Restructuring multiple partnerships to preserve maximum depreciation.

Limited partnership A, consisting of a particular group of investors, owns a 75% capital and profits interest in general partnership AB. Limited partnership B, consisting of a similar, but different, group of investors, owns the other 25% interest in AB's capital and profits. This ownership structure existed for more than five years. Other than a nominal amount of cash, A's and B's only assets were their respective partnership interests in AB.

AB, which at one time had owned substantial healthcare operating businesses, sold off most of those businesses and is left with the direct or indirect ownership of four medical office buildings, each subject to a triple net lease. Three of these buildings are owned outright by AB and the fourth is owned by limited partnership ABC, in which AB owns a 70% interest in ABC's capital and profits. The building owned by ABC, which was placed in service on Jan. 1, 1986, has a remaining depreciable basis of $10 million and an original depreciable basis of $19 million, and is being depreciated straight line over 19 years.

After the sale of its healthcare operations, the need for the multiple partnership structure no longer exists and it has been proposed that B merge into A. AB would thereby terminate under Sec. 708(b)(1)(a) and only A would remain.

On AB's termination, the basis of its assets to A and B would be computed under Sec. 732(b). This basis would equal the sum of A's and B's adjusted bases for their respective partnership interests in AB and would be allocated among the assets under Sec. 732(c).

Since A would have a combined adjusted basis for its AB interests at the moment of AB's termination'; the original Sec. 704(c) adjustments created from AB's original formation, including any additional book/tax disparities created by the merger of B into A, continue to be allocated among the assets received from AB and flowed through to A's individual investor/partners. (Regs. Sec. 1.704-3(a)(9) prescribes the tax treatment for Sec. 704(c) adjustments in tiered partnership transactions involving contributions of partnership interests.) An analysis of the above merger transaction indicated that there would be no immediate tax consequences from the transaction; initially, each investor/partner of premerger partnerships A and B would be essentially in the same position in surviving partnership A.

However, as a result of AB's termination, AB distributed all its properties to A, including its interest in ABC; under Sec. 761 (e), such a distribution is considered an exchange for Sec. 708 purposes. Accordingly, since there would be an exchange of 50% or more of ABC, it would terminate under Sec. 708(b)(1)(b)-resulting in the loss of substantial tax depreciation.

Under Sec. 168(i)(7), depreciation on the three buildings owned directly by AB would continue uninterrupted under the "step-in-the-shoes" concept. However, the building owned by ABC would be treated as new modified accelerated cost recovery system property under the last sentence of Sec. 168(i)(7)(b). Therefore, ABC's depreciation on its building would be reduced by $743,590 (from $1,000,000 a year [$19,000,000/19] to $256,410 a year [$10,000,000/39]). Surviving partnership A would lose 70% of this reduction, or $520,513 a year.

Since this loss of current depreciation deductions is so substantial, it is worth restructuring the transaction if there is a way to preserve the higher depreciation. Such a restructure might entail both A and B consolidating or merging into AB. In this process, AB would convert to a limited partnership and A's and B's respective general partners would receive general partnership interests in AB.

Under the partnership merger rules of Sec. 708(b)(2)(a) and the regulations thereunder, this transaction should be considered a termination of A and B and a continuation of AB. Sec. 708(b)(2)(a) provides that the partnership resulting from a merger or consolidation of partnerships is considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50% in the capital and profits of the resulting partnership. Regs. Sec. 1.708-1(b)(2)(i) provides that if a resulting partnership can be considered the continuation of more than one of the merging or consolidating partnerships, it will (unless the Service permits otherwise) be considered the continuation of that partnership credited with the contribution of the greatest dollar value of assets to the resulting partnership.

Since the regulations do not deal with parent/subsidiary mergers, a reasonable approach would be to look at the three premerger partnerships separately. A's former members own 75% of AB, suggesting that A might be the survivor. On the other hand, the former members of A and B owned 100% of AB indirectly before the merger and 100% of AB directly after the merger, suggesting that AB also could be considered the survivor. Therefore, since AB would be "credited with the greatest dollar value of assets," it should be considered the survivor.

If the conversion from a general to limited partnership is part of the merger, there should not be any different tax results (Rev. Rul. 84-52). However, in any merger transaction under Sec. 708(b)(2)(a), it is important to analyze the effects of constructive contributions/distributions under Sec. 752(a) and (b) to determine if there is potential gain under Sec. 731(a).

Since A and B would both be their AB partnership interests to AB in exchange for new partnership interests in AB, which are then distributed to their respective partners in liquidation of A and B, will the distribution of 100% of the new partnership interests - in AB to the former partners of A and B cause a termination of AB under Sec. 708(b)(1)(B)? Rev. Rul. 90-17 specifically addressed this issue and held that the special merger rules of Sec. 708(b)(2)(A) prevail over the general termination rules, of Sec. 708(b)(1)(B).

Finally, as previously indicated, the former Sec. 704(c) adjustments attributable to A and B, as well as any new Sec. 704(c) adjustments resulting from the merger, should flow through to the individual partners of AB.

If there are no substantial nontax reasons for using the suggested structure, in view of the substantial additional depreciation deductions that would be preserved, the transaction should be restructured.