The regulations under Sec. 708 set forth detailed rules governing the federal income tax consequences of a partnership merger. They lack, however, clear guidance on when a transaction resulting in the combination of two partnerships into a single partnership constitutes a merger governed by those regulations. The lack of guidance is especially problematic for determining the federal income tax consequences when a taxpayer collapses two partnerships—one an upper-tier partnership, or UTP, and the other a lower-tier partnership, or LTP—into a single entity.
The lack of a merger definition means that the tax characterization can vary dramatically depending on how the transaction is viewed. To illustrate possible different treatments, consider this scenario.
Example: X, Y, and a UTP own 10%, 10%, and 80% interests, respectively, in an LTP. Neither X nor Y holds an interest in the UTP. The parties agree to consolidate the two entities by having X and Y contribute their LTP interests to the UTP in exchange for interests in the UTP. For state law purposes, both legal entities still exist after the transaction, although for federal income tax purposes only one partnership remains. The remaining partnership is owned 10% by X, 10% by Y, and 80% by the UTP's former partners.
Because of the lack of guidance on partnership mergers, there appear to be at least three potential characterizations of this transaction for federal income tax purposes.
Alternative 1: LTP Merges Into UTP
It is generally thought a merger exists in any case in which (1) at least two tax partnerships exist immediately before a transaction, (2) immediately after the transaction only one tax partnership exists, and (3) the equity holders of each of the preexisting tax partnerships become equity holders in the single remaining tax partnership as part of the transaction. From this perspective, the transaction could be viewed as a merger because two partnerships existed at the beginning of the day and only one partnership remains at the end.
Sec. 708(b)(2)(A) provides:
In the case of a merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of this section, be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership [(the ownership test)].
Here, determining which of the LTP or the UTP should be considered the continuing partnership depends on whether an aggregate or entity approach to partnerships is taken.
Under an entity approach, of the historic partners of the LTP (X, Y, and the UTP), only X and Y hold interests in the resulting partnership (20%). The historic partners of the UTP hold the remaining 80% interest in the resulting partnership. Accordingly, the resulting partnership would appear to be considered a continuation of the UTP. This result depends on treating the UTP as an entity for purposes of applying the ownership test.
If the UTP were treated as an aggregate, then arguably both partnerships would be treated as continuations, but under Regs. Sec. 1.708-1(c)(1), the resulting partnership would be treated as a continuation of the LTP because the net value of the LTP's assets exceeded the net value of the UTP's assets. The aggregate approach appears to be inconsistent with the entity-level focus of Sec. 708, but if it were applied, the application of the merger rules would be largely consistent with the liquidation of the UTP and continuation of the LTP characterization discussed below. Under Regs. Sec. 1.708-1(c)(3)(i), the form of a merger then would be characterized as the LTP contributing all its assets and liabilities to the UTP for a "hook" interest, with the LTP then making a liquidating distribution of the new UTP interests to its partners (UTP, X, and Y).
The merger characterization may not be an exact fit for this transaction because a common expectation of a merger is that the resulting entity will go forward with a combination of assets and operations obtained from the merged entities. In this transaction, there has been no combination of assets and operations. The historic holding company activity of the UTP has disappeared, and the historic operating activity of the LTP has survived without any change other than the identity of the majority of its direct owners. Furthermore, application of the ownership test appears inconsistent with the realities of the transaction because the UTP would be viewed as the continuing partnership despite contributing no real assets in the transaction, while the LTP is deemed to terminate despite being the source of all the assets.
Alternative 2: UTP Liquidates and LTP Continues
If the results of the merger characterization do not quite fit the economic realities of the transaction, Sec. 708 suggests an alternative characterization. Sec. 708(a) provides that an existing partnership shall be considered as continuing if it is not terminated, and Sec. 708(b)(1)(A) provides that a partnership will be considered terminated if no part of its business, financial operation, or venture is carried on by any of its partners in a partnership form. Under this rule, the LTP would be treated as continuing because the LTP's historic business would still be operated in partnership form, while the UTP would be treated as terminating because its historic business—holding an investment in the LTP—would no longer exist.
If the LTP is considered to continue, then the substance of the transaction appears to be a liquidation of the UTP. Under a liquidation scenario, the UTP is deemed to make liquidating distributions of the LTP interests to its partners, and, pursuant to Sec. 732(b), the partners would take a substituted basis in the LTP interest received.
The UTP's liquidation view gives effect to the requirements of Secs. 708(a) and 708(b)(1)(A) and avoids creating a new layer of Sec. 704(c) gain, but it seems out of line with the form of the transaction. The partners that actually engage in a transaction (X and Y) are treated as doing nothing, while the partners of the UTP (which do not engage in a state law transaction) are treated as exchanging their interests in the UTP for interests in the LTP.
Alternative 3: X and Y Contribute LTP Interests in a Sec. 721 Transaction
As a third alternative, it may be appropriate to give effect to the form of the transaction (a Sec. 721 contribution of interests in the LTP by X and Y to the UTP). Following the contribution, the UTP would hold all the partnership interests in the LTP, and the LTP would terminate under Sec. 708(b)(1)(A).
This perspective is similar to what is described in Rev. Rul. 99-6, Situation 1, in which Partner B purchases, in a taxable transaction, the partnership interests held by Partner A. Under the ruling, Partner A is treated as selling its interest to Partner B, but Partner B must treat the transaction as if (1) the partnership made a liquidating distribution of a proportionate interest in the partnership assets to Partner A; (2) Partner A sold its proportionate interest in assets to Partner B; and (3) Partner B received a liquidating distribution of its proportionate interest in assets from the partnership.
As with the merger characterization, this viewpoint appears to create a layer of Sec. 704(c) gain for X and Y. In addition, it is not clear that Rev. Rul. 99-6 was intended to apply to a nonrecognition transaction. If it was intended to apply to this transaction, it is not clear that the Sec. 721 contribution viewpoint can be reconciled with the terms of Sec. 708(b)(1)(A). If the model of Rev. Rul. 99-6 is followed, the LTP would terminate under Sec. 708(b)(1)(A), but this characterization is inconsistent with the terms of the statute because X and Y continue to be partners with regard to the historic operations of LTP. Under existing case law (Byrum, 440 F.2d 949 (6th Cir. 1971), aff'd, 408 U.S. 125 (1972)), a revenue ruling may be disregarded if it conflicts with the statute it purports to interpret.
Conclusion
None of these three characterizations appears to meet all of the existing guidance and policies of the transaction. The absence of a definition of "merger" for purposes of Sec. 708 makes it difficult for taxpayers to know how to appropriately apply the U.S. federal income tax rules when faced with choosing among at least these three possible characterizations and possibly more when a holding partnership structure is collapsed.
EditorNotes
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
