Distributions to retiring partners.

The Revenue Reconciliation Act of 1993 (RRA) included several provisions that modify the tax treatment of distributions to retiring or deceased partners under Sec. 736. Part I of this article, published in April, examined these provisions and the significant effect they have on tax planning for Sec. 736 distributions.

The RRA also adopted uniform amortization rules for intangible assets. These rules have broad applicability, and are not limited to transactions between partnerships and partners. They do have some special ramifications, however, for distributions to retiring or deceased partners. Part II, below, will explore the most important aspects of the amortization provisions as they apply to such distributions.

Acquisition and Disposition of Intangible Assets

* Allocation of consideration

The treatment of intangible assets has long been a source of controversy between taxpayers and the IRS. One of the most important legislative provisions before 1993 was the 1986 adoption of Sec. 1060, which requires buyers and sellers of a going business to allocate values to the various assets exchanged according to the residual method. Although Sec. 1060 is a broad rule covering many transactions outside of the context of payments to partners, it does have specific application to certain partnership transactions. Sec. 1060 treats an exchange of a partnership interest, or a distribution to a partner, as an applicable asset acquisition if the partnership has a Sec. 754 election in effect, and the partnership must allocate newly acquired basis to assets under Sec. 755.(9) Therefore, Sec. 1060 requires appropriate allocation to goodwill whenever a partnership makes a Sec. 736(b) distribution and the partner recognizes either gain or loss. The regulations under Sec. 755 state that such allocation is required whenever the assets of the partnership constitute a going business, or a sufficient operation that goodwill or going concern value is associated with the partnership.(10)

* Recent developments

In the Newark Morning Ledger Co.(11) case, the Supreme Court specifically approved a taxpayer's attempt to identify and amortize short-lived intangible assets. The taxpayer's victory, however, was brief, for the Court's decision was soon eclipsed by the adoption of the Sec. 197 uniform amortization rules for intangible assets as part of the RRA.(12)

The new rules relating to intangible assets provide definite benefits for many taxpayers, since goodwill is now amortizable over a 15-year period.(13) There is a distinct disadvantage to taxpayers who have been able to accurately value intangible assets with lives shorter than 15 years. To come within the amortization rules, the intangible assets must have been purchased, rather than internally generated. In the Sec. 736(b) context, there are three implications:

1. The partnership may still separately value intangible assets, such as customer lists, covenants not to compete and other assets that might have short lives, but will amortize these assets over 15 years. Goodwill may be subject to anti-churning rules, but other intangibles will not.

2. When a partnership purchases intangible assets in a Sec. 736(b) payment, it may be subject to some anti-churning rules to determine the allowable amortization, if any, for the goodwill purchased from the retiring or deceased partner.

3. If the partnership is allowed to amortize the basis of intangible assets acquired in a Sec. 736(b) distribution, it can amortize the step-up in basis of these assets. The portion of the intangibles that represented the departing partner's basis in the assets will not be amortizable, unless the basis was amortizable before the Sec. 736 distribution.

When there are noncash distributions in a Sec. 736 context there would most likely be some allocation problems for a partnership that had a Sec. 754 election in effect. (This article deals with only cash distributions, in which the adjustments to basis are relatively simple.)

If a partner recognizes gain on receipt of a cash distribution, and the partnership has a Sec. 754 election in effect, the partnership adjusts the basis in the assets it retains in the same amount as the gain recognized by the partner who receives the distribution.(14) The partnership must allocate the step-up in basis among the assets held by the partnership immediately after the distribution. The step-up rules may result in nothing being allocated to goodwill under Temp. Regs. Sec. 1.755-2T. Any portion of this basis increase that is allocated to intangible assets held by the partnership may be amortized according to new Sec. 197, unless the partnership is barred by the anti-churning rules from claiming amortization.

Intangible Assets Subject to Amortization

The new amortization rules apply to all intangible assets acquired in the acquisition of a going business. These assets are specifically defined in Sec. 197(d) to include:

* Goodwill and going concern value.

* Workforce in place, books, records and information bases, including customer lists.

* Patents, copyrights, formulas, processes, designs, patterns, etc.

* Customer-based intangibles, such as composition of market, market share, deposit base of financial institutions and any other value resulting from relationships with customers.

* Any supplier-based intangible, including value resulting from future acquisitions of goods or services pursuant to relationships with suppliers (contractual or otherwise).

* Any other similar item.

* Any license, permit, etc., granted by a governmental body.

* A covenant not to compete, if entered into in connection with the acquisition of a going business

* Franchises, trademarks and tradenames.

When a taxpayer purchases interests in any or all of these intangibles in a single transaction, each amortizable asset must be amortized over the same 15-year period. Therefore, short-lived assets, such as customer lists, are subject to the same amortization as longer lived assets, such as goodwill. The purchaser is not allowed to deduct any loss on the sale or worthlessness of any intangible asset, unless it disposes of all of the intangibles acquired in the same transaction.15 In the context of a distribution to a retiring or deceased partner, the partnership would not be able to accelerate any amortization or other deduction on any of the distribution allocated to any intangibles, as long as the partnership remained in business. If an intangible asset expires, or is disposed of, before the 15-year amortization period ends, the partnership must add the unrecovered basis to the basis of the other intangibles acquired in the same transaction.

Example 4: Pursuant to an arm's-length agreement with a retiring partner, Z, partnership XYZ allocates $150,000 to Z's share of intangible assets in a Sec. 736(b) distribution. Assuming that the intangible assets qualify for amortization under the anti-churning rules, XYZ would claim $10, 000 per year as an amortization deduction. The deduction would not be affected by breaking the $150,000 into separate portions for goodwill, a covenant not to compete, or any other specifically identified intangibles.

Assume that the distribution occurred on Jan. 1, 1994. XYZ would claim a deduction every year through 2008. Assume that XYZ allocated $45,000 of the intangibles' value to a covenant not to compete that was to expire on Jan. 1, 1997. XYZ allocated $105,000 to Z's share of partnership goodwill. Thus, from 1994 through 1996, XYZ claimed annual amortization deductions of $3,000 $45,000 [divided by] 15) on the covenant and $7,000 ($105,000 [divided by] 15) on the goodwill. On Jan. 1, 1997, XYZ would have an unrecovered basis of $36,000 on the covenant, which has now expired. XYZ would add the $36,000 unrecovered basis to the basis of its goodwill and deduct $10,000 per year as amortization of the goodwill.

At first glance, therefore, it appears that a partnership would gain little, if any, tax advantage from allocating the Sec. 736(b) payments among differing intangibles. There may, however, be some planning opportunities in identifying different intangibles in order to reduce the impact of the anti-churning rules.

Assets Excluded From Amortization

The statute specifically excludes certain assets from the category of amortizable intangibles. Among these exclusions are any interest in land, leaseholds, computer software and interests in corporations, partnerships, estates or trusts. Certain property that would be amortizable under Sec. 197 is not treated as 15-year amortizable property if it is not acquired in connection with a going business. Thus, patents, copyrights, contracts, and interests in films and recordings are not subject to the new amortization provisions if acquired separately, rather than as part of a going concern. In the authors' opinion, these assets would not be treated as separately acquired in the Sec. 736 context, since Sec. 736 applies only to the liquidation of a partner's interest in an entire partnership.

The amortization rules do not apply to any self-created intangibles.(16) The RRA committee reports, however, specifically allow amortization of intangible assets with basis attributable to a Sec. 754 election.

Example 5: On Jan. 1, 1994, GHI, a partnership in which capital is a material income-producing factor, retires the interest of G, who had owned 10% of partnership profits, losses and capital. G owned no indirect interest in GHI. The entire Sec. 736 distribution is in cash (including liability relief). Included in the Sec. 736(b) payments are $15,000 in exchange for G's share of goodwill. GHI valued its goodwill at $150,000 at the time of G's retirement. The partnership had not purchased any of the goodwill and had no basis therein. The continuing partnership would not be able to amortize any of the goodwill, except to the extent that G recognizes gain on his Sec. 736(b) distributions. The amount of gain allocated to his goodwill would be amortizable if GHI had a Sec. 754 election in effect.

Assume that G recognized gain on the distribution and that GHI had a Sec. 754 election in effect. The adjustment to GHI's goodwill was $15,000. GHI would claim $1,000 per year as amortization of the goodwill, since its basis in $15,000 of goodwill is due to the basis adjustment under Sec. 734(b).

Example 6: Assume the same facts as in Example 5, except that GHI had purchased $100,000 of its goodwill before Aug. 11, 1993, and its basis in the goodwill was also $100,000. GHI allocates $5,000 of G's recognized gain to goodwill. Thus, GHI's basis in goodwill acquired from G is $15,000, which consists of G's portion of the predistribution basis, plus G's gain recognized. GHI will be able to amortize only $5,000 of the goodwill, at the rate of $333 per year for 15 years.

Effective Dates

Intangible assets acquired after Aug. 10, 1993 (the date of enactment of the RRA) are subject to the new amortization provisions. A special elective provision allows purchasers to claim the amortization deduction on intangibles acquired before Aug. 11, 1993, but after July 25, 1991.(17) In order to qualify for the earlier date, the purchaser must make an election to treat all intangibles acquired during this period under the new provision. In the context of a partnership, the partnership must elect to treat all intangibles acquired by means of Sec. 736(b) payments, as well as any other purchases of intangibles, under the new rule.

An election to treat post-July 25, 1991 acquisitions of intangibles as amortizable under the new provision would be beneficial to a partnership that had purchased substantial goodwill and little, if any, shorter lived intangibles during that period. The partnership might be better served by not making the election if it had purchased primarily shorter lived assets, and is assured of a shorter amortization period under the rationale of Newark Morning Ledger. The election to accelerate the new provision is binding on all taxpayers under common control within the meaning of Sec. 41(f)(1).(18) In the Sec. 736 context, this election would be made at the partnership level, and would cover any intangible assets acquired by means of Sec. 736(b) payments, as well as any other acquisitions of intangibles, after July 25, 1991. This election would not apply to any payments for partnership goodwill under Sec. 736(a), since a partnership would have had a deduction, rather than an asset acquisition, for all Sec. 736(a) payments.

Anti-Churning Rules

Perhaps the most important, and most complex, provisions of Sec. 197 are the anti-churning rules. These provisions, in general, do not allow amortization of intangible assets acquired from certain related parties if the related party owned the property on or after July 25, 1991 and before Aug. 11, 1993.(19) The only assets covered by the anti-churning rules are goodwill and going concern value.(20)

The window period prevents the related parties from churning goodwill or going concern value from unamortizable status under prior law to an amortizable asset under new law. It is not necessary to look to any earlier date than July 25, 1991 for the tainted transactions or relationships. For example, if a partner and a partnership had been related parties, but the relationship had terminated before July 25, 1991, any transfer of intangible assets would not come under the anti-churning rules.

The anti-churning rules have dual significance in the partnership context. First, there are rules that will deny amortization for any basis in goodwill obtained by a partnership from a related partner. Second, the anti-churning rules will prevent amortization of goodwill to the extent that a partner's share of partnership goodwill is acquired from a person related to that partner.

The two sets of anti-churning rules that apply to partnerships are somewhat confusing. The partnership level anti-churning rule in Sec. 197(f)(9)(C)(i) specifically states that the rules are to apply to related parties within the meaning of Sec. 707(b)(1), substituting 20% for 50%. Therefore, a partnership, in its capacity as a taxpayer, is considered to be a related party to any partner who directly or indirectly owns more than 20% of partnership capital or profits.

The second anti-churning rule, which applies at the partner level, is in Sec. 197(f)(9)(E). The construction of the provisions is not clear, and it may be a reasonable interpretation that the partner level anti-churning rules are to be applied in lieu of partnership anti-churning rules. However, the partner level rules apply only to the increase in basis under Sec. 734, and do not appear to override the partnership level related-party rules. The RRA House Report contained a description of the related-party rules in general, and then followed with the statement, "In addition,... the determinations are to be made at the partner level...."

Therefore, it appears that no goodwill is amortizable if the partnership level anti-churning rules apply. If they do not apply, there could still be proportionate disallowance of amortization to the extent that any continuing partner is related to the partner whose interest is liquidated.

* Partnership level anti-churning

In the partnership context, the related parties are generally the same as those specified under Sec. 707(b). A partner is considered a related party to the partnership if he owns more than 20% of partnership capital or profits. The relationship exists if the partner owns the requisite percentage either before or after the distribution.(21) If a partner owns more than 20% of the partnership capital or profits its immediately before the Sec. 736 liquidating distribution, the partnership will not be able to amortize any of the goodwill acquired in the Sec. 736(b) payment. Therefore, the fact that a Sec. 736 distribution entirely liquidates a partner's interest in the partnership would not prevent the anti-churning rules from applying.

When a retiring partner owns a direct or indirect interest in excess of 20% of partnership profits or capital, any intangible assets purchased from that partner would not qualify for amortization under Sec. 197 if the partnership had held the intangible assets between July 25, 1991 and Aug. 10 1993.

Example 7: G, from Example 5, indirectly owned more than 50% of partnership profits or capital before the liquidating distribution. The goodwill acquired from G would receive a step-up in basis if G recognized gain and the partnership had a Sec. 754 election in effect. GHI's basis in the goodwill would not be amortizable under the new provision, if the goodwill had been in existence at the partnership level after July 25, 1991 and before Aug. 11, 1993.

There is a special anti-churning rule for persons who own more than 20%, but not more than 50%, of partnership capital or profits. In these cases, the goodwill is subject to the anti-churning rules unless the seller agrees to report all gain on the disposition of the goodwill as ordinary income.(22)

Any accumulated amortization on intangible assets is depreciation recapture on a subsequent disposition.(23) In the context of a Sec. 736(b) cash distribution, the retiring partner's share of amortization will result in the partner recognizing ordinary income under Sec. 751(b). This would be the case in any partnership distribution that alters the partner's interest in Sec. 751 assets. The partnership obtains a "cost" basis for the portion of the goodwill attributable to prior amortization in the same manner as in any other Sec. 751(b) sale or exchange.

* Partner level anti-churning rules

It is possible that a retiring partner and a partnership will not be considered related parties under the general anti-churning rules, but that other anti-churning rules will prohibit the amortization of a portion of the goodwill acquired in a Sec. 736(b) transaction. A special rule applies to partners, who are each treated as owning a portion of the partnership goodwill and other intangible assets. Therefore, when a partnership owned goodwill between July 25, 1991 and August 10, 1993, and a partner transfers his share of partnership goodwill in a Sec. 736(b) distribution, the partnership must determine the amount of goodwill that is, in essence, purchased by partners related to the retiring partner.

Example 8: A and B, husband and wife, own exactly 10% each of capital and profits in partnership ABC. Neither A nor B owns any other indirect interest in the partnership. Since neither A nor B owns more than 20% (directly or indirectly) of partnership profits or capital, the partnership level anti-churning rules will not apply to any partnership goodwill acquired in a Sec. 736(b) payment to either partner. Both A and B were partners before Aug. 11, 1993.

In the current year, A retires. ABC determines the value of its goodwill as $300,000, of which A's share is $30,000. The agreement provides that goodwill is partnership property, and the payment to A for his share is a Sec. 736(b) payment. A recognizes gain on the Sec. 736(b) distribution, and ABC has a Sec. 754 election in effect. Under Temp. Regs. Sec. 1.755-2T, ABC allocates $30,000 of basis to goodwill.

After A's retirement, B owns 11.11 % of partnership profits and capital. Therefore, her share of the goodwill acquired from A is $3,333, which is subject to the partner level anti-churning rules and would not be amortizable.

* Minimizing the impact of the

anti-churning rules

A partnership would not receive any faster amortization period for any intangible asset than it would for goodwill. Therefore, it may make little sense to specifically value other intangible assets in a Sec. 736(b) transaction. When a partnership is subject to the anti-churning rules, however, valuation of other intangibles might result in tax savings. The anti-churning rules apply only to goodwill or going concern value, and not to the other intangible assets covered by Sec. 197.

If a partnership was in existence before Aug. 11, 1993, it is likely that any payment to a partner for his share of goodwill is subject to the anti-churning rules. However, the partnership could claim amortization on other intangibles purchased from the partner. Thus, identification of patents, copyrights or other assets would help secure an amortization deduction if the partnership could substantiate the value of these assets. They would be amortizable over the 15-year period prescribed by Sec. 197. In the absence of any identifiable assets other than goodwill, the partnership could structure the Sec. 736(b) payment as a covenant not to compete.

See the flowchart on page 310 for the amortization of goodwill acquired in a Sec. 736(b) distribution.

Transition Rules

* Amortization of intangibles

The transition rules for the amortization of intangible assets are complex. The anti-churning rules, which prohibit amortization of any intangible assets purchased from any related party if the related party held the property between July 25, 1991 and Aug. 10, 1993, will never expire. Thus, if a partnership in existence during this period had any goodwill, it will not be able to amortize goodwill acquired in a Sec. 736(b) distribution made to any related partner at any time in the future.

The transition rule regarding the elective amortization of intangibles acquired after July 25, 1991 also has its complexities. First, as discussed above, a partnership may make this election with respect to all intangibles acquired during this period.(24) A partnership could make this election to apply retroactively to all payments in exchange for partnership goodwill that were characterized as Sec. 736(b) payments during this period. This election, however, would not affect the anti-churning rules for subsequent acquisitions.

Example 9: The BCD partnership retired the interest of B in December 1992. The parties structured the payment in exchange for B's share of partnership goodwill as a Sec. 736(b) payment. B owned 10% of partnership capital and profits, and no indirect interest in the partnership. BCD did not acquire any other intangible assets between July 15, 1991 and Aug. 10, 1993. It elected to amortize the goodwill acquired from B under Sec. 197.

In early 1994, BCD retires the interest of C, who held a 22% interest in partnership profits and capital. C's wife, D, held a 30% interest in partnership profits and capital at the time of C's retirement. Capital was a material income-producing factor to BCD, and thus the payment for C's share of partnership goodwill could not be treated as a Sec. 736(a) payment.

Under the anti-churning rules, BCD could not amortize the goodwill acquired from C in the distribution, since he owns more than 50% of partnership capital and profits under Sec. 707(b). The disallowance of the amortization would appear to extend to the portion of the goodwill that the partnership was already amortizing due to the liquidation of B's interest.

* Elective binding contract exception

Any intangible asset acquired after enactment of the RRA may be amortized under the preenactment rules if there was a binding contract for the acquisition of the intangible on Aug. 10, 1993, and the contract was binding at all times until the acquisition. This binding contract exception is elective.(25) A consistency rule allows this binding contract exception only if the taxpayer does not make an election to amortize intangibles acquired after July 25, 1991 and before Aug. 11, 1993 under Sec. 197.(26) Any election under the transition rules applicable to amortization of intangible assets is revocable only with IRS consent.(27)

Conclusion

The combined effect of the changes to the partnership distribution rules and the amortization of intangibles by the Revenue Reconciliation Act of 1993 creates complex tax problems. In general, retiring partners who receive cash distributions in liquidation of partnership interests will not be adversely affected by, and may even benefit from, the changes in the law. Partnership that make these distributions may suffer adversely from the changes in definition of unrealized receivables and the forced characterization of many distributions as property, rather than income, payments. Partnerships may actually benefit from the new law, however, to the extent they are able to amortize goodwill. But both partnerships and their retiring partners must be wary of the, complex transition rules that accompany these new provisions.

(9) Sec. 1060(d). (10) Temp. Regs. Sec. 1.755-2T. (11) Newark Morning Ledger Co., 113 Sup. Ct. 1670 (1993)(71 AFTR2D 93-1380, 93-1 USTC [paragraph] 150,228). (12) RRA Section 13261(a). (13) Sec. 197(a). (14) Sec. 734(b)(1)(A). (15) Sec. 197(f)(1)(A). (16) Sec. 197(c)(2). (17) RRA Section 13261(g)(2)(A). (18) RRA Section 13261(g)(2)(B)(ii). See. 41(f)(1) includes all corporations and other entities with 50% common ownership, directly or indirectly, by five or fewer persons. (19) Sec. 197(f)(9)(A)(i). (20) Sec. 197(f)(9)(A). (21) Sec. 197(f)(9)(C)(ii). (22) Sec. 197(f)(9)(B). (23) Secs. 197(f)(7) and 1245(a)(3), as amended by RRA Section 13261(f)(5). (24) The procedures for making this election have not been promulgated at the time of this writing. The election is valid only if all businesses under common control make the same election for all intangibles acquired during this period. (25) RRA Section 13261(g)(3)(a)(iii). (26) RRA Section 13261(g)(3)(A)(ii). (27) RRA Section 13261(g)(3)(B).