In partially redacted technical advice, the IRS advised on how to determine the amount of a mandatory IRC Section 743(b) adjustment in the context of an assets-over partnership merger. Notably, the IRS considered the interaction of the netting rule of Treas. Reg. Section 1.752-1(f) with the calculation of a IRC Section 743(b) adjustment and the treatment of deferred cancellation of indebtedness (COD) income under IRC Section 108(i). The IRS concluded that deferred COD income should not be treated as "tax gain" under Treas. Reg. Section 1.743-1(d)(1)(iii) for purposes of the calculation of a partner's previously taxed capital.

Facts

The facts in the memorandum are redacted, but certain aspects of the transactions are described in the analysis. Partners A and Q were partners in Partnership X. Partnership X and Partnership Y engaged in a transaction treated as a partnership merger under Treas. Reg. Section 1.708-1(c) (the Merger). Both partnerships had the same majority partner (which appears to have been Partner A, although it is not entirely clear). Partnership Y had the greater net fair market value, so Partnership X was treated as transferring its assets and liabilities to Partnership Y in exchange for an interest in Partnership Y and then making a liquidating distribution of its Partnership Y interest to Partners A and Q. Immediately after the Merger, Partnership Y had a substantial built-in loss under IRC Section 743(d).

In 2009 or 2010, Partnership X had COD income that it had elected to defer under IRC Section 108(i), which Partnership X would be required to include in income ratably over a five-year period beginning in 2014. At some point prior to the Merger, Partner A had taken an ordinary loss with respect to its interest in Partnership X under IRC Section 165(a) (presumably a worthlessness loss), reducing Partner A's basis in its interest in Partnership X. It appears that the deemed distribution of money to Partner A under IRC Section 752, as a result of a reduction in Partner A's share of Partnership X liabilities in connection with the COD event, was partially or entirely deferred under IRC Section 108(i)(6) (as discussed in further detail below), because, and to the extent, such deemed distribution would otherwise have caused Partner A to recognize gain under IRC Section 731(a)(1). The deferral under IRC Section 108(i)(6) of the IRC Section 752(b) deemed distribution presumably arose in whole or in part from Partner A's IRC Section 165(a) loss with respect to its interest in Partnership X.

Summary of issues, IRS analysis and conclusions

1. Does IRC Section 761(e) apply to a deemed distribution of a partnership interest in an assets-over merger?

Partner A made various arguments that the deemed distribution to Partner A of the Partnership Y interest by Partnership X, pursuant to the Merger, did not constitute a "transfer" for purposes of the mandatory basis adjustment rules in IRC Sections 743(b) and (d). The IRS rejected those arguments, concluding that IRC Section 761(e)(2), which provides that a distribution of a partnership interest is treated as an exchange of the interest for purposes of IRC Section 743, applies to the deemed distribution of a partnership interest in an assets-over merger for purposes of the optional and mandatory basis adjustment rules, resulting in a downward basis adjustment for Partner A.

2. Does the Treas. Reg. Section 1.752-1(f) "netting rule" apply when determining a transferee partner's share of partnership liabilities for purposes of an IRC Section 743(b) adjustment in connection with an assets-over partnership merger?

In determining the amount of any IRC Section 743(b) adjustment, Treas. Reg. Section 1.743-1 compares (1) a transferee partner's basis in the transferred partnership interest (outside basis) to (2) the transferee's share of the partnership's adjusted basis in partnership property attributable to the transferred interest (inside basis).

Immediately after Partnership X was treated as transferring its assets, subject to any liabilities, to Partnership Y, pursuant to the Merger, Partnership X's share of liabilities of Partnership Y was determined under Treas. Reg. Section 1.752-3(a)(3), and Partner A's indirect share of Partnership Y, though Partnership X, was also determined under Treas. Reg. Section 1.752-3(a)(3) (apparently neither Treas. Reg. Section 1.752-2 nor Treas. Reg. Section 1.752-3(a)(1) or (2) was applicable to the facts). This could have caused Partner A to be treated as having received a distribution of cash, pursuant to IRC Section 752(b), in excess of Partner A's basis in its Partnership X interest, resulting in gain under IRC Section 731(a)(1). However, Treas. Reg. Section 1.752-1(f) provides that when two or more partnerships merge under Treas. Reg. Section 1.708-1(c)(3)(i), increases and decreases in partnership liabilities associated with the merger are netted by the partners in the terminating partnership and the resulting partnership, in determining the effect of the merger under IRC Section 752. As a result of Treas. Reg. Section 1.752-1(f), and taking into account Partner A's share of Partnership Y liabilities after the Merger, Partner A would in fact not recognize any gain under IRC Section 731(a)(1).

The IRS concluded that, to give effect to that result, in determining Partner A's IRC Section 743(b) adjustment, it is necessary to treat Partner A, immediately after Partnership X is treated as transferring its assets and liabilities to Partnership Y, as being allocated indirectly a share of Partnership Y liabilities sufficient to avoid a situation in which Partner A would be deemed to have received a distribution of money in excess of its basis in Partnership X (even if that is an amount greater than what Partner A's indirect share of Partnership Y liabilities would have been simply by applying Treas. Reg. Section 1.752-3(a)(3)).

3. Is deferred COD income treated as "tax gain" for purposes of Treas. Reg. Section 1.743-1(d)(1)(iii)?

The amount of an IRC Section 743(b) adjustment is equal to the excess or deficiency of a transferee's outside basis in a transferred interest over the transferee's share of inside basis with respect to the transferred interest. The transferee's share of inside basis equals its share of partnership liabilities plus its previously taxed capital. The transferee's previously taxed capital equals the sum of the cash the transferee would receive, minus the amount of tax gain and plus the amount of tax loss that would be allocated to the transferee, if the partnership disposed of all its assets in a fully taxable transaction for an amount equal to their fair market value (a hypothetical transaction) and then liquidated.

Partnership X's deferred COD income was not accelerated as a result of the Merger. Rather, under Treas. Reg. Section 1.108(i)-2(b)(6)(iii)(D) (a temporary regulation at the time of the relevant transactions), Partnership Y is subject to the provisions of IRC Section 108(i). Most notably, if Partnership Y were to dispose of all its assets in a fully taxable transaction immediately after the Merger, Partnership Y would be required to include the deferred COD income of Partnership X (to the extent not previously included by Partnership X) and to allocate the COD income to Partners A and Q.

Partner A argued that the deferred COD income that would be allocable to Partner A, if Partnership Y were to engage in a hypothetical transaction immediately after the Merger, should be treated as tax gain that reduces Partner A's previously tax capital. The IRS responded that deferred COD income is not tax gain within the meaning of Treas. Reg. Section 1.743-1(d)(1)(iii) because it does not arise as a result of a disposition of partnership assets or property at fair market value. The IRS continued:

The hypothetical transaction described in [Treas. Reg. Section] 1.743-1(d)(2) is only concerned with determining the amount of partnership tax gain or loss that would result from the disposition of partnership assets at fair market value for cash, for purposes of determining an inside basis adjustment to partnership property. Deferred COD income is not and does not relate to partnership assets or property for purposes of the hypothetical transaction described in [Treas. Reg. Section] 1.743-1(d)(2), but is simply an item of deferred income that does not have or attract basis, is not transferrable or marketable, and has no fair market value.

Partner A made various arguments for a contrary approach. Prior to the Merger, Partner A had a built-in loss in Partnership X property. Partner A argued that the IRC Section 743(b) adjustment should not upset the "status quo ante" in this manner. As a result of the proposed IRC Section 743(b) adjustment, Partner A claimed it would inappropriately have built-in gain in Partnership Y. The IRS disagreed that its position inappropriately creates gain for Partner A, responding that (i) it was Partner A's IRC Section 165 loss with respect to the transferred interest that reduced Partner A's basis in its Partnership X interest but had not created any corresponding negative adjustment to Partnership X's basis in its assets, and (ii) that the allocation of a negative basis adjustment to partnership property in order to create parity between inside basis and outside basis with respect to Partner A is precisely the purpose of IRC Section 743(b).

Partner A also argued that, if IRC Section 108(i)(6) did not apply and the partner's outside basis was able to be reduced under IRC Section 752(b) without the recognition of gain, which was not the case for Partner A, it seems necessary to treat deferred COD income as tax gain for purposes of IRC Section 743(b) and the regulations thereunder. When a partnership has a COD event, the discharge of indebtedness generally results in a reduction of the partners' outside bases under IRC Section 752(b), to the extent of the corresponding reduction in the partners' share of partnership liabilities. Under IRC Section 108(i)(6), if a partnership makes an election to defer recognition of COD income under IRC Section 108(i), any deemed distribution of money to a partner under IRC Section 752(b), as a result of a corresponding reduction in a partner's share of partnership liabilities, is deferred until the corresponding COD income is taken into account by the partnership, to the extent such deemed distribution would otherwise have caused the partner to recognize gain under IRC Section 731(a)(1). To the extent, however, such deemed distribution would not cause the partner to recognize gain under IRC Section 731(a)(1), IRC Section 108(i)(6) does not apply and the deemed distribution is taken into account at the time of the COD event and reduces the partner's outside basis.

Partner A pointed out that, if the deferred COD income was not treated as tax gain for purposes of IRC Section 743(b) and the regulations thereunder, basis disparities would arise in cases where IRC Section 108(i)(6) did not apply. The IRS agreed but instead concluded that where there was an IRC Section 752(b) distribution, a corresponding amount of deferred COD income would be treated as a positive adjustment to the partner's outside basis under IRC Section 705 for purposes of making any IRC Section 743(b) calculations, which eliminates the inside-outside basis disparity.

Observations

The IRS's conclusion that a deemed transfer of a partnership interest in an assets-over merger constitutes a "transfer" for purposes of IRC Section 743(b) is hardly surprising. The IRS's view of how to give effect to the netting rule of Treas. Reg. Section 1.752-1(f) in a multi-step transaction (such as an assets-over merger) represents a practical (albeit novel) approach that avoids the potentially artificial creation of an apparent inside-outside basis disparity.

The memorandum indicates that Partner A took an ordinary IRC Section 165(a) loss with respect to its Partnership X interest. If the loss was in fact a worthlessness loss, it is notable that the IRS apparently concedes that the loss was ordinary and not capital. Under Revenue Ruling 93-80, an IRC Section 165(a) loss from the abandonment of a partnership interest, where the abandoning partner has a share of partnership liabilities (which the partner is treated as being relieved of, as a result of the abandonment), is a capital loss instead of an ordinary loss. Revenue Ruling 93-80 says that the same analysis applies to a worthlessness loss, but it is unclear how to interpret the ruling if the partner is not relieved of any of its share of partnership liabilities in connection with the worthlessness loss. The IRS apparently concedes in the memorandum that a worthlessness loss can be an ordinary loss even in a situation where the partner is allocated a share of partnership liabilities.

IRC Section 704(c)(1)(C)(i) provides that built-in loss in property contributed to a partnership is taken into account only in determining the amount of items allocated to the contributing partner, but Prop. Reg. Section 1.708-3(f)(3)(iii)(B)(1) provides that a transferee of the contributing partner's interest in a nonrecognition transaction succeeds to the transferor's contributed built-in loss. The memorandum implicitly applies Prop. Reg. Section 1.708-3(f)(3)(iii)(B)(1), which goes beyond the legislative history, treating Partner A as succeeding to the built-in loss in the property deemed transferred by Partnership X to Partnership Y pursuant to the Merger.

The most significant aspect of the memorandum is the analysis of the deferred COD income in making IRC Section 743(b) calculations. The IRS is on solid ground, from a policy perspective in this context, in not treating deferred COD income as an item of tax gain for purposes of IRC Section 743(b) and the regulations thereunder. This can be demonstrated by the following example:

Example. Partners E and F formed 50/50 partnership PRS with nominal equity. PRS borrows $100x, purchases depreciable property Z for $100x, and takes $100 of depreciation deductions. Later, when Z is worth zero, the PRS debt is discharged. PRS made an election under IRC Section 108(i) to defer recognition of $100x of COD income. Under IRC Section 108(i)(6), the deemed distribution of $50x to E and F, pursuant to IRC Section 752(b), was deferred until PRS takes into account the deferred COD income. Later, when Z is worth $20x, E transfers its interest in PRS to a related party, E1, in a nonrecognition transaction. E1 has zero basis in its PRS interest. In a hypothetical transaction, E1 would receive $10x of cash and would be allocated gain of $10x. If the hypothetical transaction were actually to occur, E1 would also be allocated $50x of deferred COD income. If the deferred COD income is not treated as tax gain under IRC Section 743(b), E1 has no IRC Section 743(b) adjustment, leaving E1 in the same position as E. If the deferred COD income were treated as tax gain, E1 would have a positive IRC Section 743(b) adjustment of $50x, leaving E1 in a better position than E.

It is not clear whether the IRS's literal and narrow interpretation of "tax gain" for purposes of IRC Section 743(b) is intended to apply generally to other types of deferred income items that could arise in a hypothetical transaction (e.g., IRC Section 481 adjustments or deferred revenue), or whether deferred COD income is a special case that warrants special treatment for purposes of IRC Section 743(b). It is also not clear the extent to which the IRS's approach was influenced by the Merger's treatment as a nonrecognition transaction in which Partnership Y and Partner A, through its newly acquired Partnership Y interest, are supposed to step into the shoes of the deferred COD income of Partnership X, as compared to a taxable transfer pursuant to which, in the words of the legislative history cited by the memorandum, IRC Section 743(b) is supposed to cause basis adjustments such that the transferee partner "would recognize no gain or loss if the partnership immediately sold all its assets for their fair market value."

———————————————