Merger and division prop. regs.

• Author: Orbach, Kenneth N.
• Position: Partnership mergers and divisions

Until recently, the only available guidance on partnership mergers and divisions was a smattering of revenue and letter rulings. Earlier this year, Treasury released proposed regulations on such transactions; the rules are instructive, but leave many unanswered questions. This article's many examples point out the issues that need to be addressed in the final regulations.

Earlier this year, Treasury issued proposed regulations providing much-needed (and long-sought) guidance on the tax treatment of partnership mergers and divisions.(1) Although Sec. 708 and the current regulations provide rules for identifying, for Federal income tax purposes, whether the resulting partnership (1) of a merger is a continuation of one of the merging partnerships and (2) of a division is a continuation of the prior partnership, neither the statute nor the regulations prescribe a particular form of merger or division. This is a critical omission, because the form undertaken (or deemed undertaken) dictates the underlying transactions effecting the merger or division and the corresponding tax consequences. As a result, practitioners have had to rely on a relatively limited (and occasionally conflicting) number of published and private rulings in this area.

The proposed regulations provide clarification, by prescribing the form of partnership mergers and divisions and addressing some related tax issues. Specifically, the form of a partnership merger or division will be respected for Federal income tax purposes if an assets-over or assets-up form is used. The proposed regulations also address the tax treatment of Sec. 752 liability shifts and certain buyouts of exiting partners; they modify the Sec. 743 regulations when elective basis adjustments are available.(2) These regulations are proposed to be effective for partnership mergers and divisions occurring on or after the date final regulations are published in the Federal Register.(3)

Overview

Sec. 708

A threshold issue in partnership mergers and divisions is determining, in a merger, whether the resulting partnership is deemed a continuation of a merging partnership(4) or, in the case of a division, whether any of the resulting partnerships are continuations of the prior partnership. This issue is important for a variety of tax compliance reasons; only a resulting partnership that is a continuing partnership retains certain tax elections of a predecessor partnership (such as tax year). It also has significant tax consequences for partnerships not deemed continuations. The noncontinuing merging partnerships in a merger are treated as terminated under Sec. 708; the noncontinuing resulting partnerships in a partnership division are treated as newly created partnerships.(5)

Under Sec. 708(b)(2), the determination of which partnerships are continuing is made by looking to the partners' interests in partnership capital and profits. For mergers, the statute looks to the partners who hold a majority interest in the resulting partnership; for divisions, the statute looks to the partners who held a majority interest in the prior partnership.(6)

Mergers

When two or more partnerships merge, Sec. 708(b)(2)(A) provides that the resulting partnership is a continuation of the merging partnership whose partners own aggregate interests of more than 50% in the resulting partnership's capital and profits; all other merging partnerships are deemed terminated. If more than one of the merging partnerships meets this ownership test, the continuing partnership is the merging partnership that contributed the greatest dollar value of assets (net of partnership liabilities) to the resulting partnership.(7) If the partners of none of the merging partnerships own aggregate interests of more than 50% in the resulting partnership, all of the merging partnerships are deemed terminated; the resulting partnership is treated as a new partnership.

Example 1: AB Partnership is owned equally by A and B, BC Partnership is owned equally by B and C and CD Partnership is owned equally by C and D. The three partnerships merge to form ABCD Partnership, owned as follows: A, 20%, B, 30%, C, 30% and D, 20%. ABCD is deemed a continuation of BC, because B and C own more than 50% of ABCD; AB and CD are deemed terminated. If instead, ABCD is owned by A, 10%, B, 30%, C, 30%,4 and D, 30%, ABCD is deemed a continuation of either BC or CD (depending on which partnership contributed the greater net dollar value of assets to ABCD). However, if each of the ABCD partners owned a 25% interest in ABCD, all of the merging partnerships would be considered terminated; ABCD would be treated as a new partnership.

If the resulting partnership is a continuation of one of the merging partnerships (the continuing partnership), the resulting partnership and the continuing partnership are considered one and the same for Federal income tax purposes. The continuing/resulting partnership fries a return for the continuing partnership's tax year. This return must state that the resulting partnership is a continuation of the continuing partnership and include the merged partnerships' names and addresses. The respective distributive shares of the partners of the continuing/resulting partnership for periods before and after the date of merger must be broken out on the return. The tax years of the other merging partnerships (i.e., the terminated partnerships) are dosed in accordance with Sec. 706(c); a final return must be filed for their tax years ending on the merger date.(8)

Divisions

When a partnership divides into two or more partnerships, Sec. 708(b)(2)(B) provides that any resulting partnership is deemed a continuation of the prior partnership, unless the resulting partnership's partners owned aggregate interests of 50% or less in the prior partnership's capital and profits. Under this ownership test, more than one resulting partnership may be deemed a continuation of the prior partnership.(9) Any resulting partnership not deemed a continuation of the prior partnership is treated as a new partnership.

Example 2: ABCD Partnership is owned as follows: A, 20%, B, 30%, C, 30% and D, 20%. It divides into AB Partnership, BC Partnership and CD Partnership. AB is owned equally by A and B, BC is owned equally by B and C and CD is owned equally by C and D. BC is deemed a continuation of ABCD, because B and C owned more than 50% of ABCD; AB and CD are treated as new partnerships. If instead, ABCD was owned by A, 10%, B, 30%, C, 30% and D, 30%, both BC and CD would be deemed continuations of ABCD;AB would be treated as a new partnership. However, if each of the ABCD partners owned a 25% interest in ABCD, all of the resulting partnerships would be treated as new.(10)

Although the definition of a continuing partnership may seem straightforward, the following example demonstrates that the definition under the proposed (and current) regulations is inconsistent with the statute's provisions.

Example 3: ABC Partnership is owned by three partners. A, B and C have equal one-third interests in capital. A and B each have a 20% profits interest; C has a 60% profits interest. ABC divides into AB and BC Partnerships. Because the AB partners did not own aggregate interests of 50% or less in both the capital and profits of ABC (A and B had an aggregate 67% interest in ABC's capital), AB meets the statutory definition of a continuing partnership. However, Prop. Regs. Sec. 1.708-1(d)(1) requires that the members of a continuing/resulting partnership must have owned more than 50% of the prior partnership's capital and profits; thus, under the proposed regulations, AB would be treated as a new partnership (because A and B had an aggregate 40% interest in profits). On the other hand, under either definition, BC would be deemed a continuation of ABC, because the BC partners owned aggregate interests of 67% in ABC's capital and 80% in its profits.

Any resulting partnership deemed a continuation of the prior partnership must file a return for the latter's tax year. The return must contain a statement that the resulting partnership is a continuation of the prior partnership and disclose the partners' distributive shares in the resulting partnership for the periods before and after the division date. Partners of the prior partnership who do not become partners in a continuing/resulting partnership are treated as having their interests in the prior partnership liquidated at the division date. Because any resulting partnership not deemed a continuation of the prior partnership is treated as a new partnership, it must, among other things, adopt a tax year under Sec. 706(b).(11)

Importance of Form

The Federal income tax consequences of a merger or division may differ, depending on the underlying transactions associated with its form; thus, taxpayers need to know whether the form selected will be respected for tax purposes.(12) (See Exhibit 1) If the form selected is not respected, taxpayers need to know the form the IRS will impose.

Exhibit 1: Importance of Form

CD Ltd. is a limited partnership owned by C, the general partner, and D, the limited partner. The partners have equal interests in CD, except that depreciation is allocated solely to D. CD merges with AB Partnership by operation of state law, without undertaking a specific form. After the merger, C and D own 40% of new ABCD partnership. Thus, AB is the continuing/resulting partnership; CD is the terminated partnership. On the merger date, CD's assets consisted of $600 cash and depreciable real estate with a $600 basis; the basis of the partners' capital accounts was $1,000 for C and $200 for D, with no partnership liabilities. For purposes of this example, the partners can select either the assets-over form or the assets-up form of merger for Federal income tax purposes.

If the assets-over form is selected, CD would be treated as contributing its assets to ABCD for interests therein that are distributed to C and D in...