Sec. 197 antichurning implications for partnerships.
Generally, Sec. 197(a) and (c) provide that goodwill and certain other intangibles acquired by a taxpayer after Aug. 10, 1993 and held in connection with the conduct of a trade or business will be amortizable over 15 years. Sec. 197(f)(2) provides that, in carry-over basis transactions, a transferee will be treated as the transferor; thus, the transferee "steps into the shoes" of the transferor. Under this rule, the carry-over basis for a contributed intangible is not amortizable unless it was amortizable in the transferor's hands.
Sec. 197 also has an antichurning rule that prevents nondeductible goodwill from being "refreshed" into deductible goodwill. Generally, Sec. 197(f)(9)(A) provides that goodwill is not amortizable if it was held or used at any time on or after duly 24, 1991, and on or before Aug. 11, 1993 (the transition period) by the taxpayer or a related person. A related person is generally defined by Sec. 197(f)(9)(C) by reference to Secs. 267(b), 707(b)(1) and 41 (f)(1). For purposes of applying Secs. 267(b) and 707(b)(1), those sections are modified by using a 20% rather than a 50% threshold.
When a partner or limited liability company member (X) wants to obtain the benefit of tax basis for cash equity acquired in a new partnership (Z) to which the other partner (Y) is contributing an existing business, there are generally four ways to attempt to provide X with appropriate tax deductions:
1. X may contribute cash that Z will use in its ordinary course of business, end Y may contribute its operating business. Income and deduction allocations may be made under Sec. 704(c) to provide X with the benefit of its contributed tax basis.
2. X may contribute cash to Z, which is then distributed by Z to Y in a transaction treated as a disguised sale of a portion of Y's business to Z in exchange for cash (Sec. 707(a)(2)(B)). Generally, X will obtain the benefit of a stepped-up basis in Z's assets for the portion of assets deemed purchased by Z from Y.
3. X may purchase an undivided interest in Y's business (including goodwill) from Y; X and Y may then contribute their respective portions of the business to Z. X's contributed assets (including goodwill) will be stepped up to fair market value (FMV) based on the purchase price prior to contribution; the benefit of this basis (i.e., deductions) will generally be allocated to X.
4. Y (and a related party) may form Z with the contribution of Y's business assets;Y may then sell a partnership interest in Z to X. If Z elects to step up X's tax basis in Z assets under Sec. 754, X will have the benefit of an FMV tax basis and associated tax deductions.
Generally, but for the antichurning provisions of Sec. 197(f)(9), any of these methods of forming Z would provide X with the benefit of an FMV tax basis (either through specially allocated tax deductions or an actual tax basis step-up) in its share of partnership assets (including goodwill), and X would obtain the benefit of associated amortization expense relating to acquired goodwill.
However, when Y acquires a greater-than-20% interest in Z, the antichurning rules may apply to deny Z (and therefore X) amortization of acquired goodwill. The proposed regulations specifically address the four circumstances outlined above:
* When X relies on deductions allocated to it under the curative or remedial allocation methods of Sec. 704(c) to obtain the benefit of its cash equity relating to goodwill, Prop. Regs. Sec. 1.197-2(g)(2)(vi) notes that curative or remedial allocations made to a partner that does not contribute goodwill will be treated in the same manner as the tax basis of contributed goodwill. Thus, under the "step-into-the-shoes" rue of Sec. 197(f)(2), the curative or remedial allocations will not be "amortizable" if the goodwill basis contributed by Y is not amortizable. If the regulations are adopted as proposed, X will not be able to rely on Sec. 704(c) to recover the basis of its share of the goodwill. Note: It appears that this rue applies regardless of whether the antichurning rues apply to the transaction. Thus, this is the least desirable manner in which to attempt to obtain the benefit of tax basis for X for its share of Z's goodwill.
* In the context of a disguised sale under Sec. 707(a)(2)(B), Z is treated as if it purchased a portion of the goodwill of Y's business in exchange for cash that had been contributed to Z by X. Generally, Z would take a basis in such purchased asset equal to the asset's FMV and would be able to amortize or depreciate it. However, if Y acquires a greater-than-20% interest in Z, Prop. Regs. Sec. 1.197-2(k), Example (15), illustrates that X will not receive the benefit of amortization deductions with respect to purchased goodwill. Under Sec. 197(f)(9), Y and Z will be related parties; because Y held the goodwill during the transition period, Z will be unable to amortize the purchased goodwill for X's benefit.
* To avoid the limitations described, X may try to purchase its share of Z's goodwill from Y before forming Z. Clearly, such a purchase by a party unrelated toY generally provides amortizable basis to X. Under Sec. 197(f)(2), one would expect X would obtain amortizable tax basis relating to the goodwill.
Prop. Regs. Sec. 1.197-2(h)(10) provides that, if both the antichurning rules of Sec. 197(f)(9) and the "step-into-the-shoes" rue of Sec. 197(f)(2) apply, the antichurning rues control. Thus, although the goodwill is amortizable in X's hands, if X contributes its purchased goodwill to Z and Z is related to Y because Y has a greater-than-20% interest in Z, the goodwill contributed by X will cease to be amortizable goodwill; X, thus, will not obtain the benefit of amortizable tax basis. Prop. Regs. Sec. 1.197-2(k), Example (16), illustrates the application of this provision.
If Y forms Z with a related party, contributes the intangible to Z and then sells an interest in Z to X (in an unrelated transaction), Z will be treated as owning two assets. X's proportionate share of Y's contributed goodwill is one asset, and it is not amortizable by Z for X's benefit. X's step-up in goodwill under either Sec. 734(b) or 743(b) will be the second asset; this basis will be amortizable by Z for X's benefit (assuming X and Y are not related). Even in this case, although X has achieved amortizable basis for the step-up in goodwill, the portion of basis that Y contributed that was essentially purchased by X is not refreshed into amortizable basis for X's benefit; see Prop. Regs. Sec. 1.197-2(g)(1)(B) and 1.197-2(k), Example (17).