Tax Department

Built In Gains


BACKGROUND

As discussed in greater detail below, the IRS and Treasury Department issued proposed regulations in 2007 addressing the consequences under sections 704(c)(1)(B) and 737 of certain partnership mergers.

The IRS and the Treasury Department received a number of comments in response to these proposed regulations expressing concern about the proposed treatment of section 704(c) layers in connection with a partnership merger. In addition, the IRS and the Treasury Department have become aware that practitioners are taking positions based upon different interpretations of the current tiered partnership rules (Treas. Reg. §1.704-3(a)(9)). A number of practitioners suggest that the tiered partnerships rules may need to be clarified and similar rules be provided with respect to partnership mergers. The IRS and Treasury believe that further study of certain aspects of the application of section 704(c) is necessary before finalizing the Proposed Merger Regulations.

Section 704(c), in relevant part, provides:

April 15 Tax Filing Deadline
Contributed Property
(1) In General - Under regulations prescribed by the Secretary

(A) income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution,

(B) if any property so contributed is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed

(i) the contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner under subparagraph (A) by reason of the variation described in subparagraph (A) if the property had been sold at its fair market value at the time of distribution.

Section 704(c)(1)(A) was enacted as part of the Tax Reform Act of 1984 (P.L. 98-369). Congress determined that special rules are needed to prevent an artificial shifting of tax consequences between the partners with respect to pre-contribution gain or loss. This is particularly important since the various partners may have different tax positions. H.R. Rep. No. 432, Pt. 2, 98th Cong., 2d Sess., 1209 March 5, 1984. See also, Staff of Joint Committee on Taxation, 98th Cong., 2d Sess., General Explanation of H.R. 4170, 212, Dec. 31, 1984.

Section 704(c)(1)(B) was enacted as part of the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239). It was Congress's view that the prior law made it possible for partners to circumvent the rule requiring pre-contribution gain on contributed property to be allocated to the contributing partner. S. Finance Comm. 101st Cong., Revenue Reconciliation Act of 1989, Explanation of Provisions Approved by the Committee on Oct. 3, 1989, 196 (Comm. Print 1989).

While section 704(c)(1)(B) addresses the recognition of gain by the contributing partner if property contributed by the partner is distributed to another partner, section 737 addresses the tax consequences when a partner who contributed built-in gain or loss property receives a distribution of other property.

Sections 737(a) and (b), in relevant part, provide:

General Rule - In the case of any distribution by a partnership to a partner, such partner shall be treated as recognizing gain in an amount equal to the lesser of

(1) the excess (if any) of

(A) the fair market value of property (other than money) received in the distribution over

(B) the adjusted basis of such partner's interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or

(2) the net precontribution gain of the partner.

Gain recognized under the preceding sentence shall be in addition to any gain recognized under section 731. The character of such gain shall be determined by reference to the proportionate character of the net precontribution gain.

(b) NET PRECONTRIBUTION GAIN. For purposes of this section, the term “net precontribution gain” means the net gain (if any) which would have been recognized by the distributee partner under section 704(c)(1)(B) if all property which

(1) had been contributed to the partnership by the distributee partner within 7 years of the distribution, and

(2) is held by such partnership immediately before the distribution, had been distributed by such partnership to another partner.

Sections 737(a) and (b) were enacted as part of the Energy Policy Act of 1992 (P.L. 102-486) as a result of Congress's concern that “a partner who contributes appreciated property to a partnership may be able to avoid or defer the recognition of gain with respect to that property through the mechanism of having the partnership distribute other partnership property to him in partial or complete redemption of his interest while the partnership continues to own the contributed property.” H.R. Rep. 102-631, 102nd Cong., 2d. Sess., 68 (June 30, 1992). See also, S. Finance Comm. Technical Explanation, 138 Cong. Record S11246, S11265, Aug. 3, 1992 (Daily Ed.). Final regulations under sections 704(c)(1)(B) and 737 were issued in T.D. 8642, dated December 22, 1995. Amendments to these provisions were included in T.D. 8717, dated May 8, 1997, T.D. 9193, dated March 21, 2005 and T.D. 9207, dated May 23, 2005.

On August 22, 2007, the IRS and the Treasury Department published in the Federal Register (2007-41 I.R.B. 790 [72 FR 46932]) a notice of proposed rulemaking (REG-143397-05) (the Proposed Merger Regulations), consistent with Notice 2005-15 (2005-1 C.B. 527), providing that (1) section 704(c)(1)(B) applies to newly created section 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over merger, but does not apply to newly created reverse section 704(c) gain or loss resulting from a revaluation of property in the continuing partnership, and (2) for purposes of section 737(b), net precontribution gain includes newly created section 704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership in an assets-over merger, but does not include newly created reverse section 704(c) gain or loss resulting from a revaluation of property in the continuing partnership. On November 6, 2007, corrections to the proposed regulations were published in the Federal Register (72 FR 62608).

The proposed regulations include several examples. Example (3) of the proposed regulations (see Treas. Proposed Reg. §1.704-4(c)(4)(ii)(F), Example (3)) involves a situation where built-in gain property contributed to the transferor partnership has both a revaluation loss in the transferor partnership and additional gain upon merger with the transferee partnership. The example concludes that the section 704(c) layers are collapsed in the merger and that upon contribution to the transferee partnership the property had only built-in gain and no built-in loss.

Congress was trying to prevent Disguised Sales ... I'm guessing that prior to 1984 there were a good many disguised sales that took place as contributed property to a partnership.