Service Issues Favorable Private Letter Ruling on the Diversification of Stock Portfolio Under Section 721(b) and Potential For Applying the Netting Rule For Both Contributions And Reverse Section 704(c) Allocations

By: Jerald David August

In a recent private letter ruling issued on November 18, 2016, PLR 201710007, the Service ruled that the transfer of a stock portfolio to a surviving partnership from four terminating partnerships will not, under the facts, result in a diversification of portfolios under §721(b) thereby avoiding gain recognition.  This provision may pose a trap for the wary for taxpayers who do not give careful consideration in transferring appreciated property to a partnership (or corporation). The Service further ruled on the application of technical rules under §704(c) permitting partial or full netting of built-in gains and losses.

Section 721(b) The Investment Partnership Rule

Section 721(a), in general, provides that  no gain or loss is recognized to a partnership or to any of its partners where property is contributed to a partnership in exchange for an interest in the partnership. As an exception, §721(b) provides that §721(a) does not apply to gain realized on a transfer of property to a partnership that would be treated as an investment company as per §351, and in particular, Treas. Reg. §1.351-1(c)(1), were the partnership incorporated.

As an analogue to §721 for certain contributions of property to a corporation, §351(a) provides that no gain or loss is recognized, subject to applicable exception, where the transferor(s) of property receives solely stock in the exchange and immediately after the  transferors "control" the transferee corporation. However, like  §721(b), §351(e)(1) provides that § 351(a) will not apply to a transfer of property to an "investment company."

Treas. Reg. §1.351-1(c)(1) provides that the transfer of assets to an investment company will occur when (i) the transfer results in diversification of the transferors' interests, and (ii) the transferee is a regulated investment company (RIC), a regulated investment trust (REIT), or a corporation more than 80% of the value whose assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stocks or securities or interests in RICs or REITs.

Treas. Reg. §1.351-1(c)(6)(i)  provides that a transfer of stocks and securities will not be treated as resulting in diversification where each transferor transfers a diversified portfolio of stocks and securities. A portfolio of stock and securities is diversified if it satisfies the 25% and 50% tests of § 368(a)(2)(F)(ii), applying the relevant provisions of § 368(a)(2)(F). For this purpose, government securities are included in determining total assets, unless the government securities are acquired to meet § 368(a)(2)(F)(ii).

Section 704(c) Built-In Gain or Loss On Contributed Property: Application to Investment Partnerships

 Section 704(c)(1)(A) requires that income, gain, loss, and deduction for property contributed to the partnership by a partner is shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution.

Treas. Reg. §1.704-3(a)(1) acknowledges that §704(c) is to prevent the shifting of tax consequences among partners for pre-contribution gain or loss. Under § 704(c), a partnership must allocate income, gain, loss, and deduction with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of the contribution. This allocation must employ a reasonable method that is consistent with the purpose of § 704(c).

Treas. Reg. § 1.704-3(a)(6) provides that the principles of Treas. Reg.  § 1.704-3 apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property under § 1.704-1(b)(2)(iv)(f) (so-called reverse § 704(c) allocations). A partnership that makes allocations with respect to revalued property must use a reasonable method consistent with the purposes of §§ 704(b) and 704(c).

Treas. Reg. § 1.704-3(a)(2) provides § 704(c) applies on a property-by-property basis. In determining whether there is a disparity between adjusted tax basis and fair market value, the built-in gains and built-in losses on items of contributed or revalued property generally cannot be aggregated.

Treas. Reg. § 1.704-3(e)(3) provides a special rule allowing certain securities partnerships to make reverse § 704(c) allocations on an aggregate basis. Specifically, Treas. Reg. § 1.704-3(e)(3)(i) provides that, for purposes of making reverse § 704(c) allocations, a securities partnership may aggregate gains and losses from qualified financial assets using any reasonable approach that is consistent with the purposes of § 704(c). Once a partnership adopts an aggregate approach, the partnership must apply the same aggregate approach to all of its qualified financial assets for all taxable years in which the partnership qualifies as a securities partnership.

Treas. Reg. § 1.704-3(e)(3)(iii)(A) provides that a securities partnership is a partnership that is either a management company or an investment partnership, and that makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner who provides management services or investment advisory services to the partnership). Under Treas. Reg.  § 1.704-3(e)(3)(iii)(B)(2), a partnership is an investment partnership if: (1) on the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90% of the fair market value of the partnership's non-cash assets; and (ii)  the partnership reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach under Treas. Reg. § 1.704-3(e)(3), to make revaluations at least annually.

Treas. Reg. § 1.704-3(e)(3)(ii) provides that a qualified financial asset is any personal property (including stock) that is actively traded, as defined in Treas. Reg. § 1.1092(d)-1 (defining actively traded property for purposes of the straddle rules).

Treas. Reg. § 1.704-3(e)(3)(iv) and Treas. Reg. § 1.704-3(e)(3)(v) set forth  two methods for  making aggregate reverse §704(c) allocations that are generally reasonable: (i) the partial netting approach and (ii) the full netting approach. However, Treas. Reg. § 1.704-3(e)(3)(i) provides that other approaches may be reasonable in appropriate circumstances.

Treas. Reg. §1.704-3(a)(10) provides that an allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in so-called reverse § 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequence of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability.

In addition, Treas.Reg. § 1.704-3(e)(3)(vi) provides that the character and other tax attributes of gain or loss allocated to the partners under an aggregate approach must (i) preserve the tax attributes of each item of gain or loss realized by the partnership, (ii) be determined under an approach that is consistently applied, and (iii) not be determined with a view to reducing substantially the present value of the partners' aggregate tax liability.

This aggregation rule set forth in Treas. Reg. § 1.704-3(e)(3) applies only to reverse § 704(c) allocations. Therefore, a securities partnership using an aggregate approach must generally account for any built-in gain or loss from contributed property separately. The preamble to Treas. Reg. § 1.704-3(e)(3) explains that the final regulations do not authorize aggregation of pre-contribution built-in gains and losses with built-in gains and losses from revaluations because this type of aggregation can lead to substantial distortions in the character and timing of income and loss recognized by contributing partners. T.D. 8585, 1995-1 C.B. 120, 123.  The same preamble also recognizes that there may be instances in which the likelihood of character and timing distortions is minimal and the burden of making § 704(c) allocations separate from reverse § 704(c) allocations is great.  In this regard, Treas. Reg. § 1.704-3(e)(4)(iii) authorizes the Commissioner to permit, by published guidance or private letter ruling, aggregation of qualified financial assets for purposes of making § 704(c) allocations in the same manner as that described in Treas. Reg. § 1.704-3(e)(3).

In Rev. Proc. 2001-36, 2001-1 C.B. 1326, the IRS granted automatic permission for certain securities partnerships to aggregate contributed property for purposes of making § 704(c) allocations. Rev. Proc. 2001-36 also described the information that must be included with the ruling requests for permission to aggregate contributed property for purposes of making § 704(c) allocations submitted by partnerships that do not qualify for automatic permission.

Facts In Ruling Request

A "Surviving" and four "Terminating" Partnerships are general partnerships. Each partnership owns a diversified portfolio of stock and securities and a small amount of cash, and the partnerships are owned by identical or related parties in substantially similar proportions. In order to reduce administrative costs, the partnerships sought to merge into a single, surviving partnership.

Under Treas. Reg. §1.708-1(c), the Surviving partnership will continue and the four other partnerships will be treated as having terminated. The merger will take the assets-over form as per Treas. § 1.708-1(c)(3).  The partners in the terminating partnerships will  be issued interests in the Surviving Partnership in exchange for their interests in the terminating partnerships in liquidation.

Each partnership, both Terminating and Surviving, represented it will own a diversified portfolio of assets . In each case, the test for diversification will apply the tests of § 368(a)(2)(F)(ii), § 351(e), and Treas. Reg. §1.351-1(c).  The taxpayer seeking the ruling stated that the contributions are not part of a plan to achieve diversification without recognition of gain as described in Treas. Reg. § 1.351-1(c)(5).Surviving Partnership represents that after the merger it will qualify as a "securities partnership" as defined in Treas. Reg. § 1.704-3(e)(e)(iii).

Each partnership currently uses, and Surviving Partnership will continue to use, the partial netting approach contained in Treas. Reg. § 1.704-3(e)(3)(iv) in making reverse § 704(c) allocations. Surviving Partnership's § 704(c) and reverse § 704(c) allocations made under the partial netting approach will at all times comply with § 1.704-3(e)(3)(vi). Surviving Partnership will consistently apply the partial netting approach to all of its qualified financial assets for all taxable years in which it qualifies as a securities partnership. Surviving Partnership represents that the partial netting approach it adopted will preserve the tax attributes of each item of gain or loss it realizes and will not be used with a view to reducing substantially the present value of the partners' aggregate tax liability.

The merger agreement will provide for a mandatory deficit make-up upon the winding up of Surviving Partnership. The agreement will also require the maintenance of separate unrealized gain and loss accounts for each partner so as to comply with the partial netting approach in Treas. Reg. § 1.704-3(e)(3)(iv). The Surviving Partnership will make revaluations at least annually in accordance with Treas. Reg. § 1.704-3(e)(3)(iii)(B)(2)(ii).

After the mergers, Surviving Partnership will continue to be managed by professional investment managers and subject to defined investment objectives and guidelines. The investment managers will actively manage Surviving Partnership's assets and make decisions about selling and buying securities based on their perception of opportunities. Thus, Surviving Partnership will continue to have significant turnover in the composition of its portfolio of assets. The burden to Surviving Partnership of making § 704(c) allocations separately from reverse § 704(c) allocations is substantial.

Rulings Requested From National Office

The partnerships request the following rulings:

1. The transfers of the stock portfolios from each Terminating Partnership to the Surviving Partnership will not be taxable under §721(b).

2. The Surviving Partnership may use the partial netting rule in Treas. Reg. §1.704-3(e)(3)(iv) for aggregating gains and losses from qualified financial assets for making reverse §704(c) allocations per Treas. Reg. §1.704-3(e)(3).

3. Grant of permission to the Surviving Partnership to aggregate built-in gains and losses from qualified financial assets contributed by the Terminating Partnerships in making allocations under §704(c)(1)(A) and Treas. Reg..§1.704-3(a)(6).  

Service's Response

Ruling Request 1.  No gain will be recognized with respect to the assets-over form of merger of the diversified portfolio Terminating Partnerships transferred to the Surviving Partnership.

Ruling Request 2.  The Surviving Partnership may use the partial netting approach for making reverse §704(c) allocations that is reasonable per Treas. Reg. §1.704-3(e)(3) provided that there is no effort to shift the tax consequences of built-in gain or loss in a manner which substantially reduces the present value of the partners' aggregate tax liability.

Ruling Request 3.  The Service ruled that the Surviving Partnership may use the partial netting approach to the contributions of the diversified portfolios as well as in making reverse 704(c) allocations as reasonable per Treas. Reg. §1.704-3(a)(1) and permitted per Treas. Reg. §1.704-3(e)(4)(iii) as long as the allocations are not made with a view to shifting the partners aggregate tax liability.

The Service stated that it expressed no opinion on the allocations of items other than items of gain or loss from the sale or other disposition of qualified financial assets, or the aggregation of built-in gains and losses from qualified financial assets contribute to the Surviving Partnership.

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