Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

Under § 108(i) , enacted into law in  2009, a taxpayer may elect to defer recognition of discharge of business indebtedness income resulting from a “reacquisition”, a technical term contained in the statute, with respect to an “applicable debt instrument” during the calendar year 2009 or 2010. An “applicable debt instrument” is a debt instrument issued by a C corporation or by “any other person in connection with the conduct of a trade or business by such person.”  A “reacquisition” is an acquisition of a debt instrument by the “debtor” that “issued (or is otherwise the obligor under) the debt instrument” or by a person related to the debtor. In addition, a total forgiveness of the debt by the holder or a contribution of the debt to capital are also treated as “reacquisitions”. Where a taxpayer elects under §108(i), any cancellation of indebtedness income arising from the reacquisition is including in gross income ratably over a five year period beginning in 2014. Stated differently, the  deferral period for a reacquisition during in 2009,  starts with the fifth taxable year following the taxable year during which the reacquisition occurs and for a reacquisition during in 2010, the  five year deferral period starts with the fourth taxable year following the reacquisition year. If the §108(i) election is made as to a particular debt, the taxpayer may not elect to exclude the same income under another exception contained in §108, including the insolvency exception, the qualified farm or real property business indebtedness exceptions. Where, for example, a partnership reacquires its debt with COD income, the partnership must elect under §108(i). In such case, the partnership allocates the deferred income among its partners immediately before the discharge in the manner that it would have allocated the income if it had not elected to defer the income. Each partner then  recognizes his or her distributive share of the deferred income over the relevant five-year period. Any decrease in a partner's share of partnership liabilities as a result of the discharge is disregarded at the time of the discharge to the extent it would cause the partner to recognize gain. This is to prevent whipsaw from occurring under the §752 rules for deemed distributions of cash resulting from the discharge of the debt. Instead, a partner must take into account any liability decrease so disregarded “at the same time, and to the extent remaining in the same amount, as [the deferred income] is recognized.” There are events which will cause the deferral to accelerate and be included in gross income. This will occur where the taxpayer dies or he sells substantially all of the assets of the business or ceases to operate the business.

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  In Notice 2010-60, the Service has issued temporary guidance until proposed (and later final) regulations are issued, hopefully sometime in early 2011, on recent reforms law designed to attack U.S. tax evasion activities by certain U.S. and foreign persons. Notice 2010-60 addresses key provisions aimed at foreign tax compliance enacted as part of the Hiring Incentives to Restore Employment Act of 2010 (HIRE), which includes the Foreign Account Tax Compliance Act of 2009 (FATCA).  These new measures are designed to block U.S. citizens from using offshore accounts to avoid U.S. tax by imposing a 30% withholding tax obligation. A withholding provision applies with respect to payments made to a foreign entity that is either a foreign financial institution (FFI) or a nonfinancial foreign entity.  New rules on information reporting apply with respect to certain payments made to foreign entities . Enhanced penalties are imposed on disclosure failures and a special rule extending the statute of limitations is also part of FATCA. Special rules apply to foreign trusts, grantor trusts which are foreign trusts, deemed dividend equivalent payments and other provisions.  

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Background

Section 172(a) allows a taxpayer to claim a deduction in an amount equal to the aggregate of the NOL carryovers and carrybacks to the taxable year. Section 172(b)(1)(A)(i) provides that an NOL for any taxable year generally must be carried back to each of the 2 years preceding the taxable year of the NOL. Section 172(b)(3) provides that any taxpayer entitled to a carryback period under § 172(b)(1) may make an irrevocable election to relinquish the carryback period for an NOL for any taxable year.

Under the alternative minimum tax, adjustments are required to be made to taxable income under §56 in computing alternative minimum taxable income (AMTI). In the NOL area, §56(a)(4) provides that the alternative tax net operating loss (ATNOL) deduction applies in lieu of §172’s NOL deduction in computing AMTI. Section 56(d)(1) provides certain adjustments and limitations used in determining the ATNOL deduction for the taxable year. Under § 56(d)(1)(A)(i), the ATNOL deduction generally cannot exceed 90% of AMTI, determined without regard to the ATNOL deduction and the deduction under § 199 (deduction with respect to manufacturing expense attributable to U.S. production activities). 

Worker, Homeownership, and Business Assistance Act of 2009

Section 13 of the Worker, Homeownership, and Business Assistance Act of 2009 (“WHBAA”), P.L. 111-92 (Nov.6, 2009) amends §§ 172(b)(1)(H) and 810(b)(losses from operations of a life insurance company) permitting taxpayers to elect to carry back an applicable net operating loss (NOL) for 3, 4, or 5 years, or a loss from operations for 4 or 5 years, in claiming overpayments in tax in one or each of such preceding taxable years. The IRS, in providing guidance in this area, just released Notice 2010-58, 2010-37 IRB, 08/20/2010  to offset taxable income in those preceding taxable years.

This entry will not address the impact of §13 of WHBAA on life insurance companies.

American Recovery and Reinvestment Act of 2009

Section 1211 of the American Recovery and Reinvestment Tax Act of 2009, P.L. 111-5(2/17, 2009) (ARRA), amended § 172(b)(1)(H) to allow an eligible small business (ESB) to elect to carry back a 2008 applicable NOL for a period of 3, 4, or 5 years (ARRA election)(emphasis added). Unlike the § 172(b)(1)(H) election under the WHBAA (WHBAA election), the ARRA election is applicable only to an NOL attributable to an ESB. The ARRA election is irrevocable and may be made for only one taxable year. Rev. Proc. 2009-26, 2009-19 I.R.B. 935 (April 25, 2009), modifying and superseding Rev. Proc. 2009-19, 2009-14 I.R.B. 747 (March 16, 2009), advises taxpayers how to make the ARRA election. In contrast the election under §172(b)(1)(H)(i), as amended by WHBAA, i.e., the 3, 4 or 5 preceding taxable year rule, is not limited to ESBs. Under the WHBAA, the term “applicable net operating loss” is with respect to a taxpayer’s NOL for a taxable year ending after December 31, 2007 and beginning before January 1, 2010.

Revised Section 172(b)(1)(H)

 Section 172(b)(1)(H)(iii) provides that the election under § 172(b)(1)(H) is to be filed by the due date (including extensions) for filing the return for the taxpayer’s last taxable year beginning in 2009.  The election is irrevocable and, in general, may be made for only one taxable year. However, §172(b)(1)(H)(v) allows a taxpayer that made or makes an ARRA election also to make a WHBAA election.

Section 172(b)(1)(H)(iv) limits the amount of an applicable NOL that a taxpayer elects under § 172(b)(1)(H)(i) to carry back to the 5^th taxable year preceding the taxable year of the loss but subject to a limitation that the amount of the reduction to taxable income can not exceed 50% of the taxpayer's taxable income for such 5^th  preceding taxable year. The taxable income for the 5th preceding taxable year is computed without regard to the NOL for the loss year or any taxable year thereafter. The excess amount (for the 5^th year rule) may be carried to later taxable years. For the carryback of an ATNOL to the 5^th preceding taxable year, the 50% limitation is applied separately based on the AMTI. The limitation on the amount of an applicable NOL that may be carried back to the 5^th preceding taxable year does not apply to an NOL carryback under the ARRA election.

Section 13(b) of the WHBAA amends § 56(d)(1)(A)(ii) to remove the 90% limitation in computing ATNOL attributable to an  applicable NOL for which a taxpayer made an election under § 172(b)(1)(H).

Section 13(e)(4) of the WHBAA provides that a taxpayer who elects under § 172(b)(3) to forgo a carryback for a loss for a taxable year ending before the date of enactment of the WHBAA (11/6/2009) may revoke that election before the due date (including extensions) for filing the return for the taxpayer's last taxable year beginning in 2009. An application under § 6411(a) for the applicable NOL is treated as timely if filed before that due date.

Section 13(f) of the WHBAA provides that the election under § 172(b)(1)(H) is not available to certain taxpayers that receive benefits under the Emergency Economic Stabilization Act of 2008, Title I of Div. A of P.L. 110-343, and certain affiliates of these taxpayers.

Notice 2010-58, supra, adopts a question and answer format which should facilitate a more complete understanding of the new labyrinth of rules to wade through in a timely manner.

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Congress enacted §280G in 1984 over concern that contracts between a corporation and its employees providing golden parachutes directly (or indirectly) attributable to a takeover of a target company would have an adverse effect on takeover activity in general, elevate the concerns of the management of the target company beyond permitted boundaries, including the deflection of shareholder value from the target’s shareholders to key management and control shareholders of the target company. S280G applies to payments under agreements entered into or renewed after June 14, 1984. Section 280G also applies to certain payments under agreements entered into on or before June 14, 1984, and amended or supplemented in significant relevant respect after that date. This section applies to any payment that is contingent on a change in ownership or control and the change in ownership or control occurs on or after January 1, 2004.

 As a result, § 280G disallows any deduction for certain payments to a “disqualified individual” (whether or not incident to termination of the individual's employment) if the payment: (i) is contingent on a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of a corporation's assets, provided the present value of the payment exceeds 3 times a defined base amount, or (ii) is paid pursuant to an agreement violating any generally enforced securities laws or regulations. Any payment pursuant to an agreement or amendment thereof entered into within one year before a change of ownership or control is presumed to be contingent on the change unless the contrary is established by clear and convincing evidence. Stated in more technical language, a parachute payment means any payment (other than an exempt payment, as defined in the regulations), that is: (i) in the nature of compensation; (ii) is made or is to be made to (or for the benefit of) a disqualified individual; (iii) is contingent on a change—(a)in the ownership of a corporation; (b)in the effective control of a corporation; or (iii) in the ownership of a substantial portion of the assets of a corporation; and (iv) has an aggregate present value of at least 3 times the individual's base amount.

A “disqualified individual” includes an officer, shareholder, or highly compensated individual (including a personal service corporation or similar entity), as well as any employee, independent contractor, or other person who performs personal services for the corporation and is specified in regulations. A disqualified individual's “base amount” is defined by reference to the individual's average annual taxable compensation for a five-year base period preceding the change of control or ownership. The parachute payments that are compared with three times the base amount to determine the excess parachute payments are net of an allowance for amounts established as reasonable compensation for personal services that were rendered before the change (if not already compensated for) or that are to be rendered after the change. The definition of “base amount” not only determines whether § 280G will apply but also determines the amount of the deduction limitation, since only payments in excess of the portion of the base amount allocable to the payment are nondeductible.

While many compensation agreements will be, by statutory presumption, subject to § 280G because they were made or modified within one year before the change in ownership, others must be shown to be contingent on the change. The arrangement must also be pursuant to a prescribed “change in ownership” transaction. Generally, “change in ownership” means the acquisition of more than 50% of the corporate stock (tested by vote or value) by one person or by a group of persons acting in concert. A change in effective control is presumed to occur when one person or a group acting in concert acquires 20% or more of the total voting power or when a majority of the board is replaced during a twelve-month period against the wishes of a majority of the old board. See Square D Co and Subsidiaries v. Comm’r,  121 TC 168 (2003).

Section 280G applies whether a change in ownership or control is friendly or hostile and whether the corporation is closely held or publicly traded. There are, however, two important exceptions that cause the change of control transaction to be exempt from application of §280G and §4999: (i) a “small business corporation,” defined by § 1361(b) as a corporation that is eligible to elect S corporation status or ii) a corporation whose stock is not readily tradable (on an established securities market or otherwise), provided the parachute payment is approved by the owners of more than 75% of the corporation's voting stock after adequate disclosure of all material facts. The provision is also inapplicable if the acquirer enter into a separate and independent contract with an employee (otherwise a disqualified person) after the change of ownership.

When §280G applies, there is also imposed on the recipient of the payment an excise tax under §4999(a) equal to 20% of an “excess parachute payment” . For this purpose, an “excess parachute payment is defined under the golden parachute rules, which deny a deduction to a corporation for any excess parachute payment that it makes §4999(b) .

The disallowance of the target corporation’s deductions under §280G will have a direct economic impact on the target shareholders. Such shareholders will bear the economic cost by the additional corporate level tax that will be imposed as well as the required withholding on the 20% excise tax. See §4999(c). Unfortunately, a disallowance of the corporation's deductions under § 280G will increase the loss suffered by the target shareholder group. This is because the target group bears the ultimate burden of both the golden parachute payments and the additional corporate tax attributable to § 280G , even if the shareholders sell out, because the well-advised buyer of stock will discount the value of the corporation by this dual burden on the corporation.

Congress again, also provided in §4999, to impose a 20% excise tax on the recipient of the parachute payment. Some  insiders will require the corporation to reimburse them if subject to the excise which in turn will increase the excess payment and in turn the excise payment. reimbursements will be additional parachute payments, creating a pyramid effect. On the other hand, corporations may attempt to write caps into parachute agreements to avoid excess payments or may attempt to characterize such excess amounts as loans. But see Yocum v. U.S., 96 AFTR2d 2005-5030 (Ct. Fed. Cl. 2005)(§4999 penalty imposed on retired CEO/president for payments received under restrictive stock agreement in  connection with corporation’s asset transfer to new co./joint venture: change in ownership occurred under §280G(b)(2)(A)(i)(II) triggering excise tax upon stock that became vested as result). See CCA 200923031 (June 5, 2009).

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One of the various requirements to qualify an acquisitive transaction as a tax-free reorganization is the continuity of business enterprise requirement. A tax-free reorganization requires a “continuity of business under modified corporation forms”. (citation omitted). The courts have entered into this area from time to time dealing with such issues as post reorganization asset drop-downs (Standard Realization Co. v. Comm’r, 10 TC 708 (1948) (acq.)) or asset sales (Pridemark, Inc. v. Comm’r, 345 F2d 35 (4th Cir. 1965) . .(reorganization treatment denied under preconceived sale of assets where business operations had been suspended during the interim period). The reported cases in this area may be viewed as having turned on the specific facts in each case.

The COBE rule requires that there be a continuity of business activity of the historic business of the acquired entity. The regulations provide that in order to meet the COBE requirement, in general, the acquiring corporation must: (i) continue the target corporation’s historic business; or (ii)) continue the use of a “significant portion” of the target corporation’s historic business assets in a business. Logically the regulations state that the fact that the acquiring corporation is engaged in the same line of business as the target corporation should result in a finding that COBE is present. Where the target had been engaged in more than one business, COBE requires that the target only continue a significant line of its business. Another rule provides that the acquiring corporation may continue the “historic business” of the target which is the business most recently conducted.

While the COBE requirements applies to the various species of tax-free reorganizations, for insolvency (Type G) reorganizations, the COBE requirement may present a greater obstacle particularly where the historic business operations of the debtor-reorganized corporation have been substantially reduced in size of operation. Examples are contained in the regulations applying these principles.

Regulations adopted in 1998, liberalized the COBE requirements by permitting post-reorganization asset drop-downs to controlled subsidiaries or even partnership if certain conditions are met. Numerous examples are contained in the regulations. Additional changes to the COBE regulations were promulgated in 2007.

Another COBE rule is contained in section 382(c) pertaining to the portability of net operating losses in particular ownership change and equity structure shift events.

Against this backdrop in PLR 201015024 (4/16/2010) the National Office of the IRS ruled that using historic business assets to conduct research and development activities in order to perfect and protect patent rights satisfied the continuity of business enterprise (COBE) test.

The taxpayer-corporation seeking the ruling was had engaged in research and development activities in years one to three for one aspect of “Business A”. It applied for and/or received patents for this new technology; created a product based on this new technology; and brought this product to the commercial market. In year two an “ownership change” occurred per §382(g). The §382(c) 2 year testing period for COBE or the “COBE Period) began on Date A and ended on Date B. In year 3 Competitor A (as it was referred to in the ruling), an established company in the same line of business as Taxpayer), engaged in vigorous action to compete with the taxpayer’s commercial marketing of its product. Within the 2 year COBE Period, on Date C, as a result of the competition of Competitor A, taxpayer sold part of its business relating to the commercial marketing of its product to Acquiring-1. The taxpayer, however, retained all or part of its R&D department, its patents and patent applications and law suits or potential lawsuits against Competitor A for patent infringement and antitrust violations. In year 4, after the end of the COBE Period. Pm Date D. the taxpayer sold its R&D activities to Acquiring 2 for potential future payments. In year 5 the taxpayer received a payment from Competitor A in settlement of the patent infringement and antitrust lawsuits and for the right to the future use of Taxpayer's patents. The amount of the settlement payment was substantially more than the funds previously received by taxpayer for the part of its business it sold in year 2. 

In addition to certain other representations made by the taxpayer as set forth in the ruling request and recited in the ruling, the Service ruled: 

1. Taxpayer’s activities after the asset sale in developing and perfecting new technology; in applying for and/or perfecting patents; and negotiating with and litigating against Competitor A with regard to its business and patents and with regard to the patent infringement and antitrust lawsuits constitute the use of “historic business assets” by Taxpayer. See Treas. Reg. §1.368-1(d)(3)(ii).

2. The “historic business assets” with regard to which Taxpayer received the large settlement payment constitutes a “significant portion” of Taxpayer's pre–asset sale historic business assets.

3. Taxpayer's use of its “historic business assets” from DateC until the DateB end of the 2–year COBE Period constitutes a continued business use by Taxpayer of a significant portion of its historic business assets sufficient to meet the continuity of business enterprise requirement in Treas. Reg. § 1.368-1(d) and, accordingly, the DateC asset sale does not bring into effect the § 382(c) carryforward limitation (2 year COBE period).

As various corporate tax jocks would say, “what a ruling” this one is (and favorable at that). Note §6110(k)(3)’s warning: “Unless the Secretary otherwise establishes by regulations, a written determination [e.g., private letter ruling] may not be used or cited as precedent. The preceding sentence shall not apply to change the precedential status (if any) of written determinations with regard to taxes imposed by subtitle D of this title.”

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At the present time the good people of the Swiss Federal Tax Administration are sorting out which of the thousands of requested names of US persons and account numbers with UBS will be turned over to the United States shortly in accordance with the U.S.-Swiss agreement.

In 2008 the Department of Justice and the Internal Revenue Service filed a court action in Federal District Court for the Southern District of Florida seeking to obtain information on UBS account holders through a John Doe summons. This led eventually to a February 2009 deferred prosecution agreement between the Department of Justice and UBS in which the bank accepted responsibility for a charge of conspiracy to defraud the United States admittedly perpetrated by its bankers and account managers. What some consider to be tantamount to a “slap on the wrist”,UBS agreed to pay $780 million in fines, penalties, interest, and restitution; close down its private wealth pitch to US persons from  its foreign based executives and disclose the names of U.S. clients. The agreement requires UBS to present to the IRS the remaining 4,500 names of U.S. clients of UBS AG owning or having beneficial interests in Swiss Accounts. The US government is moving forward beyond the UBS scandal to pursue other jurisdictions which have bank secrecy rules which are utilized by US persons and others to avoid detection and to potential evade the payment of income tax.

The Internal Revenue Service has indicated that it will use more John Doe summonses to identify U.S. taxpayers and others who are using offshore accounts and entities in tax haven and bank secrecy jurisdictions to evade U.S. tax as well as failing to report foreign financial accounts under the FBAR reporting requirements. Under § 7609(f) , a so-called John Doe summons is one that does not identify the person under investigation. It may be issued after a federal magistrate or district court judge determines: (i) the summons relates to the investigation of a particular person or ascertainable group or class of persons, (ii) there is reason to believe that the person, group, or class may fail or may have failed to comply with the tax laws, and (iii) the information sought and the identity of the persons whose liability is involved cannot be readily obtained from other sources. See. e.g., US v. Samuels, Kramer & Co., 712 F2d 1342 (9th Cir. 1983) .

Whistleblowers have also played an important role in assisting the U.S. investigations of offshore accounts, both inside and outside UBS, including former UBS banker Bradley Birkenfeld.   See §7623(b).

Under the limited amnesty program offered last year, it has been reported that 14,700 returns were filed under this special voluntary disclosure program for taxpayers with unreported income from offshore accounts. Under limited amnesty, taxpayers coming forward and reporting past omissions were required to pay either a 20% accuracy related penalty or a delinquency penalty on up to 6 years of non-compliance covered under the program plus a 20% penalty on the amount in the foreign bank account (FBAR penalties) in the year with the highest aggregate account or asset value, in lieu of all other applicable penalties.

It is presently uncertain as to how the IRS will generally treat those who decide to come forward and make a disclosure after the limited amnesty period has ended. The Service will obviously decide each of those disclosures on a case by case basis and decide which of the disclosures are appropriate for criminal prosecution as well. They already have.

More updates on this area in the future.

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On August 11, 2010, the Service issued temporary regulations (T.D. 9498) under §108(i)’s election to defer cancellation of indebtedness income for  corporations, partnerships and S corporations. The provision was enacted as part of the American Recovery and Reinvestment Act of 2009 and was intended by Congress to allow business to defer COD income ratably over a five hear period. The election is irrevocable. The IRS on August 11 released a set of temporary regulations providing rules for the section 108(i) election to defer cancellation of debt (COD) income for partnerships and corporations. The provision sunsets at the end of 2010 which limits the time that eligible taxpayers can restructure reacquisitions of debt to take advantage of the deferral. See also Rev. Proc. 2009-37, 2009-36 IRB 309.

This post reviews a few of the more noteworthy aspects of the rulemaking. A careful reading of the language contained in section 108(i) and the temporary regulations is a must.

Application to Corporations

Where a debtor corporation liquidates and dissolves or disposes of its assets connected with deferred COD income, an acceleration of the entire balance of deferred income is required. While the thought is that the scope of the acceleration provision should be narrow, the regulations provide for acceleration events for electing corporations which change their tax status or go out of existence. Exception is provided for section 332 and section 381 transactions but includes situations where the electing corporations files a Title 11 bankruptcy. Another acceleration event is where the corporation takes part in a transaction which might impair its ability to pay the related COD income tax liability, i.e., an impairment transaction. The regulations note that while a sale of substantially all assets results in an acceleration event for electing partnerships, it does not constitute an acceleration for electing corporations.

If a corporation engages in an impairment transaction under section 108(i), the regulations provide a net value acceleration rule that identifies when the electing corporation must accelerate its remaining deferred COD income. Acceleration is required only if immediately after the transaction, the gross value of the corporation's assets is less than 110% of its liabilities plus the related deferred COD tax. To avoid an acceleration under the impairment rule, the corporation must restore a certain amount of assets, i.e., either the amount removed in the impairment transactions or the difference between the gross value of its assets and the sum of its liabilities plus the related deferred COD tax, in a timely manner. This requires that corporations have a 10% equity base over liabilities, including deferred taxes in applying this rule. Still, this rule may prove to be a problem for heavily leveraged corporations.

For consolidated groups, the temporary regulations provide that an electing member has engaged in an impairment transaction if the transaction impairs the group's ability to pay the tax on the group's deferred COD. Groupwide treatment ensures that intercompany transactions do not qualify as impairment transactions. An impairment transaction does occur, however, when an electing member ceases to be a group member or moves to another group, although application of the net value acceleration rule is applied on a separate-entity basis (in the case of a cessation) or by reference to the members of the acquiring group (in the case of a transfer). The regulations further permit an electing member of a consolidated group to elect to accelerate in full the inclusion of its remaining deferred COD.

Dividends and charitable contributions are generally not treated as impairment transactions. Special rules in this area are also set out for regulated investment companies and REITs.

Earnings and profits of an electing corporation will increase in the year in which a §108(i) election is made and a corresponding decrease in earnings and profits when the deferred OID deduction is permitted. See §312(n).

Acceleration Events Involving Partnerships and S Corporations

Where the electing partnership or S corporation liquidates, disposes of substantially all of its assets, files for Title 11 bankruptcy, or otherwise dissolves, any COD income deferred under section 108(i) is accelerated and must be taken into account in the year of the triggering event. Similarly, where a partner or S corporation shareholder sells (or exchanges, redeems, transfers, gifts, or abandons) his interest in the electing entity, or he dies or liquidates, the deferred COD income allocated to that partner or shareholder is accelerated, and any gain must be recognized. There may not be, however, a requirement that the other partners or shareholders treat the deferred income as acceleration. The disposition of part but not all of a partner’s or S shareholder’s interest in the entity will result in only a corresponding percentage of acceleration of deferred COD income.  

As to what constitutes “substantially all” of the assets of a partnership, the regulations borrow from the safe harbor rule applied by the Service for certain reorganizations, including Type C reorganizations. Accordingly, the regulations provide that for acceleration purposes, "substantially all" assets means at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets as of the date prior to the sale. In a tiered partnership structure, where a lower-tier partnership undergoes a triggering event, that event will not generally result in an acceleration event for the upper-tier electing partnership. However, if before the triggering event the upper-tier electing partnership transferred property to the lower-tier partnership under §721, the electing partnership could be treated as having sold substantially all of its assets, which would of course result in an acceleration event.

As to redemptions of partnership interests and interests in pass thru entities, the regulations provide that liquidating distributions of cash or other property by a partnership to a partner only count as redemptions giving rise to an acceleration event where the distribution represents a complete liquidation of the partner's interest. In addition, the regulations  provide that several types of transactions would not generally cause an acceleration event, including transactions described in §721, like kind exchanges under §1031 and terminations under §708(b)(1)(B).  

The regulations also set forth five safe harbors for partnerships and S corporations to meet the trade or business requirement in making the §108(i) election. Temp. Reg. section 1.108(i)-2T(d)(1) states that if at least 95% of the interest paid or accrued on the issued debt instrument was allocated to a trade or business expense under Treas. Reg. §1.163-8T, the instrument is deemed issued in connection with the partnership’s or S corporation's trade or business. The regulations also provide that a disregarded entity may take advantage of the election by treating any debt instrument issued by it as having been issued by the person treated as owning its assets for federal income tax purposes.

Allocation of COD Income Problems.

The regulations provide  that a partnership must first allocate all of the COD income connected to a reacquired applicable debt instrument to those persons who were partners immediately before the reacquisition under the rules of §704 without regard to §108(i). Then it determines which portion of each partner's allocable share of the COD income is deferred and which portion is included in the partner's distributive share of partnership income for the year. The regulations apply the pro rata allocation method to electing S corporations. Treas. Reg. §1.108(i)-2T(c)(1).

Outside basis is not increased under §705 or §1367 until the deferred COD income is recognized. he basis adjustment rules in the regs make clear that a partner's basis in its partnership The regulations further  address how to compute a partner's deferred section §752 amount, how capital accounts are effected and the consequences under the at-risk rules in §465.

Deferral of OID Deductions

Where the reacquisition causes a debt instrument to be issued or deemed issued, §108(i) provides for the deferral of related OID expense deductions ratably over the statutory inclusion period. The regulations provide that if a debt instrument is issued and the proceeds of it are used by the issuer or a person related to the issuer to reacquire the issuer's applicable debt instrument, such instrument is treated as having been issued for the reacquired applicable debt instrument. The phrase "or a person related to the issuer" was designed to prevent related parties from avoiding the rules for deferred OID deductions.

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Incorporation of an Entity Taxable as a Partnership to a Corporation or Association Taxable as a Corporation

At times it may be desirable to convert an entity taxable as a partnership, such as a limited liability company having more than 1 member or a limited partnership, into a corporation for federal income tax purposes. There may be several reasons why this planning option should be considered including the possible IPO of the business entity although in such case the conversion of tax status should be dependent upon the successful offering.

As set forth in Rev. Rul. 84-111, supra, there are three methods by which an entity taxable as a partnership may convert to a corporation.

The first method is the “assets over” or “partnership asset transfer” approach. In such instance the tax partnership transfers its assets to the newly organized corporation in exchange for the stock and the assumption by the corporation of partnership liabilities, and the partnership then liquidates by distributing the corporate stock received in the incorporation transaction to the partners in accordance with their partnership proportions.

The second method is the “assets up” or “partner asset transfer” approach, where the tax partnership’s assets are first distributed in-kind to the partners who then transfer the assets to the corporation in exchange for the corporations's stock and the corporation assumes the liabilities of the partners which were just assumed by the partners from the distributing or liquidating partnership.

The third method is the “partnership interest transfer” approach, where the interests of the partners in the tax partnership are transferred to the corporation in exchange for the corporation's stock. This exchange will terminate the partnership (since only one “partner” will then hold interests in the former partnership). The partnership's assets and liabilities will become the assets and liabilities of the corporation.

The check-the-box regulations contain a rule whereby the partnership may elect to change from a tax partnership to an association taxable as a corporation. Treas. Reg. § 301.7701-3(g)(1)(i) sets forth the effects of the CTB election which takes the “assets over” or “partnership asset transfer” approach: (i) the partnership contributes all of its assets and liabilities to the association in exchange for stock in the association;  and (ii) immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners.

In Rev. Rul. 2004-59, 2004-1 CB 1050 the Service ruled that if an unincorporated state law entity that is classified as a partnership for federal tax purposes converts into a state law corporation under a state law conversion statute, the following (“assets over”)is deemed to occur: (i) the partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation; and immediately thereafter, (ii) the partnership liquidates, distributing the stock of the corporation to its partners. In other words, the conversion is treated in the same manner as an election (without a state law conversion to corporate status) under Treas. Reg. § 301.7701-3(c)(1)(i) .

Impact of “Assets Over” Conversion.  The exchange under §351, as mentioned, is between the partnership and the corporation. The partnership then terminates through a liquidating distribution of the newly received stock. The basis of the assets received by the transferee corporation will be the partnership's basis per §362. The basis of the stock received by the partnership will be the basis of the partnership’s assets transferred to the corporation, reduced by liabilities assumed by the corporation or to which the transferred properties were subject. § 358 . This amount may vary significantly with the partners’ basis in their partnership interests which becomes the corporation’s basis in the acquired assets under the “Assets Up” method.  The basis of the transferee corporation's stock received by the partners in liquidation of the partnership is the adjusted or outside basis of the partners' interests in the partnership less the amount of the corporation's assumption of the partnership's liabilities in the incorporation transaction.

The holding period for the stock received in the exchange and distributed to the partners in liquidation receives “tacking” of the holding period of the partnership but only as to capital or §1231 assets. Ordinary income assets of the partnership are not entitled to tacking and the holding period for the stock begins on the day following the date of the exchange. §§ 1223(1), 1223(2). The “assets over” approach is considered by many tax advisors as the least complex method for incorporating a partnership.  

“Assets Up” Approach. Under this alternative, the partnership first liquidates by distributing its assets, subject to liabilities, to the partners. The second step is the transfer of assets received from the partnership to the transferee corporation in exchange for stock in accordance with §351(a). The basis of the distributed received in liquidation to the partners is the adjusted basis of each partner's interest in the partnership, less any money distributed or property treated as money. Each partner’s basis in the stock received in the exchange (or deemed exchange) will be equal to the basis of the assets received in the liquidating distribution, less liabilities assumed by the transferee. §358. The corporation’s basis in the transferred assets is equal the partners adjusted basis in the assets “contributed” up to the corporation. § 362 . Note again, that the outside basis in the partners’ interest in the partnership will become the corporation’s basis in its assets which may produce a different result then the “Assets Over” approach.

The partners' holding period in the assets received in liquidation includes the partnership’s holding period. The holding period in the stock received in the exchange includes the holding period for the capital assets and § 1231 assets.  Ordinary ncome assets receive no tacking of holding period. §1223(1) . The holding period for the corporation in assets received in the exchange includes the (former) partners' holding periods in the assets transferred to the corporation. § 1223(2) .

Transfer of Partnership Interests Approach.  As the third alternative, the partners transfer their partnership interests to a transferee corporation in exchange for shares of the corporation under §351. The partnership terminates since upon receipt by the corporation there will be only one “partner”. The partners basis in the stock received in the exchange will be the basis for their partnership interests, reduced by any liabilities assumed. §358. The corporation’s basis for the partnership assets will be each partner's basis in the partnership interest transferred. § 362 .  Tacking of holding period is permitted for the stock received holding period to the extent that the assets in the partnership are neither §751 or ordinary income assets. The corporation's holding period in the assets received in the exchange includes the holding period of the partnership in the assets transferred. § 1223(2) .

If the corporation-transferee is an S corporation, the Assets Up method may place jeopardy on the corporation’s S status as it will have, at least momentarily, a partnership as a shareholder. This is discussed briefly in Rev. Rul. 84-111, supra.

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In Tidewater, Inc. and Subsidiaries v. U.S., 565 F.3d 299 (4/13/2009), the Fifth Circuit affirmed the District Court’s  determination in a tax refund suit, reported at 100 AFTR2d 2007-6360 (DC LA 2007), which granted controlled group/oceangoing vessel owner-operators' refund of an overpayment of tax attributable to its claim that it could deduct, under the former foreign sales corporation provision, commissions paid to a foreign sales corporation on the portion of income allocated to the leasing component of time charters/mixed lease-service agreements. The Court agreed with the trial court below that time chartered vessels constituted qualified export property for purposes of former §927 and former Treas. Reg. § 1.927(a)-1T(f)(2) 's provision for leases to controlled group members of property that is held for sublease. The resolution of the issue hinged on whether the taxpayers' agreements with customers were in the  nature of service contracts or leases/subleases. This analysis required application of the factors set forth in §7701(e). The six factors in §7701(e) that the Fifth Circuit analyzed were (1) physical possession of the property; (2) control of the property; (3) significant possessory or economic interest in the property; (4) substantial risk of nonperformance; (5) concurrent use of the property; and (6) that the total contract price does not substantially exceed the rental value of the property for the contract period.

The Fifth Circuit held that the control factor was most important and therefore concluded that the agreements in issue in this case were more akin to lease/sublease agreements due to the significant control customers exercised over every aspect of  the vessels' use.

The AOD, (AOD 2010-01, posted on the IRS website May 17, 2010; 2010-22 IRB), states the Service’s disagreement with the the Fifth Circuit’s analysis and application of the factors test under §7701(e). The Service continues to hold its position that time charters should be treated as service contracts on the basis that the right to direct the destination and itinerary of boat trips for a specific period of time is not sufficient “control” or otherwise meets the requirements of a lease of property versus a contract for services.  

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