1. Partnership Mergers and Divisions L. Andrew Immerman Alston & Bird LLP 404-881-7532 aimmerman@alston.com ABA Business Law Section April 12, 2008

2. 2 State Law vs. Tax Law For partnership mergers and divisions, there is a remarkable disconnect between: The transaction that occurs under state law. What the IRS "deems" to happen. Don’t assume that the actual transaction bears a resemblance to the "deemed" transaction under the tax rules. These partnership tax rules are an unintuitive mix between real and imaginary transactions.

3. 3 Corporate Tax vs. Partnership Tax There is almost no resemblance between the tax rules on: Corporate mergers and divisions. Partnership mergers and divisions. Don’t assume that corporate tax rules bear a resemblance to partnership tax rules.

4. 4 Contributions and Distributions This presentation, like the Code and Regulations on partnership mergers and divisions, focuses mostly on identifying the contributions and distributions that are "deemed" to take place. The tax rules break partnership mergers and divisions down into some combination of deemed contributions and distributions.

5. 5 Contributions and Distributions Once the deemed contributions and distributions are identified, the tax consequences generally follow from the rules on contributions and distributions. The key is to figure out what the deemed transactions are.

6. 6 Terminology In this presentation, "partnership" means an entity classified as a partnership for federal tax purposes. Many "partnerships" are LLCs under state law. Some state law partnerships are not "partnerships" for tax purposes.

7. Partnership Mergers The tax rules for partnership mergers also generally favorable, but often require transactions to be recharacterized in bizarre ways

8. 8 Partnership Mergers: What is a "Merger"? Definition of partnership "merger" is fuzzy. However it is clear that: Partnership "merger" does not include many transactions that are undertaken under state merger statutes. Partnership "merger" does include many transactions that are not undertaken under state merger statutes.

9. 9 Partnership Mergers: What is a "Merger"? Any time partnership transaction(s), with or without state law merger, result in fewer partnerships at the end than at the beginning, consider: Has there been a partnership "merger" for tax purposes?

10. 10 Partnership Mergers: What is a "Merger"? Any time partnership transaction(s), with or without state law merger, result in the same number of partnerships at the end as at the beginning, consider: Are the ending partnerships the same for tax purposes as the beginning partnerships?

11. 11 Termination of Partnership Under the Internal Revenue Code, a termination of a partnership results from two and only two events: "Actual Termination": The business ceases to be carried on by the partners in a partnership. If only one partner is left, the partnership has "actually" terminated. "Technical Termination": Within a 12-month period, there is a sale or exchange (not redemption) of 50% or more of the total interests in partnership capital and profits.

12. 12 Example: State Law Merger Without Tax Merger Many partnership mergers under state law are intended to change the state law form of entity and/or the state of formation. For example, changing a Georgia LP to a Delaware LLC might be accomplished by merging the LP into a new LLC. State law mergers of this kind are becoming less common now that many states authorize direct conversions without mergers.

13. 13 Example: State Law Merger Without Tax Merger In transactions like this, the IRS says that there is no partnership merger and no partnership termination. State law form of transaction is irrelevant to the IRS. See Rev. Rul. 95-37, 1995-1 C.B. 130.

14. 14 B 50% A B A B (GA LP) Property X = $300 "Non-Merger" Example: Initial Situation

15. 15 B 50% A B A B (DE LLC) No Property "Non-Merger" Example: Shell Partnership is Formed

16. 16 "Non-Merger" Example: State Law Merger 50% A B A B Property X = $300 A B (DE LLC) A B (GA LP)

17. 17 B 50% A B A B (DE LLC) Property X = $300 "Non-Merger" Example: End Result

18. 18 AB (GA LP) = AB (DE LLC) AB (GA LP) is the same partnership for tax purposes as AB (DE LLC). There is no termination of AB. Tax year does not close. EIN does not change. There is no partnership distribution or contribution. No property is deemed transferred. However, the transaction may have tax consequences. Most importantly, the amount of liabilities allocated to a member may go down, which is treated as a distribution to the member.

19. 19 Merger vs. Conversion Tax treatment of the merger of AB (GA LP) into AB (DE LCC) is more analogous to the state law treatment of a conversion of AB (GA LP) into AB (DE LLC). From a tax viewpoint, there is no difference between a state law merger into a shell and a state law conversion.

20. 20 Equivalent Transactions To the IRS, all the following actual transactions are identical: Merger of AB (GA LP) into AB (DE LLC). Conversion of AB (GA LP) to AB (DE LLC). Contribution of all interests in AB (GA LP) to AB (DE LLC). Contribution of all assets of AB (GA LP) to AB (DE LLC). Distribution to A and B of all assets of AB (GA LP) and immediate recontribution to AB (DE LLC).

21. 21 Mergers For Tax Purposes As noted, the merger of AB (GA LP) into AB (DE LCC) was not treated as a merger for tax purposes. For tax purposes: No partnership terminated. No assets moved. In a transaction treated as a partnership merger for tax purposes: At least one partnership does terminate. Assets are deemed to move.

22. 22 Partnership Mergers = Distributions + Contributions A merger that is governed by the tax rules on partnership mergers is characterized as a combination of: Distributions. Contributions. Distributions and contributions are often tax-free in the partnership environment.

23. 23 Partnership Mergers = Distributions + Contributions Since the basic partnership rules on distributions and contributions are so much favorable than those for corporations, there is no need for the elaborate definitions of tax-free mergers found in the corporate tax context. Although there are some very important exceptions, the general rule of Code § 731 renders most distributions tax-free to both the partner and the partnership.

24. 24 Partnership Mergers: Distribution Aspect But always watch out for the exceptions: Distribution of cash/marketable securities in excess of basis (including "deemed distribution" on liability shift). Code §§ 731(a)(1), 752(b). Change in shares of ordinary income ("hot") assets. Code § 751(b). "Disguised sale." Code § 707(a)(2)(B). "Mixing bowl." Code §§ 704(c)(1)(B) and 737.

25. 25 Partnership Mergers: Distribution Aspect The general rule of tax-free distributions by partnerships is in stark contrast to the comparable Subchapter C provisions, which in most instances impose tax on both: The shareholder. Code §§ 301 and 331. The corporation. Code §§ 311 and 336.

26. 26 Partnership Mergers: Contribution Aspect Code § 721 generally grants tax-free treatment to both the partner and the partnership on a contribution of property in exchange for an interest in a partnership.

27. 27 Partnership Mergers: Contribution Aspect Code § 721 is partially matched by corporate nonrecognition provisions, especially: Code § 351 (nonrecognition to contributing shareholder). Code § 1032 (nonrecognition to corporation).

28. 28 Partnership Mergers: Contribution Aspect Code § 351 is less generous, however, in that the contributing shareholders are required to have 80 percent control of the corporation immediately after the exchange. No comparable requirement is imposed on contributions in exchange for partnership interests.

29. 29 Partnership Mergers: Which Partnership Survives? Code § 708(b)(2)(A) is the sole Code provision on partnership mergers. All this Code provision does is define the survivor of a partnership merger. It says nothing about the other consequences of partnership mergers, or even about what a partnership "merger" means. The Code provision existed long before there were partnership mergers under state law.

30. 30 Partnership Mergers: Which Partnership Survives? "In the case of the merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of [Code § 708], be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership."Code § 708(b)(2)(B). See Treas. Reg. § 1.708-1(c).

31. 31 Partnership Mergers: Which Partnership Survives? What if the members of two (or more) partnerships own more than 50% of the resulting partnership? The continuing partnership is the one that is credited with the largest net value of assets. Treas. Reg. 1.708- 1(c)(1).

32. 32 Partnership Mergers: Which Partnership Survives? What if the members of no partnerships own more than 50% of resulting partnership? All the merged partnerships terminate. Treas. Reg. 1.708-1(c)(1).

33. 33 Partnership Mergers: Assets Over (Default Form) In most instances, partnership mergers will be deemed to take the "assets-over" form. The actual form of transaction under state law is irrelevant (except for "assets up," as noted below). It does not matter whether there is a merger under state law.

34. 34 Partnership Mergers: Assets Over (Default Form) Under the “assets over” form, the partnership that is considered terminated is deemed to do the following: Contribute all of its assets and liabilities to the resulting partnership in exchange for an interest in the surviving partnership. Immediately afterwards distribute interests in the resulting partnership to its partners in liquidation.

35. 35 Partnership Mergers: Assets Up However, if a partnership merger actually takes the form of an "assets up" transaction, that form will be respected. Under this form: The partnership that is terminated distributes all of its assets to its partners in liquidation. Immediately afterwards the partners contribute those distributed assets to the resulting partnership.

36. 36 Partnership Mergers: Assets Up An "assets up" transaction is never a merger under state law. However, it is still governed by the tax rules on partnership mergers. "Assets up" merger may be beneficial, for example, where outside basis (partners’ basis in their partnership interests) exceeds inside basis (partnership’s basis in its assets). Most of the time "assets over" is okay.

37. 37 Partnership Merger Example: Initial Situation 50% C D A B A B C D Property X = $300 Property Y = $200

38. 38 Partnership Merger Example: What the Parties Think Happens Y C D X A CD AB B

39. 39 Y C D X A CD AB B Parties think that: 1. X is distributed to A and B. 2.A and B contribute X to CD in exchange for interests in CD. Partnership Merger Example: What the Parties Think Happens

40. 40 20% 30% A B C D X Y C D 20% Partnership Merger Example: What the Parties Think Happens

41. 41 Partnership Merger Example: Two Perspectives The parties think this was an "assets up" transaction, in which the assets of AB were indirectly transferred to CD. However, the IRS thinks this was an "assets over" transaction, in which the assets of CD were transferred to AB.

42. 42 Interests in AB Asset Y A B C D X Y A B C D AB Partnership Merger Example: What the IRS Thinks Happens

43. 43 Partnership Merger Example: What the IRS Thinks Happens IRS thinks that C and D joined AB, instead of A and B joining CD. IRS thinks that AB just happened to change its name to CD. The state law LLC or partnership that, according to the tax rules, changed its name to CD, will use the employer identification number formerly used by AB. AB has disappeared under state law but continues under the tax rules.

44. 44 20% 30% A B C D X Y AB (now known as CD) 20% Partnership Merger Example: What the IRS Thinks Happens

45. 45 Seven Equivalent Transactions: These Are All Identical to the IRS Merger: AB into CD. Merger: CD into AB. Asset transfer: CD to AB. Asset transfer: AB to CD. Contribution of interests in CD to AB. Contribution of interests in AB to CD. Distribution of assets to A and B with immediate recontribution to CD.

46. 46 The Alternative Each of the foregoing transactions is treated as an "assets over" merger, with AB surviving. The only alternative the IRS would recognize as different is an actual "assets up" transaction, with AB surviving, that is: Distribution of assets to C and D. Immediate recontribution to AB.

47. 47 Note On a Limited Exception If certain requirements are met, the regulations permit the partners of the merging partnership in an "assets over" transaction to be treated as selling their interests to the surviving partnership. Treas. Reg. § 1.708-1(c)(4). This special rule helps avoid taxable gain to the continuing partners of the merging partnership, who are not selling.

48. 48 Note On Anti-Mixing Bowl Controversy The application of the anti-mixing bowl rules to "assets over" mergers has been especially controversial. IRS’s current position is reflected in Proposed Regulations. REG-143397-05 (August 21, 2007). Final Regulations, when issued, are expected to be retroactive. Most advisors assume that the principles of the Proposed Regulations, if not all the details, are already in effect.

49. Partnership Divisions The tax rules for partnership divisions also generally favorable, but require even weirder recharacterizations of transactions

50. 50 Partnership Divisions = Distributions + Contributions The tax consequences of partnership divisions, like partnership mergers, are governed by the rules that apply generally to partnership contributions and distributions. Since partnership contributions and distributions are often (but not always) tax free, partnership divisions are often (but not always) tax free.

51. 51 Code § 708(b)(2)(B) is the sole Code provision on partnership mergers. All this Code provision does is define which partnership is deemed to be the survivor of a partnership division. It says nothing about the other consequences of partnership divisions. Partnership Divisions: Which is the Surviving Partnership?

52. 52 Partnership Divisions: Which is the Surviving Partnership? "In the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) shall, for purposes of this section, be considered a continuation of the prior partnership." Code § 708(b)(2)(B). See Treas. Reg. § 1.708- 1(d).

53. 53 Partnership Divisions: Technical Terms "Prior partnership" = The partnership undergoing the division. "Resulting partnership" = Any partnership that exists after the division, and that has at least two partners who were partners in the prior partnership.

54. 54 Partnership Divisions: Which is the Surviving Partnership? If the members of a resulting partnership had an interest of more than 50% in the prior partnership, the resulting partnership is treated as a continuation of the prior partnership. It is possible for more than one resulting partnership to have this 50% continuity. More than one resulting partnership may be a continuation of the prior partnership.

55. 55 Partnership Divisions: Which is the Surviving Partnership? If two or more resulting partnerships are continuations of the prior partnership, then all of them are bound by the elections of the prior partnership. However, only one of the partnerships that is a continuation of the prior partnership – called the "divided partnership" – will keep the prior partnership’s EIN and will be deemed to have simply retained its assets.

56. 56 Partnership Divisions: Another Technical Term " Divided partnership" = If no resulting partnership is a continuation of the prior partnership, there is no divided partnership. If only one resulting partnership is a continuation, the divided partnership is that resulting partnership.

57. 57 Partnership Divisions: Another Technical Term " Divided partnership" (continued) If two or more resulting partnerships are continuations, the divided partnership is: The resulting partnership that, in form, transferred the assets in the division and is a continuation. If no resulting partnership, in form, transferred the assets and is a continuation, the continuing resulting partnership with the assets having the greatest net fair market value.

58. 58 Any resulting partnership that does not have 50% continuity is treated as a new partnership. It is possible for none of the resulting partnerships to have 50% continuity So there may be no partnership that is a continuation of the prior partnership. In that case all the resulting partnerships are new partnerships. Partnership Divisions: Which is the Surviving Partnership?

59. 59 Where at least one resulting partnership is a continuation of the prior partnership: The divided partnership contributes some assets and liabilities to recipient partnership(s) in exchange for interests in recipient partnership(s). Immediately after, the divided partnership distributes the interests in recipient partnership(s) to some or all partners in partial or complete liquidation of the partners' interests in the divided partnership. Partnership Divisions: Assets Over (Default Form)

60. 60 Where none of the resulting partnerships is a continuation of the prior partnership: The prior partnership contributes all of its assets and liabilities to new resulting partnerships in exchange for interests in the resulting partnerships. Immediately after, the prior partnership liquidates by distributing the interests in the new resulting partnerships to the prior partnership's partners. Partnership Divisions: Assets Over (Default Form)

61. 61 Where a continuing partnership actually distributes assets up: The continuing partnership is treated as the divided partnership, and distributes certain assets to some or all partners in partial or complete liquidation of the partners' interests in the partnership. Immediately after, such partners contribute all the distributed assets to recipient partnership(s) in exchange for interests in recipient partnership(s). Partnership Divisions: Assets Up

62. 62 Where none of the resulting partnerships is a continuing partnership: If the prior partnership actually distributes certain assets to some or all partners in partial or complete liquidation of the partners' interests in the partnership, that form is respected. Immediately after, such partners must contribute all the distributed assets to resulting partnership(s) in exchange for interests in such resulting partnership(s). If the prior partnership does not liquidate, its retained assets are treated as transferred to a new resulting partnership under the "assets over" form. Partnership Divisions: Assets Up

63. 63 X $500 Y $300 Z $200 Property: Value: 10% 40% 10% 40% ABCD ABCD Initial Situation Division Example (Treas. Reg. § 1.708-1(d)(5), Ex. 6)

64. 64 Division Example: What the Parties Think Happens Parties want X in a new partnership of A and B. Parties want Y in a new partnership of A and B. Parties want Z to remain in the old partnership, with C and D as the remaining partners. Parties think they got what they wanted.

65. 65 40% 10% B AB2 A C D ABCD X YZ AB1 Division Example: What the Parties Think Happens

66. 66 X is contributed to AB1. Interests in AB1 are distributed to A and B. Y is contributed to AB2. Interests in AB2 are distributed to A and B. Division Example: What the Parties Think Happens

67. 67 A Y Z X AB2 AB1 B C Division Example: What the Parties Think They Own ABCD C and D continue to own ABCD. A and B own two new partnerships. D

68. 68 Division Example: What The Parties Think They Own A and B think they received interests in two new partnerships. C and D don’t think they received any distribution. C and D think that they continue to own ABCD.

69. 69 ZY AB2 CD A B C AB1 = ABCD 40% 10% X D Division Example: What The IRS Thinks Happens

70. 70 Partnership Division Example: What the IRS Thinks Happens Y is contributed to AB2. Interests in AB2 are distributed to A and B. Z is contributed to CD. Interests in CD are distributed to C and D. ABCD changed its name to AB1.

71. 71 B Division Example: What The IRS Thinks The Parties Own Y Z X A AB2 AB1 = ABCD CD D C B

72. 72 Division Example: What The IRS Thinks The Parties Own CD is a new partnership, not a continuation of ABCD, because C and D, the partners of CD, owned only a minority of ABCD. AB1 and AB2 are continuations of ABCD, because they are owned by A and B, who had more than 50% of ABCD.

73. 73 Division Example: What The IRS Thinks The Parties Own AB1 is treated as the "divided" partnership (the partnership that is deemed to have retained assets in the division) because its assets have a higher value than the assets of AB2. Thus for the IRS, AB1 really is ABCD, but with a new name. AB1 will file under ABCD’s employer identification number.

74. 74 Division Example: What The IRS Thinks The Parties Own A and B continue to own ABCD. A and B own one new partnership. C and D own one new partnership. C and D have received a distribution.