Sec. 197 antichurning rules - application of election to recognize gain on a sale of goodwill between related partnerships.

The Sec. 197(f)(9) antichurning rules prevent taxpayers from transferring otherwise nonamortizable intangibles (i.e., goodwill, going concern value or any other Sec. 197 intangible for which depreciation or amortization would not have been allowable but for Sec. 197) to a related person to obtain amortization under See. 197. Specifically, the antichurning rules apply to a transfer of such an intangible to a taxpayer, if the intangible was held or used at any time on or after July 25, 1991, and on or before Aug. 10, 1993, by the taxpayer or a related person. The antichurning rules also apply in certain cases in which the user did not change or in which the taxpayer granted the right to use the intangible to a person who held or used the intangible during this period.)

Generally, persons are related if they bear a relationship described in Sec. 267(b) or 707(b)(1), determined by substituting "20 percent" for "50 percent." Under Sec. 707(b)(1), two partnerships are related if the same persons own, directly or indirectly, more than 50% of the capital interests or profits interests in each partnership. Thus, if the same persons own more than 20% of the capital interests or profits interests in each partnership, the partnerships are related for Sec. 197 antichurning purposes.

Partnerships that receive goodwill and going concern value in connection with a transfer of a business from another partnership will find themselves subject to the Sec. 197 antichurning rules if the same persons own more than 20% of the capital interests or profits interests in each partnership (when there was the reqiuisite ownership or use on or before Aug. 10, 1993). In such a case, the transferee partnership generally will not be able to amortize the goodwill and going concern value under Sec. 197.

However, where the overlapping ownership does not exceed 50%, the transferee partnership may amortize the goodwill and going concern value if the transferor partnership elects under Sec. 197(f)(9)(B) to recognize gain on the disposition of the goodwill and going concern value and to pay a tax on such gain which, when added to any other income tax on such gain, equals such gain multiplied by the highest rate of income tax applicable to such person under the Code. The amount of the goodwill and going concern value that may be amortized under this election, however, is limited. The transferee may not amortize its adjusted basis in the goodwill or going concern value to the extent this adjusted basis exceeds the gain recognized by the transferor under the election. That amount remains subject to the Sec. 197 antichurning rules.

The application of the Sec. 197(f)(91(B) election to partnerships raises several fundamental issues not addressed in Sec. 197 or its legislative history.

1. Who makes the election to recognize the gain and pay the tax? Sec. 703(b) appears to require that the partnership make the election, because the election will affect the computation of taxable income derived from the partnership and the election is not listed in Sec. 703(b) as a partner-level election. This appears to be the case even though the election provision requires that the person who makes the election must also pay a tax at the highest rate of income tax applicable to the person under the Code. Partnerships, however, do not pay income tax. 2. How is the tax computed? The election provides that the "person from whom the taxpayer acquired the intangible" (e.g., a transferor partnership) must pay a tax on the gain recognized on the disposition which, when added to any other income tax on such gain under this title, equals such gain multiplied by the highest rate of income tax applicable to such person under the Code. Sec. 701 provides that partnerships are not subject to income tax, but that the partners of the partnership are liable for income tax in their separate or individual capacities. Although an argument could be made that there is no tax due with respect to the election, because the highest rate applicable to a partnership is zero, it would appear that the tax required to be paid must be computed at the partner level based on the portion of the gain recognized on the disposition of the goodwill allocated to each partner. A corporate partner would compute the amount of tax due on the gain with respect to this election at a 35% rate and an individual partner would compute the amount of tax due on the gain with respect to this election at a 39.6% rate. 3. Who pays the tax - the partners or the partnership? Because the gain recognized on the disposition of the intangible is allocated to the partners and the amount of tax due with respect to the election appears to be computed by the partners, it would logically follow that the partners would show the tax due on their return and pay the tax with their return. Alternatively, the partnership could require that the partners submit their separate computations of the tax due to the partnership along with a check for the tax due and the partnership could pay the tax. However, there is no precedent in the Code for this alternative and it would result in a compliance nightmare. Thus, absent a regulation requiring this alternative, an acceptable approach should be to have the partners pay the tax. 4. What action should each partnership consider taking to ensure a valid election; The transferee partnership cannot amortize the goodwill or going concern value pursuant to a Sec. 197(f)(9)(B) election unless the proper amount of tax is paid by the transferor partnership. Thus, the transferee partnership likely will require that the transferor partnership indemnify the transferee partnership if all of the election requirements are not satisfied including payment of the tax) and the transferee partnership is not allowed to amortize the goodwill or going concern value. The transferor partnership, however, ordinarily will not know whether the partners have complied with the election requirements (assuming that the partners compute and pay the tax as outlined above). Thus, a partnership should consider taking the following steps to ensure that the election requirements have been satisfied. First, the partnership should separately state on each partner's K-1 the amount of the partner's share of the gain subject to the election. Second, each partner's K-1 could state that the election has been made and that the election requires that each partner must compute gain at the highest rate applicable to the partner, and that the failure of any partner to pay the required tax could result in an invalid election. Third, the partnership could attach a statement to be signed and returned by the partner stating that the partner has paid the required tax. 5. What effect does a Sec. 197(f)(9)(B) election have on a part-contribution, part-sale transaction? A transfer of a business between related partnerships may be structured as part contribution, part sale. In such a case, Sec. 197(f)(2), and not Sec. 197(f)(9)(A), appears to prevent the transferee partnership from amortizing under See. 197 the portion of the goodwill attributable to the contribution under Sec. 721. Thus, the Sec. 197(f)(9)(B) election does not appear to apply to the portion of the goodwill attributable to the contribution under Sec. 721.

Conclusion

Sec. 197 and its legislative history are silent on the application of the Sec. 197(f)(9)(B) election to partnerships. Regulations are sorely needed to address the fundamental issues that arise with respect to this election and its application to partnerships. Because of the various alternative solutions to these issues, it is hoped that regulations will provide that any reasonable position taken by a partnership in connection with the election will be respected prior to the effective date of their issuance.

From Richard G. Blumenreich, J.D., LL.M., Washington, D.C.