Proposed and final regulations affecting PTPs.

On Nov. 29, 1995, the Service issued final regulations under Sec. 7704 on the classification of certain publicly traded partnerships (PTPs) as corporations. Proposed regulations had been issued on May 2, 1995, and a public hearing had been held on July 31, 1995. The proposed regulations were adopted as final, with some revisions.

Definitions

The final regulations contain two changes to the definition of a secondary market and the substantial equivalent thereof. The determination of whether interests in a partnership are readily tradable on a secondary market, or the substantial equivalent thereof, must be based on all the facts and circumstances. In addition, the final regulations eliminate the separate definitions of a secondary market and the substantial equivalent thereof. This distinction is relevant in the proposed regulations, since several of the safe harbors apply only to the substantial equivalent of a secondary market. This distinction is eliminated in the safe harbors. As a result, the separate definitions of a secondary market and the substantial equivalent thereof are no longer necessary, and they are combined into one definition in the final regulations (Regs. Sec. 1.7704-1 (c)).

Involvement of the Partnership Is Required

The proposed regulations provided that the transfer of an interest in a partnership is taken into account for purposes of Sec. 7704(b) only if the partnership recognizes the transfer of the interest or if the interest is redeemed by the partnership. The preamble to the proposed regulations explained that this provision is intended to prevent a partnership from becoming publicly traded without its knowledge or participation. Several commentators requested a clarification of this provision, since the definition of a secondary market requires only that the interests be readily tradable, thereby creating some concern that the partnership could be publicly traded--even if there were no actual transfers of an interest in the partnership.

The final regulations address this concern by providing more explicitly that interests in a partnership will not be treated as readily tradable on a secondary market or the substantial equivalent thereof unless (1) the partnership participates in the establishment of the market or the inclusion of its interest thereon or (2) the partnership recognizes transfers made on that market. This rule also applies to an established securities market that consists of an interdealer quotation system that regularly disseminates firm buy or sell quotations. These modifications, will prevent a partnership from being publicly traded without its participation or consent (Regs. Sec. 1.7704-1 (d)). This rule is not extended

to established securities markets that consist of the exchanges described in the regulations; these exchanges list interests in the partnership only with its knowledge and participation. In addition, Regs. Sec. 1.7704-1 (e) provides that transfers not recognized by the partnership are treated as private transfers and therefore do not count for purposes of the 2% and 10% limitations in the safe harbors.

Consequences of Not Meeting Safe Harbor Provisions

Several commentators requested clarification that, as in Notice 88-75, the failure of a partnership to satisfy the safe harbors does not establish or give rise to a presumption that the partnership was publicly traded. In response, Regs. Sec. 1.7704-1 (c) (3) clarifies that the fact that a partnership does not qualify for a safe harbor or that a transfer of an interest in the partnership is not within a safe harbor is disregarded in determining whether interests in the partnership are readily tradable on a secondary market or the substantial equivalent thereof. Thus, these transfers are examined under the general facts and circumstances test in the regulations.

Safe Harbors

* Transfers not involving trading ("Private transfers"). Several commentators requested that the definition of a block transfer be expanded to include transfers by a partner or any person related to the partner within the meaning of Sec. 267(b) or 707(b) (1). The commentators noted that interests in a partnership are often held by related persons and that, while the related group as a whole may hold more than a 2% interest in the partnership, no individual partner in the group might hold more than a 2% interest. This comment is adopted in Regs. Sec. 1.7704-1 (e) (2). One commentator also suggested that the exception for transfers at death be clarified to include transfers from an estate or a testamentary trust. This comment is adopted in Regs. Sec. 1.7704-1 (e) (1) (ii).

The exception for transfers by one or more partners of interests representing more than 50% of the total interests is amended by reducing the required amount to 50% or more of the interests in partnership capital and profits, in order to coordinate the exception with Sec. 708 (b) (1) (B) terminations (Regs. Sec. 1.7704-1 (e) (1) (ix)).

* Qualified matching services. Several commentators raised various concerns about the provisions in the proposed regulations requiring subscribers to make certain representations, and the provisions preventing the operator of the matching service from quoting certain prices and buying or selling interests for itself or on behalf of others. These provisions are deleted in the final regulations, as the requirements for a matching service already provide that the service cannot list quotes that commit any person to buy or sell an interest This modification, however, does not affect the general rule that a secondary market may exist if anyone, including the operator of a matching service, quotes prices at which it stands ready to buy or sell a partnership interest (Regs. Sec. 1.7704-1 (g)).

* Private placements. The proposed regulations generally provided that interests in a partnership are not readily tradable on the substantial equivalent of a secondary market if. (1) all interests in the partnership were issued in a transaction not required to be registered under the Securities Act of 1933; (2) the partnership does not have more than 500 partners or the initial offering price of each unit was. at least $20,000; and (3) if the partnership has more than 50 partners, no more than 10% of the total interests in capital or profits are transferred during the year. Several commentators suggested expanding this safe harbor to apply to the determination of a secondary market; others suggested eliminating the 10% limitation. Several commentators suggested increasing the 50-partner limit, perhaps to 100, and modifying the rule for counting the number of partners that looked through partners that were partnerships, grantor trusts or S corporations. In response to these comments, the final regulations modify the private placement exception in the following respects.

First, the safe harbor is expanded to apply to a secondary market, as well as the substantial equivalent of a secondary market As a result, interests in a partnership that qualifies for the private placement safe harbor will not be readily tradable on a secondary market or the substantial equivalent thereof (Regs. Sec. 1.7704-1 (h) (1)).

Second, Regs. Sec. 1. 7704-1 (h) (2) provides that the safe harbor does not apply to partnerships subject to Regulation S, unless the offering and sale of interests in the partnership would not have been required to be registered if offered and sold within the U.S. Regulation S, adopted after the issuance of Notice 88-75, provides an exception from registration for any offerings and sales outside of the U.S., even if registration would have been required if the interests were offered and sold within the U.S. This modification ensures that the private placement exception applies in a similar manner to offerings within and outside of the U.S.

Third, the 10% limitation is not adopted in the final regulations. Instead, Regs. Sec. 1.7704-1 (h) (1) (ii) provides that the safe harbor applies only if the partnership has no more than 100 partners at any time during the partnership's tax year.

Regs. Sec. 1.7704-1 (h) (3) provides a new rule for determining the number of partners in a partnership. Under the proposed regulations, each person owning an interest in a partnership (lower-tier partnership) through another partnership, an S corporation or a grantor trust (flowthrough entity) was treated as a partner in the lower-tier partnership. The final regulations provide that an owner of a flowthrough entity is treated as a partner in the lower-tier partnership only if (1) substantially all of the value of the flowthrough entity is attributable to the lower-tier partnership interest and (2) a principal purpose for the tiered arrangement is to permit the partnership to satisfy the 100-partner requirement.

* Lack of actual trading. The proposed regulations provided that interests in a partnership would not be readily tradable on the substantial equivalent of a secondary market if the sum of the percentage interests transferred during the tax year does not exceed 2%. Several commentators suggested expanding this safe harbor to secondary markets so that partnerships could be assured that some level of trading would not result in public trading. This comment is adopted in Regs. Sec. 1.7704-1 (e).

Effective Date

The proposed regulations provided that they would be effective for partnership tax years beginning on or after the date final regulations are published. The preamble to the proposed regulations requested comments on whether transitional relief is necessary for partnerships that qualified for an exclusion under Notice 88-75. Many commentators suggested some from of transitional relief, ranging from 180 days to a permanent grandfather provision.

Regs. Sec. 1.7704-1 (1) (2) provides that, for partnerships actively engaged in an activity before Dec. 4, 1995, the regulations apply for tax years beginning after Dec. 31, 2005. This 10-year grandfather provision is similar to the grandfather rule provided on the enactment of Sec. 7704. The final regulations provide that this transitional relief expires if the partnership adds a substantial new line of business (within the meaning of Regs. Sec. 1.7704-2). The transitional relief is not affected by a termination of the partnership under Sec. 708(b) (1) (B). Finally, partnerships subject to transitional relief may continue to rely on Notice 88-75 for guidance.