Proposal to Permit Liability Netting for Partnerships Subject to Involuntary Conversion

• Publication year: 2017
• Author: By Veronica Long

Proposal to Permit Liability Netting for Partnerships Subject to Involuntary Conversion1

By Veronica Long²

EXECUTIVE SUMMARY

Internal Revenue Code ("IRC") section 1033 provides for the deferral of gain recognition where property is involuntarily converted and the taxpayer reinvests the conversion proceeds in similar replacement property. The purpose of section 1033 is to defer gain recognition when taxpayers use conversion proceeds to replace property, without subjecting them to unanticipated tax liability.

When a partnership uses conversion proceeds to purchase replacement property, there is no gain where the partnership pays off a liability on the converted property and takes out a similar liability on the replacement property. However, under the same facts, Revenue Ruling 81-242 requires partners to recognize gain in an involuntary conversion where their share of liability relief exceeds their basis in the partnership.³ Section 1033 is a gain deferral statute intended to allow taxpayers to put themselves in the same position as they were pre-involuntary conversion, but Revenue Ruling 81-242 conflicts with this purpose by requiring taxpayers to recognize gain and leaving taxpayers with less funds to purchase replacement property. This result is unique to partners because individual taxpayers are not required to recognize gain under the same facts. Additionally, sections 1033 and 1031 are very similar gain deferral provisions, with generally similar results. However, section 1031 allows taxpayers to defer gain under these circumstances while section 1033 does not.

Accordingly, this paper proposes the reversal of Revenue Ruling 81-242 and the adoption of new guidance to allow liability netting, by deeming the conversion and replacement of property to be a single transaction.

DISCUSSION

I. INTRODUCTION

Requiring partners to recognize gain during an involuntary conversion conflicts with the legislative intent to permit gain deferral under IRC section 1033. Section 1033 was enacted to broadly defer taxation where property is involuntarily converted, so that taxpayers may purchase replacement property and put themselves in the same position as they were prior to the conversion.⁴ By disallowing liability netting, Revenue Ruling ("Rev. Rul.") 81-242 creates inconsistencies with the legislative intent of section 1033. These inconsistencies include requiring partners to recognize gain unlike any other individual or entity, requiring partners to recognize gain in an involuntary conversion but not in a voluntary exchange, and treating partnerships subject to an involuntary conversion worse than partnership making voluntary distributions. However, these inconsistencies may be corrected by new guidance permitting liability netting under section 1033 from the Internal Revenue Service ("IRS"), Department of the Treasury, or Congress.

II. LEGISLATIVE HISTORY LEADING TO ISSUANCE OF REVENUE RULING 81-242 A. Enactment

Section 1033 was intended to help taxpayers replace converted property with similar property by deferring gain recognition. Legislation was first proposed by the Secretary of the Treasury in 1919 for inclusion in the Revenue Act of 1921.⁵ The Secretary aimed to protect property owners whose property was requisitioned by the government or destroyed during World War I. The Secretary reasoned taxpayers were unable to purchase replacement property similar to the property they had lost after paying taxes on the difference between the cost of the converted property and the amount received in compensation. The Secretary proposed taxpayers be allowed to create a tax-deferred replacement fund with the conversion proceeds, and use the fund to purchase similar replacement property with a substituted basis, thereby deferring taxation on the conversion proceeds.

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B. Private Letter Ruling

In 1979, the IRS determined liability netting should be permitted in a Private Letter Ruling ("PLR") considering whether partners may net liabilities on converted property and replacement property under section 1033.⁶ In the PLR, a taxpayer requested guidance on whether the partners of a partnership would be required to recognize gain on the conversion and replacement of property subject to a liability where the partners' share of liabilities exceeded their basis in the partnership.

The PLR began with a review of section 1033. The PLR reasoned the purpose of section 1033 was to provide tax relief where taxpayers had gain as a result of involuntary conversion. Without application of section 1033, taxpayers would have to recognize gain from the conversion proceeds to the extent the amount realized exceeded the taxpayer's basis in the property.

The PLR considered whether sections 1033 and 752(b) allow partners to defer gain recognition individually, or whether gain deferral is limited to the partnership entity. In determining whether the statute applied to the entity and the partners, the PLR considered the case Rosefsky v. C.I.R., where a statute of limitations for partnerships was applied to individual partners.⁷ In that case, the court applied the statute to the partners because they reasoned Congress did not intend to limit gain deferment to exclude partners, or to create the inconsistency of applying a statute of limitation to a partnership, but not the partners.

The PLR also considered Rev. Rul. 79-205, where the IRS allowed liability netting in a nonliquidating partnership distribution of property subject to liability.⁸ The PLR noted one of the reasons Rev. Rul. 79-205 permitted liability netting is Congress intended to narrowly limit when gain is recognized on a distribution, so as to not deter partners from moving property into and out of a partnership. The PLR concluded partners should be able to net liabilities of relinquished and replacement properties under section 1033 to conform to the legislative intent of the section, and to be consistent with Rev. Rul. 79-205.

C. General Counsel Memo

Subsequent to the PLR, the IRS began developing a revenue ruling with the same guidance as the PLR. However, upon review prior to issuance, the position of the PLR and proposed revenue ruling was reversed in a General Counsel Memoranda ("GCM").⁹

The GCM concluded that the involuntary conversion and replacement of a building should constitute two separate transactions, based on conversion and replacement not being simultaneous, and the application of section 752(b). The GCM stated section 752(b) should operate independent of section 1033, because 1033 is silent as to its application, and absent statutory language, 752(b) should apply. The GCM further reasoned section 1033 is only intended to defer the partnership's recognition of gain from the conversion of property, not the deemed distribution to the partners themselves caused by section 752(b).

In determining section 752 should operate independent of section 1033, the GCM analogized the issue to one discussed in the 1977 edition of McKee's Partnership Taxation.¹⁰ In...