IRS Issues Temporary Regulations Under Code Section 337(d)

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By Jonathan A. Stevens, Esq., and W. Justin Hill, Esq.

Baker & McKenzie, New York, NY

In 1992, New Kids on the Block were performing in arenas across the United States, the Batmobile was racing across movie screens, a Clinton was campaigning for the White House and the Treasury Department issued Proposed Regulations under §337(d) (commonly referred to as the "May Company Regulations" named after a transaction involving May Department Stores). Fast forward 23 years to 2015 and not much has changed. New Kids on the Block is still hanging tough, Batman is back in Gotham, a Clinton is running for the White House and the Treasury Department issued Temporary Regulations under §337(d).

On June 12, 2015, the Treasury Department and IRS issued temporary regulations under §337(d) designated as Reg. §1.337(d)-3T (the "Temporary Regulations") that prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving equity interests of the partner. The Temporary Regulations update and modify the May Company Regulations issued in 1992, and apply to transactions occurring on or after June 12, 2015.

Section 337(d) provides that the Treasury Department will prescribe regulations to carry out the purpose of the repeal of the General Utilities doctrine. After the repeal of the General Utilities doctrine, the IRS became concerned that corporate taxpayers were avoiding §311(b) by contributing appreciated property to a partnership and receiving their own stock, which was contributed to the partnership by another partner or purchased by the partnership, in exchange upon the partnership's liquidation. Section 1032 and the provisions of subchapter K could allow the corporate partner to dispose of appreciated property without paying tax. The May Company Regulations were issued to target these types of transactions and set forth two rules, the "deemed redemption rule" and the "distribution rule," in an attempt to prevent the avoidance of §311(b). Under the deemed redemption rule, a partner recognized gain on a transaction that had the economic effect of an exchange by a partner of its interest in appreciated property for an interest in stock of the partner owned by the partnership.  The distribution rule treated the distribution by a partnership to a partner of the partner's stock as a redemption or exchange of the partner's stock for a portion of the partner's partnership interest equal in value to the stock distributed.

The Temporary Regulations generally retain the deemed redemption rule set forth in the May Company Regulations.  The Temporary Regulations apply to a transaction or a series of transactions that have the effect of an exchange by a corporate partner of its interest in appreciated property for an interest in the stock of the corporate partner that is owned, acquired or distributed by the partnership (a "§337(d) Transaction"). Under the new regulations, a §337(d) Transaction may occur if: (1) a corporate partner contributes appreciated property to a partnership that owns stock of the corporate partner; (2) a partnership acquires stock of the corporate partner; (3) a partnership that owns stock of the corporate partner distributes appreciated property to a partner other than the corporate partner; (4) a partnership distributes stock of the corporate partner to the corporate partner; or (5) a partnership agreement is amended in a manner that increases a corporate partner's interest in the stock of the corporate partner. If a partnership engages in a §337(d) Transaction, the corporate partner must recognize gain.

The Temporary Regulations set forth general principles that apply in determining the amount of appreciated property effectively exchanged for stock of the corporate partner. Under these rules, a corporate partner that is engaged in a §337(d) Transaction must recognize gain at the time, and to the extent, that the corporate partner's interest in appreciated property is reduced in exchange for an increased interest in "stock of the corporate partner." Stock of the corporate partner includes stock of a corporate partner that is engaged in the §337(d) Transaction as well as stock of a corporation that controls, within the meaning of §304(c), such corporate partner.

The Temporary Regulations were amended on July 2, 2015, to clarify that in applying the control test in §304(c), upward attribution under §318(a)(2)(C) should be used but downward attribution under §318(a)(3)(C) should not be used. The clarification addresses the concern that downward attribution could be used sweep in stock of lower-tier corporations, which was not the intent as expressed in the preamble of the Temporary Regulations.

There are two rules that impact the basis of the corporate partner and the partnership when gain is recognized on a deemed redemption. The inside tax basis of the appreciated property deemed exchanged for the partner stock is increased by the amount of the gain recognized on the deemed redemption, and the corporate partner's basis in its partnership interest is increased by the same amount.

The Temporary Regulations do not adopt the distribution rule as set forth in the May Company Regulations. Instead, the new regulations extend the deemed redemption rule to cover situations in which a distribution of corporate partner stock has previously been the subject of a §337(d) Transaction or becomes the subject of a §337(d) Transaction as a result of the distribution. In these instances, in addition to any gain recognized under the deemed redemption rule upon the distribution of stock of the corporate partner, the Temporary Regulations also require the corporate partner to recognize gain to the extent that the partnership's basis in the distributed stock of the corporate partner exceeds the corporate partner's basis in its partnership interest immediately before the distribution.  However, this additional gain recognition rule does not apply if the gain recognition or basis reduction rules of §732(f) apply to the distribution.

There are inadvertence and de minimis exceptions in the Temporary Regulations which generally mirror the exceptions set forth in the May Company Regulations. Subject to an anti-abuse rule, the inadvertence exception applies if stock of the corporate partner is disposed of, other than by distribution to the corporate partner or a corporation possessing §304(c) control of the corporate partner, within a specified period. The de minimis exception can apply if the corporate partner and related persons own in the aggregate less than five percent of the partnership and the value of stock of the corporate partner and the partnership's ownership percentage in the stock of the corporate partner are below certain thresholds.  The Temporary Regulations also apply to tiered partnership structures.

Overall, the Temporary Regulations, which were 23 years in the making, incorporate many of the concepts in the May Company Regulations but are clearer and more objective in application.

For more information, in the Tax Management Portfolios, see Zarlenga, 784 T.M., Corporate Liquidations, Starr, 731 T.M., S Corporations: Corporate Tax Issues, and in Tax Practice Series, see ¶4290, Distributions and Repayment of Shareholder Debt.

This article first appeared in Baker & McKenzie's Tax News and Developments, "IRS Issues Temporary Regulations Under Code Section 337(d)" (August 2015, vol. XV, issue 4).

© Baker & McKenzie 2015