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The Partnership Active Trade or Business in Corporate Divisions

Posted on June 4, 2018
[Editor's Note:

 This article originally appeared in the June 4, 2018, issue of Tax Notes.

]
Pierce Randolph
Pierce Pandolph
Andrew Purcell
Drew Purcell
Robert Holo
Rob Holo

Rob Holo is the head of Simpson Thacher & Bartlett LLP’s tax department, in which Drew Purcell is a partner and Pierce Pandolph is an associate.

In this report, the authors consider how the active trade or business (ATB) requirement of section 355 applies when a corporation conducts an ATB through a partnership. They review the limited guidance on partnership ATB issues and propose specific revisions to address uncertainties and traps for the unwary.

This report is based on a paper Holo delivered at the Tax Forum January 8.

Copyright 2018 Rob Holo, Drew Purcell, and Pierce Pandolph.
All rights reserved.

I. Introduction

The rules governing the requirement that both the distributing corporation and the controlled corporation in a tax-free distribution under section 355 be engaged in an active trade or business (ATB) have mostly contemplated affiliated groups of entities treated as corporations for federal income tax purposes. When applied to the conduct of an ATB through entities treated as partnerships for federal income tax purposes, however, the ATB rules leave many uncertainties that have not been addressed by authorities and present myriad traps for the unwary. Although the IRS has addressed partnership ATB issues in limited rulings and proposed regulations, those authorities are nowhere near as extensive as those addressing issues concerning corporate affiliated groups. Further, because many of these rules were initially developed in the context of corporate affiliated groups, some of them are not well suited to address the issues that arise in the conduct of an ATB through a partnership.

This report provides a practical overview of the authorities addressing the conduct of an ATB through a partnership. It identifies some of the uncertainties related to conducting an ATB through a partnership and discusses common traps for the unwary, and it proposes revisions to specific ATB rules that could benefit from clarification or improvement.1

II. Section 355 and the ATB Requirement

A. Section 355

Section 355 permits Distributing to distribute Controlled stock or securities to its shareholders or its security holders without recognition of gain at the corporate or shareholder level if specified requirements are met.2 Those distributions may take the form of spinoffs,3 split-offs,4 or split-ups,5 and distributions are not required to be pro rata.6

There are four main statutory requirements for a corporate division to qualify for nonrecognition under section 355. First, Distributing must distribute solely stock or securities of Controlled to its shareholders “with respect to” their Distributing stock or to security holders in exchange for their Distributing securities.7 Second, the transaction must not be used principally as a device for distributing the earnings and profits of Distributing, Controlled, or both.8 Third, Distributing and Controlled must meet the ATB requirements of section 355(b).9 And fourth, Distributing must distribute all stock or securities of Controlled held by it, or an amount of stock in Controlled constituting “control” within the meaning of section 368(c).10 In addition to these four statutory requirements, the transaction must not fall under subsections (d) through (g) of section 355, which are generally intended to prevent disguised sales.

Further, there are three judicial requirements for nonrecognition treatment under section 355, which have also been adopted by Treasury regulations. First, there must be a valid corporate business purpose for the distribution.11 Second, one or more persons who were the historic owners of the business enterprise must own, in the aggregate, an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation.12 And third, the business enterprises existing before the separation must continue operation following the section 355 transaction.13

This report focuses on the ATB requirements of section 355(b).

B. ATB Requirement Under Section 355

Each of Distributing and Controlled must be engaged in an ATB immediately before and immediately after the distribution for the distribution to qualify for nonrecognition under section 355.14 The determination of whether a corporation is engaged in an ATB “will be made from all of the facts and circumstances.”15 Each ATB must have been actively conducted throughout the five-year period ending on the date of the distribution16 and must not have been acquired in a transaction in which gain or loss was recognized in whole or in part during that period.17 Also, during the five-year period, neither Distributing nor Controlled may have directly or indirectly acquired control of a corporation that, at the time of the acquisition of control, was engaged in the ATB in a transaction in which gain or loss was recognized.18

Treasury regulations specify that a transaction results in the recognition of gain or loss if the transferee does not take a carryover basis in the transferred assets (that is, determined by reference to the transferor’s basis),19 so a transaction may be deemed to result in gain or loss if the transferee takes a substituted basis (that is, determined by reference to the transferee’s basis in other property) in the acquired assets, even if no gain or loss was actually recognized in the transaction. A section 368 reorganization in which no gain or loss is recognized, or a liquidation of a corporation into a corporate parent governed by section 332 within the five-year period, should not cause a problem under section 355(b) because the transferee takes a carryover basis in the acquired assets under those provisions.20

In determining whether a corporation is engaged in an ATB, all members of a corporation’s separate affiliated group (SAG) are treated as one corporation.21 A corporation’s SAG is its affiliated group under section 1504(a), determined as if that corporation were the common parent and section 1504(b) did not apply.22 An affiliated group means one or more chains of includable corporations connected with a common parent that is itself an includable corporation, but only if (1) the common parent owns stock possessing at least 80 percent of the total vote and value of the stock of at least one other includable corporation, and (2) stock meeting the 80 percent vote and value test in each of the includable corporations (other than the common parent) is owned by at least one of the other includable corporations.23

The proposed regulations (prop. reg. section 1.355-324) modify these rules slightly by separating the SAG into a Distributing SAG (DSAG) and a Controlled SAG (CSAG), each of which must have been engaged in a separate ATB during the five-year period or have acquired an ATB in a transaction in which no gain or loss was recognized.25 The DSAG is the affiliated group that consists of Distributing as the common parent and all corporations affiliated with Distributing through section 1504(a)(1)(B) stock ownership (regardless of whether the corporations are includable corporations under section 1504(b)) and may include CSAG members before the distribution.26 The CSAG is determined in much the same manner as the DSAG (with Controlled as the common parent).27

The regulations under section 355 provide exceptions to the requirement that no gain or loss be recognized in the acquisition of an ATB during the five-year period. The direct or indirect acquisition of an ATB by one member of an affiliated group from another affiliated corporation (even if not part of the relevant corporation’s SAG), even if taxable, is disregarded in applying section 355(b)(2)(C) or (D).28 Further, the fact that an ATB underwent changes during the five-year period is disregarded if the changes do not constitute the acquisition of a new ATB.29 And if a corporation engaged in an ATB during the five-year period purchased, created, or otherwise acquired another trade or business in the same line of business as the ATB, the acquisition of the other business is ordinarily treated as an expansion of the original business, and the expanded business is treated as having been actively conducted during the five-year period unless the change constitutes the acquisition of a new or different business.30

C. Conducting an ATB Through a Partnership

The IRS has provided some guidance addressing when a partnership ATB is attributable to its corporate partners. In Rev. Rul. 92-17, 1992-1 C.B. 142, the IRS ruled that a corporate general partner that had a 20 percent interest in a limited partnership and that was required by the partnership agreement to provide the managerial services necessary to operate the partnership’s rental business was engaged in the conduct of an ATB through the partnership.31 The ruling concluded:

If officers of a corporation that is a general partner in a limited partnership perform active and substantial management functions for the partnership, including the decision-making regarding significant business decisions of the partnership and regular participation in the overall supervision, direction and control of the employees of the partnership in operating the partnership’s rental business, the corporation is engaged in the active conduct of a trade or business.32

The IRS went further in Rev. Rul. 2002-49, 2002-2 C.B. 288 (discussed at greater length in Section IV), in which Distributing owned a 20 percent profit-loss and capital interest in a member-managed limited liability company and Distributing’s officers performed active and substantial management functions for the LLC’s activities and supervised, directed, and controlled the LLC’s employees in their performance of the LLC’s operational functions. Even though neither Distributing nor the other member-manager could make significant business decisions for the LLC without the consent of the other, the IRS ruled that Distributing was conducting an ATB through the LLC.

Although section 355 and the Treasury regulations do not define active and substantial management functions, Rev. Rul. 2002-49 makes clear that a corporate partner is not required to be the general partner to perform an active and substantial management function and that two partners can both serve a management function in the same partnership. Rev. Rul. 92-17 and Rev. Rul. 2002-49 suggest that active and substantial management functions involve both the ability to make significant business decisions for the partnership (even if an unrelated manager also has that authority) and to supervise, direct, and control the employees of the partnership who operate its business. Significant business decisions include decisions regarding the purchase, sale, and improvement of partnership assets, financings, and refinancings.33 The proposed regulations follow the approach of Rev. Rul. 92-17 and Rev. Rul. 2002-49 in this regard.34

In Rev. Rul. 2007-42, 2007-2 C.B. 44, the IRS again expanded the ATB attribution rules by making clear that corporate partners are not required to perform an active and substantial management function if their economic interest in the partnership is significant enough. The IRS concluded that a distributing corporation with a 33-1/3 percent membership interest in an LLC that did not perform management or operational functions for the LLC’s business was engaged in an ATB because it had a “significant interest” in the LLC.35 Further, the IRS ruled that if Distributing had only a 20 percent membership interest in the LLC, it would not be engaged in an ATB for the LLC’s business because it would have neither owned a significant interest in the LLC nor performed active and substantial management functions for the LLC.

In summary, assuming all other ATB requirements are met, a corporate partner in a U.S. tax partnership will be treated as engaged in the ATB of the partnership if it (1) conducts an active and substantial management function for the ATB and has at least a 20 percent interest in the partnership,36 or (2) has a significant interest in the partnership.37 For these purposes, a 33-1/3 percent or greater interest in a partnership is a significant interest,38 but a 20 percent interest in a partnership is not.39 The proposed regulations adopt this approach40 and make clear that there can be multiple significant owners of a partnership.41 Notably, the stock of a corporation owned by a partnership is not attributed to its corporate partners in determining whether those partners are conducting an ATB under the proposed regulations.42

III. Measuring the Partnership Interest

A. Treatment of Tracking Interests

An issue not discussed in Rev. Rul. 2007-42 and earlier authorities is how to treat corporate partners that hold tracking interests in a partnership. Many partnerships use tracking interests to link partnership interests to the performance of specific partnership assets, recognizing that the partners may wish to adopt different sharing percentages for different assets or lines of business. Tracking interests are unlike typical partnership interests in that they generally do not receive a pro rata allocation of all partnership profits and losses.

Section 355 and its regulations don’t discuss the treatment of tracking interests, and related authorities in the partnership context seem to contemplate partnership interests that have proportionate rights to all the assets and profits and losses of the partnership.43 Although there are no authorities that speak directly to the application of the ATB rules to tracking interests, the IRS has long recognized that “partners in a partnership routinely have different sharing ratios in different assets, businesses, locations or investments held by a single partnership.”44 The section 704 regulations anticipate the possibility of tracking interests in explaining that “a partner who has a 50 percent overall interest in the partnership may have a 90 percent interest in a particular item of income or deduction.”45

Nevertheless, the section 355 authorities do not discuss how to apply the ATB attribution rules to tracking interests. How should a corporate partner value its tracking interest in determining whether it has a significant interest46 in a partnership’s ATB? Must the tracking interest be linked to the ATB assets? If so, must it track all the assets of the ATB, or merely the significant assets?

If a tracking interest is not linked to all the assets of a partnership, it clearly must track at least some ATB assets. Although Rev. Rul. 2007-42 does not expressly require that a significant interest be linked to ATB assets, all assets owned by the LLC in the ruling are part of the ATB.47 Further, the ruling cites reg. section 1.368-1(d)(4)(iii)(B), which provides that a corporation will be treated as conducting the business of a partnership if members of the qualified group “own an interest in the partnership representing a significant interest in that partnership business,” suggesting that a tracking interest must be linked to ATB assets.48 Accordingly, a partnership’s ATB will not be attributed to a tracking partner unless the tracking interest is linked to at least some partnership ATB assets.49

Also, it is unclear whether holding a significant interest in a partnership requires tracking every significant ATB asset, tracking a significant amount of the ATB assets, or tracking merely some of the significant ATB assets. The proposed regulations are somewhat vague on this point, providing broadly that a corporation “will not be treated as engaged in the active conduct of a trade or business unless it (or its SAG, or a partnership from which the trade or business assets and activities are attributed) is the principal owner of the goodwill and significant assets of the trade or business for Federal income tax purposes.”50 Nevertheless, the examples in the proposed regulations generally suggest that it is necessary to have an interest in all the significant ATB assets.51 Given the uncertainty over the treatment of tracking interests, the most conservative approach would be to ensure that the interest is linked to all significant assets of the ATB. However, because the proposed regulations often use a facts and circumstances approach,52 other more flexible approaches may be permissible, like relying on a tracking interest linked to some but not all significant assets of an ATB. Other favorable facts may support a more flexible approach, such as if the corporate partner holds a tracking interest that is linked to significant assets representing a high value relative to the total value of the ATB or that represents greater than 33-1/3 percent of the partnership as a whole.

Figure 1

In Figure 1, Distributing has adopted the conservative approach, and its tracking interest is linked to all significant ATB assets of the partnership. It is unclear, however, whether the presence of non-ATB assets in the partnership in which the corporate partner does not hold a tracking interest could prevent that partner from being engaged in the conduct of an ATB through the partnership if it clearly owns a 33-1/3 percent tracking interest in all the partnership’s ATB assets. The regulations discussing the continuity of business enterprise requirement in the reorganization context suggest that the non-ATB assets may not be relevant,53 but because of the lack of concrete authority, it seems best under current law to rely only on a partnership interest that represents at least 33-1/3 percent of the value of the aggregate partnership interests for the five-year period.

The application of the continuity of business enterprise approach to Figure 1 (assuming the other ATB requirements are met) should result in Distributing being treated as conducting an ATB, even though its tracking interest is not linked to the non-ATB asset, because the interest represents 33-1/3 percent of the value of the aggregate partnership interests and is linked to all the significant ATB assets. Given the uncertainty over whether that approach is appropriate, however, Treasury should provide guidance in any final version of the proposed regulations, making clear that an approach similar to the continuity of business enterprise regulations applies.54 Under that approach, a corporate partner should be treated as conducting an ATB if it owns a tracking interest representing 33-1/3 percent of the ATB’s value.

B. Percentage Ownership in a Waterfall

Another area of uncertainty that may arise when conducting an ATB through a partnership is how to treat a partnership interest subject to a distribution waterfall. Distribution waterfalls (often referred to as a “carried interest” or “promote structure”) are commonly used in partnerships managed by private equity funds or other investment sponsors, or partnerships in which management holds equity incentive compensation. These structures are generally intended to give the general partner (or other management partners) a specified share in profits once investors have received a minimum return on their capital. A typical arrangement has four phases: (1) return of investor capital; (2) preferred returns on invested capital; (3) catch-up phase, in which the general partner receives all or a substantial portion of distributions (for example, 50 percent) until it has received a specified share of overall partnership profits (for example, 20 percent); and (4) sharing of residual profits based on specified percentages (for example, 20 percent to the general partner and 80 percent to investors).

The general partner’s entitlement to carried interest is generally treated as a profits interest for federal income tax purposes because it represents an interest in partnership profits (rather than capital).55 Given that the general partner’s share in profits is uncertain and subject to annual fluctuations and that the general partner does not have a share in partnership capital initially, how should these partnership interests be analyzed in determining whether a partner has a significant interest under the ATB rules?

Merely measuring the general partner’s share in capital seems inappropriate because it does not properly recognize the importance and value of the general partner’s profits interest. On the other hand, simply looking at the residual allocation of profits from the partnership would likely overstate the general partner’s entitlement to the value of the partnership. As described above, the investors providing capital typically are entitled to receive both capital and perhaps a preferred distribution before the general partner is entitled to share in the partnership’s profits.

A liquidation value approach seems to be the most accurate method for determining each partner’s economic interest in an underlying ATB. Liquidation value or proceeds reflect the portion of the value (in cash) to be distributed to each partner upon the sale of the ATB assets for their fair market value, after accounting for the preferences — including capital and preferred return — of each partner. A significant flaw in this approach is that the liquidation value of the general partner’s interest is likely minimal early in the life of the arrangement. In fact, to be a valid profits interest for tax purposes, it must start with a zero liquidation value. In a successful enterprise with a waterfall arrangement, the liquidation value of the partners’ interests typically shifts over time as the partnership transitions through the phases of the waterfall, increasing the liquidation value of the general partner’s interest. These shifting values may make it difficult for the general partner to establish that it controlled a significant interest in the partnership for the entire five-year period.

Despite that difficulty, a liquidation value approach still generally seems more accurate than measuring capital or residual interests for determining a partner’s economic interest in a partnership’s ATB, because it reflects the general partner’s right to participate in proceeds from the partnership. Nevertheless, the IRS has not provided authority addressing the attribution of an ATB in a partnership with a complex waterfall, and the appropriate treatment of interests in this scenario is uncertain.

C. Aggregation of Affiliated Partners

Another question is whose interests and activities may be aggregated in determining whether a corporation is conducting an ATB through a partnership. Consistent with section 355’s approach of treating all members of a corporation’s SAG as one corporation, the proposed regulations permit aggregation of partnership interests within a corporate partner’s SAG in determining whether that corporation is conducting an ATB through the partnership.56 However, the proposed regulations do not allow aggregation of partnership interests of affiliated non-SAG members, because they reference only ownership by the partner or its SAG.57 A corporate partner may be affiliated with another entity that is not in its SAG if, for example, a common parent has control over both entities.

Also, the proposed regulations allow aggregation of activities of affiliates to determine whether a corporation performs an “active and substantial management function” for a partnership.58 However, the activities of “partners that are not affiliates (or, in certain cases, shareholders) of the partner, are not taken into account.”59 An affiliate is “any member of an affiliated group as defined in section 1504(a) (without regard to section 1504(b)).”60 This definition is more generous than the definition of SAG in section 355(b)(3) because it does not limit the activities that are taken into account to those conducted by subsidiaries of Distributing or Controlled.61 In particular, the proposed regulations allow a corporation to take into account the activities of its parent or brother-sister corporations in determining whether it is performing an active and substantial management function for the partnership.

Figure 2

In Figure 2, Distributing has less than a 33-1/3 percent interest in P and must rely on the meaningful interest rules to be treated as conducting P’s ATB.62 Distributing conducts no management activities for P’s ATB. Under section 355(b)(3), Distributing would not be attributed the active and substantial management function in the ATB of its sister corporation, Sub, because Sub is not in Distributing’s SAG. However, the proposed regulations allow attribution of the management activities of brother-sister corporations and would treat Distributing as conducting P’s ATB.63 Note that even though Distributing and Sub collectively own greater than a 33-1/3 percent interest in P, Distributing does not have a significant interest in P under the proposed regulations, which permit aggregation of interests only from other SAG members.64

As demonstrated by Figure 2, the proposed regulations take a broader approach to activities aggregation than to the aggregation of partnership interests, which is permitted only for corporations that are part of Distributing’s or Controlled’s SAG. In other words, Distributing cannot rely on a sister corporation for attribution of partnership economics but can do so for management activities. This approach seems consistent with the limited authority issued before the addition of section 355(b)(3) and the issuance of Rev. Rul. 2007-42 that suggests that the activities of affiliates may be taken into account even when the affiliates would not fall under the umbrella of the SAG.65 Moreover, the proposed regulations allow attribution of the activities of a partner’s shareholders “in certain cases.”66 It is unclear from the proposed regulations what those cases are, but the preamble suggests that the exception may be intended to apply only to shareholders of closely held corporations.67

Although the approach of the proposed regulations results in a disconnect between partnership economics and management activities, it seems rational and should be adopted. Ownership of partnership interests can be set into a SAG more easily than complicated intercompany management arrangements. Those arrangements are often structured such that employees are housed in a single entity, which may be beneficial for nontax reasons, like convenience of payroll and to centralize some operational services. The proposed regulations provide a flexible approach toward those arrangements in the section 355 context, eliminating the need for planning and structuring to ensure that officers and employees of parent or brother-sister corporations are not conducting management activities of a partnership’s ATB.

IV. Gain or Loss Recognition

A corporation is treated as engaged in an ATB only if the ATB or control of a corporation conducting the ATB was not acquired directly or indirectly by Distributing or Controlled in a transaction in which gain or loss was recognized in whole or in part within the five-year period.68 This requirement may cause complications when a corporate partner conducts or has conducted an ATB through a partnership.

Contrary to the literal language of section 355(b)(2), gain or loss being recognized during the five-year period does not necessarily violate section 355(b). In Rev. Rul. 2002-49, Distributing in year 1 held a 20 percent interest in the profits-losses and capital of an LLC and performed an active and substantial management function for its trade or business.69 In year 3 Distributing acquired the remaining 80 percent of the LLC in a taxable transaction, causing the LLC to be treated as making a liquidating distribution of all its assets (which would result in Distributing having a substituted basis — based on Distributing’s basis in its prior 20 percent interest in the LLC — in 20 percent of each asset under section 732).70 In year 6 Distributing contributed the assets to Controlled and distributed the stock of Controlled to its shareholders. The IRS concluded that Distributing’s acquisition of the remaining LLC interests did not result in the acquisition of a new or different business under reg. section 1.355-3(b)(3)(ii), so the requirements of section 355(b)(2)(C) were met even though gain or loss may have been recognized in the acquisition of the remaining interests in the LLC.71 Although the ruling did not specifically mention it, one justification for this result could be that Distributing’s acquisition of the remaining 80 percent of the LLC is analogous to a corporation already engaged in an ATB expanding its existing ATB, which is already permitted under section 355.72

Further, a transaction can be treated as resulting in the recognition of gain or loss under section 355(b)(2) even when no gain or loss is actually recognized. In situation 2 of Rev. Rul. 2002-49, the facts are the same as in situation 1, except that Distributing acquired its 20 percent interest in the LLC in year 2 by contributing appreciated securities to the LLC in a transaction qualifying for nonrecognition under section 721. Even though Distributing and the other parties to the contribution transaction did not recognize gain or loss under section 721(a), the IRS concluded that Distributing would be treated as having acquired an ATB in a transaction in which gain or loss was recognized within the five-year period, because if Distributing had directly acquired the ATB represented by the partnership interest in exchange for the property contributed, the exchange would have been a transaction in which gain or loss was recognized.

The complicated interaction of the section 355(b)(2)(C) and (D) requirements and the various exceptions (discussed in Section II) create several traps in the partnership context that may cause a distribution to fail the ATB requirement. They also raise other issues that should be considered.

A. Distributions of ATBs From Partnerships

Treasury regulations under section 355 generally require a transferee to have a carryover basis (that is, determined by reference to the transferor’s basis) in an ATB to avoid being treated as recognizing gain or loss on the transfer of an ATB.73 When a partnership distributes property to a partner other than in liquidation of the partner’s interest, the partner generally takes a carryover basis in the distributed property74 and does not recognize gain or loss.75 When a partnership makes a distribution in complete redemption of a partner’s interest, however, the partner takes a substituted basis in the partnership assets distributed by the partnership that is determined by reference to the partner’s outside basis in the redeemed partnership interest.76 Under the foregoing rules, a corporate partner’s receipt of an ATB in a nonliquidating distribution or partial redemption would generally not violate section 355(b), whereas a corporate partner’s receipt of an ATB in a liquidating distribution would violate section 355(b). Despite the treatment of distributions and redemptions in these rules, the IRS and Treasury do not always make determinations consistent with that treatment in the section 355 context.

The IRS has disregarded the substituted basis problem in some partnership-liquidating distributions when the corporate partner owns through its SAG at least 80 percent of the interests in the partnership77 or (as discussed above) when the partnership’s ATB was already attributable to the partner under Rev. Rul. 92-17 before the liquidation occurs.78 That approach minimizes the disparity between the treatment of corporations, which can distribute property to 80 percent corporate shareholders in liquidation without the corporate shareholder recognizing gain,79 and partnerships. The proposed regulations take an even more favorable approach, providing that a partner already attributed the trade or business of a partnership will not be treated as acquiring a new trade or business upon acquiring the trade or business from the partnership.80 Further, because partners with a significant interest in a partnership are treated as conducting its ATB regardless of whether they serve a management function,81 a liquidation of a partner’s significant interest in exchange for an ATB of the partnership should not cause that partner to violate section 355(b)(2) under the principles of Rev. Rul. 2002-49 and the proposed regulations (assuming the partner has held the interest for the five-year period).

An issue not explicitly addressed by Rev. Rul. 2002-49 is what treatment should apply when a partner has an interest, but not a significant interest, in a partnership during the five-year period and acquires an ATB from that partnership in a partial redemption of its interest in the partnership in a transaction in which no gain or loss was recognized. This fact pattern is in some sense similar to situation 2 of Rev. Rul. 2002-49 (in which a corporate partner contributed non-ATB assets to a partnership with an ATB), because here the corporate partner is forfeiting part of its participation regarding non-ATB assets through the partnership in exchange for a direct interest in the ATB. That transaction (which would result in a carryover basis) might be distinguished from situation 2 of Rev. Rul. 2002-49 on the grounds that the partner had at least some interest in the partnership during the pre-distribution portion of the five-year period. Nevertheless, under the proposed regulations an acquisition of an ATB consisting of a distribution from a partnership is generally treated as an acquisition paid for with assets of the DSAG and will accordingly be treated as an acquisition in which gain or loss is recognized even if no gain or loss is actually recognized.82 This rule does not apply, however, to the extent a partner is already attributed the ATB of a partnership for purposes of section 355(b).83

Figure 3

As illustrated by Figure 3, the section 355 authorities do not necessarily respect the treatment of a partner’s receipt of an ATB as provided in sections 731 and 732 in determining whether gain or loss has been recognized in the transaction. In general, if a partner is already conducting an ATB through a partnership, the receipt of that ATB in a distribution or redemption will not violate section 355(b)(2)(C), even if the partner takes a substituted basis in the property. If a partner is not already treated as conducting an ATB through a partnership, however, the receipt of that ATB in a distribution or redemption may violate section 355(b)(2)(C), even if the partner takes a carryover basis and no gain or loss is actually recognized. In situation A of Figure 3, Distributing had only a 15 percent interest in P before the partial redemption and will be treated as recognizing gain or loss on the transaction for section 355 purposes even if no gain or loss was actually recognized.84 In situation B, however, Distributing had a significant interest in P before the partial redemption and will not be treated as recognizing gain or loss on the transaction, even if gain or loss is actually recognized.85

As a policy matter, the approach of the proposed regulations is reasonable because it reduces the disparity between the treatment of a liquidating distribution of an ATB from a corporate subsidiary and a partnership.86 The receipt of an ATB by a corporate partner in complete redemption of that partner’s interest in a partnership in which it held a significant interest during the five-year period is clearly not the kind of transaction section 355(b) is intended to prevent, as indicated by the fact that there is no exception to section 355 nonrecognition for the liquidation of a corporate subsidiary into an 80 percent corporate parent under section 332. Also, the fact that the receipt of a partnership’s ATB by a corporate partner in a partial redemption when that partner did not have a significant interest in the partnership for the five-year period does not qualify under section 355(b), even when no gain or loss is recognized, is sensible.87 There is no reason to treat a partial redemption differently from a complete redemption for purposes of section 355; the determinative factor should be whether the corporate partner had a significant interest in the partnership during the five-year period.

B. Disguised Sales

Transfers of an ATB or ATB assets to or from a partnership may trigger disguised sale rules upon a later distribution or contribution, even if no gain is otherwise recognized on the contribution under section 721(a) or on the distribution.88 If a transaction involving a partnership ATB is treated as a disguised sale during the five-year period, gain or loss will be recognized and disqualify a spinoff from nonrecognition treatment under section 355(b)(2)(C) or (D).

Simultaneous transfers to a partnership are disguised sales if, based on the facts and circumstances, the transfer of money or other consideration by the partnership to the partner would not have been made but for the partner’s transfer of property to the partnership.89 A nonsimultaneous transfer is considered a disguised sale if, based on the facts and circumstances, the later transfer does not depend on the entrepreneurial risk of partnership operations.90 There is a rebuttable presumption that transfers occurring within a two-year period (regardless of the order of transfers) are a disguised sale.91 Assumption of or relief from liabilities of a corporate partner can be treated as a transfer of property for these purposes.92 The proposed regulations would not treat the assumption of liabilities as a transaction in which gain or loss is recognized unless the assumption is treated as a payment of money or other property under other provisions,93 which includes the disguised sale rules.

This report does not fully discuss the disguised sale rules and is not intended to be a comprehensive overview. Nevertheless, the unfavorable presumptions to treat particular transactions as disguised sales may cause problems when restructuring an ATB to contribute it to or distribute it from a partnership, so taxpayers should keep disguised sales rules in mind when planning for a section 355 spinoff or related transaction.

C. Mixing Bowl

Another potential trap for the unwary is transactions that run afoul of the mixing bowl rules. In general, a mixing bowl transaction is designed to allow deferred recognition of gain on the exchange of assets by implementing the exchange through a partnership, followed by a distribution of the assets to the noncontributing partners. In a typical mixing bowl, two parties each contribute a different business to a partnership, and each partner receives some level of economics and control over the business contributed by the other partner. After some time, the partnership dissolves, with each partner receiving the business contributed by the other partner.

Section 704(c)(1)(B) limits abuse of mixing bowl arrangements by requiring recognition of gain or loss by the contributing partner if property is distributed to a partner other than the contributing partner within seven years of the initial contribution. Section 737 also polices mixing bowl transactions by requiring a contributing partner to recognize gain in some circumstances if it receives a distribution of property (other than cash or previously contributed property) within seven years of its contribution of appreciated property. Also, the initial contribution of property would cause gain or loss to be recognized in the five-year period because gain or loss would have been recognized if the assets were acquired directly.94 Waiting seven years to dissolve the partnership avoids implicating situation 2 of Rev. Rul. 2002-49 because the ATB will be conducted in the partnership for the entire five-year period. Further, after seven years, the partners can dissolve the partnership without triggering tax on the partner’s’ contributed property under sections 704(c)(1)(B) and 737.

Figure 4

In Figure 4, Distributing will not recognize section 704(c)(1)(B) or 737 gain upon the windup of the partnership after seven years. Note, however, that Distributing should be able to receive and rely on ATB 2 for section 355 purposes after five years. Even though distributing ATBs 1 and 2 before seven years of their contribution would cause gain or loss to be recognized under section 704(c)(1)(B), Distributing had a significant interest in P during the five-year period, and its reliance on ATB 2 would therefore not violate situation 2 of Rev. Rul. 2002-49. The proposed regulations also provide that such a distribution does not cause gain or loss to be recognized for section 355 purposes even though gain or loss may be recognized under section 704 because Distributing did not acquire its interest in P in a transaction in which gain or loss was recognized during the five-year period.95

The preamble to the proposed regulations points to another mixing bowl transaction that violates section 355(b)(2)(C) and (D). If two partners each contribute a separate five-year ATB to a partnership and each receives a 50 percent interest in the partnership, each partner then has a significant interest in the partnership such that both ATBs will be attributed to each partner. However, the preamble explains that “while this was a transaction in which no gain or loss was recognized, the exchange of assets violates the common purpose of section 355(b)(2)(C) and (D). Further, the historic owner of [one ATB] would not participate in any distribution of controlled stock by” the other partner.96 Therefore, the preamble concludes, neither partner can rely on the other partner’s contributed ATB until five years after the acquisition of its interest in the partnership.97 That conclusion is consistent with situation 2 of Rev. Rul. 2002-49 because the contribution of an ATB for an interest in a partnership conducting a different ATB would have been a transaction in which gain or loss was recognized if the different ATB was acquired directly.

D. Section 751(b)

Another concern in structuring a section 355 transaction is whether distributions of an ATB from a partnership to a corporate partner will trigger section 751(b). Section 751(b) requires that partners that (1) receive distributions of partnership property that comprises (A) unrealized receivables or (B) inventory items that have appreciated substantially in value (hot assets) in exchange for all or part of the partner’s interest in other partnership property (including money) or (2) receive distributions of partnership property (including money) other than hot assets in exchange for all or part of the partner’s interest in hot assets treat those transactions as a sale or exchange of property between the distributee partner and the partnership.98 There is an exception for distributions of property that the distributee contributed to the partnership.99 Accordingly, if a partner receives an ATB in a distribution in exchange for unrealized receivables or inventory items that have appreciated substantially in value, and if that partner did not contribute the ATB assets to the partnership, the distribution could be considered a sale or exchange of the ATB, potentially violating section 355(b).

However, the proposed regulations provide that if a partner “is attributed the trade or business assets and activities of a partnership . . . the partner’s acquisition of such trade or business assets and activities from the partnership is not, in and of itself, the acquisition of a new or different trade or business.”100 Although the proposed regulations are not yet law, the IRS appears to have adopted this approach. In LTR 201551009, a partnership wholly owned by Distributing and its subsidiary contributed its ATB to Controlled and distributed the stock of Controlled to Distributing in a distribution “in which gain may be recognized under section 751.” The IRS concluded that any gain recognized under section 751 would not prevent Controlled from satisfying the ATB requirement of section 355(b). That conclusion is consistent with the principles of Rev. Rul. 2002-49, situation 1, in which the acquisition of an increased direct stake in an ATB previously conducted through a partnership did not violate the requirements of section 355(b). The approach is a logical solution tailored to the intent of section 355(b). The purpose of section 751(b) is to ensure that taxpayers do not avoid paying their allocable share of gain on partnership assets taxable as ordinary income. It is not intended to address the separate section 355(b) concern that a corporate partner has acquired an ATB during the five-year period. Treasury should adopt the approach of the proposed regulations to section 751(b) in final regulations.

E. Recapitalizations

Notably, a section 368(a)(1)(E) recapitalization to obtain control for section 355 purposes likely does not violate section 355(b)(2)(D).101 The proposed regulations provide that recapitalizations are not treated as acquisitions in which gain or loss is recognized if no gain or loss is actually recognized.102 This approach makes sense in the corporate context because a recapitalization would not involve a shift in value to Distributing or Controlled when assets are being used to acquire an interest in an ATB, but rather a shift in voting power to acquire control.103

A recapitalization into control of a partnership may be more complicated, however. In the partnership context, the question whether a corporate partner has a significant interest is based on a value measurement and, for a meaningful interest, a factual question whether the partner performed an active and substantial management function during the five-year period. A recapitalization to acquire a significant interest may involve a shift in the partnership assets that are tracked by the corporate partner’s partnership interest and therefore may have to be treated as an acquisition in which gain or loss is recognized for section 355 purposes. On the other hand, a recapitalization in which a corporate partner already owned a significant interest in the partnership and continues to own one after the recapitalization generally should not be treated as an acquisition in which gain or loss is recognized. For example, a corporation with a partnership tracking interest that represents at least 33-1/3 percent of the aggregate interests in a partnership but is linked to only non-ATB partnership assets should not be treated as having a significant interest in the partnership. Accordingly, if a recapitalization occurs in which the corporation gives up tracking in the non-ATB assets in exchange for tracking the ATB assets, that transaction seems like the corporation is paying for an ATB with assets of the DSAG or CSAG. Under the proposed regulations, that recapitalization should thus be treated as a transaction in which gain or loss is recognized, even if no gain or loss is actually recognized within the meaning of the proposed regulations.104

F. Transfers Within the Affiliated Group

Under the Treasury regulations, the direct or indirect acquisition of an ATB from a member of the affiliated group (disregarding the DSAG-CSAG concept introduced by the proposed regulations) is not the type of transaction to which section 355(b)(2)(C) and (D) is intended to apply, and it is disregarded for purposes of those sections even though it is a taxable transaction.105 Accordingly, under the principles of Rev. Rul. 2007-42, one member of the affiliated group may transfer a significant interest in a partnership conducting an ATB to another member of the affiliated group in a transaction in which gain or loss is recognized, and the transferee should be able to rely on that ATB for section 355 purposes. The proposed regulations reduce the scope of that exception somewhat with the DSAG-CSAG concept but generally disregard transfers between members of the applicable SAG and transfers from the DSAG to the CSAG.106

A less straightforward application of this concept is in transactions between a partnership and its corporate partner and/or another partner when all the partners of that partnership are members of the same SAG or affiliated group. Because a partnership cannot be a member of the SAG or affiliated group, those transactions are not covered by the existing regulations or the proposed regulations and will therefore be treated as acquisitions in which gain or loss is recognized under section 355(b)(2)(C) and (D). As discussed in Section V below, there is little reason for this distinction, and it would be sensible for the final regulations to incorporate a concept in which transactions between the partnership and one or more partners, when all the partners of that partnership are in the same SAG, are disregarded for section 355(b)(2)(C) and (D) purposes.

V. Tiered Structures

A. Tiered Partnerships

It is not clear from Rev. Rul. 2007-42 and earlier authorities whether a corporation may be treated as engaged in an ATB when it holds a direct interest in a partnership that holds an interest in a lower-tier partnership engaged in an ATB. If the corporation has a significant interest in the upper-tier partnership, which in turn has a significant interest in the lower-tier partnership conducting the ATB, it seems logical that the corporation should also be treated as holding its proportionate share of the upper-tier partnership’s interest in the lower-tier partnership. The proposed regulations allow attribution of a partnership’s ATB to a corporate partner if the partner “indirectly through one or more other partnerships” owns a significant interest in the partnership.107

Although the proposed regulations do not specify what it means to indirectly own a significant interest, a corporate partner presumably needs a sufficient indirect interest in the lower-tier partnership such that if it owned that interest directly, it would have a significant interest under Rev. Rul. 2007-42 (or Rev. Rul. 92-17 if the management requirements are met). For example, if a corporation has a 50 percent interest in an upper-tier partnership, the upper-tier partnership should have at least a 66-2/3 percent interest in the lower-tier partnership to attribute the lower-tier partnership’s ATB to the corporate partner.108

B. SAG Rules and Interaction With Partnerships

In contrast to the tiered partnership rules, when a partnership holds stock in a corporation with an ATB, the section 355 rules do not expressly allow its corporate partners to look through the lower-tier corporation to determine if there is an ATB, even if wholly owned by the partnership. In determining whether a corporation is engaged in an ATB, all members of the corporation’s SAG are treated as one corporation,109 but the proposed regulations specify that “the stock of a corporation owned by the partnership is not attributed to a partner.”110 Accordingly, the presence of an intervening partnership breaks the chain for purposes of whether a lower-tier corporation is a member of a corporation’s SAG.

As a policy matter, the justification for allowing a corporation to conduct an ATB through a partnership (including a lower-tier partnership)111 but not through a corporation sitting below a partnership that is 80 percent or more owned by Distributing or Controlled is not clear. The proposed regulations may be intended to prevent a situation in which Distributing owns, for example, 50 percent of a corporation conducting an ATB and contributes its stock in that corporation to a partnership in exchange for a 33-1/3 percent or greater interest in the partnership. Absent the proposed regulations, Distributing could be treated as conducting an ATB through the partnership even though Distributing’s ownership of the contributed corporation does not meet the SAG 80 percent ownership threshold.112

Figure 5

Figure 5 demonstrates the disparity between the treatment of corporations and partnerships that own interests in subsidiary corporations. In situation A, both the DSAG and the CSAG would be treated as conducting separate ATBs. In situation B, however, only the CSAG would be treated as conducting an ATB. The presence of P between Distributing and Sub 1 prevents attribution of ATB 1 to the DSAG even though Distributing indirectly owns an 80 percent interest in Sub 1, which was sufficient to attribute ATB 1 to the DSAG in situation A.

Whatever the intentions of the proposed regulations, the reason for the disparity between the treatment of lower-tier corporations and lower-tier partnerships is unclear. The section 368 regulations allow attribution of corporate stock owned by a partnership if its partners are members of a qualified group and together have section 368(c) control over the partnership for purposes of determining whether a reorganization meets the continuity of business enterprise requirement.113 Given that Rev. Rul. 2007-42 cites those regulations in its promulgation of the significant interest rule, it is puzzling that Treasury adopted a different approach to the attribution of lower-tier corporation stock in the proposed regulations (although any look-through rule in the ATB context should be based on section 1504(a) principles rather than section 368(c) control). If the DSAG or CSAG has an 80 percent or higher interest in the partnership during the five-year period, there is little reason that the ATB of a corporation wholly owned by that partnership during the five-year period should not be attributed to the applicable SAG.

Under the proposed regulations, a corporation can avoid the attribution issue by causing a partnership to make a pro rata distribution of corporate stock held by the partnership.114 If the distributed corporation was conducting an ATB during the five-year period, the acquisition of that corporation’s stock by the DSAG or CSAG should not cause a problem under section 355(b)(2) if no gain or loss was recognized in the distribution from the partnership and the distributed stock was not acquired in a transaction in which gain or loss was recognized during the five-year period.115 However, the extra step of making a pro rata distribution adds unnecessary complexity and may require other restructuring steps before a section 355 transaction.

Because the express prohibition against attributing stock owned by a partnership is inconsistent with the section 368 regulations relied on by Rev. Rul. 2007-42 and with the facts and circumstances approach to ATB analysis adopted by the proposed regulations,116 Treasury should add an exception to this restriction when a corporate partner’s SAG has owned at least 80 percent of the vote and value of the partnership for the five-year period.117 That exception would reduce the unnecessary disparity between the treatment of lower-tier corporations and lower-tier partnerships without altering the SAG rules by allowing a corporate partner with less than 80 percent indirect control of a lower-tier corporation to be treated as engaged in the lower-tier corporation’s ATB. Moreover, the exception is reasonable because Treasury has already applied a similar rule in the related continuity of business enterprise context.118

VI. Management Issues

A trade or business will be considered active for purposes of section 355 if its activities involve active and substantial management and operational functions.119 In general, those functions must be performed by employees of the corporation120 but will also be taken into account if performed by employees of an affiliate.121 Activities “performed by a corporation include activities performed by employees of an affiliate . . . if such activities are performed for the corporation.”122 Also, all members of a corporation’s SAG are treated as one corporation in determining whether the corporation conducts an ATB.123

Although it is clear that a corporation relying on an ATB conducted through a partnership can rely on the activities of employees of that partnership,124 how should activities of partners — which cannot be employees of the partnership125 — be treated? Further, how should activities of partners be treated if the partnership itself has no employees and its ATB is conducted solely by its partners?

The text of section 355 and the regulations does not literally preclude partners from conducting the ATB of a partnership. Reg. section 1.355-3(b)(2)(iii) simply provides that the corporation is “generally” required to perform active and substantial management functions. The proposed regulations provide that for “purposes of determining the activities that are conducted by the partnership that may be attributed to the partner . . . the activities of partners that are affiliates (or, in certain cases, shareholders) of the partner are only taken into account during the period that such partners are affiliates (or, in certain cases, shareholders) of the partner.”126 The emphasis on determining the activities of the partnership “that may be attributed to the partner” suggests that attribution of affiliated partners’ activities is not just limited to the determination of whether a partner is performing active and substantial management functions for the partnership but also applies to the separate question of whether a partnership’s trade or business is being actively conducted. This conclusion is further supported by the fact that the proposed regulations specifically allow attribution of active and substantial management functions performed by affiliates of the partner.127 That treatment is consistent with the treatment of activities of affiliates and their employees in the corporate context.128

Moreover, there seems to be no policy reason why partners in the partnership (rather than its employees) should be precluded from conducting the operational activities of an ATB if the other ATB requirements are satisfied. There is no specific requirement that a partnership’s own employees conduct the ATB.

In the corporate context, the IRS has applied the facts and circumstances test to determine that a corporation can have an ATB even if the corporation itself has no salaried employees.129 In Rev. Rul. 79-394, a corporation (P) owned all the stock of another corporation (Y), which was engaged in a real estate business. Y had no salaried employees, but its activities were performed by employees of another corporation wholly owned by P (X), who were under the supervision and control of Y’s officers. Y reimbursed X for the services performed by X’s employees, and Y also reimbursed P and X for the services performed by their officers. P then proposed to distribute the Y stock in a transaction intended to meet the requirements of section 355. After the distribution, Y would directly employ most of the employees who had worked on Y’s behalf before the distribution.

The ruling concluded that Y was engaged in the conduct of an ATB. The IRS reasoned that the absence of salaried employees is merely one of several factors tending to prove that a corporation is not engaged in an ATB, and that “Y’s failure to have salaried employees should not, without more, result in failure to meet the active trade or business requirement of section 355(b).” Emphasizing Y’s pre-distribution management and operational activities, Rev. Rul. 80-181 concluded that Y’s failure to reimburse X for the services performed by its employees and officers would not affect Rev. Rul. 79-394’s conclusion that Y is engaged in the conduct of an ATB.130

Given the IRS’s general flexibility in the corporate context, a corporation should be able to conduct an ATB through a partnership even if the partnership itself has no employees performing operational functions. There seems to be no requirement in section 355 or its regulations that the partnership itself have employees conducting the partnership’s ATB; therefore, a corporation should be able to conduct an ATB through a partnership even if all operational activities are performed by the partner and its affiliates.

There are limited authorities in the partnership context to support this conclusion. Before the addition of section 355(b)(3) and Rev. Rul. 2007-42, the IRS concluded that a corporate partner was conducting an ATB through a partnership even though, for part of the five-year period, all personnel performing management or operational functions for the partnership were either employees (some of whom were also officers of the corporate partner) of a non-partner corporation in Distributing’s consolidated group or employees of an unrelated partner; the partnership’s employees were performing some operational functions for the business at the time of the distribution.131 Further, in determining whether a corporation was conducting an ATB through a partnership, Rev. Rul. 92-17 treated as a negative factor the fact that the partnership’s employees conducted the operational functions of the business rather than the corporate partner.132 It would be inconsistent to treat the fact that a corporate partner does not have employees performing operational functions for a partnership’s ATB as a negative factor in determining whether that corporation is conducting an ATB through that partnership, as in Rev. Rul. 92-17, while simultaneously requiring the partnership itself to have employees conducting the ATB. For consistency with Rev. Rul. 92-17, Treasury should make clear in final regulations that a partnership is not itself required to have employees conducting the operational functions for its ATB.

VII. Conclusion

Based on the foregoing discussion, it is clear that there are still many uncertainties about the requirements for a corporation to conduct an ATB through a partnership. Although the proposed regulations go a long way toward addressing those uncertainties, they are not yet effective and still leave many issues unresolved. Practitioners should be aware of these issues and carefully plan section 355 transactions involving partnerships.

FOOTNOTES

1 Although this report does not discuss the Tax Cuts and Jobs Act (P.L. 115-97), that legislation does not fundamentally change the issues, analysis, or conclusions discussed herein.

2 Section 355(a). A complete examination of the requirements for tax-free treatment under section 355 (including the ATB requirement) is beyond the scope of this report.

3 In a spinoff, Distributing distributes Controlled stock to its shareholders, and the shareholders do not surrender any Distributing stock in exchange.

4 In a split-off, Distributing distributes Controlled stock to its shareholders in exchange for some or all of their Distributing stock.

5 In a split-up, Distributing distributes stock of more than one Controlled to Distributing shareholders in a complete liquidation of Distributing.

6 Section 355(a)(2)(A).

7 Section 355(a)(1)(A).

8 Section 355(a)(1)(B).

9 Section 355(a)(1)(C).

10 Section 355(a)(1)(D).

11 Reg. section 1.355-2(b).

12 Reg. section 1.355-2(c).

13 Reg. section 1.355-1(b) (“Section 355 contemplates the continued operation of the business or businesses existing prior to the separation.”).

14 Section 355(b)(1)(A). In a split-up transaction, Distributing and Controlled meet the requirements of section 355(b) if, immediately before the distribution, Distributing had no assets other than stock or securities in each Controlled and each Controlled would satisfy the ATB requirement. Section 355(b)(1)(B).

15 Reg. section 1.355-3(b)(2)(iii).

16 Section 355(b)(2)(B).

17 Section 355(b)(2)(C).

18 Section 355(b)(2)(D).

19 Reg. section 1.355-3(b)(4)(i) (“A trade or business acquired, directly or indirectly, within the five-year period ending on the date of the distribution in a transaction in which the basis of the assets acquired was not determined in whole or in part by reference to the transferor’s basis does not qualify under section 355(b)(2), even though no gain or loss was recognized by the transferor.”).

20 A distribution in complete redemption of a partner’s interest in a partnership is subject to different rules, discussed in Section IV.

21 Section 355(b)(3)(A).

22 Section 355(b)(3)(B). Section 1504(b) excludes foreign corporations and some other corporations, including corporations exempt from tax under section 501, from the affiliated group.

23 Section 1504(a).

24 The proposed regulations (REG-123365-03), published May 8, 2007, will not be effective until they are adopted in final form, and their rules will apply only to distributions that occur after the new final regulations are published.

25 Prop. reg. section 1.355-3(b)(3)(i).

26 Prop. reg. section 1.355-3(b)(1)(iii).

27 Id.

28 Reg. section 1.355-3(b)(4)(iii). Prop. reg. section 1.355-3(b)(4)(iii) does not adopt this exception but permits acquisitions of an ATB by the CSAG from the DSAG.

29 Reg. section 1.355-3(b)(3)(ii).

30 Id. For example, if Distributing is engaged in the active conduct of owning and operating hardware stores in several states and purchases all the assets of a hardware store in a state in which it had not previously conducted business, that purchase is an expansion of Distributing’s existing business, and its acquisition does not constitute the acquisition of a new or different business. If Distributing later contributes the assets of the new hardware store to Controlled and distributes Controlled stock to its shareholders, both Distributing and Controlled will satisfy section 355(b). Prop. reg. section 1.355-3(d)(2), Example 18.

31 Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49. The origin of the 20 percent ownership requirement in Rev. Rul. 92-17 is unclear. However, it appears that Treasury may have drawn on Rev. Rul. 92-17 in the corporate context. In 1998 Treasury amended the continuity of business enterprise regulations to add paragraph (d)(5), Example 7 (Example 8 under the latest version of the regulations), which provides that a partner who contributes a business to a new partnership, retains a 20 percent interest in that partnership, and performs an active and substantial management function for the business will maintain continuity of business enterprise. See reg. section 1.368-1(d)(5), Example 8.

32 Id.

33 See id.

34 See prop. reg. section 1.355-3(b)(2)(v)(C) (providing that performance of active and substantial management functions for a partnership includes a partner who, “for example, makes decisions regarding significant business issues of the partnership and regularly participates in the overall supervision, direction, and control of the employees performing the operational functions for the partnership”).

35 The 33-1/3 percent significant interest requirement predates Rev. Rul. 2007-42 in an analogous corporate context under the continuity of business enterprise regulations. In a 1998 amendment to those regulations, Treasury added paragraph (d)(5), Example 9 (Example 10 under the latest regulations), which provides that a partner who contributes a business to a new partnership and retains a 33-1/3 percent interest in that partnership is treated as conducting the partnership’s historic business even if that partner does not perform an active and substantial management function for the business. See reg. section 1.368-1(d)(5), Example 10. This example may be the origin of the 33-1/3 percent significant interest requirement in Rev. Rul. 2007-42.

36 See Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49.

37 See Rev. Rul. 2007-42.

38 Id. (situation 1).

39 Id. (situation 2).

40 Prop. reg. section 1.355-3(b)(2)(v) and (d)(2), examples 22-24. The proposed regulations refer to an interest qualifying under Rev. Rul. 92-17 and Rev. Rul. 2002-49 as a “meaningful interest.” Prop. reg. section 1.355-3(b)(2)(v)(C).

41 Prop. reg. section 1.355-3(b)(d)(2), Example 24.

42 Prop. reg. section 1.355-3(b)(2)(v)(A) (“However, for purposes of this paragraph (b)(2)(v), the stock of a corporation owned by the partnership is not attributed to a partner.”). This issue is discussed in greater detail in Section V.

43 See, e.g., Rev. Rul. 2007-42 (merely providing that the corporate partner has a 33-1/3 percent membership interest in the LLC).

44 Jeffrey T. Sheffield and Barbara M. St. Clair, “An Abecedarium on Alphabet Stock,” 66 Taxes 945, 961 (Dec. 1988) (providing as examples Rev. Rul. 66-187, 1966-2 C.B. 246 (upholding special allocation of expenses); and Dibble v. Commissioner, T.C. Memo. 1984-589 (upholding special allocation of losses)).

45 See reg. section 1.704-1(b)(3)(i).

46 Although Rev. Rul. 2007-42 defines a significant interest as a 33-1/3 percent interest in a partnership, except when otherwise noted, the term “significant interest” is used throughout this report to refer to the requisite degree of participation in partnership economics — be it a 20 percent interest and an active and substantial management function, or a 33-1/3 percent interest — for attribution of that partnership’s ATB to a corporate partner.

47 See Rev. Rul. 2007-42 (describing only assets connected to the LLC’s rental business).

48 Emphasis added. See also reg. section 1.368-1(d)(5), Example 10 (“P is treated as conducting T’s historic business because S-3 owns an interest in the partnership representing a significant interest in that partnership business.”).

49 Although Rev. Rul. 2007-42 seems to contemplate a straightforward situation in which the underlying entity’s assets are entirely composed of assets from a single ATB, it does not expressly require that the ATB represent a specific threshold of partnership assets. See Rev. Rul. 73-44, 1973-1 C.B. 182 (observing that “there is no requirement in section 355(b) that a specific percentage of the corporation’s assets be devoted to the active conduct of a trade or business”). However, prop. reg. section 1.355-9(b) requires that at least 5 percent of the fair market value of a corporation’s assets be attributable to an ATB. Prop. reg. section 1.355-9(c)(3)(ii) allows a corporate partner conducting an ATB through a partnership to allocate the FMV of the corporation’s partnership interest between ATB and non-ATB assets in the same proportion as that of the FMV of the partnership’s ATB and non-ATB assets.

50 Prop. reg. section 1.355-3(b)(2)(iii).

51 See, e.g., prop. reg. section 1.355-3(d)(2), Example 15 (“D transfers the store building, fixtures, inventory, and other significant assets related to the operations of the suburban store.”).

52 See, e.g., prop. reg. section 1.355-3(b)(2)(v)(C) (“Whether such active and substantial management functions are performed with respect to the trade or business assets and activities of the partnership will be determined from all of the facts and circumstances.”).

53 See reg. section 1.368-1(d)(5), Example 11 (“P is treated as conducting the sportswear manufacturing business because S-1 owns an interest in the partnership representing a significant interest in that partnership business” (emphasis added).).

54 Id.

55 Rev. Proc. 93-27, 1993-2 C.B. 343, addresses the treatment of profits interests for federal income tax purposes.

56 Prop. reg. section 1.355-3(b)(2)(v)(B) (“The trade or business assets and activities of a partnership will be attributed to a partner if the partner (or its SAG) directly (or indirectly through one or more other partnerships) owns a significant interest in the partnership.”). The IRS also took this approach before the addition of section 355(b)(3) in 2006. See LTR 200107008 (Distributing’s less than 20 percent interest in a partnership qualified under section 355(b) when the remaining interests in the partnership were owned by Distributing’s wholly owned subsidiaries).

57 Prop. reg. section 1.355-3(b)(2)(v)(B).

58 Prop. reg. section 1.355-3(b)(2)(v)(C) (“The trade or business assets and activities of a partnership will be attributed to a partner if the partner or affiliates (or, in certain cases, shareholders) of the partner performs active and substantial management functions for the partnership with respect to the trade or business assets and activities.”).

59 Prop. reg. section 1.355-3(b)(2)(v)(A).

60 Prop. reg. section 1.355-3(c)(1).

61 Section 355(b)(3)(B) (“For purposes of this paragraph, the term ‘separate affiliated group’ means, with respect to any corporation, the affiliated group which would be determined under section 1504(a) if such corporation were the common parent and section 1504(b) did not apply.”).

62 Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49; prop. reg. section 1.355-3(b)(2)(v)(C).

63 Prop. reg. section 1.355-3(b)(2)(v)(C).

64 Prop. reg. section 1.355-3(b)(2)(v)(B).

65 See LTR 9224020 (allowing attribution of management function by officers of brother corporation for businesses conducted by partnerships owned by sister corporation to sister corporation when sister corporation’s officers were supervising officers of brother corporation); cf. Rev. Rul. 79-394, 1979-2 C.B. 141, amplified by Rev. Rul. 80-181, 1980-2 C.B. 121 (allowing attribution of operational activities by employees of brother corporation to sister corporation; neither corporation would be part of the other’s SAG under section 355(b)(3)).

66 Prop. reg. section 1.355-3(b)(2)(v)(A) and (C).

67 Preamble to REG-123365-03 (Stating that the IRS and Treasury believe a corporation can satisfy the ATB requirement “even if all the management and operational functions are performed by shareholders of the corporation if it is closely held. The shareholders of closely held corporations possess a close relationship with the corporation, similar to employees of affiliates. Accordingly, these proposed regulations provide that, in determining whether a corporation is engaged in the active conduct of a trade or business, activities (including management and operational functions) performed by shareholders of a closely held corporation are taken into account in certain cases.”).

68 Section 355(b)(2)(C), (D).

69 Rev. Rul. 2002-49, situation 1.

70 See Rev. Rul. 99-6, 1999-1 C.B. 432.

71 Rev. Rul. 2002-49 (“D’s purchase of the Remaining Interests on the first day of Year 3, which causes the LLC to become disregarded as an entity separate from D, does not result in the acquisition of a new or different business. See reg. section 1.355-3(b)(3)(ii). Because this transaction does not result in the acquisition of a new or different business, the requirements of section 355(b)(2)(B) and (C) are satisfied even though gain or loss is recognized in the transaction.”). See also prop. reg. section 1.355-3(b)(4)(iii) (providing list of specific transactions in which recognition of gain or loss is disregarded).

72 Reg. section 1.355-3(b)(3)(ii).

73 Reg. section 1.355-3(b)(4)(i) (“A trade or business acquired, directly or indirectly, within the five-year period ending on the date of the distribution in a transaction in which the basis of the assets acquired was not determined in whole or in part by reference to the transferor’s basis does not qualify under section 355(b)(2), even though no gain or loss was recognized by the transferor.”).

74 Section 732(a)(1).

75 Section 731(a).

76 Section 732(b).

77 See LTR 200432017 (The IRS did not rule that the spinoff violated section 355(b) upon conversion from partnership to disregarded LLC, even though “during the five-year period preceding the Distributions . . . the identity of the partnership conducting Business C and the identity of the corporate partners in that partnership will have changed several times, in some cases when a partnership interest has been acquired by or from an unrelated party in a transaction producing recognition of gain or loss. Throughout this period, however, Business C and its officers and managers will have remained essentially unchanged, and at least 80 percent of the partnership interests will have been held at all times by entities that are or were related to Distributing 2 (each, a ‘Related Partner’). Further, all but one of the officers will at all times have been employed simultaneously as officers of the partnership and each Related Partner.”).

78 See Rev. Rul. 2002-49, situation 1 (the IRS did not rule that conversion of wholly owned LLC to disregarded entity caused gain or loss to be recognized under section 355(b)).

79 Section 332(a).

80 Prop. reg. section 1.355-3(b)(3)(iii).

81 See Rev. Rul. 2007-42.

82 Prop. reg. section 1.355-3(b)(4)(ii)(B) (“An acquisition consisting of a distribution from a partnership is generally an acquisition paid for with assets of the DSAG, and will be treated as an acquisition in which gain or loss is recognized even if no gain or loss is actually recognized.”).

83 Id. (“This paragraph (b)(4)(ii)(B) (and consequently paragraph (b)(4)(ii)(A) of this section) does not apply to any partnership distribution to which paragraph (b)(3)(iii) of this section (regarding distributions from partnerships that are not, in and of themselves, the acquisition of a new or different trade or business) applies.”).

84 Prop. reg. section 1.355-3(b)(4)(ii)(B).

85 Prop. reg. section 1.355-3(b)(3)(iii).

86 Id.

87 Id.

88 See section 707.

89 Reg. section 1.707-3(b)(1)(i).

90 Reg. section 1.707-3(b)(1)(ii).

91 Reg. section 1.707-3(c)(1).

92 Reg. section 1.707-5(a)(1).

93 Prop. reg. section 1.355-3(b)(4)(ii)(A) (“However, the assumption by the DSAG or CSAG of liabilities of a transferor shall not, in and of itself, be treated as the payment of assets if such assumption is not treated as the payment of money or other property under any other applicable provision.”).

94 Rev. Rul. 2002-49, situation 2.

95 See prop. reg. section 1.355-3(b)(3)(iii).

96 Prop. reg. section 1.355-3, preamble.

97 This conclusion is incorporated in prop. reg. section 1.355-3(b)(4)(ii)(A) (“An acquisition paid for in whole or in part, directly or indirectly, with assets of the DSAG will be treated as an acquisition in which gain or loss is recognized even if no gain or loss is actually recognized . . . [including a transaction in which] the DSAG or CSAG acquires an interest in a partnership engaged in the trade or business to be relied on by contributing assets not constituting the trade or business to be relied on to the partnership.”).

98 Section 751(b)(1).

99 Section 751(b)(2).

100 Prop. reg. section 1.355-3(b)(3)(iii).

101 Section 355(b)(2)(D)(ii) provides that a corporation is treated as engaged in an ATB if it acquires control of a corporation conducting an ATB only if “in each case in which such control was so acquired, it was so acquired, only by reason of transactions in which gain or loss was not recognized in whole or in part.” The IRS has generally permitted recapitalizations into control if the recapitalization results in a “permanent realignment of voting control” and no gain or loss is actually recognized. Compare, e.g., Rev. Rul. 69-407, 1969-2 C.B. 50 (distribution of stock in Controlled following a recapitalization resulting in control under section 368(c) is nontaxable under section 355), with Rev. Rul. 57-144, 1957-1 C.B. 123 (Distributing’s acquisition of Controlled by taxable redemption of minority stock violates section 355(b)(2)(D)).

102 Prop. reg. section 1.355-3(b)(4)(ii)(A).

103 See Rev. Proc. 81-60, 1981-2 C.B. 680, section 4.03(2)(d) (requiring representation that the FMV of the stock to be received by each exchanging shareholder will be equal to the FMV of the stock surrendered in the exchange in ruling requests for 368(a)(1)(E) reorganizations); and section 355(a)(1)(D)(ii) (requiring Distributing to distribute stock in Controlled constituting control under section 368(c), which requires ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote, as well as at least 80 percent of the total number of shares of all other classes of stock).

104 See prop. reg. section 1.355-3(b)(4)(ii)(A) (“An acquisition paid for in whole or in part, directly or indirectly, with assets of the DSAG will be treated as an acquisition in which gain or loss is recognized even if no gain or loss is actually recognized . . . include[s] for example, a transaction in which . . . the DSAG or CSAG acquires an interest in a partnership engaged in the trade or business to be relied on by contributing assets not constituting the trade or business to be relied on to the partnership.”).

105 Reg. section 1.355-3(b)(4)(iii).

106 Prop. reg. section 1.355-3(b)(1)(ii) and (4)(iii)(A).

107 Prop. reg. section 1.355-3(b)(2)(v)(B) and (C).

108 If the corporation and its affiliates perform an active and substantial management function for the lower-tier partnership, the upper-tier partnership should need only a 40 percent interest in the lower-tier partnership for the corporate partner to be attributed the ATB of the lower-tier partnership under the “meaningful interest” test. Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49; prop. reg. section 1.355-3(b)(2)(v)(C).

109 Section 355(b)(3)(A).

110 Prop. reg. section 1.355-3(b)(2)(v)(A).

111 Prop. reg. section 1.355-3(b)(2)(v)(B) and (C).

112 See section 1504(a)(2).

113 Reg. section 1.368-1(d)(4)(iii)(D).

114 Prop. reg. section 1.355-3(b)(4)(ii)(B) (“An acquisition consisting of a pro rata distribution from a partnership of stock or an interest in lower-tier partnership is not an acquisition [which will be treated as if gain or loss was recognized even if no gain or loss was actually recognized] to the extent the distributee partner did not acquire the interest in the distributing partnership during the pre-distribution period in a transaction in which gain or loss was recognized and to the extent the distributing partnership did not acquire the distributed stock or partnership interest within such period.”).

115 Prop. reg. section 1.355-3(b)(3)(i) (“Under section 355(b)(2), a trade or business that is relied upon to meet the requirements of section 355(b) must have been . . . actively conducted throughout the pre-distribution period and acquired during such period by the DSAG or CSAG in a transaction in which no gain or loss is recognized as provided in paragraph (b)(4) of this section.”).

116 Prop. reg. section 1.355-5(b)(2)(iii) (“For purposes of section 355(b), the determination of whether a trade or business is actively conducted will be made from all of the facts and circumstances.”).

117 This ownership requirement should be consistent with the requirements of sections 355(b)(3)(B) and 1504(a).

118 Reg. section 1.368-1(d)(4)(iii)(D).

119 Reg. section 1.355-3(b)(2)(iii).

120 Id. (“Generally, the corporation is required itself to perform active and substantial management and operational functions.”).

121 See Rev. Rul. 79-394, amplified by Rev. Rul. 80-181. Cf. prop. reg. section 1.355-3(b)(2)(iii).

122 Prop. reg. section 1.355-3(b)(2)(iii).

123 Section 355(b)(3)(A).

124 See Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49.

125 See Rev. Rul. 69-184, 1969-1 C.B. 256 (providing that partners cannot be employees of a partnership).

126 Prop. reg. section 1.355-3(b)(2)(v)(A) (emphasis added).

127 Prop. reg. section 1.355-3(b)(2)(v)(C) (“The trade or business assets and activities of a partnership will be attributed to a partner if the partner or affiliates (or, in certain cases, shareholders) of the partner performs active and substantial management functions for the partnership.”).

128 Prop. reg. section 1.355-3(b)(2)(iii).

129 See Rev. Rul. 79-394, amplified by Rev. Rul. 80-181. Cf. prop. reg. section 1.355-3(b)(2)(iii).

130 Rev. Rul. 80-181.

131 LTR 200044017. See also LTR 9224020 (employees of corporate partners operated businesses conducted by the partnership held by each corporation).

132 Rev. Rul. 92-17, amplified by Rev. Rul. 2002-49 (“The only factor tending to prove that D has not been engaged in the active conduct of a trade or business is D’s lack of employees to perform the operational services necessary to operate LP’s office buildings.”).

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