Subsequent dropdowns to partnerships in corporate reorganizations.

Often a corporation enters into an acquisition of a target company with a desire to use the acquired assets or stock in a joint venture with an unrelated party. Under current IRS policy, this type of transaction can be an obstacle for corporations trying to qualify the acquisition as tax-free under Sec. 368.

The Service recently released proposed regulations under Sec. 368 that would allow an acquiring corporation in certain types of reorganizations to transfer the target assets or stock to controlled corporations and, under certain circumstances, to partnerships. Such transfers would not disqualify the transaction from satisfying the continuity-of-interest or continuity-of-business doctrines required in all reorganizations.

Continuity of Interest

Dropdowns into controlled corporations or partnerships after a reorganization often have been disqualified by the IRS because of the "remote continuity of interest doctrine" described in Groman, 302 US 82 (1937), and Helvering v. Bashford, 302 US 454 (1938). These Supreme Court decisions held that stock consideration received by a target corporation's shareholders did not provice continuity, unless the target's assets or stock were ultimately held by the corporation that issued the stock.

As discussed in the preamble to the proposed regulations, the Service has, in prior years, issued several revenue rulings disqualifying an otherwise qualifying reorganization for failure to meet the "remote continuity of interest" doctrine because of subsequent transfers to corporations; in response to these rulings, Congress enacted legislation that would allow these particular transactions. However, these rulings and legislative responses all involved situations in which the ultimate recipients of the target's assets or stock were corporations, not partnerships.

Except in very limited situations, the IRS has persisted in applying the remote continuity doctrine to circumstances involving partnerships. For example, in GCM 35117 (1972), corporation U was to merge into corporation S in a statutory merger under state law. Pursuant to the plan of reorganization, the assets and liabilities of former corporation U were to be transferred by S to P, a limited partnership in which S was the sole general partner. The Service concluded that the proposed merger would not qualify as a tax-free reorganization, because S would not be a"party to the reorganization" within the meaning of Sec. 368(b).

The IRS reasoned that, under the remote continuity doctrine, the S stock received by the former U shareholders did not represent a sufficiently direct interest in the transferred assets to satisfy the continuity-of-interest requirement. Even though Congress had reformed certain of the reorganization provisions, it had not specifically allowed a transfer of the acquired assets to a limited partnership.

The conclusion in GCM 35117 has been contrasted with the conclusion in GCM 39053 (1983), which allowed an asset dropdown to a "wholly owned" partnership of a corporation's subsidiary and that subsidiary's subsidiary. In distinguishing the two rulings, the Service noted that a partnership is generally distinguishable from co-ownership of property because of its joint profit objective. When the sole owner contributes assets to a partnership in exchange for a partnership interest, he loses the right to the property for his own separate profit and commits the right to exploit the property for the joint profit of all the partners. A "wholly owned" partnership could be distinguished, since there are only controlled corporations as partners and the exploitation of assets is for the parent's benefit.

Continuity of Business Enterprise

The continuity-of-business-enterprise requirement is a factual determination and is satisfied if the acquiring corporation continues the target's business or uses a significant portion of the target's assets in a trade or business. This requirement also has posed an obstacle to a subsequent transfer by the acquiring corporation of the target's business or assets to a partnership or corporation.

Proposed Regulations

Prop. Regs. Sec. 1.368-1(f) treats a partnership as an aggregate of its partners for purposes of the continuity-of-interest and continuity-of-business requirements. Accordingly, the remote-continuity-of-interest requirement will not be violated if the acquiring corporation transfers the target's assets or stock to a partnership.

The continuity-of-business requirement will be satisfied on a subsequent transfer to a partnership if (1) the transferring corporation has active and substantial management functions as a partner in the partnership or (2) the transferring corporation's interest in the partnership represents a significant interest in the partnership's business. The transferring corporation will be treated as owning the partnership's assets in accordance with the corporation's interest in the partnership.

Caution: The preamble provides that the regulations do not affect the "control" requirement that must be met in certain reorganizations. Accordingly, a subsequent transfer of stock of the acquiring or target corporation to a partnership, although satisfying the continuity-of-interest and -business requirements, may violate the control requirement in a reorganization under Sec. 368(a)(1)(B), (a)(1)(C), (a)(2)(C), (a)(2)(D) or (a)(2)(E).

Prop. Regs. Sec. 1.368-1(f) is a significant improvement over the murky and somewhat arbitrary position previously espoused by the Service. However, the new rules will apply only to transactions occurring after the regulations are finalized. Caution should be exercised when advising clients on transactions finalized (or subject to a binding contract entered into) before that date.