On June 7, 2018, the IRS and Treasury released final regulations (T.D. 9833) under Sections 337(d) and 732(f) designed to prevent a corporate partner from avoiding corporate-level gain through partnership transactions involving stock of the partner. The final regulations largely follow temporary (T.D. 9722) and proposed (REG-149518-03 and REG-138759-14) regulations under Sections 337(d) and 732(f) that were previously issued on June 12, 2015 (together, the 2015 Regulations), and were set to expire on June 11, 2018. The final regulations make minor clarifications to the rules set forth under Section 337(d) in response to a comment letter and adopt the 2015 Regulations issued under Section 732(f) in their original form. The final regulations have an effective date of June 8, 2018, and apply to transactions occurring on or after June 12, 2015 (i.e., are currently effective).

Background

In June 2015, the IRS and Treasury issued the 2015 Regulations under Section 337(d) in order to prevent a corporate partner from avoiding corporate-level gain through partnership transactions involving the stock of the partner. These regulations withdrew proposed regulations (REG-208989-90, 1993-1 CB 919) issued in December 1992, which had been issued in response to certain transactions that were seen as using partnerships to circumvent the repeal of the General Utilities doctrine. Additionally, the 2015 Regulations sought to coordinate the regulations under Section 337(d) with those under Section 732(f).

Final regulations under Section 337(d)

The final and temporary regulations under Section 337(d) are intended to prevent corporate taxpayers from using a partnership to circumvent gain required to be recognized under Section 311(b) or Section 336(a). The regulations apply when a partnership, directly or indirectly, owns, acquires, or distributes the Stock of the Corporate Partner (capitalized terms not defined herein but used herein are defined in the final regulations). A Corporate Partner may recognize gain when it acquires or increases its interest in Stock of the Corporate Partner held by a partnership in exchange for appreciated property in a manner that avoids gain recognition under Section 311(b) or Section 336(a).

Applicable transactions

The regulations apply to Section 337(d) Transactions, which are defined as a transactions that have the effect of an exchange by a Corporate Partner of its interest in appreciated property for an interest in Stock of the Corporate Partner that is owned, acquired, or distributed by a partnership. If a partnership engages in a Section 337(d) Transaction, the Corporate Partner must recognize gain under the "deemed redemption rule," unless an exception applies. Examples of Section 337(d) Transactions include: a contribution of appreciated property by a Corporate Partner to a partnership that owns Stock of the Corporate Partner; acquisitions of Stock of the Corporate Partner by a partnership; distributions of appreciated property by a partnership that owns Stock of a Corporate Partner to a person other than a Corporate Partner; distributions from a partnership of Stock of the Corporate Partner to the Corporate Partner; and amendments to a partnership agreement that have the effect of increasing a Corporate Partner's interest in Stock of the Corporate Partner. The final regulations include additional examples of Section 337(d) Transactions.

The IRS and Treasury clarified in the final regulations that a partnership's acquisition of Stock of the Corporate Partner, in certain instances, does not have the effect of an exchange of appreciated property for that stock. For example, if a partnership with an operating business uses cash generated from operations to purchase Stock of the Corporate Partner, such that the Corporate Partner's share in appreciated property has not been reduced, the purchase would not have the effect of an exchange of appreciated property for that stock. The IRS and Treasury note that taxpayers would need to maintain appropriate records to affirmatively demonstrate that this type of facts-and-circumstances exception would apply.

Corporate Partner and Stock of the Corporate Partner

A Corporate Partner is any person classified as a corporation for federal income tax purposes that holds or acquires in interest in a partnership. Stock of the Corporate Partner includes the Corporate Partner's stock, or other equity interests, including options, warrants, and similar interests in the Corporate Partner or a corporation that controls the Corporate Partner (i.e., a Controlling Corporation) within the meaning of Section 304(c) (except that Section 318(a)(1) and (3) do not apply in making such determination). Stock of the Corporate Partner also includes interests in any entity to the extent that the value of the interest is attributable to the Stock of the Corporate Partner. The IRS and Treasury clarified in the preamble to the final regulations that equity interests in a Controlling Corporation are wholly treated as Stock of the Corporate Partner, irrespective of the extent to which the value of the Controlling Corporation's stock is attributable to the Stock of the Corporate Partner. The final regulations also include a new example to demonstrate this clarification.

Stock of the Corporate Partner does not include any stock or other equity interests held or acquired by a partnership if all of the interests in the partnership's capital and profits are held by members of an affiliated group that includes the Corporate Partner.

Deemed redemption rule

The deemed redemption rule applies to cause a Corporate Partner to recognize gain to the extent that a Section 337(d) Transaction affects an exchange by the Corporate Partner of its interest in appreciated property for Stock of the Corporate Partner. To determine the amount of gain, the Corporate Partner must first determine the amount of appreciated property effectively exchanged, and then calculate the amount of taxable gain recognized. The Corporate Partner's economic interest with respect to both Stock of the Corporate Partner and all other appreciated property of the partnership must be determined based on all facts and circumstances, including the allocation and distribution rights set forth in the partnership agreement. The Corporate Partner must recognize gain even when its allocable share of Section 704(c) gain with respect to the appreciated property is unchanged before and after the Section 337(d) Transaction (for example, if a Corporate Partner contributes appreciated property to a newly formed partnership and an individual contributes cash that the partnership later uses to purchase Stock of the Corporate Partner, the purchase of the stock is a Section 337(d) Transaction even though the Corporate Partner's Section 704(c) gain in the appreciated property is unchanged.

Amount and character of gain recognized under the deemed redemption rule

The final regulations provide that the Corporate Partner must recognize a portion of the total gain in the partnership appreciated property that is effectively exchanged for Stock of the Corporate Partner. The portion of total gain to be recognized is a fraction (the Gain Percentage), the numerator of which is the Corporate Partner's interest, by value, in appreciated property effectively exchanged under the deemed redemption rule, and the denominator of which is the Corporate Partner's interest, by value, in appreciated property immediately before the Section 337(d) Transaction. The gain that must be recognized under the deemed redemption rule equals the product of: (i) the Gain Percentage; and (ii) the gain that the Corporate Partner would recognize in respect of the appreciated property that is the subject of the exchange if, immediately before the Section 337(d) Transaction, all of the partnership's assets (including any assets contributed to the partnership as part of the Section 337(d) Transaction) were sold for fair market value in a fully taxable transaction for cash (taking into account Section 704(c), including any remedial allocations under Reg. Section 1.704-3(d)). The gain required to be recognized is reduced (not below zero) by any gain the Corporate Partner must recognize in the Section 337(d) Transaction under any other Section of the Code. The IRS and Treasury clarified that, in computing the gain the Corporate Partner would recognize in respect of the appreciated property, basis adjustments are taken into account (including those made under Section 743(b)).

The character of gain recognized under the deemed redemption rule is the character of gain that the Corporate Partner would have recognized if the appreciated property had been disposed of immediately before the Section 337(d) Transaction for cash in an amount equal to the fair market value of the property (taking Section 7701(g) into account).

Basis adjustments as a result of gain recognized

The final regulations contain two rules on the effect of the deemed redemption rule on outside and inside basis. A Corporate Partner must increase its basis in its partnership interest (i.e., its outside basis) by an amount equal to the gain it recognizes in a Section 337(d) Transaction.

A partnership must also increase its adjusted tax basis in the appreciated property that is treated as exchanged in the Section 337(d) Transaction. This inside-basis increase applies regardless of whether the partnership has a Section 754 election in effect, and for cost recovery purposes is treated as property placed in service by the partnership in the tax year of the Section 337(d) Transaction.

Partnership distributions of stock of the corporate partner

The deemed redemption rule also applies to certain distributions to the Corporate Partner of Stock of the Corporate Partner when the distributed stock was previously the subject of a Section 337(d) Transaction or becomes the subject of a Section 337(d) Transaction as a result of the distribution. This rule does not apply if Section 732(f) applies to the distribution. If the deemed redemption rule applies to a distribution, the partnership is deemed to amend its agreement immediately before the distribution to allocate a 100% interest in that portion of the Stock of the Corporate Partner that is distributed and to allocate an appropriately reduced interest in other partnership property away from the Corporate Partner. The final regulations provide special rules under Reg. Section 1.732-1 for allocating basis under Section 732 if a partnership distributes Stock of the Corporate Partner and other property in the same transaction. The Corporate Partner must recognize gain to the extent that the partnership's adjusted basis in the distributed Stock of the Corporate Partner immediately before the distribution exceeds the Corporate Partner's adjusted basis in its partnership interest immediately after the distribution.

Exceptions to gain recognition

The final regulations provide a de minimis exception if, at the time the partnership acquires Stock of the Corporate Partner or at the time of a revaluation event of the partnership: (i) the Corporate Partner and any related persons own, in the aggregate, less than 5% of the partnership; the partnership holds Stock of the Corporate Partner with a value of less than 2% of the partnership's gross assets (including such stock); and the partnership has never, at any point in time, held in the aggregate Stock of the Corporate Partner comprising more than 2% of any particular class of Stock of the Corporate Partner or Stock of the Corporate Partner with a fair market value greater than $1 million. The de minimis rule does not apply if the Stock of the Corporate Partner is acquired as part of a plan to circumvent the purpose of the final regulations.

The final regulations also do not apply to Stock of the Corporate Partner that is disposed of, by sale or distribution, by the partnership before the due date (including extensions) of its federal income tax return for the tax year during which the Stock of the Corporate Partner is acquired (or that the Corporate Partner becomes a partner, whichever applies), and that is not distributed to the Corporate Partner or a Controlling Corporation.

Tiered partnerships

The final Section 337(d) regulations apply to tiered partnerships in a manner that is consistent with the purpose of the regulations.

Final regulations under Section 732(f)

The final regulations under Section 732(f) were finalized unchanged from the 2015 Regulations. These regulations provide rules to conform the application of Section 732(f) with Sections 337(d) and 1502 in specific circumstances.

Basis aggregation

Section 732(f) generally applies on a partner-by-partner basis. The final regulations allow Corporate Partners that are members of the same consolidated group (as defined in Reg. Section 1.1502-1(h)) that are partners in the same partnership to aggregate their bases in stock distributed by the partnership when: (i) two or more corporate partners receive a distribution of stock in a distributed corporation from the partnership and (ii) the distributed corporation is or becomes a member of the distributee partners' consolidated group following the distribution.

Gain Elimination Transactions

In the event of a Gain Elimination Transaction, the final regulations require Section 732(f) to apply as though the Corporate Partner acquired control (as defined in Section 732(c)(5)) of the distributed corporation immediately before the Gain Elimination Transaction. A Gain Elimination Transaction is a transaction in which stock distributed to a Corporate Partner (distributed stock) is disposed of and less than all of the gain is recognized, unless either: (i) the transferor of the distributed stock receives in exchange stock or a partnership interest that is exchanged basis property with respect to the distributed stock, or (ii) a transferee corporation holds the distributed stock as transferred basis property with respect to the transferor corporation's gain. Gain Elimination Transactions include: (1) reorganizations under Section 368(a) in which the Corporate Partner and the distributed corporation combine; and (2) distributions of distributed stock by a Corporate Partner to which Section 355(c)(1) or Section 361(c)(1) applies.

Tiered partnerships

The final regulations apply to tiered partnerships in a manner that is consistent with the purpose of the Section 732(f) regulations.

Implications

The final Section 337(d) regulations continue to apply to a number of situations in which a partnership acquires Stock of a Corporate Partner. The regulations apply special rules to these transactions that must be carefully analyzed, as the consequences of these transactions on the amount of gain recognized and adjustments required to be made to tax basis are not always intuitive. In particular, see Reg. Section 1.337(d)-3(e)(2), which provides specific ordering rules in determining tax basis the partners take in distributed property under Section 732 when Stock of the Corporate Partner is distributed, and Reg. Section 1.337(d)-3(h), Examples 3 and 4, which provide examples of how these ordering rules apply.

Though the final regulations under Sections 337(d) and 732(f) were largely unchanged from the 2015 Regulations, the IRS and Treasury continue to study the application of these rules under specific facts and circumstances, so we may see further changes to these regulations in the future. For example, the IRS and Treasury acknowledge that the rule requiring the interest in an entity whose value is attributable to Stock of the Corporate Partner stock to be treated as Stock of the Corporate Partner may be overly broad in some instances, and is considering proposing new regulations to limit the application of this rule when such entity owns, directly or indirectly, 5% or more of the stock, by vote or value, of the Corporate Partner. These rules would also clarify how taxpayers would determine what portion of the value of the interest in the entity is attributable to Stock of the Corporate Partner. The IRS and Treasury also continue to study whether it is appropriate to exclude attribution under Section 318(a)(1) and (3) in determining whether an entity controls a Corporate Partner, and may propose new regulations further modifying the definition of Stock of the Corporate Partner in this regard in the future.

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