Partnership's sale of contributed corporate stock may be a trap for the unwary.

• Author: Hayes, Thomas M.

In Rev. Rul. 99-57, the IRS ruled that a corporate partner will not recognize gain on a contribution of its own stock to a partnership followed by the partnership's use of that stock one year later as consideration in a taxable exchange. The ruling is generally favorable for taxpayers, but contains a trap for the unwary.

Rev. Rul. 74-503 held that a corporation has a zero basis in its own stock. Nevertheless, Sec. 1032 protects a corporation from gain or loss recognition oil the use of its own stock in an exchange. Sec. 1032 does not, however, offer the same protection if a corporation's stock is used by an entity other than the issuing corporation. Such other entities might, therefore, recognize gain on the use of the corporation's stock to the extent the value of that stock exceeds the stock's zero basis.

In an analogous situation, Prop. Regs. Sec. 1.1032-3 addresses a parent's transfer of its stock to a subsidiary, followed by the subsidiary's exchange of the parent stock. If adopted, the proposed regulations would, under certain circumstances, create a fictional exchange in which a parent is deemed to make a capital contribution of cash to its subsidiary and the subsidiary is deemed to use that cash to purchase parent stock. The result of this fictional exchange is that the subsidiary takes a cost basis (i.e., at fair market value (FMV)) in the parent stock, protecting the subsidiary from gain if it uses the stock to acquire other property.

Similarly, Rev. Rul. 99-57 addresses the situation in which a corporate partner contributes its own stock to a partnership, followed by the partnership's (one year) later exchange of the stock to third parties in taxable transactions. Because the corporate partner has a zero basis in the stock and the partnership takes a transferred basis in the stock on its receipt from the corporate partner (Sec. 723), the Service ruled that the partnership realizes gain on the use of the corporate partner stock in a taxable exchange. Based on an aggregate theory of partnerships (which treats the partnership as an aggregate of its partners and not as a separate entity) and on the protection offered by Sec. 1032, the IRS also ruled that the corporate partner would not recognize the gain allocable to it from the partnership's use of the corporate partner stock. Instead, the Service ruled that the corporate partner's basis in the partnership should be increased by its allocable share of the partnership's gain from the...