the partner became a partner (whichever is applicable). Additionally, under Prop. Kegs. Sec. 1.337 (d)-3 (f) (2), stock is not included in the calculation if it is not distributed to the partner.

Partner's affiliates: Special rules govern the treatment of transactions involving the stock of an affiliate of a partner, as defined in Sec. 1504(a), without regard to the exceptions in Sec. 1504(b); see Prop. Regs. Sec. 1.337(d)3(c) and Notice 93-2.

Example

In 1997, Hex Corp. and Joe Myst form HexMyst Partnership as equal partners, to invest in raw laud. Hex contributes land with a $10,000 FMV and zero basis. Myst contributes his Hex stock, with a $10,000 FMV and basis. In 2005, when the FMV of both the land and the Hex stock are $20,000, HexMyst liquidates; Hex and Myst each receive a half- interest in the land and half of the Hex stock.

Mvst's and Hex's 1997 contributions have the economic effect of an exchange by Hex of its interest in appreciated property for stock. Under the deemed redemption rule, Hex is treated as exchanging half of the land, with a zero basis and $5,000 FMV, for 50% of the partnership's stock in Hex. Hex recognizes a $5,000 gain; both the partnership's basis in the contributed land and Hex's basis in HexMyst are increased by the $5,000 of gain recognized.

When HexMyst liquidates in 2005, the distribution rule applies. Hex receives land with a $10,000 FMV and Hex stock with a $10,000 FMV. Under the distribution rule, Hex is treated as redeeming the $10,000 of stock for half of its partnership interest (with a $2,500 basis); thus, Hex recognizes $7,500 gain. The half interest in land Hex received is treated as a liquidating distribution and takes a basis equal to Hex's remaining partnership basis--$2,500.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 18th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ([phone]; ppc.thomson.com).

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King of Norklinger, L.L.P.

Arlington, VA