Sec. 197 antichurning implications for partnerships.

• Author: Linn, Kevin
• Position: Internal Revenue Code section 197

In January 1997, the Treasury issued proposed regulations under Sec. 197, explaining its application to certain transactions. When a taxpayer enters into a joint venture with another taxpayer by contributing cash or otherwise paying for its share of equity (a portion of which pays for goodwill) of an existing business contributed to the venture by the other party, the proposed regulations clarify the availability of tax deductions to the new party related to the goodwill. Unfortunately, the proposed regulations can trap the unwary, denying them amortization deductions for which they seemingly paid.

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...