april 30, 2010 the honorable william j. wilkins irs chief ......partnership mergers, divisions and...
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April 30, 2010
The Honorable William J. Wilkins
IRS Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, Room
Washington, DC 20224 VIA E-MAIL: [email protected]
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 [email protected] or Marc
A. Hyman, AICPA Technical Manager at (202) 434-9231 or [email protected].
Sincerely,
Alan R. Einhorn
Chair, Tax Executive Committee Cc: Bob J. Crnkovich, Senior Counsel, Treasury (Room 4043 MT)
Curt Wilson, IRS Associate Chief Counsel, P&SI (Room 5300 IR)
Laura Fields, IRS Attorney, P&SI (Room 5010 IR)
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Notice 2009-70: Section 704(c) Layers relating to
Partnership Mergers, Divisions and Tiered Partnerships
Developed by the
Partnership Taxation Technical Resource Panel
Approved by the
Tax Executive Committee
Submitted to
The U.S. Department of the Treasury
The Internal Revenue Service
April 30, 2010
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Notice 2009-70: Section 704(c) Layers relating to
Partnership Mergers, Divisions and Tiered Partnerships
April 30, 2010
The 2007 proposed regulations1 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, the final regulations must 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 believe the final regulations
should also be flexible in allowing the use of either an aggregate or an entity approach with
respect to tiered partnership arrangements.
SUMMARY OF RECOMMENDATIONS
1. Partnerships should be allowed to revalue their assets when the sharing of profits and
losses is altered by agreement.
2. A lower tier partnership (LTP) should be allowed to revalue its assets when an upper-tier
partnership (UTP) revalues its interest in the LTP.
3. Partnerships should generally be allowed to either collapse or maintain section 704(c)
layers.
4. The aggregation rule for securities partnerships should be expanded to apply to other than
securities partnerships.
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.
6. The “aggregate approach” should apply to tiered partnerships only when the UTP
contributes property to the LTP or when a partner of a LTP contributes its interest to an
UTP, and the UTP controls the LTP, or the LTP otherwise agrees to revalue its capital.
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 (e.g., the UTP and
LTP should have flexibility to either collapse or maintain section 704(c) layers).
8. An UTP should be allowed to revalue its LTP interest when necessary to allow 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.
10. The continuing partnership in a merger should generally be allowed to either collapse or
maintain section 704(c) layers.
11. The new partnership created in a division should generally be allowed to either collapse
or maintain section 704(c) layers.
1 REG-143397-05
2
DETAILED 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
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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.
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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
5
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.
6
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
7
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.
8
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.
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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
704(b) Tax 704(b) Tax
Initial Contribution 200 120 50 50
Year 3 Amortization -20 -10 -5 -5
Year 4 Amortization -20 -10 -5 -5
Year 4 Adjusted Capital Accounts 160 100 40 40
To maintain parity in the aggregate approach, assume that in year 3, UTP revalued its LTP
interest to reflect the $24 of unrealized appreciation2 in the property contributed to LTP. UTP
allocated the revaluation adjustments to Partner A’s and Partner B's capital accounts equally. If
UTP applied the traditional method to the revaluation adjustments, UTP's distributive share of
LTP’s section 704(b) amortization ($20) and tax amortization ($10) for years 3 and 4 could be
allocated to Partner A and Partner B in the following manner:
The example illustrates that tax amortization may be allocated in a manner that reduces Partner
A and Partner B's relative section 704(b) book-tax basis disparities proportionately. In the
example, the amount of tax amortization allocated to Partner A and B was computed by
subtracting from their share of UTP’s “look-through” section 704(b) book amortization ($10
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).
Partner A Partner B
704(b) Tax 704(b) Tax
Initial Contribution 220 150 220 220
Year 1 Amortization -11 -4 -11 -11
Year 2 Amortization -11 -4 -11 -11
Year 2 Capital Accounts 198 142 198 198
Year 3 Revaluation adjustment 12 12
Adjusted capital accounts 210 142 210 198
Year 3 Amortization -10 -1.5 -10 -8.5
Year 4 Amortization -10 -1.5 -10 -8.5
Year 4 Capital Accounts 190 139 190 181
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each) the amount of amortization on their disparity amounts ($68 and $12, respectively),
computed over the remaining 8 year tax life of the property ($8.5 and $1.5, respectively).
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
704(b) Tax 704(b) Tax
Year 4 Adjusted Capital Accounts 160 100 40 40
Year 5 Revaluation Adjustment 24 6
Adjusted capital accounts 184 100 46 40
Year 5 Amortization -24 -10 -6 -5
Ending capital accounts 160 90 40 35
LTP can allocate the tax amortization in a manner that reduces UTP and Partner C's section
704(b) book-tax basis disparity proportionately. The amount of tax amortization allocated to
UTP and Partner C was computed subtracting from their share of book amortization ($24 and $6,
respectively) the amount of amortization on their disparity amounts ($84 and $6, respectively),
computed over the remaining 6-year tax life of the property ($14 and $1, respectively).
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:
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).
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Partner A Partner B
704(b) Tax 704(b) Tax
Year 4 Capital Accounts 190 139 190 181
Year 5 Revaluation Adjustment 12 12
Adjusted capital accounts 202 139 202 181
Year 5 Amortization -12 -1.5 -12 -8.5
Ending capital account 190 137.5 190 172.5
Under this method of allocation, Partner A's and Partner B's section 704(b) book-tax basis
disparity is reduced proportionately. The amount of tax amortization allocated to Partner A and
Partner B was computed subtracting from their share of book amortization ($12 each) the amount
of amortization on their disparity amounts ($63 and $21, respectively), computed over the
remaining 6 year tax life of the property ($10.5 and $3.5, respectively).
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-
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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
704(b) Tax 704(b) Tax 704(b) Tax
Year 2 Capital Accounts 198 142 198 198 0 0
Year 3 Contribution 210 210
Adjusted capital accounts 198 142 198 198 210 210
Year 3 Amortization -6.67 0 -6.67 -5 -6.67 -5
Year 4 Amortization -6.67 0 -6.67 -5 -6.67 -5
Year 4 Capital Accounts 184.67 142 184.7 188 196.66 200
This disparity will be eliminated when Partner D receives a distribution of $196.66 in liquidation
of its interest. Upon liquidation, Partner D should recognize a capital loss of $3.34. This result
is inevitable under the entity approach in this fact pattern. The UTP could eliminate the section
704(b) book-tax disparities in Partner B and Partner D's capital account before it liquidates by
applying the curative or remedial method at the UTP level when the LTP sells the property.
However, this would add more complexity to an already complex set of mechanical rules. The
problems created by the entity approach are mostly timing, and perhaps character, and in many
circumstances do not reduce the aggregate tax liability of the partners. Thus, it appears that
partnerships should have the flexibility to determine a reasonable and appropriate section 704(c)
method, as opposed to relying on specific rigid rules prescribed under section 704(c) to correct
these inefficiencies. Where the timing and or character differences associated with the entity
approach are too significant to the partners, the partners should be able to use the aggregate
approach (provided the information is available from the LTP as discussed above).
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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.
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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
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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.
CONCLUSION
As discussed above, we believe that the ability to collapse the section 704(c) layers or to use
section 704(c) aggregation may simplify the application of section 704(c) for many partnerships.
Conversely, where maintaining section 704(c) layers more appropriately accounts for the
partners’ expected tax treatment, taxpayers should be allowed to keep the section 704(c) layers
separate. Further, in a tiered partnership setting, we believe that an aggregate approach may
more precisely account for section 704(b) book-tax disparities and as such, the aggregate
approach should be available in certain circumstances. However, because we believe that it
would be difficult, and perhaps impossible, for some partnerships to accurately apply the
aggregate approach in all situations, such partnerships should have the flexibility to use the entity
approach. The section 704(c) regulations should be written to provide a framework that
simplifies the application of section 704(c) for all taxpayers in nonabusive situations. A
framework that allows partnerships the flexibility to apply section 704(c) in a manner that best
suits their particular fact pattern and administrative capabilities would encourage compliance
with the tax laws and thus prove ultimately to be more beneficial to the government than a more
complex framework that corrects some tax inefficiencies but which – over the life of the
partnership – may not represent a substantial reduction in the aggregate tax liabilities of the
partners.