Intersection of Subchapter K & Subchapter C. Intersection of Subchapter K & Subchapter C: Agenda

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1 artnerships & s & Corporate Tax Intersection of Subchapter K & Subchapter C October 21 & 22, 2011 Julie A. Divola illsbury LL Elaine B. Murphy Ropes & Gray LL Eric Solomon Ernst & Young LL John R. Maxfield Holland & Hart LL Eric B. Sloan Deloitte Tax LL Dana L. Trier New York, NY Intersection of Subchapter K & Subchapter C: Agenda Entity vs. Aggregate Issues Rev. Rul and Related Issues Tax-free Reorganization Issues AM Consolidated Return Issues Leveraged artnerships after Canal Corp. ublicly Traded artnership Structure 2 1

2 Entity vs. Aggregate Issues 3 Entity vs. Aggregate Issues Agenda The Scope of Aggregate Theory: The artnership Mixing Bowl and the DRD Section 1032 and Aggregate rinciples The May Department Stores Mixing Bowl The artnership Mixing Bowl Meets Section 332 Allocation of Liabilities in Section 351/304 Rev. Rul Section 355(e): artnership as Successor Section 355 ATB Through artnerships 4 2

3 The Intersection of Corporations and The artnership Mixing Bowl The Scope of Aggregate Theory: Dividends Received Deduction or Nothing at All Corporation A Corporation B 50 ercent 50 ercent Asset 1: Corporation A Stock Asset 2: Corporation B Stock Assuming Corporation A and Corporation B pay dividends that are allocated equally by artnership to the two partners, Corporation A and Corporation B, does the treatment of Corporation A and Corporation B as partners differ? How is aggregate treatment implemented here? See LR (The Cyclotron Ruling) (corporation received a dividend d from itself; no tax). Thus, it appears that Corporation A would be treated differently than Corporation B, which would be treated under general Section 702 principles. One issue e is how Section 243(c) applies. Cf. Rev. Rul (Section 902 credit granted if 20 percent indirect ownership). 5 Section 1032 and Aggregate rinciples Corporation A Corporation B 50 ercent 50 ercent roperty Corporation A Stock Other Assets Assuming income, gain and loss from assets are allocated 50-50, 50, what is the treatment of parties if swaps the Corporate A stock it holds for property with w the same value? Does it matter that the holding of the Corporation A stock is old and cold? Compare Reg See Rev. Rul ; see also LR (Oct. 3, 1997). See Reg (basis rules coordinating Sections 705 and 1032). See Section 755(c)(1) (limit on allocations under Section 755 to corporate partner s s stock). 6 3

4 Section 1032, artnerships and Son-of-Mirrorsof-Mirrors Corporation B sells 40% Interest to Corp A for 80 Corporation B Sub. 60% Sold after A purchase Corporation A Stock Other Assets Sold after A purchase BASIS = 50 FMU = 100 BASIS = 100 FMU = 100 Corporation B and Corporation B Sub own all the interests of, and allocate gain and loss owns Corporation A stock with a basis of 50 and value of 100, and Other Assets with basis of 100 and value of 100. At a time a section 754 election is not in effect, Corporation B sells its interest to Corporation A for 80. Shortly thereafter, sells all its assets, including the Corporation A stock, for 100, upon which it recognizes gain of 50, 20 of which is allocated to A. In the absence of a special rule,, Corporation A would recognize none of the 20 of income, but receive a basis step up of 20 to its interest. Thus, it would have basis of 100 in its partnership interest with value of 80, and could recognize a loss of 20 on sale of the interest or liquidation. Reg in effect mandates applicability of Section 754 to the partnership purchase, reducing the nontaxable gain and basis adjustment to A. 7 The Scope of Aggregate Theory Redux The May Department Stores Mixing Bowl Step I Corporation A 45% Interest 45% Interest Corporation B Corporation A Division Contributed Former Division of Corporation A Corporation A Stock Cash 10% Interest Corporation A Stock Corporation B Subsidiary Note: Alternatively Corporation B could contribute cash and artnership would then buy Corporation A stock from market. Assume Corporation A contributes a division with substantial appreciated assets, Corporation B contributes Corporation A stock and Corporation B Sub contributes tes cash; Corporations A, B and B Sub are partners thereafter. Should super aggregate theory be applied to treat Corporation A as having redeemed a portion of its stock for a 45 percent interest in appreciated divisional assets? That is, should the concept of the t Cyclotron ruling be applied? N.B. The actual May Department Store transaction was apparently not done in precisely this manner. Rather, cash was contributed by Corporation B to, which then purchased Corporation A stock directly from Corporation A. Thus, Corporation A was purporting simultaneously to contribute its Division to and sell A stock for cash to. This form creates a North-South issue. Compare rop. Reg (e), with Reg (paragraph e deleted). 8 4

5 The Scope of Aggregate Theory Continued: The May Department Store Mixing Bowl art II: Can otential Gain Be Eliminated ermanently? Corporation A Corporation A Stock Corporation B 45% artnership Interest 5% Corporation B Sub Former Division of Corporation A Corporation A Stock Sometime after 7 years, redeems Corporation A for 100% of the Corporation A stock owned by. How is Corporation A s A s basis in reflected after this transaction? How does Section 732(b) apply? Does Corporation A have any gain? Cf. Section Compare Notice and rop. Reg (a) Applies to any transaction or distribution that occurs after March 9, See also Rev. Rul (application of last clear chance concepts to tax distribution of corporate debt by partnership to partner debtor). 9 Section 732(f): The artnership Mixing Bowl Meets Section 332. Step 1 Corporation A 40% 40% Corporation B Corporation A Division Contributed 10% Cash Corporation B Subsidiary Appreciated Assets artnership Sub Treasuries In Step 1, as in a standard corporate mixing bowl transaction, Corporation C A contributes highly appreciated assets to and Corporation B contributes cash. The cash is then contributed by artnership to a C corporation, artnership Sub, which buys assets wanted by Corporation A (in this case Treasuries). es). 10 5

6 Section 732(f): The artnership Mixing Bowl Meets Section 332. Steps 2 and 3. Corporation A 45% Corporation B 2 Redemption of artnership Interest 5% Corporation B Subsidiary Corporation A Appreciated Assets 3 liquidation artnership Sub After 7 years, in steps 2 and 3, distributes the stock of artnership Sub to Corporation A, which in turn liquidates the artnership Subsidiary under Section n 332. rior to Section 732(f), the tax planning objective was for the inherent gain of Corporation A in its partnership interest to disappear. Could Section 269 apply to this transaction? Could step transaction tion principles apply to recast the order of the steps? Compare Rev. Rul with Rev. Rul and its progeny. Under Section 732(f), irrespective of an actual Section 332 liquidation, idation, the inside basis of the assets of artnership Sub is, in effect, stepped down to s s basis in the artnership Sub stock immediately before the distribution of the stock to Corporation A. N.B.,, this rule can apply in many ordinary transactions in which no tax avoidance is present. See also Section 734(b). 11 Section 304: General Section 304(a)(1) Section 304(a)(2) $ S1 $ S1 S2 S2 S1 sells S1 stock to S2 for property (cash). S1 sells S1 stock to S2 for property (cash). Section 304 treats certain acquisitions of related party stock for f property as resulting in deemed distributions by the acquiring corporation and/or the target corporation. Assumed liabilities generally constitute property for this purpose. Section 304(a)(1) applies to certain acquisitions of target stock k from a person that controls both target and acquiring. Section 304(a)(2) applies to certain acquisitions by a subsidiary y of stock in its parent. Section 304(b)(3) generally provides that where both Section 304 and Section 351 apply, Section 304 governs (subject to certain limited exceptions). Section 304(b)(3)(B) provides a purchase money debt exception Section 304 primacy rule does not apply to assumed liabilities incurred by the transferor to acquire the transferred d stock. 12 6

7 Allocation of Liabilities in Section 351/304 Transactions: LR S1 transfers S1, S2, S3, and partnership interests to Newco for Newco stock and assumption of liabilities Newco S1 S1 S2 S3 S2 S1 owns S1, S2, S3, and partnership interests. S1 transfers these t assets to Newco in exchange for Newco stock and the assumption of S1 liabilities. S1 s s liabilities include S1 business liabilities and debt incurred by S1 to acquire S3 ( S3( Debt ). The value of S3 has decreased, so the S3 Debt exceeds the value of the S3 stock. In LR , the IRS ruled that Section 304 does not apply to Newco s assumption of the S3 Debt. See Section 304(b)(3)(B). Section 304 applies to the portion of the remaining S1 liabilities assumed in exchange for the stock of S1, S2, and S3. See Section 304(b)(3)(A). Does it matter by how much the S3 Debt exceeded the value of S3 at the time of the transaction? What if the holder of the S3 Debt stated that it would agree to Newco s assumption of the S3 Debt if and only if S1 also contributed other assets to Newco? How is it determined what portion of the remaining liabilities are a assumed in exchange for stock and subject to Section 304? See, e.g., Rev. Rul ; Rev. Rul Did Newco s deemed assumption of S1 s s share of S2 liabilities also give rise to Section 304 treatment? 13 Rev. Rul Section 351 provides that no gain or loss is recognized if property rty is transferred to a corporation solely in exchange for its stock and immediately after the exchange the transferor or transferors are in control of the corporation. Under Section 357(c), if the sum of the amount of liabilities assumed sumed by the corporation and the amount of liabilities to which the property is subject exceeds the t transferor's total adjusted basis of the property transferred, then the excess will be considered as gain from the sale or exchange of a capital asset or of property that is not a capital asset, as the case many be. Reg (h) 1(h) provides that, if a partnership interest is sold or exchanged, ed, the reduction in the transferor partner s s share of partnership liabilities is treated as an amount realized under Section In Rev. Rul , some limited partners transferred their partnership interests ts to a new corporation in a transaction qualifying under Section 351. The share of nonrecourse liabilities allocated to the limited partners exceeded their adjusted basis in their partnership interests. Rev. Rul provides that each transferring partner's share of partnership nonrecourse liabilities is considered as a liability to which the partnership p interest is subject for purposes of Section 357(c). Consequently, each limited partner recognizes gain under Section 357(c) to the extent that the partner's share of nonrecourse partnership liabilities lities exceeds the adjusted basis of the interest transferred. 14 7

8 Section 355(b) Active Trade or Business, and Section 355(e) Step One: D incurs debt and contributes cash proceeds to C (along with unwanted assets). Step Two: D distributes C stock to ublic. ublic Step Three: D transfers all (or some) of D s D assets (and liabilities) to form /S. Step Four: A acquires an interest in the vote and value of /S. D will satisfy the Section 355 ATB requirement if it owns a significant interest in /S (at least 33-1/3%) and /S employees perform the /S management functions, or if D owns a meaningful interest in /S (at least 20%) and performs active and substantial management functions for /S.. See rop. Reg (b)(2)(v), Rev. Rul , Rev. Rul and Rev. Rul (2) C Stock D C (1) (3) /S Interest D Business /S /S interest A (4) Section 355(e)(4)(D) states that, for purposes of Section 355(e), any reference to a controlled corporation or a distributing corporation shall include a reference to any predecessor or successor of such corporation. 15 Section 355(e): artnership as a Successor Is /S a successor to D? rop. Reg (c)(1) looks to whether a Section 381 transaction has occurred although the preamble says that the IRS is still considering the issue. What if D s D s interest is a preferred interest? ublic C A The preamble to the proposed regulations states that the IRS and Treasury are studying the issue based on a concern that (i) transfers of assets to a partnership (or a corporation) may facilitate an acquisition of an interest in D's or C's assets that is functionally equivalent to an acquisition of D or C; or (ii) acquisitions in such a partnership (or corporation) by unrelated persons may also be an acquisition that is functionally equivalent to an acquisition of D or C. D referred Interest /S Common Interest 16 8

9 Rev. Rul & Related Issues 17 Rev. Rul and Related Issues Agenda Review of Rev. Rul and its history Other tax consequences Scope Interesting rulings on Rev. Rul A way forward? 18 9

10 Review of Revenue Ruling 99-6 Discusses the tax consequences in two situations that cause the conversion of a partnership to a disregarded entity. In both situations, neither n of the s owns any Section 751(b) property, has any liabilities, or has any a assets subject to liabilities. Situation 1: One member (A) of an classified as a partnership for U.S. federal income tax purposes sells its interest in the to the other member (B), and the continues to operate its business as an entity owned by B. Situation 2: The two members of the sell their interests to a third-party buyer. Rev. Rul does not address the situation in which a two-person partnership redeems one partner. 19 Revenue Ruling 99-6 A B 20 10

11 Revenue Ruling 99-6, Situation 1 A interest $10,000 B A sells its interest in to B, and continues to operate its i business as an entity owned by B. 21 Revenue Ruling 99-6, Situation 1 A B $10,000 Results terminates under Section 708(b)(1)(A), not Section 708(b)(1)(B). (B). A is treated as selling an interest. Reg (b). 1(b). Under McCauslen and Rev. Rul , 65, with regard to B, is treated as liquidating and distributing its assets to A and B. B is treated as receiving the assets attributable to B s B s interest as a distribution and is treated as purchasing the rest of s assets from A

12 Revenue Ruling 99-6, Situation 1 Results Assets deemed acquired by B from A Basis: : B s B s basis in the assets is $10,000. Section Holding period: : B s B s holding period begins on the day immediately following the date e of the sale. Rev. Rul. 66-7, C.B Section 735 (providing holding period of partnership should be included in determining the period for which a partner has held property received in a distribution from a partnership) does not apply. Assets deemed distributed to B Gain or loss: : The ruling provides that B B must recognize gain or loss, if any, on the deemed distribution of the assets to the extent required by section 731(a). Basis: : B s B s basis in the assets deemed distributed to B is determined under r Section 732(b). Holding period: : B s B s holding period for the assets deemed distributed to B includes the partnership s s holding period. Section 735(b). 23 Rev. Rul. 99-6, Situation 2 interest $10,000 A B interest $10,000 Third arty A and B sell their interests to a third-party buyer

13 Rev. Rul. 99-6, Situation 2 A B Third arty $10,000 $10,000 Results terminates under Section 708(b)(1)(A). A and B are treated as selling their interests and must report rt gain or loss under Section 741. For purposes of determining the tax consequences to the third-party buyer, is deemed to make a liquidating distribution of its assets to A and B, and the third- party buyer is deemed to buy those assets. Third-party buyer s s basis in the assets is $20,000. Section Its holding period for the assets begins on the day immediately following the e date of sale. 25 McCauslen Foundation of Rev. Rul A B ship McCauslen v. Comm r,, 45 T.C (1966)

14 McCauslen Foundation of Rev. Rul A A s Estate ship interest $10,000 B ship A dies, and B purchases A s A s partnership interest from A s A s estate. Less than six months after A s A s death, B sells some of the former partnership assets and recognizes a capital gain from the sale. 27 McCauslen Foundation of Rev. Rul A A s Estate B $10,000 DRE Results artnership terminates under Section 708(b)(1)(A). B held not to purchase A s A s partnership interest, but rather to have purchased the partnership assets attributable to A s A s partnership interest. B does not succeed to partnership s s holding period with respect to those partnership assets. From B s B s perspective, the Tax Court effectively treated the transaction as a purchase of assets for holding period purposes. Rev. Rul , 65, C.B.. 168, follows McCauslen and adds that B s s holding period attributable to its partnership interest includes the holding period of the partnership. Section 735(b). However, Section 735(b) does not apply to the assets attributable to the partnership interest purchased from A s A s estate and, therefore, B s B s holding period for those assets does not include the holding period p of the partnership

15 Summary McCauslen: : From buyer s s perspective, for holding period purposes, purchase of a partnership rship interest that results in actual termination is treated as an asset purchase with regard to the portion purchased. Rev. Rul : 65: Relies on McCauslen to conclude the same. Corporate analog Dallas Downtown Development Co. v. Comm r,, 12 T.C (1949) Treating corporate buyer s s purchase of all of seller s s stock for cash, followed by the planned complete liquidation of seller, as a stock sale from the seller s s perspective. Kimbell-Diamond Milling Co. v. Comm r,, 14 T.C.. 74 (1950) Treating corporate buyer s s purchase of all of seller s s stock for cash, followed by the planned complete liquidation of seller, as an asset purchase from the buyer yer s s perspective IRS finalizes the check-the-box regulations. Reg et seq.; T.D IRS finalizes regulations to address the consequences associated d with entity conversions by election. Reg (g); 3(g); T.D Revenue Rulings and provide missing guidance. Rev. Rul. 99-6: Extends McCauslen rationale to all aspects of transaction (i.e.( i.e.,, not limited to holding period issue). Seller: interest over. Buyer: assets up. 29 Overlap with Rev. Rul , Situation 3 Rev. Rul outlines three methods the IRS has recognized for using state e law to convert a partnership into a corporation, and the federal income tax consequences follow the selected method. The IRS effectively held that it would respect the form the taxpayer ayer chooses to accomplish a partnership incorporation. Situation 3 (partner contribution): : artners contribute their partnership interests to a corporation in exchange for its stock, which terminates the partnership (because the partnership cannot continue with only one o corporate partner), and the partnership assets and liabilities become those e of the corporation

16 Revenue Ruling , Situation 3 BEFORE AFTER X Y X Y ship Z X and Y contribute their partnership interests to Z in exchange for all the outstanding stock of Z. Sections 351, 358(a), 708(b)(1)(A), 732(b) and (c), 1223(1). 31 Overlap with Rev. Rul , Situation 3 A ship interest X stock X ship Is this covered by Rev. Rul , Situation 3, Rev. Rul , or both? Does it matter if X is a newly formed corporation? Why do we care? 32 16

17 Rationale for Revenue Ruling Rev. Rul cites Rev. Rul General Counsel Memoranda underlying Rev. Rul , GCM (May 18, 1978) and GCM (Oct. 23, 1979). GCM expresses IRS s s view of Rev. Rul as an acquisition of the underlying partnership assets by the acquiror. reamble to roposed Merger Regulations, Notice of roposed Rulemaking, 65 Fed. Reg (Jan. 11, 2000). In the context of partnership incorporations, Rev. Rul distinguishes among all three forms of incorporation. However, with respect to the Interest-Over Form, the revenue ruling respects only the transferors' conveyances of partnership interests, while treating the receipt of the partnership interests by the transferee corporation as the receipt of the partnership's assets (i.e., the Assets-Up Form). The theory for this result, based largely on McCauslen v. Commissioner,, 45 T.C (1966), is that the transferee corporation can only receive assets since it is not n possible, as a sole member, for it to receive and hold interests in a partnership (i.e., a partnership cannot have only one member; so, the entity is never a partnership in the hands of the transferee corporation). 33 Rev. Rul 99-6: Other Issues otential recognition of income or gain to the purchasing partner under Sections 731, 704(c)(1)(B), 737 and 751(b) The treatment of partnership liabilities The holding period rules The anti-churning rules The consolidated return rules under Section 1502 The depreciation rules The like-kind kind exchange rules The sale of depreciable property to related persons rules under Section 1239 Overlap of Rev. Rul with tax-free transactions and Rev. Rul

18 A Way Forward? S1 interest cash S2 35 A Way Forward? S2 S2 Adopting one-person partnership approach would eliminate many of the complexities that result from Rev. Rul Section 197 trap? Consider whether exceptions should be provided for holding period, depreciation method, etc. Other one-person partnerships? Reg (b)(4) 1(b)(4) (technical terminations), Reg (d)(3)(i) 1(d)(3)(i) (divisions), ABA Statutory Merger Comments

19 Tax-free Reorganization Issues 37 Tax-free Reorganization Issues Agenda COI and COBE Rules Reg (k) and Section 704(c) Implications Section 362(e) Corporate/artnership Mergers F Reorganizations Involving artnerships 38 19

20 COBE and ost-368 Reorg artnership Drops COBE General Rule: either continue T s T historic business or use a significant portion of T s s business assets in a business. (Reg (d)(1)). 1(d)(1)). 39 COBE and ost-368 Reorg artnership Drops Each partner of a partnership treated as owning the T business assets used in a business of the partnership in accordance with the partner s s partnership interest. (Reg (d)(4)(iii)(A)). 1(d)(4)(iii)(A))

21 COBE and ost-368 Reorg artnership Drops Issuing corporation treated as conducting a business of the partnership if: (1) Qualified group members own an interest in the partnership collectively representing a significant interest in the partnership business, or (2) One or more qualified group members have active and substantial management functions as a partner with respect to that partnership business. 41 COBE and ost-368 Reorg artnership Drops Continuation of Historic Business T (1) Merge 100% T Manufacturing Business X (unrelated) Cash 80% (2) T Business Assets (3) T Business Assets (4) T Business Assets (5) T Business Assets 20% RS S-1 S-2 S-3 100% 100% S-3 3 as partner performs active and substantial management functions for T s T s historic business. treated as conducting T s T s historic business, because S-3 S 3 performs active and substantial management functions. Reg (d)(5), Ex

22 COBE and ost-368 Reorg artnership Drops Continuation of Historic Business T (1) Merge Ski Boot Mfg. T Manufacturing Business X (unrelated) (5) Other assets 99% (2) T Business Assets (3) T Business Assets (4) T Business Assets T Business Assets RS Ski Boot Mfg. 100% (5) 1% S-1 S-2 S-3 100% 100% S-3 3 as partner performs active and substantial management functions for T s T s historic business. COBE not satisfied. The fact that a significant historic T Business is conducted in RS and is treated as conducting such business is not alone sufficient to satisfy COBE.. Reg (d)(4)(iii)(C); 1(d)(4)(iii)(C); Reg (d)(5), Ex COBE and ost-368 Reorg artnership Drops Continuation of Historic Business T (1) Merge T Manufacturing Business X (unrelated) Other assets 66-2/3% (2) T Business Assets (3) T Business Assets (4) T Business Assets T Business Assets RS 100% (5) 33-1/3% S-1 S-2 S-3 100% 100% No member of s s qualified group performs active and substantial management services. COBE satisfied. Reg (d)(4)(iii)(B)(1); 1(d)(4)(iii)(B)(1); Reg (d)(5), 1(d)(5), Ex

23 COBE and ost-368 Reorg artnership Drops Use of Historic Business Assets in artnership Business T (1) Merge 100% (2) T s s Assets S1 X (3) 95% diluted to 66-2/3% (3) T s T s Assets Historic RS 5% (3) Increased to 33-1/3% No Management T assets (primarily fabric inventory) used in RS business Sportswear Manufacturing COBE satisfied because S1 owns an interest in RS representing a significant interest in partnership business and treated as holding the assets/conducting the business of all a qualified group members. Reg (d)(5), Ex COBE and ost-368 Reorg artnership Drops Tiered artnerships Use of T s T s Historic Business Assets T (1) Merge Owns/manages office building X (unrelated) 50% (2) T s s Assets RS-1 T.V.. Stations 50% (No management) (3) T Assets + 1 T.V.. Station $ 75% (no management) RS-2 U (unrelated) 25% (oversees management) T s s Assets used in RS-2 2 Television Business treated as owning 37.5% of RS-2 s s business. treated as conducting RS-2 s s business, because > 33.33% of RS-2 2 deemed owned by. treated as using 37.5% of the historic T assets in that business. COBE satisfied because treated as using a significant portion of T s T s assets in its television business. See,, Reg (d)(4)(iii) 1(d)(4)(iii) and Reg (d)(5), 1(d)(5), Ex

24 COBE and ost-368 Reorg artnership Drops Tiered artnerships Use of T s T s Historic Business Assets T Stock T Stock (1) T Stock (2) T Stock 100% S-1 100% (3) T Stock S-2 100% (4) 20% S-3 $ (4) 80% T Stock RS COBE satisfied. qualified group ownership of RS meets requirements equivalent to Section 368(c). Therefore, T is also a member of qualified group, and is treated as owning g all T s T s assets/businesses. See,, Reg (d)(5), Ex T 100% COI and ost-368 Reorg artnership Drops COI artnerships For purposes of the COI requirement, each partner of a partnership is treated as owning or acquiring stock owned or acquired by the partnership, in accordance with the partner s interest in the partnership. Reg (e)(5). 1(e)(5)

25 COI and artnerships COI artnerships A (1) Stock 100% 100% T (1) Merge S $ (2) Stock (in connection w/merger) 85% 15% Unrelated RS S (as 85% partner) treated as having purchased from A, 85% of A s A s stock and as having furnished 85% of the consideration paid by RS. COI not satisfied because S treated as acquiring 85% of the stock issued in the merger. Reg (e)(4), 1(e)(4), (5) and (8), Ex (e)(1) Imported Loss Limitation Basis Step Down Rule A 60% 40% B Non-U.S U.S. (not subject to U.S. tax) 100% TN U.S. Investment Securities FMV 1250 Basis 750 Interest 750 FMV 200 Basis Liab TN Interest Newco U.S. Section 362(e)(1) provides that if a net built in in loss property is imported into the U.S. in a 351 exchange or in a reorganization from persons not subject to U.S. tax, the basis of such property so transferred is its FMV.. In the above situation, Section 362(e)(1) arguably requires Newco to step down its basis in TN to 200. It is doubtful that Congress intended this result because B would have recognized 200 gain had it instead sold its TN interest for 200 (i.e.,( 200 cash liability per Section 752(d) 300 basis). The solution may be to apply aggregate treatment, i.e., treat transferor partner as directly owning its proportionate share of the partnership assets for purposes of Section 362(e)(1). ). Under such an approach, 362(e)(1) would not apply because the partnership assets do not have a built in in loss

26 Upstream C Reorg with 704(c)(1)(C) Implications followed by Asset Drop to Reincorporated Sub (LR( ) Step 2: Assigns % Others S Step 1: S converts from Corp to Step 3: S reincorporates -1 <100%. Business A. Holds some 704(c)(1)(C) loss assets previously contributed by S Rulings: Step 1: S conversion from Corp to treated as C Reorg. Steps 2 and 3: The reincorporation of S did not disqualify the C Reorg by virtue of 368(a)(2)(C) and was treated as a 351 exchange. See LR succeeded to the 704(c) items attributable to the interest it received from S. 704(c)(1)(C) was not invoked to preclude the allocation to of loss or deduction attributable to the interest. 51 Merger of Corporate artner into /S Exchange Result T SHs A SHs A SHs T SHs Target Merger into /S A Stock & $$ /S Acquiring Acquiring DE (/S Assets) Merger of Target into /S. /S survives under state law; becomes a DE for tax purposes. T shareholders receive 50% A stock and 50% cash. Tested as an A reorganization. Reg (b)(1)(iii), Ex. 11. Status of transferee is tested after the merger. See reamble to Reg (b)(1). /S terminates under Section 708(b)(1)(A). reamble to Reg asks for comments on whether Rev. Rul should apply

27 Merger of Corporate artners Exchange Result T SHs A SHs A SHs T SHs Target Merger into A A Stock & $$ Acquiring Acquiring /S DE (/S Assets) Merger of Target into Acquiring in an A reorganization. /S becomes a DE for tax purposes. /S terminates under Section 708(b)(1)(A). Do the principles of Rev. Rul apply? Rev. Rul applies to taxable transfers. IRS has requested comments. 53 Conversions vs. Mergers: State Law Consequences Conversion statutes generally provide that the state law existence of a converting entity will survive the conversion process. As a result, consents generally are not required for the assumption of loans or other liabilities, and for the transfer or assignment of contracts, leases, licenses, s, permits, or other assets. Compare to a merger which results in a state law asset transfer. Delaware statute is typical: When When a corporation has been converted to another entity or business form pursuant to this section, the other entity or business form shall, l, for all purposes of the laws of the State of Delaware, be deemed to be the same entity e as the corporation.... The rights, privileges, powers and interest in property of the corporation that has converted, as well as the debts, liabilities s and duties of such corporation, shall not be deemed, as a consequence of the conversion, to have been transferred to the other entity or business form to which such corporation has converted for any purpose of the laws of the State te of Delaware. See Del. Gen. Corp. Law Section 266(h) (emphasis added)

28 Basic F Reorganization (1) S1 Stock Oldco Newco Newco (2) State law conversion Oldco (DE) Oldco (DE) forms Newco.. contributes Oldco to Newco. Oldco is converted into an under state law. Series of transactions, but result is mere change of one corporation See rop. Reg (m)(3)(i) and -2(m)(5), Ex 5. See FSA Qualifies as an F reorganization. Oldco is treated as transferring assets to Newco in exchange for Newco stock and distributing Newco stock to in exchange for s Oldco stock. 55 Basic F Reorganization into Series (1) S1 Stock Oldco Newco Newco (2) State law conversion Oldco (DE) Oldco Series (DE) Basic F reorganization: forms Newco; ; contributes Oldco to Newco; Oldco is converted into an under state law except that Oldco is converted into a Series. Should qualify as an F reorganization as long the Series is initially respected as a DE. Sale of interest in a series to another investor may create a partnership with respect to that series (only) if each series is treated as a separate eligible entity e for tax purposes. See rop. Reg (a)(5) 1(a)(5) and LR

29 Basic F Reorganization to Avoid State Law Asset Transfer to S SHs (1) S1 Stock T SHs Oldco Newco A Newco A (2) State law conversion Oldco (DE) $$ (3) Oldco Units Oldco /S Basic F reorganization: Oldco S/Hs form Newco; Oldco S/Hs contribute Oldco to Newco; Oldco is converted into an under state law. A invests directly into Oldco,, resulting in deemed formation of a partnership for tax purposes. s. Allows Oldco s assets to be transferred to a partnership for tax purposes while e avoiding a transfer of the assets under state law. Also, if Oldco is an S corporation, allows investment in Oldco by a corporation or non-resident individual or issuance of second class of stock of Oldco while preserving S status at Newco Newco level. 57 F Reorganization rop. Reg (m)(5), Ex. 8 (1) 1% S Stock 99% L S S 1% G (2) S converts to L under state law (3) S makes tax election to be treated as a corporation Step One: forms new and transfers 1% of S to. Step Two: Under statute, S converts to a limited partnership for r local law purposes. Step Three: S makes tax election to be treated as a corporation for tax purposes. Valid F reorganization since S s S s conversion to an L and tax election are a mere change

30 AM AM Z has a built-in in loss in its assets (FMV( $100; adjusted basis $120). Z has $110 of liabilities that are not securities under Section 165(g)(2). X s s adjusted basis in the Z stock is $100. Y s s adjusted basis in Z stock is $30. Z makes a CTB election to be treated as a partnership 100% Y X 20% 80% Z (foreign) CTB Election Situation 1: Z s Z s $110 of liabilities is owed to X. Situation 2: Z s Z s $110 of liabilities is owned to an unrelated foreign corporation

31 AM The deemed liquidation of an insolvent corporation does not constitute payment for stock in the liquidating corporation. The former shareholders in Situations 1 and 2 (X and d Y) are entitled to a worthless security deduction (equal to their basis in their shares) under 165(g) if they meet the other requirements of that section. The check-the the-box election by the insolvent corporation does not affect the liabilities of Z with respect to its creditors under local law, and the full amount of the liabilities ities survive the deemed liquidation. The deemed distribution of such liabilities followed by their deemed contribution to the new partnership is not a significant modification of the liabilities for purposes of Therefore, the liabilities are not treated under 1001 as exchanged for new debt of the partnership as a result of the corporation's CTB election. The ruling indicates that the same analysis would apply to an insolvent subsidiary that is actually liquidated if the debt is immediately contributed to a partnership (assuming the debt survives the liquidation under local law). Because the liabilities survive the deemed liquidation, the insolvent corporation's creditors in Situations 1 (X) and 2 (unrelated party) are not entitled to a bad debt deduction under 166 based solely on the check-the the-box election. In Situation 1, X's basis in its partnership interest is $108 and d Y's basis in its partnership interest is $2. In Situation 2, X's basis in its partnership interest is $88 and Y's s basis in its partnership interest is $22. The basis of the assets received by X and Y from Z in Situations 1 and 2 is equal to the liabilities X and Y are deemed to assume: $88 (80%) for X and $22 (20%) for Y. Y In Situation 1, the liabilities are treated as recourse to X. Under U 752, the partnership is treated as assuming liabilities up to the FMV of the assets ($100) and X and Y s Y s basis in their partnership interest is reduced proportionately by that amount, while X s X s basis in its partnership interest is also increased by the full $100. In Situations 1 and 2, the partnership's basis in its assets is $ AM Compare Rev. Rul (addressing the situation where a wholly-owned owned foreign subsidiary (FS) indebted to its parent () makes a check-the the- box election to become a disregarded entity). The worthless security analysis is similar and is entitled to a worthless security deduction under Section 165(g)(3) in the situation where FS is insolvent immediately prior to the deemed liquidation. Rev. Rul notes that as a result of the CTB election, FS's creditors, including, may be entitled to a deduction for a partially or wholly worthless debt under Section 166. AM notes that its conclusions as to debt would have been different if the election had resulted in Z being a disregarded entity. 100% FS (foreign) CTB Election 62 31

32 Consolidated Return Issues 63 Consolidated Return Issues Agenda Acceleration of Deferred Intercompany Gains and Losses Asymmetrical Views of Rev. Rul and Becoming Disregarded 64 32

33 Accelerating Deferred Intercompany Gains S1 Asset FMV $250 Tax $100 S2 X 1 $250 40% 60% $250 (1%) interest 2 assets, S1 and S2 file a consolidated return. S1 recognizes $150 of gain in step 1 that is deferred under Reg (c)(2)(ii), 13(c)(2)(ii), then accelerated under Reg (d)(1)(i)(B) 13(d)(1)(i)(B) when S2 contributes the asset to in step 2. Instead, if S1 first transfers the asset to and then S1 sells s its interest to S2, the gain on the intercompany sale of the interest would be deferred. If makes a Section 754 election, S1 would take into account its deferred gain on the sale of the interest as S2 benefits from the Section 743 adjustment. Compare a situation where the asset has a loss. 65 LR : Asymmetrical Views of Rev. Rul and Becoming Disregarded S Sale B S sells its interest to B, which terminates the. See Rev. Rul S is deemed to sell its interest under Section 741, while B is deemed to purchase S s S share of the assets from S. Is S gain deferred under -13? LR holds: Ruling (7): The income, gain, and/or loss from the sale of [S s] partnership interest (the intercompany item) can be accounted for under the matching rule. [B s] corresponding items will be [B s] items with respect to the assets that [B] is described as acquiring [under Rev. Rul. 99-6]..... Ruling (8): [B s] recomputed corresponding items will be based on the bases that t [S] would have had in the assets had those assets been received in a liquidating g distribution What if has gain and loss assets? See also LR , supplemented by LR

34 Leveraged artnerships after Canal Corp. 67 Leveraged artnerships after Canal Corp. Agenda Leveraged artnerships Overview Example Canal Corp. vs. Commissioner Decision Implications 68 34

35 Leveraged artnerships Overview Asset/business monetization strategy Traditionally used in real estate and energy transactions. Gained acceptance in M&A practice in the mid-1990s. Involves contribution to partnership and leveraged distribution Depends on exception to the disguised sales rules. Section 707(a)(2)(B). Exception turns on liability allocation. Reg (b). Liabilities allocated under Section 752. Deferral transaction Cost of deferral : : tracking built-in in gain. Ultimate recognition. Valuing deferral. 69 Leveraged artnerships - Example arent Sub (4) indemnity Corp appreciated (1) assets (2) assets or $ (4) guarantee minority interest majority interest (5) special cash distribution (3) $ note Bank Step (1): Sub contributes assets to for minority interest. Step (2): Corp contributes assets (or money) to for majority interest. Step (3): borrows money from Bank. Step (4): Corp guarantees the borrowing. Sub indemnifies Corp to ensure the liability is allocated to Sub. Step (5): distributes loan proceeds to Sub. Result: Sub should not recognize gain under either the disguised d sale or basis rules if respected as structured

36 Leveraged artnerships Key Regulations Debt-financed distribution exception to disguised sale: Distribution of debt proceeds is treated as part of a disguised sale only to the extent the distribution ibution exceeds the distributee s share of the debt. Reg (b). General rule for determining economic risk of loss for recourse liability: ersons with obligations to make payments are assumed to perform the obligations, ons, regardless of their actual net worth, unless facts and circumstances indicate a plan to circumvent or avoid the obligation. Reg (b)(6). 2(b)(6). Specific 752 anti-abuse abuse rule : A partner s s obligation may be disregarded (or treated as an obligation of another person) if the facts and circumstances indicate that a principal purpose of the arrangement between the parties is to eliminate the t partner s s economic risk of loss or create the appearance that the partner bears the economic omic risk of loss when the substance is otherwise. Reg (j)(1). 2(j)(1). 71 Leveraged artnerships Canal Corp. v. Comm r Facts (6) Canal (fka Chesapeake) cash distribution + $151m loan WISCO (4) indemnity Georgia acific (1) $775m assets (2) $376m assets (4) guarantee WISCO s Assets after the Transaction 5% common 95% common Note Rec. from Chesapeake: $151m Interest: $20m Corporate Jet: $6m (5) special cash distribution $755m (3) $755m note Bank Tax Court disregarded WISCO s indemnity in determining its share of debt, resulting in disguised sed sale treatment. Canal was subject to accuracy-related related penalty notwithstanding receipt of should opinion

37 Leveraged artnerships - Canal Corp. v. Comm r Decision The Tax Court disregarded WISCO indemnity in determining its share of debt, resulting in disguised sale treatment. The court applied Reg (j) 2(j) anti-abuse abuse rule primarily for the following reasons: No obligation for WISCO to maintain any net worth. [C]ompelling statements by executives that the only risks of transaction were e tax risks, not risks from indemnity. Significant other deficiencies of the indemnity. The court rejected the following taxpayer arguments: Reg (j) 2(j) does not apply because WISCO was not newly formed. The 10% net worth standard in Rev. roc supports respecting WISCO s indemnity. G could collect from WISCO/Chesapeake on fraudulent conveyance grounds. 73 Leveraged artnerships - Canal Corp. v. Comm r Decision Cont d The court stated that the indemnity lacked economic substance. The court imposed accuracy-related related penalty (Section 6662) on Canal The court did not permit reliance on tax opinion for reasonable cause/good faith exception. Quality of opinion. The court classified tax advisor as promoter. promoter. Note: Canal entered bankruptcy and settled the case for small portion p of amount assessed

38 Leveraged artnerships - Canal Corp. v. Comm r Implications Future use of leveraged partnership transactions. Guarantees/Indemnity: quality, value, and duration. Opinions: fee, quality, purpose(s). Economic Substance. 75 ublicly Traded artnership Structures 76 38

39 ublicly Traded artnership Structures - Agenda ublicly Traded artnerships: Overview and Requirements ubco\u U-C and Advisor T Structures 77 T rototype Sponsor ublic G L L G T Assets 78 39

40 ublicly Traded artnerships - Overview Brief background of 1987 legislation why we have Section General rule of Section 7704 is that Ts are taxed as corporations. Qualifying income exception allows for pass-through treatment if 90% of gross income is qualifying income. Qualifying income exception generally not available if the partnership registers under the Investment Company Act of T Qualifying Income: What is included? Interest (subject to exceptions) Dividends Real property rents Gain from the sale of real property Natural resources income Gain from the sale of a capital asset Income qualifying under RIC or REIT rules Income from certain notional principal contracts 80 40

41 ubco\u U-C Legacy Owners ublic ubco Why is this structure used? redecessor transaction UREIT. Combination with leveraged partnership. Tax receivable agreements and impact on acquisition structure. 81 Advisor T ost-io Structure rincipals rincipals ublic G L G T Management Holding Corp. Carry Holding G L G L Fee artnerships Carry artnerships 82 41

42 Advisor Ts: : Core Issues Mechanics of Advisor T structure Good vs. bad income Exchange features (underlying T issues) Qualifying income: the carry and the financial services Ts Treatment of the carry Other financial services issues inherent in the structure Blockers and earnings stripping Blockers market practice and structures Earnings stripping as an issue more broadly 83 42