Corporate contributions to partnerships owned by shareholders.

• Author: Ellentuck, Albert B.

When the General Utilities doctrine was repealed by the Tax Reform Act of 1986, corporate liquidations and redemptions became subject to double taxation. Certain taxpayers attempted to avoid this by using partnerships in a tiered ownership structure. Shareholders would form a partnership and contribute their stock to the new partnership. The corporation would then acquire an interest through the contribution of appreciated property and later receive a distribution of its own stock. Barring the possible application of the disguised sale roles, the contributions by the shareholders and the corporation, and the distribution of stock to the corporation, are nontaxable. However, the substance of the transaction is that the corporation has redeemed stock through a tax-free distribution of appreciated property; see Notice 89-37.

Anti-Abuse Rules

The IRS issued proposed regulations in December 1992 to address this perceived abuse. These rules apply when a partnership (either directly or indirectly) owns, acquires or distributes a partner's stock. The regulations provide that a partner may be required to recognize gain under the deemed redemption rule or the distribution rule.

Deemed redemption rule: Under this rule, a partner recognizes gain whenever a transaction effectively results in the exchange of his or her interest in appreciated property for an interest in stock of the partner owned, acquired or distributed by the partnership. According to Prop. Regs. Sec. 1.337(d)-3(d), this may occur if?

1. A partner contributes property to a partnership when the partnership owns stock in the contributing partner;

2. A partnership acquires stock in one of its partners;

3. A partnership makes a disproportionate distribution;

4. A partnership agreement is amended to provide different sharing ratios; or

5. De minimis rules (discussed below) cease to apply.

If a partner recognizes gain under this provision, the bases of the partner's and partnership's property are increased accordingly.

Distribution rule: Under this rule, a partnership's distribution to a partner of partner stock is treated as a redemption or exchange for a portion of the partner's partnership interest; the Sec. 732 nonrecognition rules do not apply. A portion of the partner's partnership interest is deemed exchanged for stock equal to the fair market value (FMV) of the stock distributed. Sec. 311 (governing corporate taxation of a distribution of its stock or other property) or 1001 (governing...