In private letter rulings (PLRs) 201710007 and 201710008, the IRS responded to a request for rulings on three issues: first, whether the merger of several investment partnerships would result in a taxable gain under Section 721(b); second, whether the use of the partial netting approach by the partnership resulting from of the partnership merger (Surviving Partnership) was a reasonable method of making reverse Section 704(c) allocations; and third, whether the resulting partnership could aggregate built-in gains and losses from qualified financial assets (QFAs) contributed by the terminating investment partnerships (Terminating Partnerships) with built-in gains and losses from revaluations of QFAs already held by the resulting partnership.

The PLRs involved partnerships owned by identical or related parties, in substantially similar proportions, that planned to merge into a single entity to reduce the costs and burdens associated with administering the separate partnerships. Each of the separate partnerships currently holds a diversified portfolio of stocks and securities, along with an insignificant amount of cash.

The PLRs state that the merger will take the assets-over form under Treas. Reg. Sec. 1.708-1(c)(3)(i). Accordingly, each Terminating Partnership will be treated as contributing its assets and liabilities to Surviving Partnership in exchange for an interest in Surviving Partnership and then distributing that interest to their partners in liquidation. The resulting partnership will be a continuation of Surviving Partnership, and Terminating Partnerships will be treated as terminated under Section 708(b)(1)(A).

Section 721(b) provides an exception to the nonrecognition rule found in Section 721(a) in instances of property contributed to a partnership that would be treated as an investment company under Section 351(e). Because the only assets that will be contributed to Surviving Partnership by Terminating Partnerships in the merger are diversified portfolios of financial assets, the IRS determined that no diversification of the transferors’ interests will result under Treas. Reg. Sec. 1.351-1(c)(1)- (6)(i). Accordingly, the IRS ruled that no gain would be recognized under Section 721 as a result of the merger.

Surviving Partnership also requested a ruling on its ability to use the partial netting approach to make reverse Section 704(c) allocations. Treas. Reg. Sec. 1.704-3(a)(2) generally requires Section 704(c) allocations to be made on a property by property basis; taxpayers may not generally aggregate the built-in gains and built-in losses on items of contributed or revalued property. However, Treas. Reg. Sec. 1.704-3(e)(3) allows certain securities partnerships to aggregate built-in gains and losses from QFAs resulting from a revaluation of partnership property for purposes of making reverse Section 704(c) allocations. Surviving Partnership has elected to use the partial netting approach to make aggregate reverse 704(c) allocations under Treas. Reg. Sec. 1.704-3(e) (3)(iv).

In the ruling request, Surviving Partnership represented that it will be a securities partnership after the merger, that it did not adopt the partial netting approach with a view of reducing the aggregate tax liabilities of the individual partners, and that it otherwise meets all the requirements to use the partial netting approach under Treas. Reg. Sec. 1.704-3(e)(iv). The IRS ruled that Surviving Partnership’s use of the partial netting approach for reverse Section 704(c) allocations is a reasonable approach under Treas. Reg. Sec. 1.704-3(e)(3).

The aggregation rule of Treas. Reg. Sec. 1.704-3(e)(3) applies only to reverse Section 704(c) allocations, not to Section 704(c) allocations from the contribution of property to a partnership. Accordingly, Surviving Partnership would generally not be permitted to use the partial netting approach for allocations of built-in gain and built-in loss of property deemed to be contributed by the Terminating Partnerships in the partnership merger. However, Treas. Reg. Sec. 1.704-3(e)(4)(iii) authorizes the IRS to permit the aggregation of qualified financial assets in certain circumstances for purposes of making Section 704(c) allocations.

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 Section 704(c) allocations. Rev. Proc. 2001-36 also provided that securities partnerships that did not qualify for automatic permission could apply for a ruling, and set forth the representations and other information required for such a ruling. The required representations include: (1) that the partnership is a “securities partnership”; (2) that revaluations of partnership property will occur at least annually; (3) that the burden of making separate Section 704(c) allocations for contributed property is substantial; and (4) that partnership’s contributions, revaluations and corresponding allocations are not made with a view towards tax avoidance.

Surviving Partnership represented that the burden of making separate Section 704(c) allocations would be substantial, and the IRS noted that it was unlikely that Surviving Partnership could abuse the aggregation of its reverse and forward Section 704(c) allocations. Applying the relevant law to the information provided and the representations made, the IRS permitted Surviving Partnership to use the partial netting approach for both its forward and reverse Section 704(c) allocations on the built-in gains or losses of its QFAs, provided that the corresponding allocation of tax items with respect to the QFAs are not made with a view to shifting the tax consequences of the built-in gains or losses among the partners in a manner to substantially reduce the present value of the partners’ aggregate tax liability.

Contact Grace Kim
Principal, Washington National Tax Office
+1 202 521 1590

Jose Carrasco
Sr. Associate, Strategy and Performance Improvement
+1 832 476 3616


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