PROPOSED REGS ADDRESS PARTNERSHIP TRANSACTIONS INVOLVING PARTNERS'S EQUITY INTERESTS

[Editor's Note: At 80 F.R. 33402-33412, June 12, 2015, the IRS withdrew the following proposed regs and issued new proposed regs (REG-149518-03) and corresponding temporary regs, Treasury Decision 9722.]

ACTION: Notice of proposed rulemaking.

SUMMARY: Section 631 of the Tax Reform Act of 1986 was intended to repeal the General Utilities doctrine which, under certain circumstances, permitted a corporation to distribute appreciated assets to its shareholders without recognizing gain. The Service has determined that, in certain circumstances, the acquisition (or mere ownership) by a partnership of stock in one of its corporate partners results in avoidance of the repeal of the General Utilities doctrine. This document contains proposed regulations that prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving equity interests of the partner. The intended effect of these proposed regulations is to provide for gain recognition in such circumstances.

DATES: Written comments and requests to appear, and outlines of oral comments to be presented, at a public hearing scheduled for February 3, 1993 must be received by January 20, 1993. See notice of public hearing on these proposed regulations published elsewhere in this issue of the Federal Register.

ADDRESSES: Send comments, requests to speak at the public hearing, and outlines of oral comments to: Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Attn: CC:CORP:T:R (PS-91-90), Room 5228, Washington, D.C. 20044.

FOR FURTHER INFORMATION CONTACT: Channing Brackey at (202) 622- 3070 or Tom Matragrano at (202) 622-7530 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

INTRODUCTION

This document contains proposed income tax regulations under section 337(d) of the Internal Revenue Code implementing Notice 89-37, 1989-1 C.B. 679. In the notice, the Internal Revenue Service stated that it would publish regulations to prevent the use of a partnership to circumvent the repeal of the General Utilities doctrine. Section 337(d) provides the Service authority to issue such regulations as may be necessary and appropriate to carry out the purposes of the repeal, "including regulations to ensure that such purposes may not be circumvented through the use of any provision of the law or regulations."

Prior to the repeal of the General Utilities doctrine, a corporation recognized no gain or loss on certain distributions of property to its shareholders. Following the repeal, a corporation generally recognizes gain on the distribution of appreciated property to a shareholder.

In Notice 89-37, the Service clarified that section 311(b), rather than section 731(a), applies when a partner receives a partnership distribution of its own stock (the distribution rule). Further, the Service stated that the partner recognizes gain when a pre-distribution transaction (or series of transactions) has the economic effect of an exchange by the partner of appreciated property for its stock (the deemed redemption rule). Finally, the Notice indicated that some of the transactions subject to these regulations also may be subject to taxation under the "substance over form" principle or section 707(a)(2)(B), and this continues to be true.

EXPLANATION OF PROVISIONS:

IN GENERAL

This section sets forth rules that apply when a partnership, either directly or indirectly, owns, acquires, or distributes the stock of a partner. The proposed regulations adopt a deemed redemption rule and a distribution rule.

THE DEEMED REDEMPTION RULE

Under the deemed redemption rule, a partner recognizes gain at the time of, and to the extent that, any transaction (or series of transactions) has the economic effect of a partner exchanging its interest in appreciated property for an interest in its stock that is owned or acquired by the partnership. The economic effect of an exchange of property for stock may occur when the partner contributes property to the partnership. It may also occur when a partnership acquires stock of a partner, when a partnership makes disproportionate distributions, or when the partnership agreement is amended to provide different sharing ratios.

THE DISTRIBUTION RULE

Under the distribution rule, a partnership distribution to a partner of its stock is treated as a redemption of the partner's stock in exchange for all or a portion of the partner's partnership interest. Therefore, the regulations provide that the general nonrecognition rule of section 731(a) does not apply to the extent a partner receives a distribution of its own stock.

The Service received comments on Notice 89-37 suggesting that a modified distribution rule be adopted. Under the modified distribution rule, the gain recognized on the distribution generally would be limited to the difference between the partnership's basis in the stock of the partner before the distribution and the partner's basis in the stock if determined under section 732(c). Proponents of the modified distribution rule believe that the stock treated as redeemed under the deemed redemption rule should be treated as owned by the redeeming partner for certain purposes and owned by the partnership for other purposes. Otherwise, they argue, the same stock could be treated as redeemed by a partner more than once. An alternative characterization, and the one adopted in the proposed regulations, is that the redeeming partner be treated as contributing the redeemed stock back to the partnership for all purposes. The Service considered the modified distribution rule, but rejected that approach because the distribution rule is more administrable and requires less complex rules.

AFFILIATE STOCK AND OTHER EQUITY INTERESTS

The proposed regulations also apply to transactions involving stock of an affiliate of the partner or other equity interests in the partner or affiliate, including options, warrants, and similar interests. A corporation is treated as an affiliate of a partner at the time of a deemed redemption or distribution by the partnership if, immediately thereafter, the partner and corporation are members of an affiliated group.

DE MINIMIS RULE AND INADVERTENCE RULE

The proposed regulations, under a de minimis rule, do not apply to a partner for a taxable year if the partner has never owned more than five percent of the partnership, and as of the close of the taxable year and while the partner is a partner, the partnership has not held in the aggregate (whether or not held at any one time) the lesser of $250,000 of stock of the partner, or two percent of the value of any class of stock of the partner. Further, the rules do not apply to any stock of a partner that is disposed of by the partnership prior to the due date (including extensions) of its federal income tax return for the taxable year during which the stock is acquired (or for the taxable year in which the partner becomes a partner, whichever is applicable) and that is not distributed to the partner or affiliate.

EFFECTIVE DATE

The regulations are proposed to apply to any transaction or distribution occurring after March 9, 1989.

SPECIAL ANALYSIS

It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on the impact of the rules on small business.

COMMENTS AND PUBLIC HEARING

Before adopting these proposed regulations as final regulations, consideration will be given to any written comments that are submitted timely (preferably a signed original and eight copies) to the Internal Revenue Service. All comments will be available for public inspection and copying in their entirety. A public hearing will be held upon written request to the Internal Revenue Service by any person who also submits written comments. If a public hearing is held, notice of the time and place will be published in the Federal Register.

DRAFTING INFORMATION

The principle authors of these regulations are Channing Brackey of the Office of Assistant Chief Counsel (Passthroughs and Special Industries) and Tom Matragrano of the Office of Assistant Chief Counsel (Corporate), Internal Revenue Service. Other personnel from the Internal Revenue Service and the Treasury Department participated in their development.

LIST OF SUBJECTS IN 1.336-1 THROUGH 1.338(h)(10)-1T

Income taxes, reporting and recordkeeping requirements, securities.

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citation to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.337(d)-3 also issued under 26 U.S.C. 337(d) * * *

Par. 1. Section 1.337(d)-3 is added to read as follows:

SECTION 1.337(d)-3 GAIN RECOGNITION UPON CERTAIN PARTNERSHIP TRANSACTIONS INVOLVING A PARTNER'S STOCK.

(a) IN GENERAL. This section applies when a partnership, either directly or indirectly, owns, acquires, or distributes the stock of a partner. Under this section, a partner recognizes gain when it is treated as increasing its interest in its own stock in exchange for appreciated property (the deemed redemption rule). Further, if the partnership distributes stock of a partner to the partner, the partner is treated as redeeming its stock for a portion of its partnership interest and recognizes gain, if any (the distribution rule).

(b) PURPOSE. The purpose of this section is to prevent corporate taxpayers, through the use of a partnership, from avoiding the gain required to be recognized under sections 311 or 337(d). The rules of this section, including the determination of the amount of gain, must be applied in a manner that is consistent with and reasonably carries out the purposes of this section.

(c) STOCK OF A PARTNER. For purposes of this section, stock of a partner includes a partner's stock, an affiliate's stock, or other equity interests in the partner or affiliate, including options, warrants, and similar interests. A corporation is treated as an affiliate of a partner at the time of a deemed redemption or distribution by the partnership if, immediately thereafter, the corporation and the partner are members of an affiliated group as defined in section 1504(a), without regard to the exceptions in section 1504(b).

(d) DEEMED REDEMPTION RULE -- (1) IN GENERAL. A partner recognizes gain at the time of, and to the extent that, any transaction (or series of transactions) has the economic effect of an exchange by a partner of its interest in appreciated property for an interest in the stock of the partner owned, acquired, or distributed by the partnership. The economic effect of an exchange of property for stock may occur when the partner contributes property to a partnership which owns stock of a partner. It may also occur when a partnership acquires the stock of a partner, when a partnership makes disproportionate distributions, when a partnership agreement is amended to provide different sharing ratios, or when the de minimis rule of paragraph (f)(1) of this section no longer applies.

(2) BASIS. If gain is recognized under this paragraph (d), appropriate adjustments in basis are made to take the gain into account.

(3) PARTNER'S INTEREST IN ITS OWN STOCK. For purposes of the deemed redemption rule, a partner's interest in the stock of the partner held by the partnership is determined based on all the facts and circumstances, including allocations and distribution rights.

(e) DISTRIBUTION RULE -- (1) IN GENERAL. The distribution by a partnership to a partner of stock of the partner is treated as a redemption or an exchange of the stock of the partner for a portion of the partner's partnership interest with a value equal to the stock distributed. Section 311 or 1001 rather than section 731 applies to that portion of the distribution.

(2) DISTRIBUTION RULE AND SECTION 732. Section 732 does not apply to a distribution of stock of a partner if this paragraph (e) applies. If the distribution to a partner of the stock of that partner is part of a larger distribution, the distribution of the stock of the partner is treated as a separate transaction that occurs before the distribution of the other property.

(f) EXCEPTIONS -- (1) DE MINIMIS RULE. This section does not apply to a partner for a taxable year if --

(i) The partner has never owned more than five percent of the partnership; and

(ii) As of the close of the taxable year and while the partner is a partner, the partnership has not held in the aggregate (whether or not held at any one time) the lesser of --

(A) $250,000 of stock of the partner; or

(B) Two percent of the value of any class of stock of the partner.

(2) INADVERTENCE RULE. This section does not apply to any stock of a partner that is --

(i) Disposed of by the partnership prior to the due date (including extensions) of its federal income tax return for the taxable year during which the stock is acquired (or for the taxable year in which the partner becomes a partner, whichever is applicable); and

(ii) Not distributed to the partner or affiliate.

(g) EFFECTIVE DATE. These regulations apply to any transaction or distribution that occurs after March 9, 1989.

(h) EXAMPLES. The following examples illustrate the principles of this section. For purposes of these examples, assume that the exceptions provided in paragraph (f) of this section do not apply.