A new private letter ruling appr

A new private letter ruling approves an alternative method for dividing partnership assets between partners who want to go their separate ways in a Section 1033 transaction

May 2009

In private letter ruling 200921009, the taxpayer, a general partnership, had made an election under §1033 to replace property sold under threat of condemnation. It now proposes to divide into two continuing partnerships during the replacement period, and the ruling holds that the two new continuing partnerships may complete the replacements under §1033. §1033(g) allows replacement into like-kind property, as defined under § 1031, and rulings under §1033 often are applicable to §1031. Therefore, the analysis in this ruling might be applied to a partnership division during an exchange period under §1031.

Under the facts of the ruling, AB and CD are equal general partners owning half interests in Taxpayer (P1), a general partnership. P1 is engaged in business of farming on Blackacre. A portion of Blackacre was acquired by a government entity under threat of condemnation. P1 has elected to defer some of the gain from that under §1033.

AB and CD disagree about the selection of the additional replacement property. Therefore, P1 proposes to create two new partnerships, P2 and P3. AB will be the general partner in P2 and CD will be the general partner in P3. P1 will transfer a portion of the condemnation proceeds, along with half of its obligation to acquire replacement property under §1033, to each of P2 and P3. In exchange for this contribution, P1 will receive a general partner interest and a limited partner interest in each entity. CD will contribute cash to P2 in exchange for a limited partner interest in P2, and AB will contribute cash to P3 in exchange for a limited partner interest in P3. P1 will then distribute its interests in P2 to AB and its interests in P3 to CD. This distribution by P1 is tax free under §731.

The partnership agreements of P2 and P3 will require that each partnership reinvest the condemnation proceeds, together with borrowed funds, in replacement properties. If this is not done, the partnership agreements will require P1 to report the income from the lack of reinvestment under § 1033 on an amended income tax return.

The ruling concludes that P2 and P3 are all continuing partnerships of P1 under the partnership division rules of §708(b)(2)(B) and Reg. 1.708-1(d)(1), and holds that as such, they are entitled to complete the §1033 replacement. These rules provide that P2 and P3 are considered a continuation of P1 provided that at least 2 partners of P2 and P3 were partners of P1 and they collectively had an interest of more than 50 percent in the capital and profits of P1.

The ruling does not state the relative percentage interests of AB and CD in P2 and P3, but the minority limited partnership interest is most likely de minimus. For example, P2 is probably owned 99% by AB as both general partner and limited partner, with all management rights. CD, on the other hand, only owns 1% of P2 as limited partner with no management rights. CD will also likely want to be bought out of P2 after a sufficient time period has passed to avoid a step transaction argument, such as two years after the replacement property is acquired. This structure may not be palatable to some partners who want a clean break from each other.

How can this be an alternative to the drop and swap for an exchange? The partners want to acquire different replacement properties. Therefore, the partnership sells the relinquished property, and then forms two new partnerships to acquire the different replacement properties, with each partner being the majority owner of the partnership holding that partner’s desired property. After the exchange is “old and cold”, the minority partner would withdraw from the new partnership in exchange for the cash contributed by the minority partner.

Does the analysis of the ruling apply to §1031 as well as §1033? §1031 requires an exchange and, like §1033, the partnership that disposes of the relinquished property must acquire the replacement property. §1031(a)(3); Chase v. Comm’r, 92 TC 874 (1989); see also TAM 9818003. It could be argued that this ruling would not also apply to §1031. While Regulation 1.708-1(d)(2) specifically states that the continuing partnerships are subject to the pre-existing elections made by the prior partnership, such as an election under §1033, §1031 is mandatory and is not an election. However, the IRS has ruled in several private letter rulings regarding non taxable corporate reorganizations, that a successor corporation may acquire the replacement property in an exchange when the predecessor corporation disposed of the relinquished property. The IRS has issued these rulings even though §381, which provides for the carryover of tax attributes including a §1033 replacement, does not specifically apply to §1031. PLR 9751012, TAM 9252001 Therefore, the IRS could be expected to issue similar rulings for partnership divisions during a §1031 exchange, given that it has done so for a §1033 replacement.