In the following article, our expert tax professional Monte Jackel will analyze the tax implications of two particular types of tax structuring arrangements and M&A transactions. These two types, partnership conversions and partnership migrations, are of particular interest in the world of mergers and acquisitions tax because some transactions may be taxable and some of these transactions may be classified as “tax nothings.”
In a “tax nothing”, the M&A transaction itself does not occur for US federal income tax purposes, and the taxpayer does not pay US federal income taxes or receive deductions on gains and losses. There are several reasons for a partnership conversion, for example, partners in a general partnership might want to undertake a partnership conversion to a limited partnership in order to take advantage of better liability protection.
A partnership migration allows the partnership to change the jurisdiction that governs the partnership. These tax structuring transactions may help a partnership appear more attractive to potential buyers or may be undertaken as a part of the M&A transaction itself to achieve certain business goals and tax objectives. As our M&A tax consultant Mr. Jackel will discuss, the transfer of assets in either of the two tax structuring strategies discussed may be disregarded by the IRS under certain scenarios.
Tax structuring through partnership conversions or migrations can have many benefits, but it is not for everyone. At Leo Berwick, we provide tax services that are strictly tailored to your business. Ask your M&A tax adviser about tax strategies that best fit your partnership’s business and tax goals.
A. Introduction and Background
First question: When is a “tax nothing” treated as a “tax something”?
Second question: When is a tax something treated as a tax nothing?
Answer (pick one or more of the following):
- When the law provides for that result
- When sound tax policy dictates that result
- When an IRS error of law leads to that conclusion
- When the IRS wants to maximize revenue to the fisc without regard to sound tax policy. The purpose of this article is to address partnership-to-partnership conversions and migrations in the context of whether the event should be treated as a tax nothing or a tax something.
A partnership conversion or migration can take many forms. For instance, it can occur through an actual, mechanical transfer of equity interests in, or assets of, an entity, or, alternatively, solely by operation of law.
Also, a conversion or migration can involve a change in the nature of the entity, such as the following:
- a general partnership in one state converting into a limited partnership in the same state or a different state;
- a domestic entity converting into a foreign entity or vice versa;
- a domestic general partnership converting into a limited liability partnership in the same or another state;
- a domestic partnership converting into a domestic limited liability company in the same state or another state ; or
- a domestic LLC converting into a domestic partnership in the same state or another state.
At issue is whether any of these conversions or migrations is essentially a “nothing” for federal income tax purposes,12 or whether the construct created by the conversion rulings should be given substantive tax effect, thereby potentially creating income, deduction, gain, or loss to the partners.
It is the premise of this article that given the importance of this issue and the dearth of guidance thereon, the government should provide guidance to specifically address what, if anything, happens on an inbound or outbound partnership-to-partnership conversion.
B. The Rulings
1. The continuation ruling. In Rev. Rul. 66-264, a five-person partnership sold its assets to a partnership owned by three of the selling partnership’s partners. Despite the form of the transaction (a sale) and the use of a separate juridical entity to “purchase” the assets, the IRS, with virtually no analysis, concluded that the selling partnership did not terminate under section 708(b).
As a result of the selling partnership “continuing,”13 the ruling concluded that the interests of the two departing partners were either purchased by the three partners in the new partnership or redeemed by the old partnership. In either case, the actual sale of assets from one legal entity to another legal entity was disregarded, there was no movement of assets for federal income tax purposes, and, as to the purchasing partners, nothing apparently occurred regarding their interests in the partnership or their shares of partnership assets.
2. The conversion rulings. In Rev. Rul. 84-52, X, engaged in the business of farming, was formed as a general partnership under the Uniform Partnership Act of State M. The partners of X were A, B, C, and D, each of whom had an equal interest in the partnership.
The partners proposed to amend the partnership agreement to convert the general partnership into a limited partnership under the Uniform Limited Partnership Act of State M, a statute that corresponded in all material respects to the Uniform Limited Partnership Act. Under the certificate of limited partnership, A and B were to be limited partners, and C and D were to be both general and limited partners. Each partner’s total interest in the partnership’s profits, losses, and capital remained the same, and there was no change in the business of the partnership.
The principal issues addressed in the ruling were “the federal income tax consequences of the conversion of a general partnership interest into a limited partnership interest in the same partnership.” After reciting the applicable statutes and regulations, the IRS concluded:
Under the facts of this revenue ruling, A, B, C, and D will remain partners in X after X is converted to a limited partnership. Although the partners have exchanged their interests in the general partnership X for interests in the limited partnership X, under section 721 of the code, gain or loss will not be recognized by any of the partners of X except as provided in section 731 of the code.
The revenue ruling provides that neither a section 708(b) termination nor a closing of the partnership tax year under section 706 occurs. It is curious that this ruling said there was a movement of property interests from one partnership to another partnership and yet also said there was no section 708(b) termination of the old partnership, meaning that the partnership was a continuing partnership under section 708(a).
This revenue ruling, although correct from a tax policy point of view, was incorrectly decided. The premise of the ruling is that a contribution of a partnership interest to another partnership is not a sale or exchange because, per the ruling, “Section 1.708-1(b)(1)(ii) of the Income Tax Regulations provides that a contribution of property to a partnership does not constitute a sale or exchange for purposes of section 708 of the Code.”
Although that premise is true when one is looking at the transferee partnership, it is not true for the partnership whose interests are transferred. For instance, if a partnership interest in partnership A is transferred for an interest in partnership B, under Treasury regulations it is clear that a sale or exchange of the transferred interest in partnership A has occurred.14
The approach in Rev. Rul. 84-52 was continued in Rev. Rul. 95-37.
In that ruling, the transactions at issue were conversions from domestic partnerships into domestic LLCs and the converse — the conversion of domestic LLCs into domestic partnerships. The key issue in the ruling was whether “the federal income tax consequences described in Rev. Rul. 84-52 . . . apply to the conversion of an interest in a domestic partnership into an interest in a domestic limited liability company . . . that is classified as a partnership for federal tax purposes.”
After reciting the facts and holdings of Rev. Rul. 84-52, the IRS concluded, without any further analysis, that the “conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes is treated as a partnership-to-partnership conversion that is subject to the principles of Rev. Rul. 84-52.” The ruling does not address domestic-to-foreign, foreign-to-domestic, or foreign-to-foreign partnership-to-partnership conversions, and no explanation is provided for not extending the ruling to cross-border conversions.
Rev. Rul. 95-55 involved a New York general partnership that registered as a New York LLP under a specific New York statute. The ruling holds that “the registration of PRS [the general partnership] as an RLLP [a registered LLP] is treated as a partnership-to-partnership conversion that is subject to the principles of Rev. Rul. 84-52. Therefore, PRS will not terminate under section 708(b) as a result of its registration as an RLLP, and PRS must continue to use the same methods of accounting used before its registration as an RLLP.”
3. The migration ruling. There is some authority under subchapter C for cross-border migrations. There is no authority under subchapter K, however, for those migrations. Rev. Rul. 88-25 deals with an inbound domestication of a foreign corporation into a U.S. corporation.
In that ruling, F was incorporated in Country Y. For valid business reasons, the shareholders of F decided that it would be advantageous for F to become a State A corporation. Under State A corporate law, a foreign corporation could become a State A corporation by filing a certificate of domestication and a certificate of incorporation with the appropriate official.
Under a plan of reorganization, F filed a certificate of domestication and a certificate of incorporation in State A. On filing those certificates, F was considered by State A to be incorporated in State A and became subject to State A law, whether or not F continued to be considered a Country Y corporation for Country Y purposes.
Thus, F was not required to incorporate again in State A but merely “converted” itself into a State A corporation by filing the appropriate documents. For State A law purposes, the existence of F was deemed to have commenced on the date F commenced its existence in Country Y. Following the domestication, F possessed the same assets and liabilities as before the domestication and continued its previous business without interruption. There was no change in the shareholders of F or in the shareholders’ proprietary interests.
In the subchapter C world, “a mere change in the identity, form, or place of organization of one corporation, however effected” and despite an actual migration, is generally a tax nothing under section 368(a)(1)(F) (an F reorganization). In an F reorganization, the tax year of the transferor corporation does not end, and various tax attributes of the transferor corporation carry over to the transferee.15
In Rev. Rul. 88-25, the IRS focused on the F reorganization rules and discussed “the federal income tax treatment of the conversion of a foreign corporation to a domestic corporation under a state domestication statute.”
The IRS concluded:
For federal income tax purposes, the conversion of F from a Country Y to a State A corporation under the State A domestication statute is treated as: (1) a transfer by a foreign corporation (F) of all of its assets and liabilities to a new domestic corporation (F-D) in exchange for F-D stock; and (2) a liquidating distribution by F to its shareholders of the F-D stock received in exchange for F’s assets and liabilities.
There was no change in the shareholders of F or in the shareholders’ proprietary interests. Furthermore, F-D possessed the same assets and liabilities and continued the same business activities after the conversion as F did before the conversion. Because there was no alteration in shareholder continuity, asset continuity, or business enterprise, the effect of the conversion was a mere change in the place of organization of F.
Therefore, the conversion qualified as a reorganization under section 368(a)(1)(F) of the Internal Revenue Code [which] provides that the term “reorganization” includes a mere change in identity, form or place of organization of one corporation, however effected.
Although the ruling concludes that the transaction was an F reorganization, it also states that for purposes of section 367(b), there was a deemed inbound transfer of assets from the foreign corporation to the continuing domestic corporation. This deemed movement of assets was presumably necessary to otherwise prevent the tax-free repatriation of untaxed offshore earnings and profits.
The key point to be taken from this ruling is that there was a deemed movement of assets from the migrating corporation to the migrated corporation, and that despite the transaction constituting an F reorganization (which is generally viewed as a nothing for federal income tax purposes), the deemed transfer had potential substantive tax effects, in that case under section 367(b) and its applicable regulations.
As noted above, section 708(a) provides that an “existing” partnership will be treated as “continuing” if it is not terminated, and section 708(b)(1)(A) refines this statement by providing that a partnership will be treated as terminated only if “no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.”
By analogy, the partnership merger and division provisions16 use similar continuation partnership terminology. In a partnership merger, the partnership into which the other partnership(s) is/are merged is a “continuation” of the old partnership, with no deemed movement of assets in that continuation of the prior partnership.17 In a partnership division, the partnership that is the transferor for federal income tax purposes must be a partnership that is a “continuing” partnership.18 Generally, the continuing partnership is not treated as transferring any assets that it continues to hold after the division.19
Except as noted above, there is no direct or even indirect statutory counterpart in subchapter K to an F reorganization.
The treatment of an F reorganization as involving the actual or deemed transfer by one separate corporation to another separate corporation when gain is not recognized under an express provision of the code should be compared to section 708(a). The latter statute merely states that a partnership continues if it is not terminated. No mention is made in the code or the underlying regulations of any kind of transfer or movement of assets that may occur when a partnership is deemed to continue under section 708(a).
In contrast to the F reorganization approach, when it is clear that there is either an actual or deemed transfer of assets from one separate corporation to another separate corporation under the code, the text of section 708(a) give absolutely no indication that any movement of assets has occurred.
It is unclear whether the proper approach is
(i) the same as an F reorganization, in which there is an actual or deemed movement of some property interest from the transferor partnership to the transferee partnership, thereby potentially implicating any code provisions dealing with the transfer of property interests from one partnership to another partnership; or
(ii) that section 708(a) should be taken at its word. That means that if a partnership is treated as continuing, it is not terminated and, unlike an F reorganization, there is no movement of property interests at all from one partnership to the other partnership — a true tax nothing.
Assuming Rev. Rul. 66-264 continues to represent the IRS’s view, it would appear that even an outright sale of one partnership’s assets to another partnership formed in a different jurisdiction by the same partners would be disregarded, much like a transaction between an owner and a wholly owned disregarded entity or between disregarded entities — these transactions are also treated as tax nothings.
The effect of this view would be even less of a movement of assets than the partnership-to-partnership conversions described in the conversion rulings. In those cases, there was a hypothetical contribution of property interests from the old partnership to the new partnership in a section 721 transaction. In Rev. Rul. 66-264, regarding the remaining partners, nothing happened.
For the past 25 years, the IRS has been on record as generally supporting the tax-free transfer of assets in interstate partnership conversions and migrations20 but has yet to address the consequences of intercountry partnership conversions and migrations. But for necessary “policing,”21 the authors see no policy reason for not applying identical principles to cross-border transactions. In fact, section 708(a) appears to clearly dictate that result.
We believe sound tax policy dictates that whatever domestic or international code or regulatory provisions could apply to an actual movement of property interests from one partnership to another partnership, those same provisions could also be applied in the context of a partnership-to-partnership conversion or migration, thereby adopting the F reorganization-type approach of Rev. Rul. 88-25.
For example, if section 721(c) or section 367(d) would apply on an actual transfer of property interests from one partnership to another partnership, those provisions could apply to a transfer on a partnership-to-partnership conversion or migration. The same analysis would hold true for other domestic or international code provisions, such as section 987 or section 904(f).
Domestically, the conversion of one partnership into an LLC or vice versa, if viewed as creating an actual asset movement as in the conversion rulings, could potentially implicate the anti-mixing-bowl provisions, such as sections 704(c)(1)(B), 704(c)(1)(C), and 737. However, the complete transfer to another partnership exception in those regulations should otherwise apply,22 and sound tax policy dictates that these anti-mixing-bowl provisions should not apply.23
The continuity and quantum of partner ownership in both the old partnership and the new partnership is also an unknown issue. For example, the partnership merger and division statutes specify that there must be a more than 50 percent continuity of partner ownership to cause an entity to be a continuation of a predecessor entity. And Rev. Rul. 66-264 involved 60 percent continuity.
But what happens in a conversion transaction, such as that in Rev. Rul. 84-52, if the partners in the old partnership are not exactly the same as those in the new partnership? What threshold of continuity of ownership would be necessary to cause this kind of transaction to no longer be a nontaxable conversion?
Would it matter if the same partners remained as owners in the new entity but their ownership interests are either increased or decreased as compared with their ownership interests in the old entity? Would a single, 1 percent continuing partner be sufficient? Section 708(b)(1)(A) merely requires the continuation “by any of its partners in a partnership.”
Section 708(a) and (b)(1)(A) are not new statutes. The increased popularity of LLCs has increased the need to provide guidance on the common business conversion transactions described in this article.
Now is the time for the IRS to address these questions. Providing guidance in the corporate reorganization area, specifically F reorganizations, while ignoring the at least equally important and similar issues under subchapter K is simply an unacceptable state of affairs.
As our mergers and acquisitions tax professional Mr. Jackel observes in the conclusion, the IRS has yet to clarify how they will treat international partnership conversions and migrations for federal tax purposes.
Regardless of whether an intercountry partnership conversion or migration is disregarded by the IRS, any international M&A transaction or international tax structuring involving a foreign partnership or partners will have several other global tax issues and cross-border tax strategies that should be considered. FIRPTA planning is almost always a requirement for international partnerships or domestic partnerships with partners domiciled outside of the United States.
The issues surrounding FIRPTA are plentiful and may include some unexpected FIRPTA withholding taxes. Our tax advisers at Leo Berwick provide domestic and global tax services to improve your M&A strategy.
by Monte A. Jackel and Robert J. Crnkovich
Monte A. Jackel is a managing director at Leo Berwick and Robert J. Crnkovich, an adjunct professor at Georgetown University Law Center, is a principal at PricewaterhouseCoopers LLP. This article represents the personal views of the authors and does not necessarily represent the views of PricewaterhouseCoopers LLP.
Copyright 2009 Monte A. Jackel and Robert J. Crnkovich.
All rights reserved.
1 As used in this article, a partnership conversion refers to the change in the form of legal entity that the partnership uses in conducting its business or investments, such as from a general partnership to a limited partnership or from a partnership to a limited liability company. Related issues involve a different type of conversion: those involving interspecies transactions such as converting tax partnerships to tax corporations or to disregarded entities (or vice versa). These issues will be addressed at another date.
2 As used in this article, a partnership migration refers to the change in the jurisdiction governing the operation of the partnership, such as changing from a domestic partnership to a foreign partnership (or vice versa), or from a State X partnership to a State Y partnership.
3 The issue of partnership conversions and migrations has been addressed in two extensive articles on the subject. See Sheldon I. Banoff, “Mr. Popeil Gets ‘Reel’ About Conversions of Legal Entities: The Pocket Fisherman Flycasts for ‘Form’ but Snags on ‘Substance’,” CCH Taxes, Dec. 1997; and Sheldon I. Banoff, “Partnership Ownership Realignments via Partnership Reallocations, Legal Status Changes, Recapitalizations and Conversions: What Are the Tax Consequences?” CCH Taxes, Mar. 2005.
4 Rev. Rul. 84-52, 1984-1 C.B. 157, posits a deemed transfer from one partnership entity to another partnership entity, apparently of equity interests and not assets, although this is not perfectly clear from the ruling.
5 See Rev. Rul. 66-264, 1966-2 C.B. 248. Although that ruling is not a conversion or migration ruling, the IRS concluded that an actual sale of assets was not an asset movement for federal income tax purposes.
6 See Rev. Rul. 2004-59, 2004-1 C.B. 1050, Doc 2004-11176 [PDF], 2004 TNT 102-6 , involving a state-law “formless” conversion from a partnership to a corporation. The exact nature of the formless conversion statute is not specified in the ruling.
7 Rev. Rul. 84-52, supra note 4.
8 Rev. Rul. 88-25, 1988-1 C.B. 116, involving a change in governing law of a foreign corporation to that of a domestic corporation.
9 Rev. Rul. 95-55, 1995-2 C.B. 313, Doc 95-7637, 95 TNT 152-8 , involving a New York general partnership that changed its legal status by registering under New York law as a New York LLP.
10 Rev. Rul. 95-37, 1995-1 C.B. 130, 95 TNT 79-7 , involving the conversion of a domestic partnership to an LLC either in the same state or in a different state, or the conversion of a domestic LLC to a domestic partnership in the same state or in a different state.
11 See id. Rev. Rul. 95-37, Rev. Rul. 84-52, and Rev. Rul. 95-55 are collectively referred to as the “conversion rulings.”
12 Deeming transactions involving actual transfers as tax nothings (with some exceptions as noted below) should be contrasted with events involving no actual movement as creating a tax something (e.g., a reg. section 301.7701-3 check-the-box election to convert a corporation to a partnership is treated as an asset transfer with potential substantive tax consequences involving two steps: first, a transfer by the corporation to its shareholders, and second, the transfer by the shareholders of those assets to the partnership).
13 Section 708(a) provides that “an existing partnership shall be considered as continuing if it is not terminated.”
14 See reg. section 1.755-1(b)(5)(iv), examples 1 and 2. However, see LTR 8819083 (Jan. 12, 1988) in which the IRS concluded that contributions of 99 percent of the interests of a partnership to a newly formed upper-tier partnership did not result in a section 708(b)(1)(B) termination of the transferred partnership.
15 See section 381(b) and (c). Various revenue rulings have treated F reorganizations as separate transactions in applying the step transaction doctrine. See, for example, Rev. Rul. 96-29, 1996-1 C.B. 50, Doc 96-15358, 96 TNT 102-6 . Proposed regulations under the F reorganization provisions even allow for less than perfect identity of shareholders before and after the reorganization by allowing some redemptions of shareholders in connection with the F reorganization. See REG-106889-04 (Aug. 12, 2004), Doc 2004-16324 [PDF], 2004 TNT 156-5 . The preamble to these proposed regulations states:
Although an F reorganization may involve an actual or deemed transfer of assets from one corporation to another, such a transaction effectively involves only one corporation. In this way, an F reorganization is much like an E reorganization, which can only involve one corporation even in form. As a result, an F reorganization is treated for most purposes of the Code as if the reorganized corporation were the same entity as the corporation in existence before the reorganization. Consequently, the taxable year of the corporation does not end on the date of the transfer, and the losses of the reorganized corporation can be carried back to offset income of its predecessor. See section 1.381(b)-1(a)(2).
16 See section 708(b)(2).
17 Reg. section 1.708-1(c).
18 Reg. section 1.708-1(d).
19 Note the common thread running between section 708(b)(1)(A) and the merger continuation rules — the continuing partnership is essentially deemed to be the “old” partnership for federal income tax purposes. If Rev. Rul. 84-52 were to be viewed under the partnership merger rules, with the old State X general partnership of Rev. Rul. 84-52 merging with the new limited partnership, the “old” partnership should always be the continuing partnership because it would have the larger share of net assets before the merger commenced. Compare, however, the hypothetical asset movement of a partnership-to-partnership conversion (assets-over to the new partnership) and a merger (assets-over to the old partnership).
20 Indeed, there has been no contrary guidance provided.
21 For example, the outbound migration of partnerships should be subject to sections 721(c) and 6038B, as in the case of any actual outbound transfer to a partnership, assuming the predicates to the application of those statutes have been met in the case of an actual transfer.
22 Reg. section 1.704-4(c)(4). See also reg. section 1.704-3(a)(3)(i), which provides in part that on a termination of a partnership under section 708(b)(1)(B), a new transfer subject to section 704(c) does not occur.
23 The term “mixing bowl” is derived from Example 8 of reg. section 1.707-3(f).