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Correction narrows scope of recently-issued regs that close corporate partner loophole

Click here for TD 9722, Partnership Transactions Involving Equity Interests of a Partner, as corrected.

IRS has corrected temporary regs that were issued June 12, 2015, that prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving equity interests of the partner.The correction somewhat narrows the scope of the regs.

Background.Code Sec. 304(c) defines the term “control” or a corporation, for purposes of the rules involving corporation redemptions using related corporations, to include ownership of stock of a corporation possessing at least 50% of the total combined voting power of all classes of the corporation’s stock that is entitled to vote or at least 50% of the value of the shares of all classes of stock of the corporation.The definition of “ownership” for this purposes incorporates all of the constructive ownership rules of Code Sec. 318, subject to a few modifications.

Code Sec. 318(a)(1) provides that stock owned directly or indirectly by family members is deemed owned by an individual.Code Sec. 318(a)(3) provides that stock owned directly or indirectly by the partners, beneficiaries and certain shareholders, is deemed owned by their partnership, trust or corporation, respectively.

In General Utilities & Operating Co., (S Ct 1935) 16 AFTR 112616 AFTR 1126, the Supreme Court held that corporations generally could distribute appreciated property to their shareholders without the recognition of any corporate-level gain (theGeneral Utilitiesdoctrine).Beginning in ’69, Congress enacted a series of statutory changes that limited and ultimately repealed theGeneral Utilitiesdoctrine.Code Sec. 337(d) permits IRS to prescribe regs that are necessary or appropriate to carry out the purposes of theGeneral Utilitiesrepeal.And, under Code Sec. 311(b) and Code Sec. 336(a), a corporation that distributes appreciated property to its shareholders is required to recognize gain determined as if the property were sold to the shareholders for its fair market value (FMV).

Late in ’92, IRS issued proposed regs (’92 proposed regs) that contained two rules to protect the repeal of theGeneral Utilitiesdoctrine.The “’92 deemed redemption rule” provided that a corporate partner would recognize gain at the time of, and to the extent that, any transaction (or series of transactions) has the economic effect of an exchange by the partner of its interest in appreciated property for an interest in its stock (or the stock of any member of the affiliated group of which such partner is a member) owned, acquired, or distributed by the partnership.The “’92 distribution rule” provided that a partnership’s distribution to a corporate partner of stock in the corporation would be treated as a redemption or an exchange of that stock for a portion of the partner’s partnership interest with a value equal to the distributed stock.

Temporary regs issued in June, 2015.The temporary regs that were issued in June, 2015 (see Weekly Alert ¶  20  06/18/2015) retain the ’92 deemed redemption rule with certain modifications, and remove the ’92 distribution rule.Instead, the regs apply the deemed redemption rule to partnership distributions of “Stock of the Corporate Partner” to the “Corporate Partner” (defined below) as though the partnership amended its agreement, immediately before the distribution, to allocate all of the distributed stock to the Corporate Partner.(Reg. § 1.337(d)-3T(b))

The temporary regs define “Stock of the Corporate Partner” to include the Corporate Partner’s stock, and other equity interests, including options, warrants, and similar interests, in the Corporate Partner or a corporation that controls (under Code Sec. 304(c)) the Corporate Partner; it also includes interests in any entity to the extent that the value of the interest is attributable to Stock of the Corporate Partner.(Reg. § 1.337(d)-3T(c)(2))

The temporary regs are effective June 12, 2015,

Reg correction narrows definition of “Stock of the Corporate Partner.”IRS has announced, and published in Internal Revenue Bulletin 2015-26 (June 29, 2015), a correction to the definition of “Stock of the Corporate Partner” for purposes of the above rules.Under that correction, the above “corporation that controls (under Code Sec. 304(c))” phrase has been narrowed to provide for control under Code Sec. 304(c) “except that Code Sec. 318(a)(1) and Code Sec. 318(a)(3) shall not apply.”(Reg. § 1.337(d)-3T(c)(2)(i))

References:For exchange by corporate partner for its stock, see FTC 2d/FIN ¶  B-1411  et seq.; United States Tax Reporter ¶  3374.03  .

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