Partnership's sale of contributed corporate stock may be a trap for the unwary.

In Rev. Rul. 99-57, the IRS ruled that a corporate partner will not recognize gain on a contribution of its own stock to a partnership followed by the partnership's use of that stock one year later as consideration in a taxable exchange. The ruling is generally favorable for taxpayers, but contains a trap for the unwary.

Rev. Rul. 74-503 held that a corporation has a zero basis in its own stock. Nevertheless, Sec. 1032 protects a corporation from gain or loss recognition oil the use of its own stock in an exchange. Sec. 1032 does not, however, offer the same protection if a corporation's stock is used by an entity other than the issuing corporation. Such other entities might, therefore, recognize gain on the use of the corporation's stock to the extent the value of that stock exceeds the stock's zero basis.

In an analogous situation, Prop. Regs. Sec. 1.1032-3 addresses a parent's transfer of its stock to a subsidiary, followed by the subsidiary's exchange of the parent stock. If adopted, the proposed regulations would, under certain circumstances, create a fictional exchange in which a parent is deemed to make a capital contribution of cash to its subsidiary and the subsidiary is deemed to use that cash to purchase parent stock. The result of this fictional exchange is that the subsidiary takes a cost basis (i.e., at fair market value (FMV)) in the parent stock, protecting the subsidiary from gain if it uses the stock to acquire other property.

Similarly, Rev. Rul. 99-57 addresses the situation in which a corporate partner contributes its own stock to a partnership, followed by the partnership's (one year) later exchange of the stock to third parties in taxable transactions. Because the corporate partner has a zero basis in the stock and the partnership takes a transferred basis in the stock on its receipt from the corporate partner (Sec. 723), the Service ruled that the partnership realizes gain on the use of the corporate partner stock in a taxable exchange. Based on an aggregate theory of partnerships (which treats the partnership as an aggregate of its partners and not as a separate entity) and on the protection offered by Sec. 1032, the IRS also ruled that the corporate partner would not recognize the gain allocable to it from the partnership's use of the corporate partner stock. Instead, the Service ruled that the corporate partner's basis in the partnership should be increased by its allocable share of the partnership's gain from the use of the corporate partner stock in the exchange. Rev. Rul. 99-57 provides the following example.

Example: Corporation P and individual B form a partnership. P contributes 100 shares of its own stock (valued at $100) to the partnership in exchange for a 50% partnership interest, and B contributes real property (valued at its adjusted basis of $100) to the partnership in exchange for a 50% partnership interest. The partnership agreement provides that partnership income is to be allocated equally between the two partners. One year later, after the value of the P stock has increased from $100 to $120, the partnership exchanges the P stock (with unrelated third parties) for property valued at $60 and services valued at $60.

Citing Sec. 723 and Rev. Rul. 74-503, the IRS concluded that the partnership has a zero basis in the P shares received from P.

The Service also ruled that the partnership realizes $120 of gain ($120 FMV -- zero basis) on the exchange, with $20 of the gain attributable to the stock's appreciation after its contribution to the partnership. Under Sec. 704(b) and (c), the gain attributable to appreciation after contribution is allocated equally, based on the partnership agreement, while the initial built-in gain on the stock is entirely allocated to P. Thus, the $120 gain is allocated to the partners as follows: $110 to P and $10 to B. The IRS ruled that P does not recognize the gain allocated to it because, under an aggregate theory of partnerships, P is protected by Sec. 1032. To preserve the nonrecognition policy of Sec. 1032, P's basis in its partnership interest is increased under Sec. 705 by the $110 gain allocated to P. B, however, is not afforded Sec. 1032 protection and must recognize the $10 gain allocated to him under the partnership agreement.

Although Rev. Rul. 99-57 shields P from gain recognition, the ruling contains a trap for the unwary--it does not address the situation in which P sells its partnership interest before the partnership uses the P stock in an exchange. A disposition of P's partnership interest may cause P to recognize a gain equal to the amount received for its partnership interest. Under Sec. 722, P's basis in its partnership interest is an exchanged basis, and, therefore, zero (assuming no other transactions occurred that would affect P's basis in its partnership interest). Corporate taxpayers disposing of partnership interests must, therefore, be wary of the tax disparity between a disposition of a partnership interest and the partnership's use of the stock in an exchange.

In summary, although Rev. Rul. 99-57 is favorable, a minor variation from the ruling's facts could result in significantly different tax consequences. This ruling offers little insight as to why the aggregate theory is appropriate in the case of Sec. 1032 nonrecognition. Thus, Rev. Rul. 99-57 leaves taxpayers wondering which other corporate provisions should embrace an aggregate theory of partnerships. To avoid potential gain exposure, corporate taxpayers should be aware of Rev. Rul. 99-57 when structuring dispositions of partnership interests. In addition, individual partners in a partnership that also has corporate partners should know that, if the corporate partner has contributed its stock to the partnership and that stock is used by the partnership in an exchange, the individual might recognize gain, even though the corporate partner will not.

FROM THOMAS M. HAYES, J.D., LL.M., WASHINGTON, DC