AICPA Comments on Treatment of Layers in Partnership Mergers, Divisions, and Tiered Partnerships

Re: Comments on Notice 2009-70, Section 704(c) Layers relating to Partnership Mergers, Divisions and Tiered Partnerships

Dear Mr. Wilkins:

The American Institute of Certified Public Accountants is pleased to comment on Notice 2009-70 regarding the treatment of different layers of section 704(c) built-in gains and losses that was issued August 13, 2009.

In 2007, the IRS and Treasury Department issued proposed regulations that addressed the consequences of certain partnership mergers under sections 704(c)(1)(B) and 737. As stated in Notice 2009-70, the government received a number of comments that expressed concern about the proposed treatment of section 704(c) layers in connection with a partnership merger. In addition, IRS and Treasury have become aware that practitioners are taking positions contrary to the proposed regulations for tiered partnerships. In response, the IRS and Treasury Department issued Notice 2009-70 requesting comments on a number of issues related to the proposed regulations.

The proposed regulations call for a netting of section 704(c) layers. Requiring all partnerships to net their section 704(c) layers may create an allocation of income or loss that was not anticipated by the partners when agreeing to the original section 704(c) method. Accordingly, we believe that the final regulations should be more flexible and allow partnerships to choose to either maintain or collapse their historic section 704(c) layers. By maintaining the historic layers, the original allocation percentages can be maintained. We also believe that the final regulations should be flexible in allowing the use of either an aggregate or an entity approach with respect to tiered partnership arrangements.

In total, our attached comment letter details 11 recommendations that we believe will significantly improve the final regulations. We appreciate your consideration of our comments on the proposed regulations and would be pleased to discuss them with you. You may contact Hughlene A. Burton, Chair of the Partnership Taxation Technical Resource Panel at (704) 687-7696 or haburton@uncc.edu or Marc A. Hyman, AICPA Technical Manager at (202) 434-9231 or mhyman@aicpa.org.

SUMMARY OF RECOMMENDATIONS

1. Treas. Reg. § 1.704-1(b)(2)(iv)(f) should be modified to allow a partnership to revalue its assets when the sharing of profits and losses is altered by agreement.

Treas. Reg. § 1.704-1(b)(2)(iv)(f) provides that a partnership agreement may, upon the occurrence of certain events, increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership's books. The revaluation events specified in the regulations currently include only contributions of money or other property to the partnership by a new or existing partner as consideration for a more than de minimis interest in the partnership; the liquidation of the partnership or a distribution of money or other property by the partnership to a partner as consideration for a more than de minimis interest in the partnership; the grant of an interest in the partnership as consideration for the provision of services to or for the benefit of the partnership; and under generally accepted industry accounting practices, provided substantially all of the partnership's property consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market.

Partners may agree to alter the way in which partnership profits and losses are allocated in circumstances that do not qualify as one of the prescribed revaluation events. For example, the partners in a partnership may agree to change an existing pro-rata sharing agreement to instead provide one partner a less variable preferred allocation. If no money or other property is transferred to or from the partnership in conjunction with the modification, Treas. Reg. § 1.704-1(b)(2)(iv)(f) does not appear to allow the partnership to revalue its assets. While an adjustment to the capital accounts may nevertheless be appropriate in this circumstance under Treas. Reg. § 1.704-1(b)(2)(iv)(q), such a result is subject to interpretation.

In the absence of a revaluation, the modification of a partner's interest in the partnership may alter the partners' relative shares of existing unrealized appreciation or depreciation in partnership assets unless the agreement is modified to call for a special allocation of such unrealized amounts. Modifying Treas. Reg. § 1.704-1(b)(2)(iv)(f) to allow a partnership to revalue its assets in conjunction with any amendment that prospectively alters the sharing of profits and losses would enable the partners to preserve their intended economic deal without the need to draft special allocation provisions.

2. Treas. Reg. § 1.704-1(b)(2)(iv)(f) should be modified to allow a lower tier partnership (LTP) to revalue its assets when an upper-tier partnership (UTP) revalues its interest in the LTP. In the event of such a revaluation, Treas. Reg. § 1.704-1(b)(2)(iv)(f)(4) should be modified to require the UTP's allocation of its distributive share of LTP items to take account of the variation between the adjusted tax basis and book value of the LTP's property consistent with section 704(c) principles.

Treas. Reg. § 1.704-1(b)(2)(iv)(f) provides that a partnership agreement may, upon the occurrence of certain events, increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership's books. Treas. Reg. § 1.704-1(b)(2)(iv)(f)(4) provides that if a partnership revalues its property, the partnership agreement must require that the partners' distributive shares of depreciation, depletion, amortization, and gain or loss as computed for tax purposes with respect to such property, be determined so as to take account of the variation between the adjusted tax basis and book value of such property in the same manner as under section 704(c).

If a partnership (the UTP) revalues its assets, and such assets include an interest in another partnership (the LTP), the regulations do not currently prescribe a corresponding revaluation of the LTP's assets. In the absence of a revaluation at the LTP, the UTP's distributive share of the LTP's profits and losses cannot take into account the variation between the adjusted tax basis and fair market value that existed in each of the LTP's assets at the time of the UTP's revaluation. As a result, any realized gains and losses flowing from the LTP would be treated as section 704(b) items and allocated in accordance with the current sharing regime for such items at the UTP. Any section 704(c) differentials attributable to the investment in the LTP would remain unaccounted for until disposition of the investment in the LTP. Where the investment in the LTP is long term, this may result in timing and character differences, and potentially the inappropriate shifting of recognized built-in gain and losses among the partners of the UTP.

This situation presents a particularly prominent issue for publicly traded partnerships (PTPs), the interests of which must be fungible under SEC regulations. To accomplish this result, PTPs must often apply section 704(c) to allocations from LTPs as if the PTP held the LTP's assets directly. Existing authorities do not definitively provide for such an allocation.

Allowing an UTP to take the unrealized gains and losses of a LTP into account in applying section 704(c) would be consistent with analogous existing rules. Treas. Reg. § 1.704-3(a)(9) provides that if a partnership contributes section 704(c) property to a second partnership (the LTP), or if a partner that has contributed section 704(c) property to a partnership contributes that partnership interest to a second partnership (the UTP), the UTP must allocate its distributive share of LTP items with respect to that section 704(c) property in a manner that takes into account the contributing partner's remaining built-in gain or loss.

3. Partnerships should generally be allowed to either collapse section 704(c) layers or maintain section 704(c) layers. Further, if the IRS decides to generally require the collapsing of section 704(c) layers, partnerships should be allowed to require that layers be maintained when applying the remedial method.

In the absence of definitive guidance, taxpayers have developed various methodologies for applying section 704(c) both to contributed properties that have subsequently been revalued and to properties that have undergone multiple revaluations under Treas. Reg. § 1.704-1(b)(2)(iv)(f). In general, we recommend that taxpayers who have developed such methodologies should be allowed to continue applying those methodologies, provided that they otherwise represent a reasonable method consistent with the purpose of section 704(c) as is required under Treas. Reg. § 1.704-3(a)(1). Maintaining layers consistently is the most accurate way to track the economics of the partnership to each partner for each period. It is, however, burdensome, expensive, and perhaps unnecessary in many situations.

Accordingly, in general, prospective guidance should allow taxpayers to either collapse or to maintain section 704(c) layers.

Even if the IRS ultimately does not generally allow for layer tracking, it may nevertheless be appropriate to allow partnerships to stipulate in their agreement that the partnership must maintain separate layers where the remedial allocation method described in Treas. Reg. § 1.704-3(d) is chosen with respect to a property. The remedial method ensures that the correct cost recovery and gain or loss is allocated to each partner even if it is necessary to create notional amounts. A partner who enters into a partnership under an agreement to use the remedial method should not be concerned that the remedial layer will be blended into a collapsed layer that may not be subject to the remedial method which would disrupt the accuracy of his/her agreement.

4. The special aggregation rule for securities partnerships under Treas. Reg. § 1.704-3(e)(3) should be expanded to apply to non-securities partnerships.

Treas. Reg. § 1.704-3(e)(2) allows the aggregation of specified types of property for purposes of making allocations under section 704(c), provided such property is contributed by one partner during the partnership taxable year. The types of property that may be aggregated under this rule are limited to (i) property other than real property that is included in the same general asset account of the contributing partner and the partnership under section 168, (ii) property with a basis equal to zero, other than real property, and (iii) for partnerships that do not use a specific identification method of accounting, each item of inventory, other than qualified financial assets.

Treas. Reg. § 1.704-3(e)(3) provides that for purposes of making reverse section 704(c) allocations, a securities partnership may aggregate gains and losses from qualified financial assets using any reasonable approach that is consistent with the purpose of section 704(c). The regulations describe two approaches for aggregating reverse section 704(c) gains and losses that are generally reasonable (the Full Netting and Partial Netting approaches), and indicates that other approaches may be reasonable in appropriate circumstances. The regulations further provide that a partnership using section 704(c) aggregation must separately account for any built-in gain or loss from contributed property. Thus, section 704(c) aggregation is not available under current regulations with respect to forward section 704(c) property.

The Full Netting and Partial Netting approaches described by Treas. Reg. § 1.704-3(e)(3) greatly simplify the application of section 704(c) to qualifying partnerships by eliminating the need to track each partner's share of the revaluation gain or loss associated with any given asset. Instead, the partnership tracks each partner's share of the partnership's cumulative unrealized gains and losses on a gross or net basis, (respectively, Revaluation Accounts). The partnership's taxable gains and losses are then specially allocated in proportion and to the extent of each partner's Revaluation Account.

Treas. Reg. § 1.704-3(e)(4)(i) authorizes the Commissioner, by published guidance or by letter ruling, to permit the aggregation of properties other than those described in Treas. Reg. §§ 1.704-3(e)(2) and 1.704-3(e)(3). Whether by exercise of this authority or by regulation, the IRS should allow an approach similar to those described in Treas. Reg. §§ 1.704-3(e)(2) and 1.704-3(e)(3) to partnerships other than securities partnerships. We believe this can be accomplished in a manner that reasonably reflects the purpose of section 704(c) to avoid the inappropriate shifting of gains and losses, while substantially reducing the associated administrative burden. The availability of such a method would greatly reduce the complexity of applying section 704(c), particularly for partnerships with large numbers of assets, numerous partners or which are subject to frequent revaluations.

For example, a partnership could maintain an account for each partner representing his share of the partnership's overall unrealized gain or loss. The built-in gain or loss associated with each asset or group of assets would continue to be separately maintained for the purpose of determining annual differences between section 704(b) book income and taxable income. Such annual differences could then be allocated in proportion to each partner's unrealized gain or loss account. The application of this expanded aggregate approach could be limited solely to section 704(b) book-tax differences created by revaluations, or could include unrealized gain or loss on contributed property.

5. The definition of "small disparity" for purposes of the special rule under Treas. Reg. § 1.704-3(e)(1) should be modified to refer to a total gross disparity that does not exceed $250,000.

Treas. Reg. § 1.704-3(e)(1) provides that if a partner contributes one or more items of property to a partnership within a single taxable year of the partnership, and the disparity between the book value of the property and the contributing partner's adjusted tax basis in the property is a small disparity, the partnership may either use a reasonable section 704(c) method, disregard the application of section 704(c) to the property, or defer the application of section 704(c) to the property until the disposition of the property.

For this purpose, a disparity between book value and adjusted tax basis is a small disparity if the book value of all properties contributed by one partner during the partnership taxable year does not differ from the adjusted tax basis by more than 15 percent of the adjusted tax basis, and the total gross disparity does not exceed $20,000. We believe the gross disparity threshold for this exception should be increased to $250,000, consistent with statutory thresholds for mandatory basis adjustments under sections 734 and 743.

Section 734 requires that the basis of a partnership's property be adjusted in the case of certain distributions to partners where the partnership has made a section 754 election or where there is a "substantial basis reduction" with respect to such distribution. For this purpose, there is a substantial basis reduction with respect to a distribution if the amount of the adjustment computed under section 734(b) exceeds $250,000. Similarly, section 743 requires that the basis of partnership property be adjusted in the case of certain transfers of partnership interests where the partnership has made a section 754 election or where there is a "substantial built-in loss" immediately after the transfer. For this purpose, a partnership has a substantial built-in loss with respect to a transfer of an interest if the partnership's adjusted basis in its property exceeds by more than $250,000 the fair market value of such property.

Prior to statutory changes in 2004, basis adjustments under sections 734 and 743 were elective. Congress originally made these provisions elective in recognition of the potential administrative burden associated with calculating and tracking the tax effects of the adjustments. The American Jobs Creation Act of 2004 amended the statute to require basis adjustments in the case of a substantial basis reduction or substantial built-in loss. The legislative history indicates that the reason for the change was that Congress believed the elective nature of these adjustments facilitated the inappropriate transfer of losses among partners. Nevertheless, Congress apparently believes that the potential administrative complexity of these provisions outweighs the potential for loss shifting where the built-in loss does not exceed $250,000.

Like sections 734 and 743, section 704(c) is intended to prevent the inappropriate shifting of gains and losses among partners. And like sections 734 and 743, the application of section 704(c) may impose significant administrative burdens on taxpayers. Accordingly, we believe the threshold for mandatory application of section 704(c) should be consistent with the thresholds Congress believes are appropriate for the mandatory application of sections 734(b) and 743(b).

Alternatively, and at a minimum, we believe the threshold of the small disparities exception should be increased to $50,000 to reflect inflation since publication of the regulation on December 22, 1993.

6. The "aggregate approach" should apply to tiered partnerships only when the UTP contributes property to the LTP, when a partner of a LTP contributes its interest to an UTP, when the UTP controls the LTP, or when the LTP otherwise agrees to revalue its capital.

As discussed, Treas. Reg. § 1.704-3(a)(9) provides that section 704(c) principles apply when property is contributed by an UTP to a LTP, or if a partner of a LTP contributes its interest to an UTP. As such, it appears that an "aggregate approach" is applied with respect to these tiered partnership situations.

When property is contributed by an UTP to a LTP, the LTP will account for the disparity between the value of the assets and their adjusted tax basis. The UTP could revalue its LTP interest to reflect the built-in gain or loss in the property contributed to the LTP, so that it may allocate its distributive share of section 704(b) and tax items flowing from the LTP to the partners of the UTP in a manner that eliminates the book-tax disparities at the UTP level. Similarly, the UTP could revalue its LTP interest each time the LTP revalues its assets.

When an interest in the LTP is contributed to the UTP with a built-in gain or loss that exceeds the built-in gain or loss in the property the contributing partner previously transferred to the LTP, it is not clear whether an adjustment at the LTP should be made for the additional built-in gain or loss that is reflected in the interest transferred by that partner to the UTP. Treas. Reg. § 1.704-1(b)(2)(iv)(q) provides that if the capital account maintenance rules in Treas. Reg. § 1.704-1(b)(2)(iv) fail to provide guidance on how adjustments to the capital accounts of the partners should be made to reflect adjustments to partnership capital, such capital accounts will not be considered maintained in accordance with the capital account maintenance rules unless the adjustments are made in a manner that maintains equality between the partnership's books and the partners' section 704(b) capital accounts, is consistent with the underlying economic arrangement, and is based, when practicable, on Federal tax accounting principles. However, it is not clear whether this rule permits the use of the aggregate approach in these tiered partnership situations.

We recognize the importance of maintaining section 704(c) allocations at the LTP and UTP levels to ensure that tax items are allocated through the tiers in a manner that properly accounts for all section 704(b) book-tax disparities. It appears that over time, a pure aggregate approach to tiered partnerships would eliminate or minimize section 704(b) book-tax disparities and prevent the shifting of the built-in gain or loss in all contributed or revalued property. However, the aggregate approach may not be administrable in all situations. For example, an UTP may not have access to the information used by the LTP to compute the LTP's revaluation adjustment, or have access to its current year distributive share of section 704(b) book items, unless the UTP controls the LTP or the LTP otherwise agrees to provide this information to the UTP. Similarly, the LTP would not be aware of a revaluation at the UTP level, unless notified by the UTP.

The current tax reporting regime for multi-tiered partnership structures does not facilitate easy access and flow of information between the partnership tiers. UTPs that hold minority interests in LTPs often have difficulty obtaining the LTP Schedules K-1 in sufficient time to compute the amount of taxable income they must include and report on their own Schedules K-1. This is particularly prevalent for partnerships holding interests in widely held private equity funds, hedge funds, or other alternative investment funds. Such partnerships often file their income tax returns just before the extended filing deadline because they do not receive the information they need to prepare their own Form 1065 well in advance of the deadline. Requiring each tier to maintain, allocate, and report the section 704(b) and tax items for each contributed and revalued asset to its partners would place an additional administrative burden on such partnership's tax departments and tax return preparers, and further exacerbate the existing delay in providing tax information to the partners in sufficient time for the partners to incorporate it into their own tax computations. Even in tiered partnership structures with a smaller number of partners, the UTP's distributive share of section 704(b) and tax items related to the LTP's revalued property is not readily available to the UTP. Further, a required revaluation at the LTP level due to a revaluation event at the UTP level imposes section 704(c) computations that may affect the tax allocations among all the partners at the LTP, and not just with respect to the UTP. Finally, revaluations impose administrative costs that the LTP should be able to consent to.

In order to maintain a framework that is administratively workable, the aggregate approach should be required for tiered partnerships only in limited circumstances -- that is (1) where the UTP contributes property to the LTP and (2) where a LTP interest that has a section 704(c) attribute is contributed to a UTP. However, we recommend that the aggregate approach be available on an optional basis in situations where the UTP has access to the information necessary to determine its distributive share of section 704(b) and tax items related to contributed or revalued property, that is, if the UTP controls the LTP, or if the LTP agrees to revalue its property and to provide the corresponding section 704(c) information to the UTP. Control may be defined as ownership of a 50 percent or greater capital and profits interest in the LTP.

We recognize that timing problems may be created at UTP levels if revaluation adjustments are not made each time a property is contributed to or revalued by the LTP, and vice versa. As illustrated in Recommendation #7's example below, the ceiling rule is more likely to apply in a situation where the property contributed to a LTP has not been revalued at the UTP level. However, we believe the costs of complying with the complex mechanical rules of section 704(c) at each level would outweigh the additional tax burden a noncontributing partner of the UTP might face from the application of the ceiling rule. It is possible to write a rule requiring that all of the information necessary to maintaining section 704(c) allocations be shared with the responsible parties, but this would be very burdensome and compliance levels may be low.

7. When the aggregate approach is used by tiered partnerships, section 704(c) should be applied in the same manner that it is applied to single partnerships. Thus, the UTP and LTP should have the flexibility to collapse section 704(c) layers or maintain section 704(c) layers and apply reasonable allocation methods.

When the aggregate approach is applied to the UTP and LTP, the permissible section 704(c) methods should apply in the same way they would apply to single partnerships. Treas. Reg. § 1.704-3(a)(1) provides that when property is contributed by the UTP to the LTP, the LTP is required to allocate tax items to the UTP in a manner that takes into account the difference between fair market value and tax basis (the forward section 704(c) layer), applying one of the permissible methods (traditional, curative, remedial or other reasonable method). Treas. Reg. § 1.704-3(a)(9) requires that the UTP allocate its distributive share of tax items from the LTP in a manner that takes into account the contributing partner's remaining built-in gain or loss. Treas. Reg. § 1.704-1(b)(iv)(f) and § 1.704-3(a)(6)(i) provide that when property is revalued by either the UTP or LTP, the built-in gain or loss in the property created as a result of the revaluation (the reverse section 704(c) layer) is allocated in a manner that takes into account the variation between book value and adjusted tax basis.

When the UTP revalues its LTP interest to reflect the built-in gain or loss in the property transferred to the LTP, the UTP should allocate its distributive share of section 704(b) and tax items from the LTP to its partners in a manner that eliminates the newly created section 704(b) book-tax disparity in the LTP interest. If UTP revalues its LTP interest a second time, the UTP should have the ability to collapse the reverse section 704(c) layers to determine how its distributive share of the LTP's tax items should be allocated to its partners.

For example, assume that in year 1, Partner A contributed an amortizable section 197 intangible asset worth $220 with an adjusted tax basis of $150 for a 50 percent interest. On the date of contribution, the remaining life of this intangible was 10 years. Partner B contributed $220 cash for the other 50 percent interest. Assume that during years 1 and 2, UTP allocated a two-year total of $44 of section 704(b) amortization equally between Partner A and Partner B, and a two-year total of $30 of tax amortization in accordance with the traditional method.

Assume that at the beginning of year 3, UTP contributed the intangible to LTP for an 80 percent interest at a time when the property was worth $200 and had an adjusted tax basis of $120. Partner C contributed $50 of cash to the LTP for the other 20 percent interest.

If LTP applied the traditional method to the contributed property, UTP's share of section 704(b) and tax items for years 3 and 4 would be computed as follows:

                                        UTP                 Partner C

                                    Partner A              Partner B

Assume that at the beginning of year 5, the contributed intangible is subsequently revalued by the LTP when it is worth $180 and has an adjusted tax basis of $90. At this point, LTP has one forward section 704(c) layer with respect to the intangible ($60) and one reverse section 704(c) layer ($30). When the LTP applies the traditional method to these layers, LTP may allocate the tax amortization on the intangible in any reasonable manner in which UTP and Partner C agree. UTP's share of section 704(b) and tax amortization could be determined as follows:

                                          UTP             Partner C

UTP makes a corresponding revaluation adjustment of $24 to its 80 percent interest in LTP. At this point, UTP has one forward section 704(c) layer³ and two reverse section 704(c) layers with respect to its LTP interest. UTP may collapse its reverse section 704(c) layers for purposes of computing the allocation of its share of LTP's tax amortization. When applying the traditional method to its forward and reverse layers, the UTP should apply a reasonable method for allocating the tax items to partners A and B. UTP could allocate the section 704(b) and tax items to Partner A and Partner B as follows:

                                   Partner A                  Partner B

This example illustrates collapsing section 704(c) layers and one potential method for allocating tax amortization among the partners that have a section 704(b)/tax disparity amount. There may be other methods of collapsing section 704(c) layers (e.g., allowing collapsing solely for reverse built-in loss layers with prior gain layers) or for allocating tax amortization among the partners with a section 704(b) claim. Our recommendation is to allow the partnership the flexibility to either collapse or maintain section 704(c) layers, and to allow the partners the flexibility to negotiate a reasonable allocation of available tax items.

8. Treas. Reg. § 1.704-1(b)(2)(iv)(f) should be modified to permit the UTP to revalue its LTP interest when necessary to allow the UTP to apply the aggregate approach.

Currently, Treas. Reg. § 1.704-1(b)(2)(iv)(f) does not permit the UTP to revalue its assets when property is contributed to, or revalued by a LTP. It is not clear whether Treas. Reg. § 1.704-1(b)(2)(iv)(q) permits this revaluation adjustment. We recommend that Treas. Reg. § 1.704-1(b)(2)(iv)(f) be modified to permit a revaluation adjustment to the UTP's interest in the LTP to enable the UTP to apply the aggregate approach.

9. The section 704(b) book-tax disparities at the UTP level resulting from the application of the "entity approach" should be eliminated when the UTP is liquidated, rather than when the contributed or revalued property is sold by the LTP.

If the "entity approach" is applied, it appears that section 704(b) book-tax basis disparities will be created in the interests held by the partners of the UTP in many situations. This is clearly the case where an UTP admits a new partner and revalues an interest it holds in a LTP, but the LTP does not correspondingly revalue its assets. In such a case, all tax items allocated from the LTP may be treated as section 704(b) items regardless of whether there was a value-basis disparity in those assets at the time that the new partner of UTP is admitted. Section 704(b) book-tax basis disparities can also be created where an UTP does not revalue its LTP interest to reflect the built-in gain or loss in property contributed to the LTP at a time when new partners are admitted to the UTP. In such a case, it appears that the partners who were just admitted to the UTP will not receive the allocation of tax depreciation that corresponds to their distributive share of UTP's section 704(b) depreciation that is passed through from the LTP. As a result, at the end of the depreciable life of the contributed property, such newly admitted partners will have a section 704(b) capital account at the UTP that is less than their tax capital account. When the UTP liquidates for section 704(b) book value, the newly admitted partners should recognize a capital loss (except to the extent recharacterized by section 751(b)).

Assume the same facts in the example above, except that a) Partner D is admitted to the UTP in year 3 on the same date that the intangible is contributed to LTP, and b) UTP does not revalue its LTP interest on this date. Partner D contributes $210 for a 1/3 interest in the UTP. Because the UTP does not revalue its interest in LTP by the $24 of unrealized appreciation in that intangible contributed to the LTP, it appears Partner D may have a $3.34 section 704(b) book-tax capital account disparity at the end of year 4, computed as follows:

                               Partner A        Partner B         Partner D

10. The continuing partnership in a merger should generally be allowed to either collapse section 704(c) layers or maintain section 704(c) layers. Further, if the continuing partnership elects to collapse its section 704(c) layers, it must restart the "seven-year clock" of section 704(c)(1)(B).

The merger of two independent partnerships into one can be effected under different legal forms. In conjunction with the merger, one or more of the historic partners may choose not to become partners of the combined entity, instead choosing to either sell their interests or have their interests redeemed.

Treas. Reg. § 1.708-1(c)(1) provides generally that a merged partnership is considered a continuation of the old partnership whose prior partners own more than 50 percent of the capital and profits of the merged partnership. Treas. Reg. § 1.708-1(c)(3)(i) deems the merger to be effected by the "assets over" form (i.e., the terminating partnership contributes its assets to the continuing partnership in exchange for partnership interests in the continuing partnership, which are then distributed to the terminating partnership's partners in redemption of their interests in the terminating partnership). However, where the merged partnership that is deemed to go out of existence actually liquidates by distributing its assets to its partners who then contribute these assets to the continuing partnership, Treas. Reg. § 1.708-1(c)(2)(ii) will respect the "assets up" form of this transaction in spite of the temporary ownership of the assets by the partners. Pursuant to Treas. Reg. § 1.708-1(c)(4), if a partner in the terminated partnership sells his/her interest in that partnership to the continuing partnership before the merger, the transaction will be accounted for as a sale of an interest to the continuing partnership prior to the merger, assuming the transaction agreement provides for the sale and the selling partner agrees to treat the transaction as a sale under section 741. The regulations do not discuss any other transactions that may result in a partner of either the continuing or terminating partnership not continuing as a partner following the merger.

Proposed Treas. Regs. §§ 1.704-4(c)(4) and 1.737-2(b) provide that an assets over merger does not result in a distribution of assets for purposes of section 704(c)(1)(B) or section 737. Rather, the continuing partnership will inherit the historic forward section 704(c) built-in gain or loss layer that existed in the terminated partnership prior to the merger. The regulation further provides that the seven-year clock will not restart with respect to this historic forward section 704(c) layer. However, the proposed regulation provides that a new forward section 704(c) gain or loss layer will be created for assets deemed contributed by the terminating partnership to the continuing partnership. This new forward section 704(c) layer is equal to the difference between the value of the transferred property and its tax basis at the time of the merger adjusted for any historic forward section 704(c) gain or loss that is deemed to carry over. This new forward section 704(c) layer is allocated to the partners of the terminating partnership who become partners of the consolidated partnership. The historic forward section 704(c) attributes that carried over will continue to be allocated as these were prior to the merger. If a partner sold his/her interest to the continuing partnership prior to the merger, then pursuant to Example 5 of Treas. Reg. § 1.708-1(c)(4), the section 704(c) gain or loss attributes of the selling partner are allocated to the historic partners of the continuing partnership.

Proposed Treas. Reg. § 1.704-4(c) also contains an ordering rule. Under this rule, a post-merger revaluation that reduces a prior section 704(c) gain is deemed to first reduce the forward section 704(c) gain generated in the merger and then the historic section 704(c) gain that existed prior to the merger and which was carried over to the continuing partnership. In other words, the proposed regulation nets built-in loss layers against prior built-in gain layers.

We recommend that the continuing partnership in a merger be allowed to choose to either collapse its section 704(c) layers, as provided in the proposed regulations, or to maintain its existing section 704(c) layers. Maintaining the layers most accurately tracks the economics to the partners. Further, maintaining the layers would not convert the reverse layers into forward layers that would be subject to the seven-year clock. By maintaining the historic forward section 704(c) layers in a merger, the remaining built-in gain subject to the terminating partnership's seven-year clock can be easily tracked. Maintaining the section 704(c) layers is more complex, however, and we recommend that a partnership be allowed to weigh the benefits against the costs of performing these calculations.

11. The new partnership created in a division should generally be allowed to either collapse section 704(c) layers or maintain section 704(c) layers. Further, if such new partnership elects to collapse its section 704(c) layers, it must restart the seven-year clock.

Treas. Reg. § 1.708-1(d) contains the rules applicable to partnership divisions. This regulation provides that the original partnership continues if one of the post-division partnerships has partners who owned over 50 percent of the profits and capital of the original partnership. Where the legal form of the division is undertaken in a manner that the partnership assets are distributed to the partners (in such a manner that the partners take legal title to the assets), the form will be respected for tax purposes as an "assets up" division. In all other cases, the division will be treated as occurring through the "assets over" form. Neither this regulation nor proposed Treas. Reg. § 1.704-4 addresses the taxation of a partnership division under sections 704(c)(1)(B) and 737.

Treas. Reg. § 1.708-1(d)(3)(A), which discusses the assets over form, provides that when at least one resulting partnership is a continuation of the prior partnership, the divided partnership is deemed to contribute certain assets and liabilities to a recipient partnership. The divided partnership is the partnership that is treated as a continuation of the prior partnership (i.e., the original partnership) under the regulations. The recipient partnership is the post-division partnership that is treated as newly formed under the regulations. The divided partnership may have one or more section 704(c) layers. The divided partnership's remaining section 704(c) gain or loss at the time of the division may consist of one or more layers related to previously contributed property, and one or more layers related to revaluation adjustments. The layers related to previously contributed property are subject to sections 704(c)(1)(B) and 737, but one layer may have more time remaining on "the clock" than the other layer. The revaluation layers are not subject to section 704(c)(1)(B) or section 737.

We recommend that divided partnerships have the option to choose whether to maintain their section 704(c) layers or to net them, with one exception. If assets transferred to the new partnership in an assets-over transaction have a historic forward section 704(c) built-in gain or loss associated with them and the historic contributing partners continue as partners in the new partnership, we suggest that the historic built-in gain or loss be carried over to the new partnership and tracked to the original contributors for purposes of applying sections 704(c)(1)(B) and 737, similar to the proposed treatment of historic layers of a terminating partnership in the proposed merger regulations discussed above. A new section 704(c) layer would be created to the extent that the fair market value of the contributed assets is greater than their tax bases, after adjustments for the carried forward historic section 704(c) built-in gain or loss. Furthermore, where the historic forward section 704(c) layer is thus maintained, the seven-year clock will not be restarted.

² The unrealized appreciation is $420 gross asset value ($200 value in section 197 intangible plus $220 cash) less $396 remaining section 704(b) basis of the assets ($176 remaining section 704(b) basis in section 197 intangible plus $220 cash).

³ The forward section 704(c) layer relates to A's contribution of the intangible in year 1. The LTP interest received by UTP in year 3 is the substituted basis property that is treated as section 704(c) property under Treas. Reg. § 1.704-3(a)(9).