Tax Due Diligence: Transferred Partnership Interests and Liabilities
Monte A. Jackel is a contributing columnist for Tax Notes and a managing director at Leo Berwick, LP. All views expressed herein are his own knowledge on tax due diligence in incorporation transactions.
In this article, Jackel discusses the treatment of the transfer of a partnership interest with a share of debt to a corporation and the potential conflict between section 357(d) and Rev. Rul. 80-323.
Copyright 2011 Monte A. Jackel.
All rights reserved.
If you are a corporate buyer interested in purchasing a partnership, there are a number of M&A tax considerations that should be taken into account as you approach your M&A transaction. As our expert tax consultant Monte Jackel will point out in this article, the purchasing corporation will be responsible for the target partnership’s existing liabilities. Therefore, corporate buyers should ensure that they conduct their tax due diligence early, and thoroughly, to fully understand the nature of the liabilities that they will eventually assume. Additionally, it is critical that the buyers include all liabilities assumed into their tax modeling of Target. As you will also learn, not all liabilities are treated in the same way by the IRS. Depending on the specific fact situation and the outcomes of the tax due diligence process, corporate purchasers should consider the tax strategies and M&A tax structuring possibilities that will put them in the best position when it comes to confronting the tax consequences of the liabilities that they will assume as a result of the M&A transaction.
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Background and Introduction
Tax Due Diligence: Recourse and Non-recourse Liabilities
Liabilities assumed in connection with or taken subject to the transfer of property are a pervasive theme throughout the code. For example, section 1001(b) defines the term “amount realized” for purposes of computing gain or loss from the sale or other disposition of property as the sum of any money received plus the fair market value of the property (other than money) received. Reg. section 1.1001-2(a)(1) states the general rule that the amount realized from the sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or other disposition. Specifically, the regulation provides that the sale or other disposition of property that secures a non-recourse liability discharges the transferor from the liability,1 and that the sale or other disposition of property that secures a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from the liability).2 Contributions and distributions of property between a partner and a partnership, however, are not sales or other dispositions of property for that purpose.3 The regulation does not define non-recourse and recourse liabilities for that purpose.
Section 357(a)(2) states the general rule that if, as part of the consideration in a section 351 or 361 exchange, another party to the exchange assumes a liability of the taxpayer, that assumption will not be treated as money or other property received in the exchange. Exceptions to that general rule are in section 357(b) (tax avoidance transfers) and 357(c) (liabilities in excess of basis). The pertinent Treasury regulations provide that “section 357(a) does not affect the rule that liabilities assumed are to be taken into account for the purpose of computing the amount of gain or loss realized under section 1001 upon an exchange.”
Another area in which the treatment of recourse and non-recourse liabilities is a major theme is section 752. The statute provides that increases and decreases in a partner’s share of partnership liabilities or in the partner’s individual liabilities are to be treated as either a contribution of money to the partnership by the partner (in the case of an increase) or a distribution of money to the partner by the partnership (in the case of a decrease).
Section 362(e), dealing with the limitations on built-in losses in some corporate transfers, does not on its face address the question of liabilities, but it makes express reference to cases in which adjusted basis exceeds the FMV of the property or properties transferred in the exchange. However, in the preamble to proposed regulations issued in 2006,4 the IRS requested comments on the interaction of section 362(e)(2) and the transfer of partnership interests to a corporation in a section 351 exchange.5
In a recent response to that request for comments,6 the American Bar Association Section of Taxation made several recommendations on how to treat a transferred partnership interest with allocated debt under the section 752 regulations as a built-in loss asset in applying section 362(e).7 It is not the purpose of this article to comment on the ABA recommendations. Rather, it is to point out a potential trap for the unwary: the possible silent repeal of Rev. Rul. 80-3238caused by the enactment of section 357(d) more than a decade ago.
In the ruling, a group of limited partners in a transaction that qualified under section 351 transferred their partnership interests to a newly formed corporation. The purpose of the ruling was to determine the application of sections 357(c) and 358 on the transfer of the partnership interests to the corporation. The ruling states, under the section 752 regulations then in effect, that because a share of non-recourse liabilities was allocated to the partners transferring their partnership interests, the amount of debt allocated to the transferring limited partners would be determined based on their shares of partnership profits.9 The ruling is very explicit that the amount of partnership debt deemed shifted to the corporation was determined under section 752 and its governing regulations. The ruling is still in existence today and has not been modified or amended since its issuance.
Section 357(d) Changes the Law
Before the enactment of section 357(d) in 1999 tax legislation,10 section 357(a)(2) (as well as other pertinent corporate provisions) referenced both the assumption of a transferred liability in a section 351 or 361 exchange, as well as acquiring from the taxpayer property subject to a liability. To clarify when liabilities were to be treated as assumed in or taken subject to those corporate exchanges and to better reflect the economics of those corporate liability transfers,11 Congress added section 357(d) to the code.12 The statutory provision states:
- d) Determination of amount of liability assumed. –
(1) In general. — For purposes of this section, section 358(d), section 358(h), section 361(b)(3), section 362(d), section 368(a)(1)(C), and section 368(a)(2)(B), except as provided in regulations —
(A) a recourse liability (or portion thereof) shall be treated as having been assumed if, as determined on the basis of all facts and circumstances, the transferee has agreed to, and is expected to, satisfy such liability (or portion), whether or not the transferor has been relieved of such liability; and
(B) except to the extent provided in paragraph (2), a nonrecourse liability shall be treated as having been assumed by the transferee of any asset subject to such liability.
(2) Exception for nonrecourse liability. — The amount of the nonrecourse liability treated as described in paragraph (1)(B) shall be reduced by the lesser of —
(A) the amount of such liability which an owner of other assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is expected to, satisfy; or
(B) the fair market value of such other assets (determined without regard to section 7701(g)).
(3) Regulations. — The Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this subsection and section 362(d). The Secretary may also prescribe regulations which provide that the manner in which a liability is treated as assumed under this subsection is applied, where appropriate, elsewhere in this title.
As stated earlier, the purpose of the new statute13 was to make the transfer of liabilities to a corporation in a section 351 or 361 exchange more economic when those liabilities were assumed by the corporation. To provide more consistent treatment, the legislation deleted the reference to “property subject to a liability” and made the exclusive means of transferring a liability to a corporation those transfers in which the liability was “assumed.” The statute then sets forth the circumstances in which both a recourse liability and a non-recourse liability are treated as assumed. The general rule for recourse liabilities is that a liability is treated as assumed if the corporate transferee agrees to and is expected, based on the facts and circumstances, to satisfy the liability. For non-recourse liabilities, the general rule in the statute is that the liability is treated as assumed if the property is transferred “subject to” the liability. However, the amount of the non-recourse liability treated as assumed generally is reduced when other property of the taxpayer not transferred to the corporate transferee serves as security for the liability.
Of particular importance to Congress were transactions in which multiple related entities of a taxpayer transferred assets subject to liabilities that were cross-collateralized and took the position that more than one transferor recognized gain on the transfer of the same liability to the corporation. If the transactions were successful, the basis of all the transferred properties would be increased up to the amount of the liability, even though the values of the transferred assets in the aggregate were significantly less than the amount of that liability. Given that those transactions were carried out by corporations not subject to U.S. tax on the transfer, multiple step-ups of property took place without payment of any U.S. tax.
Neither the statute nor its legislative history define the key terms used in the statute — namely, what is a recourse liability and what is a non-recourse liability. Further, no mention is made of Rev. Rul. 80-323, partnerships, or section 752 and its governing regulations. There have been no regulations or other guidance issued under section 357(d) even though the statute was enacted into law more than a decade ago.14
Section 752 Regulations
The section 752 regulations are basically divided between the treatment of recourse liabilities and non-recourse liabilities. For recourse liabilities, the regulations adopt a rule of administrative convenience and generally assume that all partnership property becomes worthless to determine whether the obligor bears the economic risk of loss.15 For non-recourse liabilities, the regulations adopt a three-tiered system for allocation of those liabilities, with the general share of profits being the default governing rule.16
Although section 357(d) does not expressly override the rules of section 752 in providing rules for allocating partnership liabilities among the partners, it does provide an exclusive set of rules in testing the liabilities that are treated as assumed by a corporation in a section 351 or 361 exchange. Those rules clearly include liabilities attributable to a transfer of a partnership interest since recourse and non-recourse liabilities under the statute do not exclude partnership liabilities.17 Thus, if the rules of section 752 as applied in Rev. Rul. 80-323 are determined to be inconsistent with section 357(d), the latter must prevail.
For example, if the corporate transferee is not expected to pay a partnership recourse liability but the corporate transferee would be allocated the liability under reg. section 1.752-2, section 357(d) would say there has not been an assumption of the liability, but reg. section 1.752-2 would say that the corporate transferee has the risk of loss for that same liability. Clearly there is a need to conform the rules of section 357(d) to those of section 752 when a partnership interest is transferred to a corporation in a section 351 exchange. Although overall conformity between the rules of sections 357(d), 1001, and 752 would be desirable, it is most important in the context of the transfer of partnership interests to address the interface between sections 357(d) and 752, at least as it is applied in Rev. Rul. 80-323.18
Section 357(d) has been with us since 1999, and yet no guidance has been issued under the statute. To make matters worse, Rev. Rul. 80-323 is still outstanding and, to many readers, is still good law. That would be a reasonable assumption given that it was not revoked, modified, or amended after the enactment of section 357(d). However, although penalties may not be an issue when a revenue ruling remains outstanding but is inconsistent with a later enacted statute, the fact remains that as a matter of substantive law, the statute will always trump the ruling, whether modified or not. That may be the case with Rev. Rul. 80-323. However, the uncertainty in this situation is unacceptable. The law should be clarified as soon as possible.19
Tax due diligence is an important step to take early on in an M&A transaction as a corporation prepares to acquire a partnership interest to determine the amount of liabilities that may be assumed. Of equal importance is tax modeling to properly account for the liabilities assumed for US tax purposes. Other complexities may arise when a partnership is acquired, especially if the partnership has foreign partners. In such cases, you may want to consider certain international tax structuring strategies and possibly FIRPTA planning. It is worth noting that international tax structuring opportunities will be affected by the existence (or nonexistence) of tax treaties that the United States may have with the country in question. At Leo Berwick, our tax professionals are experts in providing domestic and global tax services for M&A transactions, and we are here to help you make your M&A transaction as headache-free as possible.
1 Reg. section 1.1001-2(a)(4)(i).
2 Reg. section 1.1001-2(a)(4)(ii).
3 Reg. section 1.1001-2(a)(4)(iv).
4 71 Fed. Reg. 62067-62101 (Oct. 23, 2006).
5Id. “The IRS and Treasury Department are further exploring how the provisions of section 362(e)(2) apply to partnerships. The IRS and Treasury Department invite comments on this general issue and specifically invite comments regarding the transfer of a partnership interest in exchange for stock in a section 351 transaction to which section 362(e)(2) applies. For example, individuals A and B contribute cash to form a partnership, PRS. PRS purchases property that subsequently decreases in value. A contributes his PRS interest to a corporation in a transaction that qualifies under section 351. PRS does not make an election under section 754. Comments are invited regarding the interaction of section 362(e)(2) and the partnership provisions under these and similar facts.”
6See ABA comment letter (Oct. 26, 2011), Doc 2011-22595 , 2011 TNT 208-21 . As pointed out in Example 4, if the transferred partnership interest has a substantial built-in loss as defined in section 743(d)(1), a section 743(b) adjustment to the assets attributable to the transferred partnership interest will be mandatory, and a negative inside basis adjustment will be required regardless of whether a section 754 election is in effect. The net effect is that if the stock basis reduction election under section 362(e)(2)(C) is not made, the stock basis will reflect the built-in loss in the transferred partnership interest, but neither the transferred partnership interest nor the transferee’s share of partnership inside basis will reflect that loss. However, if the stock basis reduction election is made, then the stock basis will no longer reflect that loss and neither will the inside basis of the transferred partnership interest, but the partnership interest itself will retain the built-in loss.
7 The key recommendation of the report, as stated in the executive summary:
These Comments recommend that the regulations [under section 362(e)], when finalized, provide that if a partner transfers a partnership interest to a corporation in a transaction to which section 362(e) applies, the fair market value of that partnership interest is deemed to be the sum of (i) the amount of cash that the corporation would receive if the corporation sold the partnership interest to an unrelated person for cash in an arm’s-length transaction and (ii) the corporation’s share of the partnership’s liabilities as determined under section 752 and the regulations thereunder.
8 1980-2 C.B. 124.
9 Those regulations under reg. section 1.752-1(e) were first replaced by a set of detailed temporary regulations and later by final regulations under reg. section 1.752-1, -2, and -3. SeeT.D. 8380.
10 The Miscellaneous Trade and Technical Corrections Act of 1999, P.L. 106-36.
11See Joint Committee on Taxation, “General Explanation of Tax Legislation Enacted in the 106th Congress,” JCS-2-01 (Apr. 19, 2001), at 9-11, Doc 2001-11335 , 2001 TNT 77-4 .
12 A companion provision, section 362(d), was also part of this tax legislation.
13See JCS-2-01, supra note 11, at 9-11.
14 Although regulations were never proposed under section 357(d), the IRS issued an advance notice of proposed rulemaking (REG-100818-01, Doc 2003-11334 , 2003 TNT 91-35 ), raising several issues under the statute and asking for comments. See also Announcement 2003-37, 2003-1 C.B. 1025, Doc 2003-14474 , 2003 TNT 115-8 (same). Guidance under that statute once appeared imminent, but it never materialized. See Lee A. Sheppard, “Treasury May Change Nonrecourse Liability Assumption Default Rule,” Tax Notes, Jan. 28, 2002, p. 434, Doc 2002-1916 , or 2002 TNT 16-6 (quoting Jeffrey Paravano as saying that the regulations were imminent); Sheppard, “Treasury Official Discusses Liability Assumptions in Section 351 Transfers,” Doc 2003-12145 , 2003 TNT 94-6 (quoting Audrey Nacamuli as saying there were issues in applying the default rule under the statute for non-recourse liabilities and questioning whether section 357(d) should apply to underwater transfers in which no net equity is transferred to the corporation because section 351 may not apply). After the issuance of Announcement 2003-37, the ABA Corporate Tax Committee issued a report pointing out concerns with the advance notice of proposed rulemaking. See Doc 2003-20791 or 2003 TNT 185-42 . The ABA had previously issued comments on the proposed statutory provision before ultimate enactment. See Doc 98-21073 or 98 TNT 127-10 . The issues related to transfers of partnership interests with section 752 liabilities in a section 351 or 361 transfer are not addressed in that commentary, which also does not discuss Rev. Rul. 80-323. However, the 2003 ABA report requests some conformity between the liability assumption rules in subchapters C and K, and it makes frequent reference to the then-proposed regulations under reg. section 1.752-1(a)(4) and -7 (which the report simply refers to as the section 752 proposed regulations).
15 Reg. section 1.752-2.
16 Reg. section 1.752-3.
17 Regulations could provide otherwise but, as noted above, none exist.
18 There are many more problems with implementing section 357(d), as commentary on the provision brought to light. See supra note 14. The most significant issue under the statute was the implementation of the rule for assumption of non-recourse liabilities. This article focuses solely on the transfer of partnership interests and the integration of sections 357(d) and 752 in that context.
19 Perhaps as part of the finalization of the proposed regulations under section 362(e).
END OF FOOTNOTES