The partner-to-partner attribution trap and the anti-churning rules

By Richard D. Liebman, CPA, J.D., Chicago; Jerome M. Schwartzman, J.D., LL.M. (Tax), Charlotte, N.C.; and Joanna Zhang, CPA, Fort Lauderdale, Fla.

Editor: Kevin D. Anderson, CPA, J.D.

Any time taxpayers are dealing with tax basis step-up transactions involving related parties or rollover equity interests, consideration should be given to the application of the anti-churning rules to avoid any surprises or unforeseen results. Consider the following:

Example: Target X, a domestic LLC that is treated as a partnership for federal income tax purposes, was engaged in an active trade or business before Aug. 10, 1993, and is owned 50/50 by Partners A and B. W, a limited partnership formed by private-equity funds, incorporated Buyer Z, a C corporation, to purchase Target X. As a part of the transaction, Buyer Z purchased 100% of the LLC interests of Target X from Partners A and B. The transaction was a deemed asset purchase under Situation 2 in Rev. Rul. 99-6. In connection with the transaction, Partner A invested in the equity of partnership W, receiving a 1% capital and profits interest. A was the only individual partner in partnershipW.

A trap for the unwary

The anti-churning rules under Sec. 197(f)(9) were adopted in 1993 to prevent the amortization of goodwill or going concern value acquired by a taxpayer if the intangible was held or used by the taxpayer or a "related" person before Aug. 10, 1993.

To determine whether a person is related to any person when applying the anti-churning rules, Sec. 197(f)(9) refers to Secs. 267(b) and 707(b)(1), substituting "more than 20%" for "more than 50%" when applying both Code sections.

Sec. 267(c) provides rules for constructive ownership of stock when determining whether taxpayers are related under Sec. 267(b). Sec. 267(c) contains both a vertical and a horizontal attribution rule. Sec. 267(c)(1), which contains the vertical attribution rule, requires stock owned by an entity to be attributed upward to its shareholders, partners, or beneficiaries. Sec. 267(c)(3) provides a horizontal attribution rule and attributes to an individual partner the stock owned, directly or indirectly, by or for his partner.

Applying the statutory language of Sec. 267(c)(3) literally leads to a trap for the unwary because Partner A would be treated as owning 100% of Buyer Z, since Partner A is deemed to own the 99% of Buyer Z stock indirectly owned by the private-equity funds in addition to the 1% interest in Buyer Z owned indirectly due to his actual 1% interest in W. Under this literal application of the attribution rules, the anti-churning rule would be triggered to disallow any amortization expense attributable to the goodwill or going concern value purchased from TargetX.

Potential narrower interpretation of Sec. 267(c)(3)

IRS Letter Ruling 201208025 discusses a publicly traded company that owned certain subsidiaries, which met the ordinary gross income requirement of Sec. 542(a)(1) on a separate-company basis. The publicly traded company appears to have been owned by several private-equity funds and sought a ruling from the IRS that the company did not meet the stock ownership requirement under Sec. 542(a)(2) so that it would not be classified as a personal holding company (PHC). The IRS ruled that when stock of a potential PHC is owned by a partnership, corporation, estate, or trust, Sec. 544(a)(1) provides that this stock is treated as being owned proportionately by the entities' shareholders, partners, or beneficiaries. This language excludes these entities from being considered to be the owner of the potential PHC stock, and attributes any direct or indirect interest in the potential PHC only to individuals.

After the stock is allocated to individuals, Sec. 544(a)(2) provides that an individual is considered as owning the stock, directly or indirectly (after indirect allocations under Sec. 544(a)(1)), by or for his family or by or for his partners, and is applied to attribute ownership between those individuals who directly own the stock or who have been allocated the indirect interests in the PHC under Sec. 544(a)(1). According to the approach adopted by the IRS in Letter Ruling 201208025, if a partner is an entity, any stock vertically attributed to the entity partner cannot be horizontally attributed to an individual partner of the same partnership under Sec. 544(a)(2).

Soon after the publishing of Letter Ruling 201208025, the New York State Bar Association (NYSBA) requested IRS guidance on the application of Sec. 267(c)(3) to stock held by partners that are not individuals, and included this suggestion as one of the items that the NYSBA recommended for the 2012-2013 IRS Tax Guidance Priority List (New York State Bar Association Tax Section, Recommendations for 2012-2013 Tax Guidance Priority List (Report No. 1263, April 24, 2012)).

The predecessor of Sec. 267 was enacted by the Revenue Act of 1937, which also amended the predecessor of Sec. 544(a)(2). When the predecessor of Sec. 544(a)(2) was enacted in 1936, it provided stock ownership attribution only between an individual and specified family members. The Revenue Act of 1937 expanded the scope of the predecessor of Sec. 544(a)(2) to include the stock of a partner of such individual because of the close business relationship between partners. The Senate report on the Revenue Bill of 1937 provides: "Because of the close business relationship existing between members of a partnership, your committee is of the opinion that it is proper to extend the provision so as to include in determining the ownership of stock by an individual the stock owned by or for a partner of such individual" (S. Rep't 1242, 75thCong. 1st Sess., at 9 (1937)). The Revenue Act of 1937 modeled the predecessor of Sec. 267(c)(3) on the predecessor of Sec. 544(a)(2). The House committee report states: "Amendments made [to now Sec. 267(c)] further strengthen the existing law by applying, for the purpose of determining stock ownership in a corporation, substantially the same rules as used in determining the stock ownership of a personal holding company" (H.R. Rep't 75-1546, 75th Cong. 1st Sess., at 7 (1937)).

When the partner-to-partner attribution rules were enacted, partnerships were mostly closely held by individuals and family members, and partners had close fiduciary and business relationships between each other. The Senate report on the Revenue Bill of 1937 appears to recognize this rationale to justify the extension of family attribution in the predecessor of Sec. 544(a)(2) to include stock directly or indirectly owned by a partner of that individual. The House committee report further indicates Congress's intention of adopting the same theory as applied for the predecessor of Sec. 544(a)(2) to strengthen the attribution rule for the predecessor of Sec. 267(c)(3). The IRS has implicitly recognized the legislative intent underlying the partner-to-partner attribution rule in the letter ruling and restricted the application of Sec. 544(a)(2) to individual partners.

Congress used the identical wording for Secs. 544(a)(1) and 267(c)(1) to provide rules for upward attribution. Sec. 544(a)(2) and Sec. 267(c)(3) partner-to-partner attribution are the same in substance. Thus, it is logical and reasonable to apply the same interpretation of these Code sections.

Also, the purpose of Sec. 197(f)(9) is to prevent a direct or an indirect owner of goodwill that was not amortizable under pre-August 1993 tax law from transferring ownership of that goodwill after Sec. 197 made goodwill amortizable, in order to obtain amortization deductions while maintaining significant direct or indirect ownership of that goodwill. The measure of significant ownership chosen in the statute is 20%. Sec. 267 is the rule chosen for determining indirect ownership that applies to Sec. 197(f)(9) in the facts described above, and Sec. 267 was enacted long before Sec. 197. Read literally, Sec. 267(c)(3) can operate to create 20%-or-greater indirect ownership of transferred goodwill when there is no close business or fiduciary relationship between individual and entity partners, as in the example discussed previously. This broad reading of Sec. 267(c)(3) can lead to an outcome that is inconsistent with the congressional intent for Sec. 197(f)(9).

Possible solutions to mitigate the impact of Sec. 267(c)(3)

To mitigate the uncertainties around Sec. 267(c)(3), horizonal attribution can be cut off by using a partnership as an acquisition vehicle instead of a corporation. If such a strategy is adopted, Sec. 707(b) would be the controlling Code section in determining whether two parties are considered to be related for purposes of the anti-churning rules, and Sec. 267(b) would not apply. Congress specifically carved out the Sec. 267(c)(3) partner-to-partner attribution under Sec. 707(b)(3) for purposes of applying the Sec. 707(b) related-party rules, and the issue that was discussed previously can be avoided entirely, provided the rollover equity individual partner owns less than 20% of the equity interest in the upper-tier partnership.

Requiring all individual rollover investors to invest in the top partnership through a separate S corporation or partnership (entity investor) could be an alternative solution. Because an S corporation or partnership is not an individual, stock vertically attributed to the private-equity fund cannot be horizontally attributed to an individual investor who holds his or her partnership interest through an entity investor. Therefore, so long as the constructive equity interests held by all individual investors in the top partnership are less than 20%, none of the goodwill acquired would be subject to anti-churning rules under Sec. 197(f)(9). Finally, making a Sec. 754 election as part of the acquisition may avoid application of the anti-churning rules (see Regs. Secs. 1.197-2(g)(3) and 1.197-2(k), Example (19)).

While the technical application of the anti-churning rules may be overly broad because Congress relied upon the Sec. 267 related-party rules for Sec. 197(f)(9) purposes, a well-advised taxpayer may be able to avoid the loss of goodwill and going concern tax amortization with proper planning. The authors also encourage Congress and Treasury to revisit the application of the Sec. 267 attribution rules in light of current trends where partners may not have the close personal relationship they were presumed to have when the predecessor of Sec. 267(c)(3) was enacted.


Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or

Contributors are members of or associated with BDO USA LLP.

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