Proposed regulations eliminate deemed distributions on technical termination of partnerships.

Background

Sec. 708(b)(1)(B) provides that if within a 12-month period there is a sale or exchange of 50% or more of the total interest in partnership capital or profits, a partnership shall be considered terminated. However, the Code and legislative history do not specify the tax consequences or steps by which the termination occurs. Regs. Sec. 1.7081(b)(1)(iv) has interpreted Sec. 708(b)(1)(B) to provide that on termination the partnership distributes its assets and liabilities to the purchaser and the other continuing partners in proportion to their respective partnership interests, and the purchaser and other continuing partners contribute these assets and liabilities to a new partnership. This deemed distribution could result in taxable gain to a continuing partner (under Sec. 731(a)) and may affect the basis of the partnership property in the hands of the new partnership (under Sec. 732(b)). Also, the holding period of the partners, interests in the partnership may be affected.

Deemed Distribution

The deemed distribution raises concerns as to its interaction with other partnership provisions, specifically Secs. 704(c) and 737. Sec. 704(c) provides that, if property is contributed by a partner and distributed to another partner within a five-year period, the contributing partner must recognize gain or loss in an amount equal to the gain or loss the partner would have been allocated on a sale of the property by the partnership. Sec. 737 provides that property distributed to a partner who contributed other property to the partnership within five years must recognize gain equal to the lesser of the partners net precontribution gain or the excess of the value of die distributed property over the adjusted basis of the partners interest.

The legislative history of Secs. 704(c) and 737 indicates that these sections are to be coordinated with the Sec. 708(b)(1)(B) termination provisions. The deemed distribution regulations under Sec. 708(b)(1)(B), as noted, indicate that the deemed distributions are made pro rata. The pro rata deemed distribution under these regulations appears to conflict with Secs. 704(c) and 737, which contemplate that Partnership property previously contributed will be distributed to that partner - at least to the extent of any remaining built-in gain or loss.

Simplification of Sec. 708 Rules

Eliminating Deemed Distribution

Conflict

On May 9, 1996, the IRS issued proposed regulations to revise Regs. Sec. 1.708-1(b)(1)(iv) and to propose other conforming revisions to other regulation sections to reflect the proposed changes to revised Regs. Sec. 1.7081(b)(1)(iv). Under the proposed regulations, a termination under Sec. 708(b)(1)(B) would no longer result in a deemed distribution, thus eliminating the Federal tax consequences previously discussed. If a partnership is terminated under the revised regulations, the partnership is deemed to transfer all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership. Immediately thereafter, the terminated partnership distributes the interests in the new partnership to the purchasing and other remaining partners in liquidation of the terminated partnership. Thus, the terminated partnerships assets and liabilities are never deemed to be distributed to the individual partners. Without a pro rata deemed distribution, the conflict between the regulations under Sec. 708(b)(1)(B) and the provisions of Secs. 704(c) and 737 has been eliminated.

It is important to note that the proposed regulations are clear that they do not change the Federal tax consequences of a termination except for the deemed distribution provisions. For example, the tax year of the terminated partnership will still close, the elections of the terminated partnership will be invalivated, a termination win continue to be treated as a liquidation under Sec. 704(b) and the property deemed contributed to the new partnership will be subject to the anti-churning provisions of Sec. 168(f)(5). The proposed regulations are effective for terminations occurring on or after the date final regulations are published.