Sec. 197 anti-churning rules for partnerships.

Final regulations amended Nov. 20, 2000 apply the Sec. 197 anti-churning rules to a partnership basis step-up under Sec. 732(b) or 734(b). Practitioners have had time to digest and use these regulations, and determine what (if anything) is missing from them.

Sec. 197 was enacted in 1993 to reduce the' controversy between taxpayers and the IRS over amortizing intangibles. Sec. 197(f)(9) contains anti-churning rules that in general prevent amortizing previously nonamortizable assets held or used by a related party at any time between July 25, 1991-Aug. 10, 1993 (i.e., the transition period).

Under Sec. 197(f)(9)(E) and Regs. Sec. 1.197-2(h)(12), determinations on whether the anti-churning rules apply are made at the partner level, with each partner treated as having owned and used the partner's proportionate share of partnership property. The regulations specifically apply the anti-churning rules to Secs. 732(b) and 734(b) step-up transactions, using Regs. Sec. 1.197-2(h)(12)'s approach.

For a Sec. 732(b) step-up, the related-party determination is made by examining the partners' relationships. Generally, the anti-churning rules involving a transition-period intangible apply to the distributee partner to the extent of that partner's (and any related partner's) deemed proportionate interest in the intangible. The proportionate share of the transition-period intangible deemed owned by nonrelated partners is not subject to the anti-churning rules in the distributee's hands. The regulations essentially bifurcate a transition-period intangible. The portion deemed owned by the distributee and any related partner is not amortizable by that distributee; the portion attributable to the nonrelated partners' deemed ownership, immediately before the intangible was distributed, is amortizable in the distributee's hands.

The application of the anti-churning rules to Sec. 734(b) step-ups is somewhat different, as that step-up applies only to partnership property and (in a number of Sec. 734(b) situations) the distributee continues as a partner after the transaction. One similarity is the bifurcation of the step-up pertaining to the intangible. The partnership can amortize the step-up amount attributable to the nondistributee partner; the portion related to the distributee partner and a partner related to that partner may be amortizable by the partnership.

Generally, if the partnership acquired the transition-period intangible before Aug. 11,1993 and the distributee partner acquired his partnership interest after that date, the anti-churning rules would not apply to the portion attributable to this distributee and the partnership could amortize it. Also, if the partnership acquired an intangible after Aug. 10, 1993 that it cannot amortize and the distributee acquired his partnership interest after the partnership acquired that intangible, the anti-churning rules would not apply to the portion attributable to that distributee, and the partnership would amortize that portion. If the distributee failed either of these tests, the portion attributable to him would be subject to the anti-churning rules.

The regulations lack guidance on partnership goodwill, step-up of partnership basis and the application of the anti-churning rules. The problem begins even before the anti-churning rules' application, because Sec. 197(c)(2) excludes certain self-created intangibles (including goodwill) from a designation as amortizable Sec. 197 intangibles.

Sec. 197 does not define "serf-created." The regulations' definition is ambiguous on partnership step-up transactions. Regs. Sec. 1.1972(d)(2)(ii)(A) states that an intangible "is created by the taxpayer to the extent the taxpayer makes payments or otherwise incurs costs for its creation." This definition probably suffices when applied to taxpayers other than partnerships. However, it leaves a lot to be desired for partnerships, in which basis step-ups occur with great frequency. When a step-up transaction occurs, tax basis results without the partnership making payments or incurring costs. Also, none of the regulations' examples deal with self-created intangibles. Therefore, taxpayers are left with only the regulatory definition.

For example, if a Sec. 734(b) step-up transaction occurs for a partnership, the distributee partner would continue after the transaction and all of its assets (other than goodwill created by the partnership) would have bases equal (or close) to their fair market values (FMVs). Goodwill has a zero tax basis and a FMV large enough to absorb the step-up. This type of transaction is not rare. Under the step-up rules, the majority (or all) of the step-up is allocated to goodwill. The question is whether the goodwill is amortizable. The regulatory definition implies that the basis resulting from the step-up is not self-created and, hence, can be amortized. The goodwill step-up does not meet the "self-created" definition because the partnership does not make payments (or otherwise incur costs) on the basis resulting from that step-up.

Further, if the anti-churning rules were to apply, the goodwill would have had to exist during the transition period. If the partnership's business started after Aug. 10, 1993, the anti-churning rules would not be an issue and the partnership would be able to amortize all of the basis step-up. If the partnership existed before that date, the date the goodwill was created would be of great importance. For this purpose, the partnership has to create goodwill on the date it first had value, which is not necessarily the date the basis step-up occured.

However, partnerships can have a problem in determining the first day the goodwill has value. Reasonably, most partnerships would not have had an appraisal as of Aug. 10, 1993 to determine if goodwill existed on that date. Obviously, in light of the anti-churning rules, this would affect only the distributee partner and only to the extent that the partner failed the anti-churning tests previously discussed. However, if the partnership can show that the goodwill did not exist during the transition period, failing the anti-churning rules tests would not be an issue for the distributee, and all of the step-up would be amortized. It is incumbent on the partnership to show the date on which goodwill first existed.

The partnership should consider if it would be reasonable to take the position that goodwill did not exist until the day the step-up caused the goodwill's basis. If taxpayers can take such a position, goodwill resulting from a step-up after Aug. 10, 1993 might not be subject to the anti-churning rules. However, until the IRS issues guidance on amortization of goodwill arising in step-up transactions and application of the anti-churning rules, taxpayers are left to resolve these questions on their own.

FROM J. ERIC KEA, CPA, NEW YORK, NY

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY