University of Chicago 2016 Federal Tax Conference

Nothing from Something: Partnership Continuations under Section 708(a)

Phillip GallErnst & Young LLP November 12, 2016

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Nothing from Something: Partnership Continuations under Section 708(a)1

Don’t be fooled by the insipid language of section 708(a): “GENERAL RULE.—For

purposes of this subchapter [i.e., Subchapter K], an existing partnership shall be considered as

continuing if it is not terminated.” Tempting as it is to gloss over a provision that seems so

painfully obvious,2 doing so – as far as these things can go – is perilous. More heft can be found

in section 708(b), which provides that a partnership is considered as terminated (and thus not

continuing), only if “(A) no part of any business, financial operation, or venture of the

partnership continues to be carried on by any of its partners in a partnership, or (B) within 12-

month period there is a sale or exchange of 50 percent or more of the total interest in partnership

capital and profits [(a “technical termination”)].” Said another way, if any part of the business,

financial operation, or venture of the partnership continues to be carried on by any of the partners

in a partnership and there is not a technical termination, the partnership continues. What will

become clear, if it is not already clear from the breadth of that statement, is that there are a lot of

1 I would like to thank my colleague, Monisha Santamaria, for her tireless work andenthusiasm in assisting me with this paper. I would also to thank my partners, Andy Dubroff,David Franklin, Todd Golub, and Franny Wang, and my former partner, Don Turlington, fortheir helpful comments and insights. A special thank you to Monte Jackel and Bob Crnkovichfor their blessings in my use of the title, despite the similarity to the title of their excellent articleon partnership conversions. See Monte A. Jackel and Robert J. Crnkovich, PartnershipConversions: Making Something Out of Nothing, 123 Tax Notes 275 (July 20, 2009). Allsection references are to the Internal Revenue Code of 1986, as amended (the “Code”), or theregulations thereunder.

2 Section 708(a) has been said to “challenge[] the definition of ‘foreign corporation’ forsimple-mindedness.” Henry Jordan and Herman Schneider, New Developments and ExistingProblems in the Taxation of Partnerships and Subchapter S Corporations, 43 Taxes 366, 381(1965). (Section 7701(a)(5) states (and stated in 1965): “The term ‘foreign’ when applied to acorporation or a partnership means a corporation or a partnership which is not domestic.”)

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partnership continuations (sometimes referred to as “partnership F reorganizations”). Be

forewarned, an appreciation for the scope of section 708(a) is a bit like being armed with

Maslow’s hammer.3

Many partnership continuations are readily apparent. For example, a partnership may

continue notwithstanding the death or withdrawal of one of its partners; a partnership may

continue notwithstanding a change in its place of organization or a change in the type of legal

entity; and a partnership may continue notwithstanding the conversion of a partner’s interest

from a common interest to a preferred interest or other amendments to the partnership’s

operating agreement. However, partnership continuations are not always so easy to identify. For

example, a transaction that is legally a sale or transfer of assets to a newly formed legal entity

that has some unrelated members and other assets may be treated as a partnership continuation.

In many cases, treating a partnership as continuing will result in a recast of the transaction to one

that could have vastly different tax consequences than the form would produce. The stakes of

whether a transaction results in a partnership continuation, therefore, involve not only

administrative issues such as whether the partnership’s year ends, its elections terminate, and its

employee identification number (“EIN”) should continue to be used, but also more substantive

issues concerning the proper characterization of the transaction for U.S. federal income tax

purposes. But the stakes don’t end there.

After the transaction is recharacterized in a manner consistent with the continuation

conclusion, a question remains as to the consequences, if any, to the continuing partners in the

3 See Abraham Maslow, The Psychology of Science: A Reconnaissance 15 (1966) (“Isuppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were anail.”).

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continuing partnership: As a legal matter, such partners may own interests that have different

legal and economic rights. Not only might that result in different sharing of partnership

liabilities under section 752 (e.g., if a partner who was a general partner becomes a limited

partner), different treatment for self-employment tax purposes due to the application of the

exception under section 1402(a)(13) (e.g., again, if a partner who was a general partner becomes

a limited partner), or the need to file a check-the-box election (e.g., if the default classification

for the legal entity is not a partnership), but it also raises fundamental questions as to whether the

transaction should be treated as a “tax nothing” or as a realization event.

This paper is divided into three parts. Part I addresses the background of partnership

continuations, focusing on the history of section 708(a) and the relationship between partnership

continuations, on the one hand, and partnership mergers and divisions, on the other hand. Part II

reviews the continuation authorities and identifies partnership continuations and the resulting

transactional recast in a variety of structures. Finally, Part III addresses the treatment of the

continuing partners in the continuing partnership and argues in support of treating a partnership

continuation as a “tax nothing,” rather than as a realization event, for such partners.

I. Background of Partnership Continuations

A. Section 708(a) History4

In 1919, the Treasury Department issued O.D. 228,5 a ruling that set the wheels in motion

for the eventual enactment of section 708 in 1954. The ruling concludes that a short-period

4 See James E. Thomas, Continuity of Partnerships for Federal Income Tax Purposes, 40ABA Journal 157 (Feb. 1954).

5 1 C.B. 190 (1919).

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return is required when a partnership dissolves under local law upon the death of a partner,

regardless of whether the partnership’s business is continued by the remaining partners:

As the death or withdrawal of a partner ordinarily dissolves the partnership, areturn would be required covering the period from the beginning of thepartnership’s taxable year to the date of its dissolution. If the business of thepartnership is continued as such, a new accounting period would be establishedupon the necessary reorganization of the partnership, and its next return shouldcover the period from the date of reorganization until the end of the taxable year.

Implicit in the conclusion in O.D. 228 was that the dissolution of a partnership under local law

results in the termination of the partnership for U.S. federal income tax purposes.

Perhaps because O.D. 228 was issued while the nation was distracted by war, or perhaps

because rulings did not have the same clout in 1919 as they do today, several contrary court

decisions were later issued without even citing the ruling. In Tooke v. Commissioner6 and

Reynolds v. Commissioner,7 which were companion cases, the issue was whether a partnership’s

year ended upon its dissolution under local law. Tooke and Reynolds were partners in two

partnerships that each had a March 31 fiscal year. On September 30, 1922, both partnerships

dissolved and their combined business was incorporated in a single corporation, the stock of

which was issued to the two partners. The issue was whether the income of the partnerships

from April 18 through September 30, 1922, was to be included in the partners’ 1922 tax returns,

which would be correct under O.D. 228, or their 1923 tax returns, as reported. The taxpayers’

seemingly preposterous theory was that the partnerships’ accounting periods did not end upon

6 17 B.T.A. 690 (1929).

7 17 B.T.A. 693 (1929).

8 The decisions use March 31 as the beginning date for the short periods.

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their incorporation; rather, they argued they were not required to include the partnerships’

income in their returns until 1923, the year in which the partnerships’ accounting periods would

have ended. The crux of the argument was that, even though the partnerships dissolved and their

businesses ceased to be conducted in partnership form, their accounting periods did not end.

Although these cases should have been straightforward, particularly in light of O.D. 228, the

court agreed with the taxpayers,9 and, more surprising, the Commissioner acquiesced.10

The Supreme Court entered the fray in Guaranty Trust Co. v. Commissioner,11 holding

that a deceased partner’s share of partnership income for 1933 includes his share of partnership

income for its year ending on July 31, 1933, and for the period from August 1, 1933, to

December 16, 1933, which was the date of the partner’s death.12 Due to the taxpayer’s death, the

partnership dissolved under local law and an accounting was required. The taxpayer did not

even try to contend, “nor could well do so,”13 that the short period ending on the date of death

did not result in the end of the partnership’s taxable year. Instead, the taxpayer argued that

requiring both periods’ income (over 16 months of income) to be included “offends against the

9 The court relied on the decision in Bankers’ Trust Co. v. Bowers, 295 F. 89 (2d. Cir.1923), which held that an individual’s death did not end his or her accounting period; rather, theperiod continued for the full 12-month period. The Tooke court stated: “We are unable to seewhy a different rule should apply in the case of the end of a partnership.” 17 B.T.A. at 692.

10 1930 IX-1 C.B. 46 (acquiescing to Reynolds v. Commissioner); 1930 IX-1 C.B. 54(acquiescing to Tooke v. Commissioner).

11 303 U.S. 493 (1938).

12 Although the partnership dissolved under state law upon the partner’s death, thesurviving partners agreed to continue the partnership’s business until July 31 of the followingyear.

13 303 U.S. at 499.

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policy of the revenue acts to assess income taxes annually on the basis of twelve month periods,”

even though such income would then not be subject to tax in any other taxable year.14 The Court

rejected the taxpayer’s argument because it believed the policy of requiring a partner to include

his share of partnership income for any partnership year ending with or within his year was

served as long as there was an accounting of such income by the partnership. Although the

Court did not cite O.D. 228, the decision is consistent with its conclusion.15

In Walsh v. Commissioner,16 the issue was whether the death of a partner, which the

parties agreed caused the partnership to dissolve under local law, resulted in the termination of

the partnership’s taxable year for the surviving partners, thereby requiring such partners to

include their shares of the partnership’s income for the short-period ending on the date of the

partner’s death.17 The court noted a distinction under local law between the dissolution of a

partnership, which occurred on the death of a partner, and the termination of a partnership, which

14 303 U.S. at 497.

15 Under current law, a partnership’s taxable year does not close for tax purposes upon thedeath of a partner. However, the result in Guaranty Trust Co. is now codified in section706(c)(2)(A): “The taxable year of a partnership shall close with respect to a partner whoseentire interest in the partnership terminates (whether by reason of death, liquidation, orotherwise).”

16 7 T.C. 205 (1946).

17 Specifically, the case involved two partnerships in which the decedent was a partner: Onewas a calendar-year partnership, and the other had a May 31 taxable year. The decedent died onJuly 7, 1939. The issue was relevant for a trust, which was a partner in both partnerships, thathad an August 31 taxable year and for an individual whose husband was a partner in thepartnership with the May 31 taxable year. For the trust, the stakes were whether it had to includeits share of the calendar-year partnership’s income from January 1 through July 7, 1939, in itsreturn for its taxable year ending August 31, 1939, and its share of the May 31-year partnership’sincome from June 1 through July 7, 1939, in such return. For the individual, the stakes werewhether her husband’s share of the May 31-year partnership’s income from June 1 through July7, 1939, had to be included in the return for her taxable year ending December 31, 1939.

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occurred only after its affairs were wound up. The court concluded that the taxable year of the

partnership did not end for the surviving partners upon its dissolution.

After many years of inconsistent decisions, O.D. 228 was revoked in Rev. Rul. 144.18

Significantly, Rev. Rul. 144 de-links state law from the treatment of partnerships for tax

purposes:

[T]he term “partnership” for tax purposes is broader than the term under commonlaw, the Uniform Partnership Act, or individual State laws. Accordingly, theFederal tax consequences of transactions involving partnerships and interests inpartnerships will be determined on the basis of their substance and in accordancewith the Federal tax laws without regard to the technical refinements of Statelaws.

Rev. Rul. 144 then focuses on the entity treatment of partnerships for tax purposes being

inconsistent with the notion that changes in the membership of a partnership should have an

impact on the partnership and, thus, concludes:19

[A] change in the membership of a partnership resulting from the death,withdrawal, substitution, or addition of a partner, or a shift of interests amongexisting partners does not, in itself, effect a termination of a partnership forFederal income tax purposes. Ordinarily, a partnership will be treated ascontinuing where the business of the partnership, or a substantial portion thereof,is continued. [Emphasis added.]

18 1953-2 C.B. 212.

19 The entity features of partnerships relied upon to establish that a partnership continuesnotwithstanding a change in membership were (i) the fact that a partnership has its own taxableyear, (ii) the fact that under Walsh the taxable year of the partnership does not terminate upon thedeath of a partner insofar as the surviving partners were concerned, (iii) the fact that apartnership’s basis in its assets is not affected by changes in membership, and (iv) the fact that asale of a partnership interest is treated as a sale of a capital asset, distinct from the partner’sinterest in the partnership’s assets. The ruling does note that the entity treatment of partnershipsis not always appropriate: “It is not intended herein to state that a partnership is invariably to betreated as a unit intervening between a partner and partnership transactions and income [sic] forFederal tax purposes.”

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In 1954, one year after Rev. Rul. 144 was issued, section 708 was enacted with language

similar to the language of Rev. Rul. 144.20 Section 708 was “designed to insure that the entity

would continue for taxing purposes so long as the business was continued by the partnership,

regardless of state law characterization.”21 An article published shortly after the enactment of

section 708 provides even more context:22

At common law no distinction has been made between the dissolution of apartnership and its termination. The death or withdrawal of an existing partner, theadmission of a new partner or partners or a change in the partnership interests of thepartners resulted in the dissolution of the firm; if the business was continued, a neworganization was formed. This rule, applied to income tax law, permitted thetermination of partnership accounting and taxable periods almost at the will of thepartners, thus enabling them to throw anticipated partnership income into subsequenttaxable years whenever they wished to do so. . . . Revenue Ruling No. 144 put an endto the practice of partners terminating the partnership year by changing their interestsor admitting new partners into the firm, and through the tortuous path of litigation theresult was reached that the death of a partner closed the year as to him – not as to theother members.

It remained, however, for the 1954 Code to clarify this entire problem. Under section708, a partnership year continues despite the death or withdrawal of members, theadmission of new members or a change in the partnership interests of old members.

Section 708 provides, “[f]or purposes of this subchapter [i.e., Subchapter K],”23 an

existing partnership is treated as continuing if the following three requirements are satisfied: (i)

20 Section 708 has remained unchanged since its enactment.

21 John Birkeland and Philip Postlewaite, The Uncertain Tax Ramifications of aTerminating Disposition of a Partnership Interest – The Constructive Termination of aPartnership, 20 Tax Law. 335, 335 (1976-77).

22 John C. Bruton, Subchapter K: Partners and Partnerships, 32 Taxes 724, 728-29 (1954).

23 There is some ambiguity as to whether the lead in language to section 708 limits thescope of the provision: Outside of subchapter K, can a partnership be treated as terminating evenif it is treated as continuing under section 708? It is unlikely that this language was intended tocreate differences between subchapter K and the rest of the Code as to when a partnershipcontinues. Rather, the language was likely distinguishing between the treatment under state lawand the treatment for U.S. federal income tax purposes. See John Birkeland and Philip

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any part24 of any business, financial operation, or venture of the partnership continues to be

carried on (ii) by any of the partners of the existing partnership (iii) in a partnership.25

Notwithstanding the fact that the policy that led to the enactment of section 708 was grounded in

an entity approach to partnerships, the statute requires a minimal level of continuity in the

partnership’s membership in order for the partnership to continue: “[A]ny partner” from the

existing partnership must continue to be a partner in the partnership for it to be considered a

continuation of the existing partnership.

The regulations under section 708, which were finalized in 1956,26 appear to add an

additional limitation on when a partnership is treated as terminated: “A partnership shall

terminate when the operations of the partnership are discontinued” and the three continuation

requirements set forth above are not satisfied.27 Read literally, the regulation would treat a

partnership as continuing even if there are no partners from the existing partnership, as long as

Postlewaite, The Uncertain Tax Ramifications of a Terminating Disposition of a PartnershipInterest – The Constructive Termination of a Partnership, 20 Tax Law. 335, 342 (1976-77)(“[m]ore likely . . . the clause was designed to have a positive effect, inferring that thepartnership continued for tax purposes even if it terminated under state law”).

24 One notable difference between section 708 and Rev. Rul. 144 is that under section708(b)(1)(A), a partnership terminates if “no part” of any business, financial operation, orventure continues to be carried on, meaning the partnership continues if any part continues to becarried on, whereas Rev. Rul. 144 provided that a partnership “[o]rdinarily” continues if a“substantial portion” of the business continues to be carried on.

25 Of course, even if the three requirements are satisfied, the partnership will terminate ifthere is a sale or exchange of 50% or more of the total interest in partnership capital and profitswithin a 12-month period. Section 708(b)(1)(B).

26 The aspect of the regulations that deals with partnership continuations (not technicalterminations or partnership mergers and divisions) has remained unchanged since 1956.

27 Treas. Reg. § 1.708-1(b)(1).

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the operations of the partnership continue. Because that interpretation would likely be an invalid

expansion of the statute, it is more likely that the language was intended to ensure, as indicated

by some of the earlier cases cited above, that the partnership will be treated as continuing for tax

purposes, even after there is a decision to wind-up the partnership’s affairs, until the operations

are actually discontinued.28 Once a partnership has been established, it will thus be treated as

continuing as long as any part of its business, financial operation, or venture continues.29

28 The regulations contain the following example, which supports the more limitedinterpretation:

[W]here partners DEF agree on April 30, 1957, to dissolve their partnership, but carry onthe business through a winding up period ending September 30, 1957, when all remainingassets, consisting only of cash, are distributed to the partners, the partnership does notterminate because of cessation of business until September 30, 1957.

29 See Foxman v. Commissioner, 41 T.C. 535 (1964), aff’d, 352 F.2d 466 (3d Cir. 1965)(partnership continued even after it sold all of its assets and retained only promissory notes);Ginsburg v. United States, 396 F.2d 983, 988 (Ct. Cl. 1968) (requiring a complete cessation ofactivity, not simply an abandonment of partnership’s primary purpose, to cause a termination);Baker Commodities, Inc. v. Commissioner, 415 F.2d 519 (9th Cir. 1969) (“Even if operations‘are limited to winding up the business, the partnership is not considered terminated until theonly remaining asset, cash, is distributed to the partners and all other activity ends.’”); Neubeckerv. Commissioner, 65 T.C. 577, 582-83 (1975) (“section 708(b)(1)(A) requires complete cessationof business in order to effect a termination”); Sirrine Building No. 1 v. Commissioner, 69 TCM(CCH) 2476 (1995) (rejecting the argument that the partnership did not exist in the year inquestion under the Culbertson standard as “there is no question that at one time a partnershipexisted. The issue concerns whether it terminated”); Harbor Cove Marina Partners v.Commissioner, 123 T.C. 64 (2004) (partnership continued pending resolution of lawsuit thatcould result in realization of significant taxable income, gain, loss, deduction or credit). But cf.LaRue v. Commissioner, 90 T.C. 465 (1988) (partnership terminated even though legal entityremained in existence to defend lawsuit); Hatch’s Estate v. Commissioner, 198 F.2d 26 (9th Cir.1952) (sale of assets treated as sale of partnership interests even though certain assets remainedbehind); Barran v. Commissioner, 334 F.2d 58 (5th Cir. 1964) (sale of assets treated as sale ofpartnership interests notwithstanding retained parcel of land, where there was no income orbusiness activity whatsoever after the asset sale); Goulder v. United States, 1995 U.S. App.LEXIS 24667 at 4 (6th Cir. 1995) (not for publication) (partnership terminated based on parties’stipulation that “partnership neither operated or carried on any business, financial operation, orventure” even though it retained assets in anticipation of specific liabilities); Sargent v.

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The regulations contain an example illustrating the third continuation requirement (i.e.,

that the partnership’s business continues to be carried on in a partnership):

[O]n November 20, 1956, A and B, each of whom is a 20-percent partner inpartnership ABC, sell their interests to C, who is a 60-percent partner. Since thebusiness is no longer carried on by any of its partner in a partnership, the ABCpartnership is terminated as of November 20, 1956.

(Emphasis added.) Even though C, who was a partner in the existing partnership, continues the

business of the partnership, the partnership does not continue, since C does not continue the

business in a partnership but rather as a sole proprietor.30

The regulations do not, however, elaborate on the first two continuation requirements.

The first requirement – that any part of the partnership’s business, financial operation, or venture

continues to be carried on – is analogous to the “continuity of business enterprise” (“COBE”)

requirement for corporate reorganizations. The second requirement – that at least one of the

members in the existing partnership continues to be a partner31 – is analogous to the “continuity

Commissioner, T.C. Memo. 1970-214, 15 n.4 (partnership terminated notwithstanding“miniscule activity” that continued).

30 The transaction described in the example would be governed today by Rev. Rul. 99-6(Situation 1), 1999-1 C.B. 432, which would treat A and B as selling their partnership interests toC but treat C as if the partnership had liquidated, distributing the assets to the partners, and thenas purchasing the assets deemed distributed to A and B.

31 The legislative history to section 708 raises a question as to whether more than onecontinuing partner is necessary to find that a partnership continues: “Paragraph (1) provides thata partnership shall be deemed terminated only if no part of the business, financial operations, orventures of the partnership continue to be carried on by the partners in any partnership.”(Emphasis added.) H.R. Rep. No. 1337, at 388 (1954). The statute and the regulations state,however, that a partnership is terminated only if “no part of any business, financial operation, orventure of the partnership continues to be carried on by any of its partners in a partnership.”(Emphasis added.) While there needs to be at least two partners to have a partnership, nothingsuggests that the two partners had to have been partners in the existing partnership. Because thelanguage of the legislative history is not unambiguous, and requiring more than one continuingpartner would be inconsistent with the statutory language and regulations, it is unlikely that the

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of interest” (“COI”) requirement for corporate reorganizations. The relevance of those

requirements to partnership continuations will be considered in Part II.

B. Relationship of Partnership Continuations to Partnership Mergers and Divisions

Partnership mergers and divisions are naturally viewed as partnership versions of

reorganizations under section 368(a) and distributions under section 355, respectively. Unlike

sections 368(a) and 355, however, the partnership merger and division rules are not standalone

provisions that set forth a path to nonrecognition. Instead, the stakes are far more modest.

Under section 708(b)(2)(A), in the case of a merger or consolidation of two or more partnerships,

the resulting partnership is treated as the continuation of the merging partnership whose

members own an interest of more than 50% in the capital and profits of the resulting partnership.

Under section 708(b)(2)(B), in the case of a division of a partnership into two or more

partnerships, the resulting partnerships are treated as continuations of the prior partnership, other

than those resulting partnerships the members of which had an interest of 50% or less interest in

the capital and profits of the prior partnership. Thus, the stakes involved for partnership mergers

and divisions are simply the determination of whether a particular entity is to be treated as a

continuation. To be sure, once that determination is made, the regulations characterize the

transaction in a manner consistent with the conclusion as to which partnership or partnerships

continue, and that characterization itself could have significant consequences to the parties

involved.32 But the mere identification of a transaction as being a partnership merger or

legislative history could properly be interpreted as requiring more than one continuing partner tohave a partnership continuation.

32 See Treas. Reg. § 1.708-1(c), (d). For example, assume a partnership among relateddomestic partners (“PRS 1”) merges with a partnership among related foreign partners (“PRS 2”)

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partnership division, does not, in and of itself, qualify the transaction for special treatment, nor

does the failure of a transaction to qualify as a partnership merger or partnership division lead

necessarily to adverse tax consequences.

Although the stakes involved for whether a transaction qualifies as a partnership merger

or partnership division are not nearly as high as the stakes involved in whether a transaction

qualifies as a reorganization under section 368(a) or a distribution under section 355, a

determination still needs to be made as to whether a transaction is a partnership merger or a

partnership division to know whether the rules in section 708(b)(2) are applicable.

Unfortunately, neither the Code nor the regulations define partnership mergers and divisions.33

However, purposive definitions of the terms emerge when the provisions are considered in their

proper context.

by having the partners in PRS 1 contribute their interests to PRS 2 in exchange for PRS 2interests. If PRS 2 is treated as continuing under section 708(b)(2)(A), PRS 1 would be treatedas contributing its assets (and liabilities) to PRS 2 in exchange for PRS 2 interests and thendistributing those interests in liquidation of PRS 1. See Treas. Reg. § 1.708-1(c)(3)(i). Thatcharacterization of the transaction would potentially be subject to Notice 2015-54, 2015-34I.R.B. 210, requiring gain recognition unless the “gain deferral method” is elected. However, ifPRS 2 is treated as a continuation of PRS 1 under section 708(b)(2)(A), PRS 2 would be treatedas contributing its assets (and liabilities) to PRS 1 in exchange for PRS 1 interests and thendistributing those interests in liquidation of PRS 2. That characterization of the transactionwould not be subject to Notice 2015-54, since there is no “U.S. Transferor” within the meaningof Section 4.01(1) of Notice 2015-54.

33 The absence of definitions in the regulations was intentional:

Some commentators have requested that these terms be defined in the finalregulations. Other practitioners have stated that the selectivity that would becreated by attempting to draw lines in such definitions could lead to planningopportunities that would be adverse to the government’s interest. The IRS andTreasury have decided not to provide comprehensive definitions of what is apartnership merger or division in these final regulations.

T.D. 8925, 66 Fed. Reg. 715 (Jan. 4, 2001).

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The partnership merger and division rules in section 708(b)(2) are identified as “Special

Rules,” whereas section 708(a) is identified as the “General Rule.” The merger and division

rules address when a partnership should be treated as continuing in specific circumstances where

the application of the general rule does not provide clarity. For example, without regard to the

special rule for partnership mergers in section 708(b)(2)(A), if Partnership AB and Partnership

CD combined to create Partnership ABCD, Partnership ABCD could be treated as a continuation

of both Partnership AB and Partnership CD under the general rule, since partners from

Partnership AB and Partnership CD continue part of the business, financial operation, or venture

of each partnership in a partnership. The special partnership merger rule provides the resolution

for which partnership is continuing. In that light, a partnership merger could be thought of as

any transaction in which a single partnership would be a continuation of more than one

partnership under the general rule, making the special rule in section 708(b)(2)(A) necessary.

A purposive definition for partnership divisions can similarly be developed. Without

regard to the special rule for partnership divisions in section 708(b)(2)(B), if Partnership ABCD

were to divide into Partnership AB and Partnership CD, both Partnership AB and Partnership CD

would be treated as continuations of Partnership ABCD under the general rule, since each

partnership has a partner from Partnership ABCD and continues to carry on part of the business,

financial operation, or venture of Partnership ABCD. The special partnership division rule

provides the resolution for which partnership, if any, is the continuation of Partnership ABCD.

In that light, a partnership division could be thought of as any transaction in which more than one

partnership would be a continuation of a single partnership under the general rule,34 making the

34 This definition would create a discrepancy with the current division regulations. Underthe purposive definition, a transaction would be treated as a division even if there is only one

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special rule in section 708(b)(2)(B) necessary.35 Given the breadth of the general partnership

continuation rule, which will be explored in detail in Part II, the “Special Rules” for partnership

mergers and divisions are needed to resolve the anomalies that would otherwise arise. Thus,

partnership mergers and divisions are those transactions in which such anomalies would arise

under the general partnership continuation rule.

II. Transactional Analysis of Partnership Continuations

The general partnership continuation rule can be implicated in a variety of commercial

transactions. Despite the prevalence of partnership continuations, there is little guidance. Part A

of this section discusses the principal authorities governing partnership continuations, and Part B

analyzes more complex transactions that are not directly covered by the existing guidance.

partner from the original partnership. For example, if Partnership ABC contributes some assetsto a new partnership with D and immediately distributes the interest to C, Partnership CD (aswell as Partnership ABC) would be treated as a continuation of Partnership ABC under thegeneral rule, since a partner of Partnership ABC continues to carry on part of Partnership ABC’sbusiness in a partnership. However, under Treas. Reg. § 1.708-1(d)(4)(iv), Partnership CDwould not be a “resulting partnership” because it does not have at least two partners who werepartners in Partnership ABC, and thus the transaction would not be a partnership division.Without explanation, the preamble to the partnership merger and division regulations rejecttreating a resulting partnership with only one partner from the existing partnership as a division:“To have a division, at least two members of the prior partnership must be members of eachresulting partnership that exists after the transaction.” T.D. 8925, 66 Fed. Reg. 715 (Jan. 4,2001).

35 Under section 708(b)(2)(B), in some divisions it is possible that none of the partnershipswould be treated as a continuation of the existing partnership (e.g., a split up of a partnership intomultiple partnerships none of which has partners that owned more than 50% of the originalpartnership) and it is possible that multiple partnerships could be treated as a continuation of theexisting partnership (e.g., a proportionate distribution of one or more new partnerships to allpartners).

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A. Principal Authorities

1. Rev. Rul. 66-264 and Neubecker

The first significant authority addressing partnership continuations after the enactment of

section 708 is Rev. Rul. 66-264.36 Although the ruling is only five sentences long, it highlights

the significance of section 708 in evaluating the tax consequences of a transaction. The ruling

involved the results of litigation among the partners in an equal five-member partnership, where

the court ordered the partnership’s assets to be sold at a judicial sale. Three of the five partners

bought all the assets of the partnership and continued the operation of the business as partners.

The other two partners received a share of the proceeds of the sale in liquidation of their

interests. Without analysis or discussion, the ruling states that the partnership did not terminate

under section 708(b).37 The conclusion is undoubtedly correct based on the language of the

statute, since three of the five partners continued to carry on the partnership’s business in a

partnership. Moreover, the transaction did not involve the sale or exchange of 50% or more of

the total interests in partnership capital and profits within a 12-month period. As a result, under

section 708(a), because the partnership did not terminate, it continued.

In light of the conclusion that the partnership did not terminate, the ruling addresses how

the transaction would be treated. The ruling states that the transaction would not be treated as a

36 1966-2 C.B. 248.

37 The background for Rev. Rul. 66-264 appears to be contained in GCM 33200 (Feb. 25,1966). Initially, the transaction was the subject of a proposed private letter ruling, in which theService respected the sale and was considering the possible application of the capital gainrecharacterization rule under section 707(b). The GCM concluded that there was no terminationof the existing partnership under section 708 and, thus, no sale transaction between twopartnerships potentially subject to section 707(b).

17

sale of assets but would be considered as a sale or liquidation of the partnership interests of the

two withdrawing partners, depending on the facts and circumstances of the particular case. As

discussed in Part III, there is no indication that there were any tax consequences whatsoever to

the continuing partners.

Similar to Rev. Rul. 66-264,38 Neubecker v. Commissioner39 involved the creation of a

new partnership by two of the three partners in a law firm partnership following the dissolution

of that partnership. The issue in the case was whether one of the two partners who was both a

member in the dissolved partnership and in the new partnership was entitled to a loss upon the

dissolution of the prior partnership. The court easily dispensed of the case, citing section 708

and concluding that the new partnership was a continuation of the existing partnership by two of

its partners. Because the two partners “retained certain clients and cases for which they had

responsibility when practicing as partners in [the existing partnership], the continuity of

operation contemplated in section 708(b)(1)(A) is clearly established.”40 The court assigned

“little significance” to the fact that the new partnership relocated to new offices, concluding that

“some physical interruption of operation [was] irrelevant in terms of the criteria set forth in

38 See also GCM 33774 (Mar. 22, 1968) (new partnership formed with four new partnersand most of the partners of an existing partnership to purchase assets of existing partnershiptreated as continuation of existing partnership); PLR 8302108 (Oct. 15, 1982) (relying on Rev.Rul. 66-264 to conclude that three new partnerships formed to hold assets purchased at auctionby two of the partners in the three selling partnerships were continuations of the priorpartnerships; other partners treated as selling partnership interests to continuing partners).

39 65 T.C. 577 (1975).

40 Id. at 582. Though certainly not dispositive, it was not helpful to the taxpayer’s case thatthe new partnership had used the same EIN as the prior partnership.

18

section 708.”41 Finally, the court recharacterized the transaction consistent with its continuation

conclusion, treating the non-continuing partner as withdrawing and denying the taxpayer a loss

because he was treated as continuing as a partner in the partnership.42

2. The Conversion Rulings43

The first published ruling involving the consequences of the conversion of a partnership

from one legal form to another was issued in 1984. In Rev. Rul. 84-52,44 the Internal Revenue

Service (the “Service”) addressed the tax consequences of the conversion of a general

partnership into a limited partnership by way of an amendment to the partnership agreement. In

the conversion, two members became limited partners and two members became both general

partners and limited partners.45 The general partnership’s business continued after the

conversion, and each partner’s interest in profits, losses, and capital remained the same after the

41 Id. at 583.

42 The court noted that, even if the new partnership was not treated as a continuation, thetaxpayer would not have been entitled to a loss under section 731(a)(2) because he received adistribution of property other than cash and property described in section 751(c) or (d).

43 See generally Monte A. Jackel and Robert J. Crnkovich, Partnership Conversions:Making Something Out of Nothing, 123 Tax Notes 275 (July 20, 2009); Sheldon I. Banoff, Mr.Popeil Gets “Reel” About Conversions of Legal Entities: The Pocket Fisherman Flycasts for“Form” but Snags on “Substance,” 75 Taxes 887 (Dec. 1997); Sheldon I. Banoff, PartnershipOwnership Realignments via Partnership Reallocations, Legal Status Changes, Recapitalizationsand Conversions: What Are the Tax Consequences?, 83 Taxes 105 (Mar. 2005); Jeff Erickson,Recapitalizations of Partnerships: General Issues Under Subchapter K, 45 TM Memorandum(BNA) (Mar. 22, 2004).

44 1984-1 C.B. 157.

45 The ruling provides that its holdings apply with equal force to a conversion of a limitedpartnership into a general partnership.

19

conversion.46 It was clear that the limited partnership represented a continuation of the general

partnership, since all the continuation requirements were satisfied: The partnership’s business

continued to be carried on by its partners in a partnership. The ruling recognized that, even

though the partnership continued, there could be consequences to the partners resulting from

changes in the partners’ share of partnership liabilities under section 752 (and the regulations

thereunder) as a result of their change in status. For example, the basis in the interests held by

the partners holding general partnership interests could be increased as a result of the deemed

contribution of money under section 752(a), resulting from an increase in such partners’ shares

of partnership liabilities under the regulations, while the basis in the interests held by the partners

holding only limited partnership interests could be decreased as a result of the deemed

distribution of money under section 752(b), resulting from a decrease in such partners’ shares of

partnership liabilities under the regulations. The ruling also properly notes that the deemed

distribution under section 752(b) could cause a partner to recognize gain under section 731(a)(1)

if the deemed distribution exceeded the partner’s basis in its partnership interest.

As discussed in Part III, the ruling treats the conversion as an exchange of the partners’

interests in the general partnership for interests in the limited partnership, with no gain or loss

recognized (assuming no reductions in liability shares resulting in gain under section 731(a)(1))

because the exchange qualifies for nonrecognition under section 721(a). In addition, the ruling

46 It is not clear from the ruling whether the fact that each partner’s interest in profits,losses, and capital remained the same was necessary or even relevant to its conclusion. In fact,unless the partners who became only limited partners agreed to full deficit restorationobligations, it is not clear how the statement could be true. That fact was not present in Rev.Rul. 95-37, 1995-1 C.B. 130 (discussed below), and, thus, should not be viewed as essential tothe conclusion.

20

concludes that there is no change to the holding period of any partner’s interest in the

partnership.47

Because the ruling concluded that the conversion resulted in exchanges of interests in the

general partnership, the ruling addressed whether such exchanges caused a technical termination

of the partnership. Citing Treas. Reg. § 1.708-1(b)(2)(ii),48 the ruling concludes that the

exchanges do not result in a technical termination because, under that provision, “a transaction

governed by section 721 of the Code is not treated as a sale or exchange for purposes of section

708 of the Code.” The ruling’s application of that provision is flawed. The language of the

regulation reads: “[T]he contribution of property to a partnership does not constitute such a sale

or exchange.” The regulations exclude the issuance of a partnership interest in exchange for

property as a sale or exchange of the interest in the issuing partnership in determining whether

there is a technical termination of the issuing partnership. Thus, the issuance of the partnership

interests by the limited partnership in the ruling would not be treated as an exchange of interests

in determining whether there is a technical termination of the limited partnership. However,

notwithstanding the ruling, it is clear that where the property contributed to a partnership is itself

47 The ruling relies on section 1223(1) for its holding period conclusion, which is consistentwith the treatment of the conversion as giving rise to an exchange of interests in the generalpartnership for interests in the limited partnership, since that provision applies to determine theholding period of certain property received in an exchange. The ruling did not necessarily needto rely on section 1223(1) for its conclusion. In PLR 200932017 (Apr. 22, 2009), withoutrelying on section 1223(1), the Service ruled that the shareholder of a corporation thatreincorporated in a transaction qualifying as an F reorganization qualified for treaty benefitsbased on its satisfaction of the 12-month stock ownership requirement in Article 10(3)(a) of theUnited States-United Kingdom income tax treaty because the newly formed corporation “will betreated for U.S. tax purposes as the same entity” as the prior corporation. (Presumably, section1223(1) was not applicable to determine whether the holding period under the treaty wassatisfied.)

48 The provision cited is now contained in Treas. Reg. § 1.708-1(b)(2).

21

a partnership interest, there is a sale or exchange of the contributed interest for purposes of

section 708(b)(1)(B).49 Thus, the ruling does not properly answer why there is no sale or

exchange of the interests in the general partnership under section 708(b)(1)(B).50 As discussed

in Part III, if the conversion is a nonrealization event to the continuing partners, there would not

be a sale or exchange of their interests and the potential technical termination issue would not

arise.

In Rev. Rul. 95-37,51 the Service concluded that the conversion of a domestic partnership

into a domestic LLC classified as a partnership for federal tax purposes is subject to the

principles of Rev. Rul. 84-52.52 The ruling also addresses the consequences of the conversion

49 See PLR 8116041 (Jan. 21, 1981) (“if as a result of the contribution of [partnership] interestsin the Programs to P, fifty percent or more of the total interest in partnership capital and profitsof a Program is sold or exchanged within a period of 12 consecutive months, such Program willbe deemed terminated as a partnership”); PLR 8229034 (Apr. 20, 1982) (similar); but see PLR8819083 (Jan. 12, 1988) (contribution of 99% of the interests in a partnership to new upper-tierpartnership did not result in a technical termination of the partnership whose interests weretransferred).

50 Monte A. Jackel and Robert J. Crnkovich, Partnership Conversions: Making SomethingOut of Nothing, 123 Tax Notes 275, 276 (July 20, 2009).

51 1995-1 C.B. 130.

52 The ruling concludes that the consequences are the same regardless of (i) the manner inwhich the conversion is achieved under state law, (ii) whether the LLC is formed in the same ordifferent state from the converting domestic partnership, or (iii) whether the conversion had beenof a domestic LLC that is classified as a partnership for federal tax purposes into a domesticpartnership. Thus, based on the ruling, the analysis is the same for conversions of the form oflegal entity and migrations of the legal entity from one jurisdiction to another. Moreover, theresults would be the same whether the conversion occurs by operation of law, by asset transfer orby interest transfer. While the rulings do not explicitly address conversions of foreign entities ormigrations of an entity from a foreign jurisdiction to the United States, or vice versa,presumably, the same principles would apply, since there is no indication that section 708(a)would apply in a different manner. See Monte A. Jackel and Robert J. Crnkovich, PartnershipConversions: Making Something Out of Nothing, 123 Tax Notes 275, 278 (July 20, 2009); Jeff

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under section 706(c)(2)(A), which provided that the taxable year of a partnership closes with

respect to any partner who sells or exchanges the partner’s entire interest in the partnership.53

Notwithstanding the conclusion in Rev. Rul. 84-52 that the conversion results in an exchange of

interests in the general partnership for interests in the limited partnership, the Service concluded

that there was not such an exchange under section 706(c)(2)(A): “[B]ecause each partner in a

converting domestic partnership continues to hold an interest in the resulting domestic LLC, the

conversion is not a sale, exchange, or liquidation of the converting partner’s entire partnership

interest for purposes of section 706(c)(2)(A).” The Service did not address or even acknowledge

the inconsistency with its conclusion in Rev. Rul. 84-52.54 Finally, the Service concluded that

Erickson, Recapitalizations of Partnerships: General Issues Under Subchapter K, 45 TMMemorandum (BNA) (Mar. 22, 2004).

53 Section 706(c)(2)(A) now provides: “The taxable year of a partnership shall close withrespect to a partner whose entire interest in the partnership terminates (whether by reason ofdeath, liquidation, or otherwise).”

54 The issue under section 706(c)(2)(A) had previously been presented in a slightly differentcontext in Rev. Rul. 86-101, 1986-2 C.B. 94. That ruling, which was relied upon in Rev. Rul.95-37, involved the automatic conversion under the partnership agreement of a general partner’sinterest to a limited partnership interest upon the death of the partner. Under the law at the time,the partnership’s year did not end with respect to a partner as a result of the death of the partner.The issue was whether the conversion of the interest would be treated as an exchange of theentire interest under section 706(c)(2)(A), which would cause the partnership’s year to close withrespect to the partner. The ruling cites Rev. Rul. 84-52 for its treatment of the conversion of ageneral partnership interest into a limited partnership interest as an exchange; however, based onthe policy of section 706(c)(2) at the time, the ruling concludes that the conversion is not anexchange of the partner’s entire interest for purposes of section 706(c)(2)(A) or the regulationsthereunder. The ruling, thus, answers the “highly controversial” question that the court inApplebaum v. Commissioner, T.C. Memo. 1982-278, aff’d, 724 F.2d 375, 378 (3d Cir. 1983),refused to address concerning whether the conversion of a general partnership interest into alimited partnership interest was an exchange under section 706(c)(2)(A); the court was able toside-step the issue because the taxpayer had failed to prove that the conversion actually occurred.

23

the domestic LLC “does not need to obtain a new taxpayer identification number,” suggesting

that the continuing entity may obtain a new taxpayer identification number.55

Rev. Rul. 95-5556 involved the consequences of registering a New York general

partnership as a New York limited liability partnership (“RLLP”). The economic interests of the

partners remained the same and the business of the partnership continued after registration. The

ruling first concluded that the RLLP qualified as a partnership under the prior entity-

classification regulations. The ruling then concludes that the registration of the general

partnership as an RLLP “is treated as a partnership-to-partnership conversion that is subject to

the principles of Rev. Rul. 84-52.” As a result, the ruling concluded that the partnership did not

terminate and was required to use the same methods of accounting used before its registration as

an RLLP.57

B. Continuations in Practice

Continuations can be found in numerous commercial transactions. The examples in this

part present the following questions that arise in determining whether a transaction should be

treated as a partnership continuation:

55 The ruling does not state that each partner’s interest in profits, losses, and capitalremained the same; rather, the ruling simply states that each partner continues to hold “aninterest” in the LLC.

56 1995-2 C.B. 313.

57 Although the effect of a partnership conversion on the partners’ capital accounts was notaddressed by the conversion rulings, in PLR 200414013 (Dec. 10, 2003), the Service ruled that,in connection with a partnership’s conversion from a general partnership to an LLC (taxed as apartnership), the partners’ capital accounts would be unchanged.

24

(i) Is a partnership continuation tested “in a bubble,” or can the step transactiondoctrine apply in determining whether a partnership continues?

(ii) Can there be a partnership continuation if, as a consequence of treating thepartnership as continuing, there is a technical termination of the partnership?

(iii) What is the minimum level of continuity of interest required for a partnership tobe considered as continuing, and can it be satisfied indirectly, i.e., through remotecontinuity principles?

(iv) Does the continuing partnership need to conduct some part of the same business,financial operation or venture of the original partnership, or can it conduct anybusiness, financial operation, or venture?

1. Drop-Down and Distribution-Up Continuations

For many reasons, it is common in commercial transactions for members of an existing

partnership to create a two-tier legal structure by contributing their interests to a newly formed

entity (a “drop-down continuation”).58

58 Some of the reasons include setting up a tiered financing structure and allowing for thetransfer the partnership’s business in the future without having to transfer assets.

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Example 1. A and B, members of Old LLC,59 contribute their Old LLC interests toNew LLC, a newly formed entity, in exchange for all the interests in New LLC. As aresult, New LLC is a partnership and Old LLC becomes a disregarded entity forfederal tax purposes.

A B

Before After

Old LLC

A B

Old LLC

New LLC

Example 1

It is clear that New LLC is a continuation of Old LLC under section 708(a): Both partners in

Old LLC continue Old LLC’s business as partners in New LLC.60 A question that often arises in

drop-down continuations (as well as in other forms of partnership continuations) is whether the

legal entity that is the continuing partnership (i.e., New LLC) is required to use the EIN of the

existing partnership (i.e., Old LLC) or whether it can obtain its own EIN and the existing

partnership may continue to use its own EIN after it becomes a disregarded entity. Since Rev.

Rul. 95-37 suggests that the continuing partnership may obtain a new EIN, it would seem

59 For purposes of this paper, assume no LLC makes an election to be classified as anassociation taxable as a corporation under Treas. Reg. § 301.7701-3(c)(1).

60 See CCA 201315026 (Apr. 12, 2013) (new partnership treated as continuation of oldpartnership where old partnership merged into a disregarded entity of new partnership andmembers exchanged interests in old partnership for same interests in new partnership).

26

permissible for the existing partnership to continue to use its own EIN after it becomes a

disregarded entity.61

61 It is common for disregarded entities to have their own EINs. See Sheldon I. Banoff,Shop Talk: Should (or Must) Single-Member LLCs Obtain Federal EINs?, 118 J. Tax. 270 (May2013). Allowing the continuing entity to use a new EIN (or to continue to use its own EIN if ithad one prior to the transaction), rather than the prior partnership’s EIN, is often desirable wherethe prior partnership continues as a disregarded entity, so as to allow the prior partnership tocontinue to use its EIN. See Rev. Rul. 2001-61, 2001-2 C.B. 573 (partnership converting todisregarded entity must continue using the same EIN for employment tax purposes). In recentpronouncements, the Service specifically permitted entities that were treated as continuations touse a different EIN than the prior partnership. See FAA 20132101F (Apr. 16, 2013); CCA201315026 (Apr. 12, 2013). In PLR 201605004 (Oct. 19, 2015), the Service, relying on Rev.Rul. 95-37, ruled that a disregarded entity that became a partnership and was a continuation of aprior partnership did not need to obtain a new EIN. It is not entirely clear whether that meantthat the entity could continue to use the same number it had been using while it was adisregarded entity or whether that meant that the entity did not have to get a new EIN, since itcould simply continue to use the number of the prior partnership. Rev. Rul. 95-37 was clearlyfocused on the latter, since the LLC was newly formed and would not have had its own EINprior to the conversion. Whether the continuing partnership should use the EIN of the existingpartnership or a different EIN is an issue that should be considered carefully, since the confusioncreated within the Service by using a different EIN cannot be overstated.

27

Example 2. X owns 100% of an LLC that is in a partnership with Y. Y contributesits partnership interest to the LLC. The LLC becomes a partnership, and thepartnership becomes a disregarded entity of the LLC.

Example 2Before After

YX

Partnership

Partnership

X

YLLC

LLC

In this variation of a drop-down continuation, it is clear that LLC is a continuation of the

partnership under section 708(a): Both partners in the partnership, X (through the LLC) and Y,

continue the partnership’s business as partners.62

62 See PLR 201605004 (Oct. 19, 2015).

28

Example 3. A and B are members of AB LLC. C is the sole member of OpCo LLC.Both LLCs conduct operating businesses. A and B contribute their interests in ABLLC to OpCo LLC, solely in exchange for 60% of the interests in OpCo LLC. OpCoLLC becomes a partnership for federal tax purposes, and AB LLC becomes adisregarded entity for federal tax purposes.

Example 3Before After

AB LLC

A B C

OpCo LLC

OpCo LLC

A C

40%

AB LLC

B

In this variation of a drop-down continuation, OpCo LLC is a continuation of AB LLC,

since A and B continue to carry on AB LLC’s business through OpCo LLC, a partnership. As in

Rev. Rul. 66-264, the transaction must be recharacterized for federal income tax purposes in a

manner that is consistent with the continuation conclusion. Because OpCo LLC is the

continuation of AB LLC, the proper recharacterization of the transaction is to treat C as

contributing the assets and liabilities of OpCo LLC to AB LLC in exchange for AB LLC

interests.63

63 The recharacterization should apply for all U.S. federal income tax purposes. Thus, forexample, C’s deemed contribution will need to be analyzed under the disguised-sale regulationsand Notice 2015-54, will create a forward section 704(c) layer in the contributed assets for C(and could create reverse layers under section 704(c) for A and B), and will start the seven-yearperiod under sections 704(c)(1)(B) and 737 for C.

29

Example 4. Assume the same facts as in Example 3, except that A and B haveonly a 40% interest in OpCo LLC after the contribution.

Example 4Before After

AB LLC

A B C

OpCo LLC

OpCo LLC

A C

60%

AB LLC

B

This example raises the question of whether a minimum level of continuity of interest by

the partners is required for a transaction to be treated as a partnership continuation. Although

there is no authority directly on point, the language of section 708(b)(1)(A) would suggest there

is no minimum level of continuity necessary for a partnership to be treated as continuing. Under

that provision, a partnership will be treated as continuing if “any of its partners” continues to

carry on any part of the business, financial operation, or venture of the partnership in a

partnership. Thus, AB LLC should be treated as continuing whether A and B end up with 5% or

95% of the interests in OpCo LLC.64

64 Although AB LLC would be treated as issuing a 60% interest to C in exchange for thedeemed contribution by C of the assets and liabilities in OpCo LLC, there would not be atechnical termination of AB LLC under section 708(b)(1)(B). The issuance of interests to C isnot taken into account in determining whether there is a technical termination of AB LLC. SeeTreas. Reg. § 1.708-1(b)(2).

30

Example 5. Assume the same facts as in Example 3, except OpCo LLC is newlyformed and holds only cash that C contributed to effect the transaction and, inaddition to receiving the 60% interests in OpCo LLC, A and B receive the cash that Chad contributed to OpCo LLC.

Example 5Before After

Cash Ca

sh

AB LLC

A B C

OpCo LLC

OpCo LLC

A C

40%

AB LLC

B

Consistent with the conclusion in Example 3 that OpCo LLC is a continuation of AB

LLC, C would be treated as transferring cash to AB LLC in exchange for partnership interests.

However, in this example, AB LLC would then be treated as distributing the cash to A and B.

The deemed contribution of cash followed by the deemed distribution of cash would likely be

characterized as a disguised sale of partnership interests by A and B to C under section

707(a)(2)(B).65

65 See FAA 20132101F (Apr. 16, 2013) (relying on Rev. Rul. 66-264 to conclude that atransaction similar to Example 5 resulted in a continuation of a partnership and a sale of interestsin the continuing partnership). Some commentators have suggested that a transaction cannot berecharacterized as disguised sales of partnership interests in the absence of implementingregulations. See Samuel Grilli, Can the IRS Currently Contend That There Has Been aDisguised Sale of a Partnership Interest, 123 Journal of Tax. 289 (Dec. 2015). However, theService clearly disagrees. See, e.g., Announcement 2009-4, 2009-8 I.R.B. 597 (“[A]nydetermination of whether transfers between a partner or partners and a partnership is a transfer ofa partnership interest will be based on the statutory language, guidance provided in legislativehistory, and case law”).

31

Another straight-forward and relatively common transaction implicating the partnership

continuation rules involves the distribution of interests in a disregarded entity to the partners,

turning the disregarded entity into a partnership (a “distribution-up continuation”).

Example 6. Holdings LLC distributes interests in OpCo LLC, which is adisregarded entity for federal tax purposes, to its members in liquidation ofHoldings LLC. OpCo LLC becomes a partnership for federal tax purposes.

Example 6AfterBefore

Holdings LLC

A B

OpCo LLC

A B

OpCo LLC

Although the form is different from a drop-down continuation, it is clear that OpCo LLC will be

treated as a continuation of Holdings LLC, since the members of Holdings LLC will continue to

carry on Holdings LLC’s business in a partnership.

32

Example 7. A and B are members of Holdco LLC. Holdco LLC owns 100% ofOpCo LLC (an operating business) and other assets. Holdco LLC distributes theother assets and a portion of its interest in OpCo LLC to A in completeredemption of A’s interest in Holdco LLC. Thus, Holdco LLC becomes adisregarded entity of B and OpCo becomes a partnership between A and B(through Holdco LLC).

Example 7Before After

Other Assets

OpCo LLC

Other Assets

Holdco LLC

Holdco LLC

A B

OpCo LLC

A B

In this variation of a distribution-up continuation, OpCo LLC should be a continuation of

Holdco LLC, since A and B (through a disregarded entity) continue to carry on the business that

Holdco LLC was treated as having conducted through OpCo LLC in a partnership. Consistent

with that conclusion, the transaction should be treated for all U.S. federal income tax purposes as

a distribution of the other assets to A in partial redemption of its interest in the partnership.

2. Partnership Continuations “in a Bubble”?

In many cases, a drop-down continuation or a distribution-up continuation may occur in

the context of a series of transactions. In such cases, the question arises as to whether certain

33

steps are isolated, i.e., by treating such steps as occurring “in a bubble,” when determining

whether the partnership continues or whether step-transaction principles66 are to be applied.

Example 8. Assume the same facts as in Example 1, except that immediatelyfollowing the contribution of the Old LLC interests to New LLC, New LLC sells theOld LLC interests for cash and liquidates, distributing the cash to its members.67

Example 8

Buyer Buyer

Old LLCInterests

Before Interim After

Old LLC

A B

New LLC

A B

Cash

Old LLC

A B

Cash Cash

Old LLC

The question presented by Example 8 is whether the transaction should be treated as a drop-

down continuation followed by a sale of assets and liquidation68 or as a sale of interests in Old

66 See Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations andShareholders ¶12.61[3] (Thomson Reuters/Tax & Accounting, 7th ed. 2000 & Supp. 2015-03)(under the step-transaction doctrine “a series of formally separate steps may be amalgamated andtreated as a single transaction if the steps are, in substance, integrated, interdependent, andfocused toward a particular end result. . . . [T]he separate steps must be fused in determining theoverall tax consequences of the transaction.”).

67 This structure may be used for a variety of reasons. For example, the structure wouldallow the buyer to contract with only a single selling party while facilitating the buyer’sacquisition by allowing for an interest transfer rather than a direct transfer of the assets.

68 It is possible that a drop-down continuation followed by a sale of the interests in thedisregarded entity could be treated as a sale of interests under the outmoded “sale-of-going-business doctrine,” which treats a sale of a partnership’s business as, in substance, a sale ofpartnership interests. See Barran v. Commissioner, 334 F.2d 58 (5th Cir. 1964); Dahlen v.Commissioner, 24 T.C. 159 (1955) (acq. 1955-2 C.B. 5). See also William S. McKee, WilliamF. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships & Partners ¶16.03[3]

34

LLC in a Rev. Rul. 99-6 (Situation 2)69 transaction. (While the buyer would be indifferent to the

characterization, since it would be treated as acquiring assets in either case, the members of Old

LLC could have vastly different tax consequences.) The resolution of the question depends on

whether continuations are to be identified “in a bubble” or whether the step-transaction doctrine

can apply to disregard a potential partnership continuation.

The argument in support of identifying continuations in a bubble stems from the analogy

of partnership continuations to corporate reorganizations under section 368(a)(1)(F) (“F

reorganizations”). In Treas. Reg § 1.386-2(m), which was promulgated in September 2015, the

bubble concept was formally embraced in determining whether a transaction is to be treated as

an F reorganization. The concept had previously emerged only as a rationalization of the ad hoc

guidance that had been issued involving potential F reorganizations.70

In Rev. Rul. 58-422,71 the merger of a parent corporation and its two subsidiaries into a

newly formed corporation was treated as an F reorganization of the parent and liquidations of the

two subsidiaries under section 332. In Rev. Rul. 68-349,72 corporation Y contributed all of its

assets and liabilities to newly formed corporation X in exchange for X stock and then liquidated.

(Thomson Reuters/Tax & Accounting, 4th ed. 2007 & Supp. 2016-2) (“McKee”); Arthur B.Willis and Phillip F. Postlewaite, Partnership Taxation, ¶16.01[2] n.15 (Thomson Reuters/Tax &Accounting, 7th ed. 2011 & Supp. 2016-1) (“Willis”) (“whatever vitality was historicallyaccorded the doctrine, it should be infrequently, if ever, applied”).

69 1999-1 C.B. 432.

70 See generally Jasper L. Cummings, A General Theory of F Reorganizations, Tax Notes797 (Nov. 6, 2012); Robert Rizzi, The Bubble Principle Survives Final F Reorganization Rules,43 J. Corp. Tax’n 16 (Jan./Feb. 2016).

71 1958-2 C.B. 145.

72 1968-2 C.B. 143.

35

Simultaneously, individual A contributed property to X in exchange for X stock; the amount of

X stock received by A did not constitute control under section 368(c). The Service concluded

that, because X was organized for the purpose of enabling A to transfer appreciated assets

without the recognition of gain, it was “merely a continuation” of Y, which was treated as an F

reorganization of Y. Viewing the transaction as an F reorganization of Y, A’s contribution was

not entitled to nonrecognition. In Rev. Rul. 76-123,73 the Service distinguished Rev. Rul. 68-

349. In that ruling, two individuals, A and B, each transferred stock in their wholly owned

corporations, X and Y, respectively, to Z, a newly formed corporation, in exchange for Z stock

(60% and 40%, respectively). Immediately following the transfers, X liquidated into Z. The

Service respected the steps, concluding that “Z was not employed solely for the purpose of

enabling B to transfer B’s Y stock without the recognition of gain and was not merely a

continuation of X.” In Rev. Rul. 79-250,74 the Service ruled that the reincorporation of a parent

corporation immediately following an acquisition through a triangular reorganization qualified as

an F reorganization notwithstanding the change in shareholders because the triangular

reorganization and the reincorporation were each “sufficiently meaningful on its own account.”

That holding was modified in Rev. Rul. 96-29,75 which stated that the reincorporation qualified

as an F reorganization due to the “unique status” of F reorganizations, implying that the steps

that had occurred “pursuant to an overall plan” might have otherwise been subject to the step-

transaction doctrine.

73 1976-1 C.B. 94.

74 1979-2 C.B. 156, obsoleted by T.D. 9739, 80 Fed. Reg. 56904 (Sept. 21, 2015).

75 1996-1 C.B. 50, obsoleted by T.D. 9739, 80 Fed. Reg. 56904 (Sept. 21, 2015).

36

While the rulings do not articulate a rationale for the bubble concept for F

reorganizations, the preamble to Treas. Reg. § 1.368-2(m) provides some explanation in its

description of the proposed regulations:76

The Treasury Department and the IRS also recognized that an F reorganizationmay be a step in a larger transaction that effects more than a Mere Change. Forexample, in Situation 1 of Rev. Rul. 96-29, 1996-1 CB 50, the IRS ruled that areincorporation qualified as an F reorganization even though it was a step in atransaction in which the reincorporated entity issued common stock in a publicoffering and redeemed preferred stock having a value of 40 percent of theaggregate value of its outstanding stock immediately prior to the offering. InSituation 2 of the same ruling, the IRS ruled that a reincorporation of acorporation in another state qualified as an F reorganization even though it was astep in a transaction in which the reincorporated entity acquired the business ofanother entity.

Consistent with Rev. Rul. 96-29, the 2004 Proposed Regulations provided thatevents occurring before or after a transaction or series of transactions thatotherwise constitutes a Mere Change and related thereto would not cause theMere Change to fail to qualify as an F reorganization (the Related Events Rule).The 2004 Proposed Regulations further provided that the qualification of theMere Change as an F reorganization would not alter the treatment of the otherevents.

The Related Events Rule would have operated in tandem with the proposal, whichwas made a final rule in the 2005 Regulations, that the continuity of interest andcontinuity of business enterprise requirements of § 1.368-1(d) and (e) that aregenerally applicable to reorganizations under section 368 do not apply to Freorganizations. These rules, together, would have focused the F reorganizationanalysis on the discrete step or series of steps (to use the words of manyobservers, those steps occurring “in a bubble”) that may satisfy the fourrequirements for a Mere Change, even if these steps constitute part of a largerseries of steps. In other words, these rules rejected the application of steptransaction principles to integrate all the steps of the overall plan or agreement toaccomplish the larger transaction and thereby potentially prevent the transactionfrom qualifying as an F reorganization.

The preamble then elaborated on the approach in its description of the final regulations:77

76 T.D. 9739, 80 Fed. Reg. 56904 (Sept. 21, 2015).

77 Id.

37

[A]n F reorganization may be a step, or a series of steps, before, within, or afterother transactions that effect more than a Mere Change, even if the ResultingCorporation has only a transitory existence following the Mere Change. In somecases an F reorganization sets the stage for later transactions by alleviating non-tax impediments to a transfer of assets. In other cases, prior transactions maytailor the assets and shareholders of the Transferor Corporation before thecommencement of the F reorganization. Although an F reorganization mayfacilitate another transaction that is part of the same plan, the TreasuryDepartment and the IRS have concluded that step transaction principles generallyshould not recharacterize F reorganizations because F reorganizations involveonly one corporation and do not resemble sales of assets.

What can be gleaned from the preamble and the rulings that preceded the issuance of

Treas. Reg. § 1.368-2(m) is that the step-transaction doctrine really ought not to apply to cause a

potential F reorganization to fail to qualify, since the stakes of not qualifying – possible taxation

at both the shareholder and corporate levels – are too severe in relation to the limited effects that

are actually achieved in the transaction.78 One commentator describes the rationale as follows:79

Although the policy basis for distinguishing F reorganizations is clear, and isconsistent with the modern focus of the nonrecognition rules on whether or not aparticular transaction “resembles a sale,” the rationale for treating Freorganizations on a standalone basis and for turning off the step-transactiondoctrine in connection with F reorganizations, has a larger history. A prior effortin Rev. Rul. 96-29 to justify this distinction between F reorganizations andvirtually all other nonrecognition transactions simply noted the “unique status ofreorganizations under §368(a)(1)(F).” That ruling in turn modified (substantially)the IRS’s earlier approach to separating two different transactions, and topermitting the step-transaction doctrine to be switched off. In Rev. Rul. 79-250,the rationale behind the conclusion that the merger and reincorporation wereseparate was because “the economic motivation supporting each transaction issufficiently meaningful on its own account.” Since the “unique status” approach

78 See Berghash v. Commissioner, 43 T.C. 743, 752 (1965), aff’d, 361 F.2d 257 (2d Cir.1966) (“the (F) reorganization typically has been understood to comprehend only suchinsignificant modifications [such as] surviving under a new charter either in the same or in adifferent State, the renewal of a corporate charter having a limited life, or the conversion of aU.S.-chartered savings and loan association to a State-chartered institution”).

79 Robert Rizzi, The Bubble Principle Survives Final F Reorganization Rules, 43 J. Corp.Tax’n 16, 20 (Jan./Feb. 2016) (internal footnotes omitted).

38

to F reorganizations reached the same result as the “sufficiently meaningful”theory, no damage was done to the fabric of the step-transaction doctrine, and onecould argue that the 1996 approach was more transparent.

Although the stakes are not as high for characterizing partnership transactions as

continuations as they are for characterizing corporate transactions as F reorganizations, because

of the similarities between F reorganizations and partnership continuations, some of the same

justifications for the application of the bubble concept to F reorganizations are relevant to

partnership continuations. First, a partnership continuation, like an F reorganization, does not

resemble a sale. Moreover, according to Rev. Rul. 96-29, F reorganizations are “treated for most

purposes of the Code as if there had been no change in the corporation, and, thus, as if the

reorganized corporation is the same entity as the corporation that was in existence prior to the

reorganization.” As a result, the step-transaction doctrine does not apply in determining whether

a transaction qualifies as an F reorganization because the consequence of being an F

reorganization under various provisions of the Code is to treat the reorganized entity as the same

corporation. Based on that same logic, the step-transaction doctrine should not apply in

determining whether a transaction constitutes a partnership continuation, since by definition

under section 708(a), the consequence of being a partnership continuation is that the entity is the

same partnership.80

80 The partnership merger and division regulations, by contrast, provide the Commissionerwith the discretion to recast a potential merger or division when it is part of a larger series oftransactions the substance of which is inconsistent with the form of the merger or division. SeeTreas. Reg. §§ 1.708-1(c)(6) and 1.708-1(d)(6). Because partnership mergers and divisions areless analogous to F reorganizations, the bubble concept may have less relevance to suchtransactions. However, the Service recently issued a private letter ruling that could be read tosuggest that there is a role for the bubble concept to apply in partnership mergers and divisions.See PLR 201619001 (May 6, 2016) (partnership division and merger respected as suchnotwithstanding the termination of what appears to be the divided partnership in connection withthe subsequent merger); see also PLRs 201643016-019 (Oct. 21, 2016) (same).

39

While the Service has not explicitly adopted the bubble concept for partnership

continuations, there are a number of private letter rulings that have reached the conclusion that a

partnership continued notwithstanding prior or subsequent transactions that occurred as part of

the overall plan. For example, in PLR 8448060,81 the transfer by a partner of a portion of its

partnership interest to a wholly owned subsidiary prior to the conversion of the partnership from

a general partnership to limited partnership did not affect the conclusion that the limited

partnership was a continuation of the general partnership. And more recently, in PLR

201605004,82 the subsequent sale of interests in the continuing partnership did not affect

continuation conclusion.83

The application of the bubble concept to treat the transaction as a partnership

continuation does not provide any party with an unwarranted tax benefit that could not have

otherwise been achieved. The consequence of treating the contribution of the Old LLC interests

81 (Aug. 28, 1984).

82 (Jan. 29, 2016).

83 See also GCM 33774 (Mar. 22, 1968) (partnership continuation conclusion not affectedby the withdrawal of two partners and addition of four new partners occurring in connection withthe continuation transaction); PLR 8246095 (Aug. 19, 1982) (conversion of limited partnershipto a general partnership did not result in a sale or exchange of interests notwithstanding mergerof general partnership into another partnership following the conversion); PLR 8302108 (Oct.15, 1983) (transfer of part of partnership interest to other partner immediately followingcontinuation transaction did not affect the continuation conclusion); PLR 8542044 (July 23,1985) (admission of new partner in connection with conversion of general partnership to limitedpartnership did not affect conclusion that limited partnership was a continuation of generalpartnership); PLR 8904061 (Nov. 3, 1988) (sale of interest in general partnership andamendment of agreement to provide for special allocations prior to conversion to limitedpartnership did not affect conclusion that limited partnership was a continuation of generalpartnership); PLR 9419017 (Feb. 8, 1994) (admission of two new partners simultaneously withthe conversion of partnership from one state to another did not affect the conclusion that thepartnership continued).

40

in exchange for the New LLC interests in Example 8 as a partnership continuation is to allow the

transaction to be treated in the same manner as if Old LLC had simply sold its assets directly to

the buyer, had already owned its assets in a disregarded entity that it could sell to the buyer, or

had transferred its assets to a disregarded entity, the interests in which could then be sold to the

buyer. Despite the fact that New LLC’s existence and ownership of Old LLC are transitory, the

transaction should be viewed in a bubble, i.e., without the application of the step-transaction

doctrine, and treated as a partnership continuation followed by an asset sale.

3. The Technical Termination Paradox

One of the more vexing problems that can arise in a potential partnership continuation

transaction involves the effect of a technical termination on the continuation conclusion.

Unfortunately, none of the guidance has confronted this problem.

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Example 9. A and B are members of AB LLC. C is the sole member of OpCo LLC.OpCo LLC is newly formed and holds only cash that C contributed to effect thetransaction. A and B contribute their interests in AB LLC to OpCo LLC in exchangefor the cash C contributed and 40% of the interests in OpCo LLC. OpCo LLCbecomes a partnership for federal tax purposes, and AB LLC becomes a disregardedentity for federal tax purposes.

Example 9Before After

AB LLC

A B C

Cash

OpCo LLC

A C

60%

B

Cash

AB LLC

OpCo LLC

For the same reasons as discussed above regarding Example 5, OpCo LLC should be

treated as a continuation of AB LLC under the general continuation rule. As in Example 5, to

characterize the transaction consistent with the continuation conclusion, A and B likely would be

treated as selling partnership interests to C under section 707(a)(2)(B). However, in this

example, the sale to C would cause a technical termination of AB LLC because there would be a

sale or exchange of 50% or more of the interests in partnership capital and profits in a 12-month

period. If the technical termination prevents OpCo LLC from being treated as a continuation of

AB LLC in the first instance, this would create a paradox: The partnership terminates under

section 708(b)(1)(B) as a result of the deemed transactions that arise in connection with the

recast of the transaction consistent with the continuation conclusion, which means the

partnership doesn’t continue, which means there won’t be a recast and the partnership won’t

42

have a technical termination. The transaction would presumably be treated as if AB LLC

contributed its assets and liabilities to a newly formed partnership with C in a transaction

governed by Rev. Rul. 99-5 (Situation 2),84 in a part-sale, part-contribution transaction.85 On the

other hand, if the technical termination was viewed as one of the consequences of the transaction

after it has been identified (in a bubble) as a continuation, the technical termination would not

undermine the initial continuation conclusion – the transaction would be treated as if AB LLC

continued but then immediately had a technical termination.

Rev. Rul. 90-17,86 could be read to support another approach: Once the continuation

conclusion is made, the transactions that are deemed to occur cannot cause a technical

termination. In Rev. Rul. 90-17, three partnerships combined into a single partnership that was

treated as the continuation of one of the partnerships under section 708(b)(2)(A). The other two

partnerships were considered to terminate. Under Rev. Rul. 68-289,87 the terminating

partnerships were treated as contributing their assets and liabilities to the continuing partnership

in exchange for interests in the continuing partnership, then distributing the interests in the

continuing partnership in liquidation.88 Under section 761(e), the distributions of the interests in

the continuing partnership by the terminating partnerships are treated as exchanges of such

84 1999-1 C.B. 434.

85 Query whether A and B might be respected as transferring their partnership interests toOpCo LLC under the approach of Rev. Rul. 99-6, 1991-1 C.B. 432?

86 1990-1 C.B. 119.

87 1968-1 C.B. 314.

88 That construct for a partnership merger is now contained in Treas. Reg. § 1.708-1(c)(3)(i), which applies in all cases, except in the case of a transaction qualifying as an “assets-up” merger under Treas. Reg. § 1.708-1(c)(3)(ii).

43

interests for purposes of section 708. Under the facts of the ruling, 50% of the interests in the

continuing partnership were treated as distributed by the terminating partnerships, thereby raising

the question as to whether the continuing partnership had a technical termination. Rev. Rul. 90-

17 concluded that the distribution of the interests in the continuing partnership that occurred

“during the course of the merger” does not cause a technical termination of the continuing

partnership.

While the conclusion of Rev. Rul. 90-17 might support an argument that a sale or

exchange in the continuing partnership that occurs in connection with the recharacterization of

the transaction consistent with the continuation conclusion cannot cause a technical termination,

the rationale of the ruling suggests a more limited application of its holding. The ruling notes

that the distributions of the interests in the continuing partnership are part of the merger

transaction itself, and there is a specific rule in section 708(b)(2)(A) that determines when a

partnership continues and when it terminates in the context of a partnership merger. The ruling

cites the principle of statutory construction that “a specific statutory provision, like section

708(b)(2), is not controlled or nullified by a more general one, like section 708(b)(1), unless that

result is clearly intended.” The ruling then cites a lack of any indication from the legislative

history of section 708(b)(1)(B) or section 761(e) that the provisions of section 708(b)(1)(B) were

to take precedence over section 708(b)(2)(A). The ruling thus concludes that “a resulting

(continuing) partnership in a merger to which section 708(b)(2)(A) applies is, as to the elements

of the merger itself, excepted from the application of the termination provisions of section

708(b)(1).” In Example 9, by contrast, initially AB LLC continues because it does not terminate

under the “General Rule” in section 708(b)(1)(A). However, it does not follow that AB LLC

cannot then terminate under the other “General Rule” in section 708(b)(1)(B). Unlike the

44

situation in Rev. Rul. 90-17, there is no specific statutory rule that applies to characterize the

entire transaction and mandates that AB LLC be treated as the continuing partnership. Thus,

Rev. Rul. 90-17 does not support insulating AB LLC from a technical termination.

In order to avoid the paradox described above, the better view is that the technical

termination does not preclude the initial continuation conclusion. Consistent with the application

of the bubble concept to partnership continuations, OpCo LLC is the continuation of AB LLC in

the bubble, but then should be treated as having a technical termination under section

708(b)(1)(B).

4. To Continue or Not To Continue: The Role of Continuity of Business Enterpriseand Continuity of Interest

The following examples, which address the role of the law surrounding the COBE and

COI requirements in evaluating potential partnership continuation transactions, demonstrate that,

in certain cases, whether a partnership continues can be controlled by the parties.

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Example 10. A and B are members of AB LLC. AB LLC’s assets and liabilities areheld through a disregarded entity. C contributes cash to OpCo LLC, a newly formedLLC. AB LLC transfers the disregarded entity to OpCo LLC for cash and 60% of theinterests in OpCo LLC, then liquidates.

Example 10Before After

AB LLC

DRE interests

DRE

Cash Cash

A B C

Cash

OpCo LLC

OpCo LLC

A C

40%

B

DRE

Although Example 10 uses the “assets-over” form rather than the “interests-over” form as in

Example 5, the conclusion should be the same: OpCo LLC is a continuation of AB LLC, and C

is likely treated as purchasing AB LLC interests from A and B under section 707(a)(2)(B).

46

Example 11. Assume the same facts as in Example 10, except that AB LLCdistributes the interests in OpCo LLC but retains the cash for reinvestment in otherassets.

Example 11Before After

OpCo LLCAB LLC

40%

Cash

DRE

AB LLC

DRE interests

DRE

A B C

Cash

OpCo LLC

A CB

As in Example 10, OpCo LLC is a continuation of AB LLC, since A and B are each partners in

OpCo LLC, which is continuing the business of AB LLC. But AB LLC is also continuing as a

partnership, using the cash it received for reinvestment in other assets; however, its assets will be

newly acquired assets and not any assets used in AB LLC’s historic business, financial operation,

or venture. As a result, whether post-transaction AB LLC is a continuation of pre-transaction

AB LLC under section 708(a) depends on whether the cash and newly acquired assets will

establish the “continuity of operation contemplated by section 708(b)(1)(A)” as described in

Neubecker.89

Similar issues are presented for corporate reorganizations in connection with the COBE

requirement. As that requirement was initially interpreted, it did “not demand that the new

89 65 T.C. at 582.

47

corporation engage in the same or a similar business as its predecessor; it require[d] only that

there be continuity of business activity. . . . [C]ontinuity of a business enterprise using the

transferor’s assets, whether or not it was carried on before the reorganization by a party thereto,

was sufficient.”90 Although the COBE regulations now require the transferee corporation either

to continue the transferor’s historic business or to continue to use a significant portion of the

transferor’s historic business assets in a business,91 the regulations are not applicable to F

reorganizations.92 Because those regulations do not apply to F reorganizations, the approach

should not be applicable to partnership continuations. Instead, the historic, judicial approach to

the COBE requirement would seem to be a more relevant standard for partnership continuations.

Any other approach would lead to the absurd result of having partnerships terminate under

section 708(b)(1)(A) upon a sale or other disposition of substantially all of its assets, including in

a like-kind exchange, in a section 351 exchange, or simply in a contribution into a lower-tier

partnership in a section 721 exchange.93 Thus, AB LLC should be treated as continuing under

section 708(a).

Since both OpCo LLC and AB LLC should be treated as continuations of AB LLC under

the general continuation rule, the transaction ought to be treated as a partnership division under

90 Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations andShareholders ¶12.61[2][a] (Thomson Reuters/Tax & Accounting, 7th ed. 2000 & Supp. 2015-03).

91 See Treas. Reg. § 1.368-1(d)(5).

92 See Treas. Reg. § 1.368-2(m)(2).

93 Such an approach was rejected in Foxman v. Commissioner, 41 T.C. 535 (1964), aff’d,352 F.2d 466 (3d Cir. 1965) (holding that a partnership continued even after it sold all its assetsand retained only promissory notes).

48

section 708(b)(2)(B).94 Assuming the transaction is treated as a partnership division,95 AB LLC

would be treated as the “divided partnership” because it is a “resulting partnership” that is a

continuing partnership that, in form, transferred the assets and liabilities; thus, C would be

treated as contributing cash and AB LLC would be treated as transferring its assets and liabilities

to OpCo LLC in exchange for OpCo LLC interests and cash in a part-sale, part-contribution

transaction, then it would be treated as distributing the OpCo LLC interests to A and B.96

94 See discussion in Part I.B., above.

95 It is somewhat unusual to have a partner admitted to the recipient partnership prior to itsdistribution by the divided partnership, but there is no reason to believe that the transactionwould not be treated as a partnership division.

96 See Treas. Reg. § 1.708-1(d)(3)(i), -1(d)(4)(i).

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Example 12. Assume the same facts as in Example 11, except that AB LLCdistributes the cash but retains the interests in OpCo LLC.

Example 12Before After

OpCo LLC

A CB

AB LLC40%

Cash Cash

DRE

AB LLC

DRE interests

DRE

A B C

Cash

OpCo LLC

For the reasons discussed above, AB LLC should be treated as continuing under section 708(a)

even though it has transferred a portion its assets to OpCo LLC, since it continues to exist as a

partnership between A and B, and holding the OpCo LLC interest should be treated as

continuing “part of any business, financial operation, or venture of” AB LLC.

In this example, OpCo LLC should not be treated as a continuation of AB LLC. Even

though OpCo LLC continues to carry on the business of AB LLC and even though A and B are

indirect partners of OpCo LLC, the plain language of section 708(b)(1)(A) does not appear to

permit a partnership to be viewed as a continuation where the partners in the existing partnership

are merely indirect partners. This literal interpretation of section 708(b)(1)(A) is consistent with

how the COI requirement for corporate reorganizations was applied prior to the issuance of

50

regulations beginning in 1998 that allowed for the COI requirement to be satisfied remotely

through indirect ownership.97 If a partnership could be treated as a continuation when partners

are merely indirect partners, every contribution of assets into a lower-tier partnership would

result in the lower-tier partnership being a continuation, not only of itself (if it is not newly

formed), but also of the contributing partnership. Thus, remote continuity should not be

sufficient for a partnership to continue. In this example, OpCo LLC would simply be a newly

formed partnership that is not a continuation of AB LLC, and AB LLC should be treated as

transferring its assets and liabilities to OpCo LLC in a part-sale, part-contribution transaction

governed by Rev. Rul. 99-5 (Situation 2), then distributing the cash to its members.98

97 Treas. Reg. §§ 1.368-1(e) and 1.355-2(c). See Groman v. Commissioner, 302 U.S. 82(1937) (COI requirement not satisfied to the extent target shareholders received stock of theacquiring corporation’s parent). See generally Boris I. Bittker and James S. Eustice, FederalIncome Taxation of Corporations and Shareholders ¶12.21[3] (Thomson Reuters/Tax &Accounting, 7th ed. 2000 & Supp. 2015-03).

98 There are some advisors who believe that the transaction should be treated as governedby Rev. Rul. 99-5 (Situation 1), since the cash was immediately distributed by OpCo LLC.While there is no authority directly on point, the better view is that the transaction is governed byRev. Rul. 99-5 (Situation 2) and treated as a part-sale, part-contribution, in which the exceptionsto disguised-sale treatment in Treas. Reg. § 1.707-4 are potentially applicable.

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Example 13. Assume the same facts as in Example 12, except that AB LLCliquidates one week later, distributing the OpCo LLC interests to A and B.

40%

Example 13

AB LLC

A B C

OpCo LLC

A C

Cash Cash

OpCo LLC

A C

40%

B

Cash Cash

DRE

DRE

OpCo LLC

B

DRE

Cash

Before Interim One Week Later

DREinterests

AB LLC

If the liquidation had occurred immediately following the contribution, as in Example 10,

OpCo LLC would clearly be a continuation of AB LLC under the general continuation rule. If

AB LLC did not liquidate, as in Example 12, OpCo LLC would not be a continuation of AB

LLC. Where there is a delay in the liquidation of AB LLC, does the step-transaction doctrine

apply to nevertheless treat OpCo LLC as a continuation where the liquidation was part of a plan?

The answer is unclear, although a case can be made that OpCo LLC should not be a continuation

of AB LLC.99 If the step-transaction doctrine does not apply to prevent a transaction from being

99 In Neubecker v. Commissioner, 65 T.C. 577, 578 (1975), a newly formed partnership wastreated as a continuation of a prior partnership where the prior partnership dissolved and the newpartnership was formed “immediately thereafter.”

52

a continuation, it arguably should not be applied to permit a transaction to be a continuation.100

In addition, under Neubecker, AB LLC would not terminate until there is a complete cessation of

business; thus, if AB LLC continues until it liquidates, and OpCo LLC is formed and operates

before AB LLC liquidates, during which time it cannot be a continuation of AB LLC, it would

begin as a new partnership but then later be treated as a continuation of AB LLC, which does not

seem viable. As a result, an argument can be made that OpCo LLC should not be a continuation

of AB LLC, even though that creates optionality as to whether a transaction results in a

partnership continuation.

100 In the context of a potential F reorganization, however, Treas. Reg. § 1.368-2(m)(3)(i)provides that “a series of related transactions that together result in a mere change of onecorporation may qualify as [an F reorganization] whether or not certain steps in the series,viewed in isolation, could be subject to other Code provisions.”

53

5. Partnership Continuation or Division?

Example 14. A and B are members of Old LLC, which owns 100% of twodisregarded entities, LLC 1 and LLC 2. C contributes assets to LLC 1 in exchangefor LLC 1 interests. Immediately following C’s contribution and as part of the sameoverall plan, Old LLC distributes its interest in LLC 1 to A in complete redemption ofA’s interest in Old LLC. Thus, LLC 1 is a partnership between A and C, and OldLLC and LLC 2 are disregarded entities of B.

Example 14Before Interim After

A B

C

A B C BA

Old LLC Old LLC LLC1

LLC1 LLC2

LLC1

LLC2 LLC2

Old LLC

LLC 1 would seem to be a continuation of Old LLC, since a partner of Old LLC is continuing to

carry on part of the business of Old LLC as a partner in a partnership. Consistent with the

continuation conclusion, the transaction should be treated as if C contributed assets to Old LLC,

which distributed LLC 2’s assets to B in liquidation of B’s interest in Old LLC.101 The same

101 There would have been an issue under the proposed disguised sale of partnership interestregulations under section 707, which were (thankfully) withdrawn, as to whether C’scontribution of assets, together with Old LLC’s distribution of other, historic assets to B, couldhave been recharacterized as a disguised sale of a B’s partnership interest to C (after Cexchanged its assets for the assets in LLC 2 (likely in a taxable transaction to C and Old LLC)).See Prop. Treas. Reg. § 1.707-7(l) (Example 3), withdrawn by Announcement 2009-4, 2009-8I.R.B. 597.

54

result would occur if the distribution of the LLC 1 interests to A happened immediately prior to

C’s contribution to LLC 1, since LLC 1 would still be treated as a continuation of Old LLC.

Example 15. Assume the same facts as in Example 14, except that D is also amember of Old LLC. Thus, after the distribution to A, Old LLC remains apartnership.

Example 15Before Interim After

A B

C

A B

Old LLC Old LLC

LLC1

LLC2

D B DD

LLC2

Old LLC

C A

LLC1

LLC1 LLC2

Example 15 presents an analytical anomaly. It is clear that Old LLC continues, since two of its

partners continue to carry on part of its business as partners in a partnership. And for the reasons

discussed above, LLC 1 should also be viewed as a continuation of Old LLC under the general

continuation rule, since a partner continues part of the business of the existing partnership in a

partnership. As discussed above in Part I.B., because two partnerships resulting from a

transaction would be treated as a continuation of a single partnership, the transaction ought to be

55

treated as a partnership division governed by section 708(b)(2)(B). However, under Treas. Reg.

§ 1.708-1(d)(4)(iv), LLC 1 cannot be a “resulting partnership” because it has only one partner

from Old LLC. Therefore, under the regulations, the transaction would not be treated as a

division under section 708(b)(2)(B). Nevertheless, LLC 1 would still seem to be a continuation

of Old LLC under the general continuation rule.102 Even though it is not entirely clear whether

LLC 1 would be treated as a continuation of Old LLC, the transaction should be treated as Old

LLC contributing the assets and liabilities of LLC 1 to a partnership with C in a transaction

governed by Rev. Rul. 99-5 (Situation 2) followed by a distribution of the partnership interest to

A, a construct that is generally consistent with the partnership division regulations. 103

6. What’s Old Is New

The transaction structure presented below is common in situations where a new partner is

to be admitted to an existing partnership, but the existing partners want to keep their economic

and legal arrangements private, or at least separate, from the new partner.

102 A similar analysis would apply if Old LLC had simply distributed a portion of its interestin LLC 1 to A (without involving C at all). LLC 1 would appear to be a continuation of OldLLC because it has a partner (A) continue part of its business in a partnership, but it cannot be adivision under the regulations, since it has only one partner from Old LLC.

103 See Treas. Reg. § 1.708-1(d)(3)(i). Query whether the treatment of the transaction wouldbe different if A had owned 60% of the capital and profits of Old LLC so that post-transactionOld LLC would not be treated as a continuation of pre-transaction Old LLC if the transactionwere treated as a partnership division governed by section 708(b)(2)(B)?

56

Example 16. X and Y, members of Old LLC, contribute their Old LLC intereststo New LLC for all the interests in New LLC. Thus, New LLC becomes apartnership for federal tax purposes, and Old LLC becomes a disregarded entityof New LLC for federal tax purposes. Immediately following that transaction andas part of the overall plan, Z contributes assets to Old LLC, turning Old LLC backinto a partnership for federal tax purposes.

Example 16Before Interim After

X Y X Y X Y

Old LLC New LLC

Old LLC

Old LLC

Z Z

New LLC

In the bubble immediately following the contribution of the Old LLC interests to New LLC, New

LLC would be a continuation of Old LLC in a drop-down continuation. New LLC, which is a

continuation of Old LLC, would then be treated as contributing its assets and liabilities into a

new partnership (named Old LLC) with Z in a transaction governed by Rev. Rul. 99-5 (Situation

2). New LLC is a continuation of Old LLC, and Old LLC is a new partnership: What’s old is

new, and what’s new is old.104

This example presents a real challenge to the application of the bubble concept to

partnership continuations. Because Old LLC is a partnership at the beginning and end of the

104 Engage in this form of transaction at your peril, as it typically maximizes confusionamong all parties involved, given the conflict between the tax construct and the legal construct.

57

transaction, it would certainly seem reasonable to conclude that Old LLC remained a partnership

throughout the transaction; Z simply made a contribution directly to Old LLC, and X and Y

contributed their Old LLC interests to New LLC,105 which would be treated as a new partnership

for federal tax purposes. However, that is not the better view. First, that approach requires a

resequencing of the transactions that occurred, and such a resequencing should not be permitted

as the transactions have the same number of steps.106 Second, if the bubble concept were not

applied to partnership continuations, at the end of the transaction, post-transaction Old LLC

would not be a continuation of pre-transaction Old LLC under the statute, since none of pre-

transaction Old LLC’s partners is a direct partner in post-transaction Old LLC, whereas New

LLC would still be a continuation of Old LLC, since, as discussed above, the fact that New LLC

does not continue the same business as Old LLC – New LLC is simply an upper-tier holding

partnership, owning an interest in a partnership that conducts the business of Old LLC – should

not mean that it does not continue to carry on the “business, financial operation, or venture” of

Old LLC.

If the transaction were structured to have Z’s contribution to Old LLC precede the

transfer by X and Y to New LLC, then there would not be a transaction in a bubble where New

LLC would be a continuation of Old LLC; rather, there is a transaction in a bubble where Old

105 In this view of the transaction, if X and Y owned 50% or more of the interests in thecapital and profits of Old LLC after Z’s contribution, Old LLC would terminate under section708(b)(1)(B) as a result of the contribution to New LLC.

106 See Esmark v. Commissioner, 90 T.C. 171 (1988), aff’d, 886 F.2d 1318 (7th Cir. 1989);Rev. Rul. 84-111, 1984-2 C.B. 88. In fact, following the sequence of the actual legal stepsresults in the transaction having only one step for federal tax purposes: The formation of anewly formed partnership with Z. The resequenced transaction would result in the transactionhaving two steps for federal tax purposes: Z’s contribution to Old LLC, followed by thecontribution of the Old LLC interests by X and Y to New LLC.

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LLC is the continuing partnership. Thus, the form should be respected and not resequenced, and

Old LLC should be treated as continuing following Z’s contribution (the continuation in a

bubble), and the transfer by X and Y to New LLC should not then disturb that continuation

conclusion even though neither X nor Y continues to own a direct interest in Old LLC.107

7. Partnership Continuation or Merger?

Example 17. A and B are members of AB LLC. OpCo LLC is a newly formedpartnership between C and D, which each contributed cash to effect the transaction.A and B transfer their interests in AB LLC to OpCo LLC in exchange for the cashcontributed by C and D and 60% of the interests in OpCo LLC.

Example 17Before After

A B C D

AB LLC OpCo LLC

B DCA

AB LLC

OpCo LLC

OpCo LLC should be viewed as a continuation of AB LLC (as in Example 5). The

question is whether OpCo LLC should also be viewed as an “existing partnership” under section

708(a) that also continues, resulting in the transaction being viewed as a partnership merger and

107 The transfer would result in a technical termination of Old LLC under section708(b)(1)(B) if 50% or more of the capital and profits interests in Old LLC is transferred to NewLLC.

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governed by section 708(b)(2)(A). Assuming OpCo LLC was formed immediately prior to and

solely for the purposes of effecting the transaction, for the same reasons transitory merger

subsidiaries are disregarded,108 it should not be treated as an existing partnership for purposes of

section 708(a).109 Thus, the transaction should be treated in a manner similar to Example 5:

OpCo LLC should be a continuation of AB LLC, and C and D should be treated as contributing

cash to the partnership which is distributed to A and B, resulting in C and D being treated as

purchasing partnership interests from A and B under section 707(a)(2)(B).110

Example 18. Assume the same facts as in Example 17, except that OpCo LLC is anold and cold partnership between C and D (and the cash transferred to A and B wason hand in OpCo LLC).

Example 18Before After

A B C D

AB LLC OpCo LLC

B DCA

AB LLC

OpCo LLC

108 See Rev. Rul. 90-95 (Situation 1), 1990-2 C.B. 67.

109 Similar to the result in Example 13, this allows for some optionality in whether atransaction will constitute a partnership merger. Query how long OpCo LLC would need to bein existence and with what quantum of assets and activity for it not to be regarded as transitory?

110 If C and D are treated as purchasing 50% or more of the capital and profits interests in Aand B, AB LLC would have a technical termination under section 708(b)(1)(B). See discussionin Part II.B.3., above.

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The consequences in Example 18 are quite clear. The transaction should be treated as a merger

under section 708(b)(2)(A). Whether AB LLC or OpCo LLC (or neither) will be treated as the

continuing partnership will depend on whether A and B or C and D own more than 50% in the

capital and profits of OpCo LLC after the transaction. If AB LLC is the continuing partnership,

OpCo LLC will be treated as contributing its assets and liabilities to AB LLC in exchange for

AB LLC interest and then liquidating.111 The cash would then be treated as distributed to A and

B, resulting in A and B being treated as selling a portion of their partnership interests. On the

other hand, if OpCo LLC is the continuing partnership, AB LLC will be treated as contributing

its assets and liabilities to OpCo LLC in exchange for OpCo LLC interests and cash, the receipt

of which will give rise to a disguised sale of property under section 707(a)(2)(B) and Treas. Reg.

§ 1.707-3,112 and then liquidating.113

8. What is it?

While the consequences of many of the above examples are far from clear, the following

examples present even more uncertain consequences, where multiple positions are likely

defensible. As a result, in any transaction like the ones presented below, it is advisable (even

more so than for partnership continuations generally) that all parties agree as to how the

transaction should be reported and agree to report the transaction consistently.

111 Treas. Reg. § 1.708-1(c)(3)(i).

112 If A and B were sharing the cash disproportionately, they would likely want to rely on theso-called partner buy-out rule under Treas. Reg. § 1.708-1(c)(4) to ensure the gain follows thereceipt of cash.

113 Treas. Reg. § 1.708-1(c)(3)(i).

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Example 19. A and B are members of AB LLC, which owns 100% of LLC 1 andLLC 2. C and D are members of OpCo LLC, an operating partnership. AB LLCcontributes the LLC 2 interests to OpCo LLC in exchange for OpCo LLCinterests and, as part of the same overall plan, distributes the OpCo LLC interestsproportionately to A and B. Thus, A and B are members of AB LLC, which holds100% of LLC 1, and are members of Opco LLC, which holds OpCo LLC’shistoric assets as well as LLC 2.

Example 19Before After

A B C D

AB LLC OpCo LLC

B DCA

LLC2 Interests

LLC1

AB LLC

LLC2 LLC1 LLC2

OpCo LLC

AB LLC and Opco LLC would both be continuations of AB LLC under the general continuation

rule, since A and B are members of both partnerships, which both continue part of AB LLC’s

business. As discussed above in Part I.B., where two partnerships can be treated as a

continuation of one prior partnership, the transaction ought to be governed by the special

division rule in section 708(b)(2)(B). However, that provision requires the partnerships to be

“resulting partnerships,” and OpCo LLC would not appear to be a partnership “resulting” from

the division, since it existed prior to the division. Thus, the special rule in section 708(b)(2)(B)

does not appear applicable.

Under the general continuation rule, OpCo LLC would be a continuation of OpCo LLC

and of AB LLC, since it has partners from each entity and continues part of the business of each

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entity. As discussed above in Part I.B., where a partnership can be treated as the continuation of

more than one partnership, the special merger rule in section 708(b)(2)(A) ought to apply. Under

that rule, OpCo LLC would be treated as a continuation of the partnership whose members own

more than 50% of the capital and profits of OpCo LLC after the transaction. However, it is

difficult to see how the transaction could be a merger when the number of partnerships has not

been reduced in the transaction: Neither should be treated as terminating because both continue.

Although the transaction could be viewed as a partnership merger or division, it is likely neither.

If the transaction is neither a partnership merger nor a partnership division, but the

general continuation rule would treat OpCo LLC as a continuation of both AB LLC and OpCo

LLC, it is not entirely clear what the continuation conclusion should be nor is it clear how the

transaction should be characterized. Perhaps it is most sensible not to treat OpCo LLC as a

continuation of AB LLC, notwithstanding the general continuation rule, since AB LLC is a

continuation of AB LLC and OpCo LLC is a continuation of OpCo LLC.114 Under that approach

the transaction would presumably be taxed in accordance with its form.

114 Query how the transaction would be treated if AB LLC first distributed the LLC 2interests to A and B, who then contributed the interests to OpCo LLC? Would that be apartnership division (in a bubble?) followed by a partnership merger? Or how the transactionwould be treated if, after the distribution of LLC 2 interests to A and B, they contributed the ABLLC interests to OpCo LLC? Again, would that be a partnership division (in a bubble?)followed by a partnership merger? Even if the “divided partnership” terminates in thepartnership merger? This question appears to have recently been answered. In PLR 201619001(May 6, 2016), the Service respected a series of related transactions as a partnership divisionfollowed by a partnership merger even though what appears to have been treated as the dividedpartnership terminated in the merger. The implication of the ruling is that the bubble concept hasrelevance with partnership mergers and divisions as well.

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Example 20. A and B are equal members of UTP 1. C and D are equal members ofUTP 2. The sole assets owned by UTP 1 and UTP 2 are 90% and 10% interests inLTP, respectively. UTP 1 merges into UTP 2. As a result, A and B each own 45% ofUTP 2 and C and D each own 5%, and LTP becomes a disregarded entity of UTP 2.

Example 20Before After

A B C D

UTP1 UTP2

B DCA

45% 5%5%45%

LTP

UTP2

merger

LTP

90% 10%

The transaction would appear to be merger of UTP 1 and UTP 2, governed by the special merger

rule in section 708(b)(2)(A). Under that rule, UTP 2 would be a continuation of UTP 1, since the

members of UTP 1 own more than 50% of the capital and profits interests in UTP 2 after the

transaction. Thus, UTP 2 would be treated as transferring its assets (its 10% interest in LTP) to

UTP 1 in exchange for UTP 1 interests and then liquidating.115 Because UTP 1 would own

100% of LTP, LTP would terminate under section 708(b)(1)(A).116

115 Treas. Reg. § 1.708-1(c)(3)(i).

116 The termination of LTP would be treated either under the bifurcated approach ofSituation 1 of Rev. Rul. 99-6, 1999-1 C.B. 432, or as a transfer of UTP 2’s LTP interest to UTP1, followed by a liquidation of LTP into UTP 1, its sole member, since the holding of Rev. Rul.99-6 is directly applicable only in taxable transactions. The Service would likely apply theapproach in Rev. Rul. 99-6, which the Service has extended to nonrecognition transactions. See,e.g., PLR 201505001 (Sept. 11, 2014) (applying the principles of Rev. Rul. 99-6 to a tax-free

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UTP 2 might be seen as a continuation of LTP under the general continuation rule, since

LTP’s business is carried on by UTP 2. That would presumably result in recharacterizing the

transaction as if UTP 1 and UTP 2 liquidated, distributing interests in LTP to their partners,

which would result in a technical termination of LTP. As discussed in Part II.B.3., above, the

fact that a continuing partnership terminates under section 708(b)(1)(B) in the recharacterized

transaction should not affect the continuation conclusion. However, because none of LTP’s

partners are members of UTP 2, UTP 2 cannot properly be viewed as continuation of LTP.

A case can be made to treat the transaction as not implicating the continuation rules at all.

If UTP 1 and UTP 2 each liquidated, distributing LTP interests to A, B, C, and D, the transaction

would likely be seen as liquidations of UTP 1 and UTP 2.117 Because the result in Example 20 is

identical when viewed with “tax goggles,” it arguably should not be treated any differently.118

While there is a superficial appeal to that argument, it helps demonstrate the scope and

occasional hidden nature of partnership continuations. If UTP 1 and UTP 2 had actually

liquidated, the more analytically correct approach (but likely never followed) would be to treat

(with Maslow’s hammer firmly in hand!) LTP as a continuation of UTP 1. Under the general

continuation rule, LTP could not be a continuation of LTP, since none of the members in pre-

transaction LTP own interests in post-transaction LTP; it would, however, be a continuation of

incorporation of a partnership based on Service’s erroneous view that Rev. Rul. 84-111(Situation 3), 1984-2 C.B. 88, is consistent with Rev. Rul. 99-6). The transaction might also beviewed as a merger of the three partnerships, with UTP 1 as the continuing partnership for taxpurposes.

117 The distribution would cause LTP to terminate under section 708(b)(1)(B).

118 The transactions would not be identical if either UTP 1 or UTP 2 (or both) had assets (orliabilities) other than the LTP interest.

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UTP 1 and UTP 2 under the general continuation rule, since partners in each entity are partners

in LTP, and LTP would be viewed as continuing the business, financial operation, or venture of

UTP 1 and UTP 2, albeit with LTP’s assets, which replaced the LTP interests. Because LTP

could be viewed as a continuation of both UTP 1 and UTP 2, the transaction should arguably be

treated in the same manner as Example 20.

III. Treatment of Continuing Partners: Tax Nothing vs. Realization Event

Once a partnership continuation has been identified, which Part II demonstrates is not

always an easy task, and the transaction recharacterized in a manner consistent with the

continuation conclusion, a question remains as to the tax consequences, if any, to the continuing

partners in the continuing partnership. In many cases, the continuing partners will hold interests

in a different legal entity that may have different legal and economic rights than their interests in

the original partnership.119 Of course, the change in legal rights alone could have incidental

effects on the continuing partners. For example, when a limited partnership converts to an LLC,

the continuing partner that was the general partner may no longer bear the economic risk of loss

for a partnership liability under Treas. Reg. § 1.752-2(b)(1). As a result, there could be a deemed

distribution of money to such partner under section 752(b) that could result in gain recognition

under section 731(a)(1). Or when an LLC converts to a limited partnership, the continuing

119 For example, an entity conversion or migration would result in the continuing partnershaving different legal rights with respect to their continuing partnership interests. In addition,even in transactions where the legal transaction involves an exchange of interests in the sametype of entity in the same jurisdiction, the governance provisions and economic rights may bedifferent in the continuing partnership.

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partners who become limited partners under state law may more comfortably120 exclude their

distributive share of the partnership’s income (other than certain guaranteed payments for

services under section 707(c)) from “net earnings from self-employment” under section

1402(a)(13). Or the default entity classification for the new entity may require a check-the-box

election to be made under Treas. Reg. § 301.7701-3(c) in order for the entity to be treated as a

partnership.121

A change in legal rights may also result in consequences to the partnership and its

creditors with respect to the partnership’s debt. Where a partnership continuation transaction

involves a change in the type of legal entity or a change in the state of organization for the legal

entity, the transaction could cause there to be a “new obligor” with respect to the partnership’s

recourse debt under Treas. Reg. § 1.1001-3(e)(4)(i)(A), which could be a significant

modification of the debt. However, the substitution of a new obligor is not a significant

modification if the new obligor acquires substantially all of the assets of the original obligor, the

transaction does not result in a change in payment expectations, and the transaction does not

120 See Renkemeyer v. Commissioner, 136 T.C. 137 (2011) (attorney-partners of an limitedliability partnership engaged in the practice of law were not limited partners within the meaningof section 1402(a)(13) for purposes of excluding their distributive share of the LLP’s incomefrom the self-employment tax); Riether v. United States, 919 F.Supp. 2d 1140 (D. N.M. 2012)(husband and wife members of LLC not limited partners within the meaning of section1402(a)(13)); CCA 201436049 (May 20, 2014) (members of a management company LLCclassified as a partnership were not “limited partners” within the meaning of section 1402(a)(13)and therefore were subject to the self-employment tax on their distributive shares of income).See generally Sheldon I. Banoff and Richard M. Lipton, Who’s a ‘Limited Partner’? MoreConfusion Courtesy of Renkemeyer and Howell, 118 J. Tax. 212 (Apr. 2013).

121 See also Mark Opper and Dustin Janes, Which Actions under State Law Create a NewEligible Entity under the Check-the-Box Regulations, J. of Passthrough Entities (Nov. 25, 2015)(analyzing whether an entity conversion results in the creation of a new entity that is eligible tomake a first election under the check-the-box regulations). Other relevant provisions that mightbe implicated include sections 465, 469, and 736(a)(2).

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result in a significant alteration.122 That exception would typically apply in the context of a

partnership continuation transaction.123 However, if the continuation transaction occurs at a time

when there has been such a deterioration in the financial condition of the partnership that the

partnership’s debt obligation would no longer be considered debt, the transaction could be

considered a debt-for-equity exchange.124 Thus, the continuation transaction could have tax

consequences to both the partnership and its creditors.

Aside from the incidental effects from changes in legal rights, there is a question as to

whether the continuing partners should be treated as if nothing happened, that is, that the

transaction is a “tax nothing,” or whether, as a result of such changes, the continuing partners

should be treated as having a realization event that would potentially be taxable unless a

nonrecognition provision, such as section 721(a), applied (as concluded in the conversion

rulings).125 Part A identifies some of the potential stakes that could be involved if the continuing

partners have a realization event, Part B discusses the progression of the law on this question,

and Part C makes the case that the continuing partners should not have a realization event.

122 Treas. Reg. § 1.1001-3(e)(4)(i)(C).

123 A similar rule applies in the context of section 381(a) transactions. See Treas. Reg. §1.1001-3(e)(4)(i)(B).

124 Under Prop. Treas. Reg. § 1.1001-3(f)(7)(ii)(A), the financial deterioration in the obligorfrom the date of issuance to the date of a modification or alteration is not taken into account indetermining whether the instrument remains debt, that rule does not apply in the case of thesubstitution of a new obligor. See Prop. Treas. Reg. § 1.1001-3(f)(7)(ii)(B).

125 See generally Philip F. Postlewaite, The Transmogrification of Subchapter K, 83 Taxes 3(Mar. 2005); Sheldon I. Banoff, Partnership Ownership Realignments via PartnershipReallocations, Legal Status Changes, Recapitalizations and Conversions: What Are the TaxConsequences?, 83 Taxes 105 (Mar. 2005) .

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A. Tax Nothing vs. Realization – The Stakes

In most cases, treating a partnership continuation as a realization event will not produce

different tax results than treating it as a tax nothing, since under the conversion rulings section

721(a) would provide for nonrecognition treatment. However, there are circumstances where

serious questions would arise if the transaction is treated as a realization event to the partners

and, consistent with the conversion rulings, an exchange of interests in the existing partnership

for interests in the continuing partnership, particularly if the transaction is treated as an exchange

for all purposes of the Code (the “full-blown section 721 approach”). To be sure, the transaction

would be a somewhat unusual section 721 transaction, since the property being contributed does

not exist in the hands of the continuing partnership.126 It may be possible, however, to interpret

the conversion rulings as invoking section 721(a) solely to deem the transaction a nonrecognition

transaction and treat the transaction as an exchange only for limited and specified purposes (the

“section 721 lite approach”). The section 721 lite approach would require the Service to identify

what aspects of the full-blown section 721 approach would be implicated (e.g., section

1223(1)).127 The following discussion identifies some of the issues that could be implicated

under a full-blown section 721 approach and would need to be invoked by the Service under a

section 721 lite approach.

126 That anomalous situation also exists in the case of debt-for-equity exchanges, which aretreated as contributions to the partnership by the creditor governed by section 721(a) (except tothe extent attributable to unpaid rent, royalties, and interest (including accrued original issuediscount)). See Treas. Reg. § 1.721-1(d).

127 For example, Rev. Rul. 95-37 does not treat the conversion as an exchange for purposesof section 706(c)(2)(A), and PLR 200414013 (Dec. 10, 2003) does not treat the conversion as anexchange for purposes of the partners’ capital accounts.

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1. Business Purpose

To the extent section 721(a) or the partnership anti-abuse regulations128 require a business

purpose (or a “substantial business purpose”129) in connection with a contribution of property to

a partnership, the continuing partners would need to establish such a business purpose to be

eligible for nonrecognition under a full-blown section 721 approach. While continuation

transactions are typically undertaken solely for non-tax reasons, in many cases, at least part of

the impetus for the transaction could be tax-motivated. For example, a change in the form of

entity may be desirable to achieve a particular liability allocation under the section 752

regulations or it may be desirable for self-employment tax purposes for certain partners to be

treated as limited partners under state law rather than general partners or members of an LLC.

2. Insolvent Partnerships

Suppose a New York LLC converts to a Delaware LLC at a time when it is insolvent. If

the transaction is treated as though the members contributed their New York LLC interests to the

Delaware LLC in exchange for Delaware LLC interests, as opposed to simply a tax nothing,

there is some question as to whether the members are entitled to nonrecognition under section

721(a). Although a net value requirement has been explicitly adopted in proposed regulations

for a transaction to be entitled to nonrecognition under section 351130 and certain other

provisions in subchapter C, the preamble to the proposed section 351 regulations requests

comments on whether the principles should be extended to partnerships, suggesting there is no

128 Treas. Reg. § 1.701-2.

129 See Treas. Reg. § 1.701-2(a)(1).

130 Prop. Treas. Reg. § 1.351-1(a)(1)(iii)(A).

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such net value requirement in section 721 under current law.131 Nevertheless, there is some

authority suggesting that there is a net value requirement in section 721,132 creating at least some

level of uncertainty.133

The proposed net value regulations do not extend the net value requirement to

reorganizations under section 368(a)(1)(E) or (F).134 Due to the similarity of partnership

continuations to reorganizations under section 368(a)(1)(F),135 it would be appropriate to

similarly not apply a net value requirement to a partnership continuation. Thus, even if the LLC

conversion were treated as a realization event, and even if there is (or will be) a net value

131 The preamble states:

The IRS and the Treasury Department recognize that the principles in theproposed rules under section 351 may be applied by analogy to other Codesections that are somewhat parallel in scope and effect, such as section 721,dealing with the contribution of property to a partnership in exchange for apartnership interest. The IRS and the Treasury Department request comments onwhether rules similar to the rules of the proposed regulations should be proposedin the context of subchapter K and the considerations that might justifydistinguishing the relevant provisions in subchapter K from those provisions thatare the subject of these proposed regulations.

REG-163314-03, 70 Fed. Reg. 11903 (Mar. 10, 2005).

132 See Santa Monica Pictures v. Commissioner, T.C. Memo. 2005-104. See also Stafford v.United States, 727 F.2d 1043 (11th Cir. 1984); Hayutin v. Commissioner, T.C. Memo. 1972-127,aff’d, 508 F.2d 462 (10th Cir. 1974); McKee ¶4.02[1] (“Regardless of how broadly the term‘property’ is defined under § 721, it is obvious that § 721 does not apply unless the personreceiving the partnership interest surrenders something of value to the partnership.”).

133 The potential application of section 752(c) in connection with the exchange would alsoraise a number of questions.

134 Prop. Treas. Reg. § 1.368-1(b)(1).

135 Certain partnership continuation transactions are also similar to reorganizations undersection 368(a)(1)(E). For example, a partnership continues upon the conversion of a partner’scommon interest into a preferred interest and upon the adoption of other amendments to thepartnership agreement that alter the allocations among the partners.

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requirement for section 721 generally, under a section 721 lite approach for partnership

continuations, the net value requirement should not be applicable. Of course, none of this comes

into play if the partnership continuation is treated as a tax nothing.

3. Investment Companies – Section 721(b)

Contributions of property to a partnership in exchange for a partnership interest are

generally entitled to nonrecognition under section 721(a). However, under section 721(b), gain

realized on a contribution of property to a partnership that would be an investment company

within the meaning of section 351 if the partnership were incorporated is not eligible for

nonrecognition. If a continuation transaction is a realization event for the continuing partners,

section 721(b) would need to be considered. At the moment of the continuation transaction, it is

not likely that the contribution would be treated as a transfer to an investment company, since

under the conversion rulings each continuing partner would be transferring identical assets – an

interest in the existing partnership.136 However, if other assets are contributed to the continuing

partnership as part of the same plan by new partners (or the continuing partners), the

contributions of such other assets would need to be taken into account in determining whether

the continuing partners would be eligible for nonrecognition under section 721(a) with respect to

their partnership interests.137

136 See Treas. Reg. § 1.351-1(c)(5). Query whether different types or classes of interests in apartnership would be treated as identical assets?

137 Id.

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4. Section 704(c) and Mixing-Bowl Rules

Generally, when a partner contributes property to a partnership, the income, gain, loss,

and deductions with respect to the property are to be shared among the partners so as to take

account of any built-in gain or loss in the property at the time of contribution to prevent the

shifting of the built-in gain or loss from the contributing partner to the non-contributing

partners.138 The so-called mixing-bowl rules139 can also require the acceleration of such built-in

gain or loss in connection with certain distributions occurring within seven years of the

contribution. In addition, upon the contribution to a partnership, the partnership’s assets are

generally revalued and income, gain, loss and deductions associated with the partnership’s

property are to be shared among the partners in a similar manner so as to take account any

revaluation gain or loss in the partnership’s assets (“reverse section 704(c) allocations”).140 If

the continuing partners are treated as contributing property to the continuing partnership, there is

a question as to whether section 704(c) and the mixing-bowl rules can apply to the contributed

property by starting a new seven-year period, which would be difficult, since the contributed

property (the partnership interest in the old partnership) is not an asset of the continuing

138 Section 704(c)(1)(A); Treas. Reg. § 1.704-3.

139 Sections 704(c)(1)(B) and 737.

140 Treas. Reg. § 1.704-3(a)(6).

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partnership.141 There is also a question as to whether the continuing partnership would need to

revalue its assets for purposes of making future reverse section 704(c) allocations.142

5. Notice 2015-54143

In Notice 2015-54, the Service announced its intention to issue regulations under the

authority of section 721(c) that would apply when a “U.S. Transferor” transfers certain built-in

gain property to a partnership with a related foreign partner if the U.S. Transferor and related

parties own more than 50% of the interests in capital, profits, deductions, or losses in the

partnership after the contribution. In such case, the U.S. Transferor would be entitled to

nonrecognition under section 721(a) only if the partnership complies with the requirements of

the “gain deferral method” as described in the Notice, which requires, among other things, the

adoption of the remedial allocation method for making section 704(c) allocations with respect to

the appreciated property contributed by the U.S. Transferor. If, under the full-blown section 721

approach, the continuing partners in the continuing partnership are treated as contributing

property to the partnership that is built-in gain property, and the contributing partners consist of

U.S. and foreign related parties that own more than 50% of the interests in capital, profits,

deductions, or losses in the partnership after the contribution, the transaction could be subject to

141 No new section 704(c) amounts are created in connection with a technical terminationunder section 708(b)(1)(B), nor are the mixing-bowl rules implicated. See Treas. Reg. §§ 1.704-1(b)(2)(iv)(l), -3(a)(3)(i), -4(c)(3); Treas. Reg. § 1.737-2(a). It would be surprising if a differentresult occurred in connection with a partnership continuation.

142 PLR 200414013 (Dec. 10, 2003) would suggest not, since the ruling concluded that therewas no change in the partners’ capital accounts in connection with a partnership continuationtransaction.

143 2015-34 I.R.B. 210.

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the Notice, requiring compliance with the gain deferral method to achieve nonrecognition.

Because no new section 704(c) layer would exist with respect to the property deemed contributed

by the U.S. Transferor (since it disappears), it is not entirely clear how the Notice could apply or

the gain deferral method could be complied with. Even if continuation transactions were treated

as realization events, they should clearly be excluded from the Notice.144

6. Disguised Sale Rules

Under section 707(a)(2)(B), if a partner transfers property to a partnership and there is a

related direct or indirect transfer of money or other property by the partnership to the partner (or

another partner), and the two transfers, when viewed together, are properly characterized as a

sale or exchange of property, they are treated as a sale or exchange of property. The regulations

under section 707 presume that certain transfers that occur within two years of each other are

properly characterized as a sale or exchange of property and require disclosure of such

transfers.145 If the continuing partners are treated as transferring property to the continuing

partnership, the question is whether that transfer could be coupled with a later transfer by the

continuing partnership to such partner and result in a presumed disguised sale. The practical

impact of that would seem to be minimal, since the continuing partner would be presumed to sell

or exchange the partnership interest to the partnership itself in exchange for the money or

property transferred; it would seem likely that such a transaction would simply be treated as a

144 Recently, the IRS Associate Chief Counsel (International) was reported to have saidpublicly that a partnership conversion would implicate the Notice. See Rollinson PromisesTemporary Partnership Transfer Regs in Summer, 2016 TNT 84-4 (May 2, 2016).

145 Treas. Reg. § 1.707-3(c).

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distribution with respect to the partnership interest. Nevertheless, it could result in a disclosure

obligation, which is generally undesirable.

7. Holding Periods

The conversion rulings conclude that the holding period of the interests of the continuing

partners includes the holding period of the interests in the existing partnership under section

1223(1). The application of section 1223(1) presupposes an exchange of interests, since it

applies to determine the holding period of an asset received in exchange for a capital or section

1231 asset. In Rev. Rul. 84-111 (Situation 3),146 the Service concluded that, under section

1223(1), the holding period of stock treated as received in exchange for a partnership interest did

not include the transferring partners’ holding period in the partnership interests to the extent of

the transferring partners’ interests in “section 751 assets . . . that are neither capital assets nor

section 1231 assets.”147 Thus, there could be a conflict between the conversion rulings and Rev.

Rul. 84-111, raising a question as to the holding period of the continuing partners’ interests.148

B. Tax Nothing vs. Realization – Progression of the Law

There was no indication in Rev. Rul. 66-264 that there were any consequences to the

continuing partners in connection with the partnership continuation transaction, even though

146 1984-2 C.B. 88.

147 That conclusion is controversial. McKee ¶ 18.03[10] (“Revenue Ruling 84-111 denies atacked holding period, however, to the extent the stock is acquired in exchange for a partner'sinterest in partnership § 751 assets that are neither capital assets nor § 1231 assets. No authorityis cited for this aggregate approach to the holding period determination, and this aspect of theruling is questionable.”).

148 Treas. Reg. § 1.1223-3(b)(4) may alleviate any impact of the failure of the holding periodto fully tack under the approach of Rev. Rul. 84-111 (Situation 3).

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such partners held interests in a different legal entity. Certainly, there was no suggestion that the

continuing partners should be treated as having engaged in an exchange or in any other

transaction.149 It was only the partners who did not continue in the continuing partnership who

had consequences from the transaction: The transaction was to be a sale or liquidation of their

interests depending on the facts and circumstances of the particular case.

In GCM 38687,150 the Service considered a proposed revenue ruling involving the

conversion of a general partnership into a limited partnership. (The proposed revenue ruling

would eventually become Rev. Rul. 84-52.) According to the GCM, the proposed revenue ruling

had concluded that the conversion did not result in a sale or exchange of partnership interests. In

its evaluation of that conclusion, the GCM, which does not cite Rev. Rul. 66-264, stated: “The

question of whether the conversion of a general partnership interest into a limited partnership

interest is a taxable exchange is a question of first impression.” (Emphasis added.) Thus, the

GCM seems to have viewed the available options as either treating the conversion as not

involving a sale or exchange, i.e., a nonrealization event, or treating the conversion as a taxable

transaction. The GCM then refers to the leading partnership tax treatises, which had both viewed

the issue as involving whether a partnership should be viewed as an entity or an aggregate:

Willis discusses the issue and refers to a “natural repugnance” to the concept thatwhen an individual changes his status from that of a general partner to that of alimited partner in the same partnership he has made a sale or exchange. But healso says that generally a partnership is treated as an entity under the Code andthat an analogy to the corporate area suggests the existence of a taxable

149 Similarly, there was no indication in Neubecker v. Commissioner, 65 T.C. 577 (1975),that the continuing partners had a realization event even though the prior partnership dissolvedand the business continued in a new partnership as a legal matter.

150 (Apr. 10, 1979).

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transaction. 1 A. Willis, Partnership Taxation § 26.10 (2d ed. 1976). Similarly,McKee, Nelson, and Whitmire suggest there is no taxable transaction under anaggregate approach but there would be under an entity approach. W. McKee, W.Nelson, and R. Whitmire, Federal Taxation of Partnerships and Partners §15.04[3][c] (1977).

The corporate analogy suggested by Willis is presumably to cases such as United States

v. Phellis151 and Marr v. United States,152 which both found realization events upon the exchange

of stock in a New Jersey corporation for stock in a Delaware corporation due to the different

legal rights afforded to shareholders.153 In contrast, in Weiss v. Stern,154 no realization event was

found in a similar transaction where the original corporation and successor corporation were both

incorporated in Ohio.155

Most difficult partnership tax questions involve the choice between treating the

partnership as an entity or an aggregate. Viewing the partnership as an entity supports the

151 257 U.S. 156 (1921).

152 268 U.S. 536 (1925).

153 The Court in Marr also relied on differences in the characteristics in the stock (6% non-voting preferred vs. 7% voting preferred) to support the conclusion that the transaction resultedin a realization event to the shareholders. These differences were ignored by the Supreme Courtin its description of Marr in Cottage Savings Assoc. v. Commissioner, 499 U.S. 554 (1991),which viewed only the differences in the state of incorporation as the determinative factor.

154 265 U.S. 242 (1924).

155 This would suggest that a drop-down continuation of a partnership involving the sametype of legal entity, in the same jurisdiction, with the identical operating agreement would not bea realization event. See Willis ¶12.01[1] (“Only a movement by a person from general togeneral, limited to limited, or member to member would not constitute a realization event if there-structured enterprise continued its existence in the jurisdiction of its original formation and allof the exchanging parties neither increased nor decreased their legal entitlements in somefashion”). Cf. PLR 201026010 (July 2, 2010) (citing Weiss v. Stearn for the proposition that acorporate name change is not a realization event).

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finding of a realization event because of the change in the legal rights in the interests.156

However, viewing the partnership as an aggregate treats the partners as owning the assets of the

partnership directly, which would ignore changes to the legal rights in the interests, and thus not

give rise to a realization event. The GCM ultimately concluded that the aggregate approach was

the more reasonable approach:157

Our initial reaction to the issue was that the Service should take a strict entityapproach and find a sale or exchange whenever there is a conversion of a generalpartnership interest into a limited partnership interest. This appeared to be themost supportable position under the statute and regulations. After carefulconsideration, however, we have come to the conclusion that there is no clearlycorrect answer to this question and that an aggregate approach may be the morereasonable one under the facts of this case.

The nonrealization approach of the GCM and proposed revenue ruling was followed in

PLR 8150134,158 which also involved the conversion of a general partnership into a limited

156 Certainly, Cottage Savings Assoc. v. Commissioner, 499 U.S. 554, 566 (1991), whichrelied on Phellis and Marr the above cases, would also support the view that the “legally distinctentitlements” between interests would be sufficient to create a realization event. The Courtstated: “[T]he distinction in Phellis and Marr that made the stock in the successor corporationsmaterially different from the stock in the predecessors was minimal. Taken together, Phellis,Marr, and Weiss stand for the principle that properties are ‘different’ in the sense that is‘material’ to the Internal Revenue Code so long as their respective possessors enjoy legalentitlements that are different in kind or extent.” Id. at 564-65. See also Treas. Reg. § 1.1001-1(a) (“gain or loss realized . . . from the exchange of property differing materially either in kindor in extent, is treated as income or as loss sustained”).

157 In support of its conclusion, the GCM also cited Sheldon I. Banoff, New OpportunitiesNow Exist for General and Limited Partnership Conversions, 52 J. Tax 130 (1980), whichdiscussed PLR 7948063, a letter ruling holding that the conversion of a general partnership into alimited partnership did not constitute a sale or exchange. The article observed, “[t]o the extentthat the aggregate approach to partnership taxation is applicable, the partner has retained hisinterest in the same partnership assets both before and after the conversion.”

158 (Sept. 21, 1981). See also PLR 7848063 (Aug. 31, 1978) (“The conversion of the generalpartnership into a limited partnership will not constitute a sale or exchange of a partnershipinterest by any of the partners.”); PLR 8211121 (Dec. 22, 1981) (conversion of limitedpartnership interest into general partnership interest “will not be a sale or exchange of a

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partnership by an amendment to the partnership agreement. However, in GCM 39095,159 the

proposed revenue ruling was again addressed, this time in the context of providing technical

advice on the consequences of the conversion of a limited partnership interest into a general

partnership interest.160 Without explanation,161 GCM 39095 concluded:

The conversion of part of the limited partnership interest into a generalpartnership interest results in an exchange of partnership interests, but underI.R.C. s 721 gain or loss will not be recognized by any of the partners except asprovided in section 731. This is the treatment of conversion of partnershipinterests agreed upon in the *** proposed revenue ruling.

When Rev. Rul. 84-52 was eventually issued, its conclusion was consistent with GCM 39095 –

the conversion of a general partnership into a limited partnership was a partnership continuation,

but the partners had a realization event, whereby they were treated as exchanging partnership

interests in a nonrecognition transaction governed by section 721(a). The subsequent conversion

rulings, Rev. Rul. 95-37 and Rev. Rul. 95-55, followed the approach of Rev. Rul. 84-52.

partnership interest”); PLR 8213146 (Dec. 31, 1981) (conversion of general partnership interestinto limited partnership interest does “not constitute a sale or exchange of a partnershipinterest”).

159 (Dec. 21, 1983).

160 GCM 39095 noted that the proposed revenue ruling had been modified, at the suggestionof Tax Legislative Counsel, to make it clear that a partner that is both a limited and generalpartner has a single basis in the partnership. However, no other modifications to the proposedrevenue ruling were mentioned.

161 See Glenn E. Mincey and Judd A. Sher, Recent Guidance Permits Revaluation ofPartnership Property in Connection with the Issuance of a Profits Interest, 6 J. PassthroughEntities 45 (Nov./Dec. 2003).

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A number of private letter rulings issued after Rev. Rul. 84-52 explicitly followed the

approach of the ruling.162 However, the approach was not followed uniformly. In two private

letter rulings involving the conversion of a general partnership into a limited partnership, Rev.

Rul. 84-52 was cited but the Service concluded that the conversion “will not result in the sale or

exchange by the partners of any of their interests.”163 A number of other rulings were silent as to

whether the continuing partners had a sale or exchange.164 In addition, in a recent private letter

ruling, Rev. Rul. 84-52 was described as concluding that the conversion was treated as an

exchange under section 721; however, the ruling concluded: “[T]he conversion of PRS 3 into

PRS 1 did not cause the partners in PRS 3 or PRS 1 to recognize gain or loss under section 741

or 1001, except as provided in section 752. . . . Finally, the conversion PRS 3 into PRS 1 did not

result in the assets of the partnership being contributed or distributed to the partners of the

partnership.”165 The lack of explanation of the change in position between GCM 38687, on the

one hand, and GCM 39095 and Rev. Rul. 84-52, on the other hand, in addition to the lack of

uniformity in the treatment of the continuing partners, raise real questions about the strength of

162 See, e.g., PLR 9350013 (Sept. 15, 1993); PLR 9226035 (Mar. 26, 1992); PLR 8904061(Nov. 3, 1998); PLR 8542044 (July 23, 1985).

163 See also PLR 8448060 (Aug. 28, 1984); PLR 8448062 (Aug. 28, 1984).

164 See, e.g., PLR 8805062 (Nov. 13, 1987); PLR 9010027 (Dec. 7, 1989); PLR 9029019(Apr. 19, 1990); PLR 200022016 (Feb. 29, 2000). The Service even flirted with the notion thatthe conversion of a general partnership interest into a limited partnership interest was anexchange but qualified for nonrecognition under section 1031 (limiting the exclusion ofpartnership interests in section 1031(a)(2)(D) to exchanges of partnership interests in differentpartnerships). PLR 8912023 (Dec. 22, 1988). However, that ruling was later revoked. PLR8944043 (Aug. 8, 1989).

165 PLR 201605004 (Oct. 19, 2015). See also PLR 200022016 (Feb 29, 2000); PLR200414013 (Dec. 10, 2003); PLR 200538005 (June 14, 2005).

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the position of the conversion rulings that the continuing partners should be treated as having a

realization event.

C. The Case for Nonrealization

In view of the history of section 708, it is clear that the provision was born out of an

entity approach to partnerships: Even though there may be changes in the membership of the

partnership that causes it to dissolve under state law, if the business continues with at least one of

the partners, the partnership is treated as continuing for tax purposes unless it terminates under

section 708(b)(1)(B). As discussed above, based on Cottage Savings, Marr, and Phellis, treating

the partnership as an entity leads naturally to the conclusion that a continuation transaction

should be treated as a realization event for the continuing partners where there is a change in the

type of legal entity, place of organization, or other changes in the legal or economic rights of the

partners, including simply as a result of an amendment to the partnership’s operating

agreement.166

Treating continuation transactions as realization events for the continuing partners,

however, would be inconsistent with Rev. Rul. 66-264, the first revenue ruling issued after the

enactment of section 708. Rev. Rul. 66-264 in no way suggested that there is a realization event

for the continuing partners, notwithstanding the fact that they owned interests in a different legal

entity. More significantly, treating a continuation transaction as a realization event would ignore

166 Willis ¶ 12.01[1] (“The Supreme Court’s articulated prerequisites to a finding ofrealization typically will be met in re-structurings involving legal status changes and partnershiprecapitalizations. In each of those, either a different state of formation would be involved or,more likely, material differences in rights, powers and obligations would arise between theinterests relinquished and those received.”).

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the language of section 708(a). Section 708(a) deems a continuing partnership to be the same

partnership for tax purposes – even if there are legal differences in the entities – essentially

making those differences irrelevant: The continuing partners are deemed to have an interest in

the same partnership.167 Thus, the interests are deemed not to be materially different in kind,

meaning there cannot be a realization event. Section 708(a) trumps realization.

The notion that realization can be trumped is not entirely unique to section 708(a). If a

taxpayer contributes property to a wholly owned LLC, the taxpayer’s legal rights with respect to

the property have changed – the taxpayer owns something materially different in kind under

Cottage Savings. Nevertheless, it is clear that the transaction is not a realization event, since the

entity is disregarded as separate from its owner. The entity-classification regulations, thus,

trump realization. For example, if each partner in a general partnership were to contribute its

interest to its own wholly owned LLC or if the general partnership were to contribute all of its

assets and liabilities to a wholly owned LLC, aside from the impact that might have on the

partners’ shares of liabilities under section 752 (and the regulations thereunder), the transaction

would be a tax nothing to the partners. If, instead, the general partnership were to convert to an

LLC, the conversion rulings would treat the transaction as a realization event. In each case, the

partnership continues under section 708(a). In each case, the partners have different legal rights.

In each case, the transaction should be treated as a tax nothing. The entity-classification

regulations support treating the partners’ transfers to their own LLCs (and the partnership’s

167 In the corporate context, by contrast, the successor in a reincorporation is not treated asthe same corporation under the statute. In fact, under Marr and Phellis, a reincorporation istreated as giving rise to an exchange that is now entitled to nonrecognition treatment undersection 368(a)(1)(F). In addition, the corporate attributes carry over, but only because section381(a) mandates that result not because it is the same corporation.

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transfer to its wholly owned LLC) as tax nothings, and section 708(a) supports treating a

partnership conversion as a tax nothing.

Although the continuation conclusion under section 708(a) should preclude realization by

the continuing partners in the partnership, it is less clear whether the continuation conclusion

should preclude realization by the creditors of the partnership. As discussed above, in certain

circumstances, if a creditor’s legal rights change as a consequence of the change in the legal

status of the obligor, the change can result in an exchange of debt under Treas. Reg. § 1.1001-3,

having consequences to both the creditor and the obligor. Perhaps section 708(a) could be

interpreted to preclude realization to the partnership’s creditors in the same way that it should be

interpreted to preclude realization to the partners: The creditors are deemed to hold debt

obligations of the same partnership. However, section 708(a) is part of subchapter K, which

governs the relationship between a partnership and its partners. While the partnership should be

deemed to be the same partnership for purposes of determining the tax consequences to the

partnership vis-à-vis its partners, it is not clear that the partnership should always be deemed to

be the same partnership to a creditor. The fact that Treas. Reg. § 1.1001-3 can create a

realization event for a creditor with respect to a debt obligation issued by a partnership is treated

as a continuation under section 708(a) but that changes its legal status does not, therefore, mean

that the partners must also have a realization event.168

168 Similarly, a creditor of a disregarded entity can have a realization event upon the changein legal status of the disregarded entity even though the owner of the disregarded entity does nothave a realization event with respect to its ownership in the disregarded entity upon the change inlegal status.

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While section 708(a) should be interpreted as trumping realization in partnership

continuation transactions where the only differences in the partnership interests are attributable

to different legal rights associated with the different entities, the argument against realization is

less clear where there are different economic rights in the interests. Deeming the entity to be the

same entity for tax purposes would not necessarily preclude a realization event when a partner’s

economic interest in future169 profits or losses is modified (i.e., recapitalized).170 The partnership

clearly continues under section 708(a), and the continuing partner continues to hold an interest in

the same partnership, but the interest is a different interest economically, and such differences

could be material enough to constitute a realization event under Cottage Savings.

Even if section 708(a) does not trump realization in the context of a recapitalization of

partnership interests, the basic framework of subchapter K and its intended flexibility should be

viewed as trumping realization:

The real tension is between subchapter K and Cottage Savings’ hair trigger. It issubmitted that it is more in line with the overall structure of partnership taxationto analyze the tax treatment of partnership realignments in terms of concepts suchas capital shifts (or the lack thereof) and shifts of unrealized appreciation ordepreciation, rather than under traditional concepts of realization as to whetherthere is anything “materially different” after the reallocation of profits and losses(i.e., the test employed in Cottage Savings).171

169 A change to future profits or losses should include changes made in the partnershipagreement with respect to a taxable year by the time prescribed for filing the partnership taxreturn for such year in accordance with section 761(c).

170 If a partner’s interest in partnership capital is modified, the partner would likely betreated as having a realization event.

171 Sheldon I. Banoff, Partnership Ownership Realignments in Partnership Reallocations,Legal Status Changes, Recapitalizations and Conversions: What Are the Tax Consequences, 83Taxes 105 (Mar. 2005). See also Philip F. Postlewaite, The Transmogrification of Subchapter K,83 Taxes 3 (Mar. 2005).

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The ability to modify a partner’s economic interest in future profits and losses is inherent in the

very nature of a partnership interest; thus, a modification does not represent a change in what a

partner holds, it represents the activation of a feature of what the partner already holds and

continues to hold:172

[T]he malleability of these flexible interests [i.e., partnership interests] ascompared to the status quo of corporate interests may be the nature of the beast.Subchapter K is not perfectly symmetrical with Subchapter C. Everydayoperational allocations should not precipitate issues of realization. Somethingmore is required.173

Subchapter K taxes partners with respect to changes in the sharing of future profits and losses

under section 704, which subjects the partners to tax as the profits or losses are recognized by the

partnership. A strong argument can be made that this is the same approach that subchapter K

takes with respect to profits interests: There is no realization upon the receipt of a profits interest

by a partner; rather, the partner is subject to tax under section 704 when the profits are

recognized by the partnership. This point was made by Arthur Willis in his testimony to the

House Ways and Means Committee in 1956 concerning grants of profits interests: “If [the

service provider] were to receive merely an interest in future profits in exchange for his services,

he would have no immediate taxable gain because he would be taxed on his share of income as it

was earned.”174 The receipt of a partnership profits interest for services was not a taxable event

172 Cf. Treas. Reg. § 1.1001-3(c)(ii) (certain alterations of legal rights that occur by operationof the terms of a debt instrument are not treated as modifications).

173 Willis ¶12.01[1]. The Willis treatise distinguishes between changes in “[e]verydayoperational allocations” and more permanent changes in a partner’s economic interest. However,there would not appear to be an analytical distinction between them.

174 Advisory Group Recommendations on Subchapters C, J, and K of the Internal RevenueCode: Hearings Before the Committee on Ways and Means, House of Representatives, 86th

Cong., 1st Sess. 53 (1959).

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prior to the enactment of the 1954 Code, and nothing in the 1954 Code or Section 83 should be

viewed as having changed this result:

As a matter of statutory construction, the tax-free nature of such transactions isestablished by the fact that Section 707 provides the exclusive circumstances inwhich partnership-to-partner transactions can be taxed outside the confines ofSubchapter K, as if they occurred between unrelated parties, and by the fact thatthe receipt of a profits interest for services is not described in Section 707.Instead, tax on a partner’s entrepreneurial share of partnership profits should beimposed under the framework of Subchapter K when the partnership realizesactual profits that are included in the partner's distributive share.175

Weaved into the fabric of subchapter K is that partners can alter the manner in which future

profits or losses are to be shared among them or with a new partner and that the alteration is not,

in and of itself, a realization event.

There is guidance that supports the position that a recapitalization is not a realization

event. In PLR 8238066,176 the Service ruled that the conversion of general partnership interests

into limited partnership interests with a reduced interest in the partnership’s residual profits “will

not constitute a sale or exchange of such interests.”177 In addition, Prop. Treas. Reg. § 1.704-

1(b)(2)(iv)(f)(5)(v) proposes to add recapitalizations as an event that could give rise to a

175 McKee ¶5.02[6][d].

176 (June 24, 1982).

177 See also PLR 9821051 (Feb. 23, 1998) (change to economic arrangement of partners byamendment “will not result in the realization of income”). The approach in PLR 200345007(Aug. 7, 2003) is more ambiguous. That ruling involved the conversion of partnership interestsinto interests with “different rights, preferences, privileges, and restrictions”; however, eachpartner’s proportionate share of capital remained the same. The ruling cited Rev. Rul. 84-52,although not expressly for its holding that the conversion was an exchange under section 721;rather, the ruling simply concluded that no gain or loss will be recognized in connection with therecapitalization. The ruling did, however, cite section 1223(1) as supporting the conclusion thatthere was no change to the holding period of any partner’s interest, suggesting that therecapitalization did constitute an exchange.

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revaluation of capital accounts; if recapitalizations constituted a contribution of property to the

partnership under a full-blown section 721 approach, the proposed regulation would be

unnecessary as the transaction would already be a revaluation event under Treas. Reg. § 1.704-

1(b)(2)(iv)(f)(5)(i), which allows for a revaluation in connection with a contribution of money or

other property as consideration for an interest in the partnership. On the other hand, Treas. Reg.

§ 1.721-2(a) would treat the conversion of a convertible preferred partnership interest into a

common partnership interest as a transaction governed by section 721. Nevertheless, even if

recapitalizations were to be treated as realization events governed by section 721, the section 721

lite approach should be followed, treating the transaction as an exchange only for limited and

specified provisions of the Code.

There is no compelling policy justification for treating a partnership continuation as a

realization event. Given the language of section 708(a), the application of section 708(a) in Rev.

Rul. 66-264, the unexplained change in position between GCM 38687 and GCM 39095, and the

authorities that exist, the better path is to follow the nonrealization approach or, at the very least,

the section 721 lite approach.

Conclusion

Partnership continuations arise all the time in commercial transactions. It is critical that

they be identified (in a bubble) so that the transaction can be evaluated and treated in a manner

consistent with the continuation conclusion. As to the continuing partners, either the transaction

should be treated as a tax nothing, i.e., a nonrealization event, or it should be treated as an

exchange under the section 721 lite approach, whereby section 721 applies only for the limited

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purpose of achieving nonrecognition and the transaction is not otherwise treated as an exchange

unless the Service specifically provides for such treatment for purposes of a particular provision.