PLR 1032003: Securities partnership may use full-netting allocation method

Plain-English summary

A partnership classified as a securities partnership held actively traded securities contributed by pension-plan, VEBA, and regulated-investment-company owners. It used the full-netting approach to aggregate built-in gains and losses for reverse section 704(c) allocations when partnership property was revalued. The IRS ruled that this method was reasonable and also permitted the partnership to aggregate specified built-in gains and losses from contributed and revalued qualified financial assets for section 704(c) and reverse section 704(c) allocations. The permission was conditioned on consistent application, preservation of tax attributes, and no purpose to shift tax consequences in a way that substantially reduced the owners' aggregate tax liability.

Ruling snapshot

• Question: May the securities partnership aggregate specified built-in gains and losses using the full-netting method for section 704(c) allocations?
• Outcome: Approved
• Key authorities: IRC § 704(c); Treas. Reg. § 1.704-3(e)(3)-(4).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201032003 Third Party Communication: None
Release Date: 8/13/2010 Date of Communication: Not Applicable
Person To Contact:
Index Number: 704.01-04 ------------------, ID No. -------------
Telephone Number:
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---------------------- Refer Reply To:
------------------------------------ CC:PSI:B02
---------------------------------------------------------- PLR-102486-10
------------------------------------------------ Date:
------------------------ April 21, 2010

LEGEND

X = ----------------------------------------------------------
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a = ------------------------------------
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b = ------------------------------------------------------------------------------------------
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c = -----------------------------------------------------
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d = ----------------------------------------------------------------------------------------------------
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e = ---------------------------------------------
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State = -------------

Date 1 = ---------------------

Dear --------------------:

This responds to a letter dated January 15, 2010, and subsequent correspondence,
submitted on behalf of X by X's authorized representative, requesting rulings under
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§ 704 of the Internal Revenue Code.

X was formed as a statutory trust on Date 1 under the laws of State. X’s entity
classification is a partnership for federal income tax purposes. X’s owners are a, b, c, d
and e (collectively, the “Owners”). a is a trust holding assets of a pension plan qualified
under § 401(a). b, c, and d are voluntary employees’ beneficiary associations (VEBAs)
that have received favorable determination letters under § 501(c)(9) and provide welfare
benefits to covered current and former employees of a common employer. e is a
regulated investment company described in § 851.

X represents that contributions of securities to X from its Owners in exchange for
interests therein were non-recognition exchanges under § 721(a) and that
§ 721(b) did not apply to any such contribution because each Owner contributed a
portfolio of assets that was “diversified” within the meaning of § 1.351-1(c)(6)(i).

X’s agreement requires that a separate capital account be established and maintained
for each Owner in accordance with the capital account maintenance rules of § 1.704-
1(b)(2)(iv). The agreement requires that on liquidation of X (or any Owner's interest in
X), liquidating distributions are to be made in accordance with the capital account
balances of the Owners. The agreement also contains a qualified income offset, as
defined by § 1.704-1(b)(2)(ii)(d). Except as required by § 704(c), items of profit or loss
are allocated in accordance with the Owners' relative capital account balances.

The agreement also provides that the capital accounts of the Owners will be increased
or decreased to reflect a revaluation of the property of X on X’s books upon the
occurrence of a revaluation event. X will make revaluations at least annually in
accordance with § 1.704-3(e)(3)(iii)(B)(2)(ii). Revaluation events include:

   (a) A contribution of money or other property (other than a de minimis amount) to
       X by a new or existing owner as consideration for an interest in X;

   (b) The liquidation of X or a distribution of money or other property (other than a
       de minimis amount) by X to a retiring or continuing owner as consideration for
       an interest in X; and

   (c) The end of each quarter in accordance with generally accepted industry
       accounting practices.

X further represents that it qualifies as a "securities partnership" as defined in § 1.704-
3(e)(3)(iii). The stock contributed to X is actively traded within the meaning of
§ 1.1092(d)-1. For purposes of making reverse § 704(c) allocations, X will adopt the full
netting approach as described in § 1.704-3(e)(3)(iv). All § 704(c) and reverse § 704(c)
allocations made under the full netting approach will at all times comply with § 1.704-
3(e)(3)(v). X will consistently apply the same aggregate approach to all of its qualified
PLR-102486-10 3

financial assets for all taxable years in which X qualifies as a securities partnership.
The full netting approach adopted by X will preserve the tax attributes of each item of
gain or loss realized by X.

X represents that contributions or revaluations of property and the corresponding
allocations of tax items by X will not be made with a view to shifting the tax
consequences of built-in gain or built-in loss among the partners in a manner that would
substantially reduce the present value of the Owners' aggregate tax liability.

X requests the following rulings:

   (1) X’s use of the full netting approach method, as provided by § 1.704-3(e)(3)(v),
       for aggregating built-in gains and built-in losses from qualified financial assets
       for purposes of making reverse § 704(c) allocations is reasonable within the
       meaning of § 1.704-3(e)(3).

   (2) X has permission to aggregate built-in gains and built-in losses from qualified
       financial assets contributed to X by the Owners with built-in gains and built-in
       losses from revaluations of qualified financial assets held by X for purposes of
       making § 704(c) and reverse § 704(c) allocations.

Ruling # 1

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

Section 1.704-3(a)(1) of the Income Tax Regulations provides that the purpose of
§ 704(c) is to prevent the shifting of tax consequences among partners with respect to
precontribution 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 be made
using a reasonable method that is consistent with the purpose of § 704(c).

Section 1.704-3(a)(6) provides that the principles of § 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)
(reverse § 704(c) allocations). A partnership that makes allocations with respect to
revalued property must use a reasonable method that is consistent with the purposes of
§ 704(b) and § 704(c).
PLR-102486-10 4

Section 1.704-3(a)(2) provides that § 704(c) generally applies on a property-by-property
basis. Therefore, 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.

Section 1.704-3(e)(3) provides a special rule allowing certain securities partnerships to
make reverse § 704(c) allocations on an aggregate basis. Specifically, § 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 purpose of § 704(c). Once a
partnership adopts an aggregate approach, that 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.

Section 1.704-3(e)(3)(iii)(A) provides that a partnership is a securities partnership if the
partnership is either a management company or an investment partnership, and the
partnership makes all of its book allocations in proportion to the partners' relative book
capital accounts (except for reasonable special allocations to a partner that provides
management services or investment advisory services to the partnership). Under
§ 1.704-3(e)(3)(iii)(B)(2), a partnership is an investment partnership if (i) on the date of
each capital account restatement, the partnership holds qualified financial assets that
constitute at least 90 percent 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 § 1.704-3(e)(3), to
make revaluations at least annually.

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

Section 1.704-3(e)(3)(iv) and § 1.704-3(e)(3)(v) provide two approaches to making
aggregate reverse § 704(c) allocations that are generally reasonable -- the partial
netting approach and the full netting approach. However, § 1.704-3(e)(3)(i) provides
that other approaches may be reasonable in appropriate circumstances.

Section 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 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.

Section 1.704-3(e)(3)(vi) provides that the character and other tax attributes of gain or
loss allocated to the partners under § 1.704-3(e)(3) must (1) preserve the tax attributes
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of each item of gain or loss realized by the partnership, (2) be determined under an
approach that is consistently applied, and (3) not be determined with a view to reducing
substantially the present value of the partners' aggregate tax liability.

X has elected to use the full netting method for making reverse § 704(c) allocations as
described in § 1.704-3(e)(3)(v). Section 1.704-3(e)(3)(v) provides that to use the full
netting approach, the partnership must establish appropriate accounts for each partner
for the purpose of taking into account each partner's share of the book gains and losses
and determining each partner's share of the tax gains and losses. Under the full netting
approach, on the date of each capital account restatement, the partnership (A) nets its
book gains and book losses from qualified financial assets since the last capital account
restatement and allocates the net amount to its partners; (B) nets tax gains and tax
losses from qualified financial assets since the last capital account restatement; and (C)
allocates the net tax gain (or net tax loss) to the partners in a manner that reduces the
book-tax disparities of the individual partners.

After applying the relevant law to the information and representations submitted, we rule
that X’s method of making reverse § 704(c) allocations is a reasonable method within
the meaning of § 1.704-3(e)(3), provided that a contribution or revaluation of property
and the corresponding allocation of tax items with respect to the property are not made
with a view to shifting the tax consequences of built-in gain or loss among the
partnership in a manner that substantially reduces the present value of the Owners'
aggregate tax liability.

Ruling # 2

The aggregation rule of § 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 § 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 preamble, however, 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.
Consequently, § 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 § 1.704-3(e)(3).

In Rev. Proc. 2001-36, 2001-1 C.B. 1326, the Service 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
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purposes of making § 704(c) allocations submitted by partnerships that do not qualify
for automatic permission.

In this case, X represents that the burden to X of making § 704(c) allocations separate
from reverse § 704(c) allocations is substantial. X will use the full netting approach
described in § 1.704-3(e)(3)(v) for making forward and reverse § 704(c) allocations.
The likelihood that X and its owners could abuse this type of aggregation is minimal.

After applying the relevant law to the information submitted and representations made,
we rule that X’s method of making § 704(c) allocations, including reverse allocations, for
its owners is permissible under § 1.704-3(e)(4)(iii), provided that a contribution or
revaluation of the property and the corresponding allocation of tax items with respect to
the property are not made with a view to shifting the tax consequences of built-in gain or
loss among the partners in a manner that substantially reduces the present value of the
Owners' aggregate tax liability.

Except as specifically ruled upon above, we express no opinion on the federal tax
consequences of the transactions described above under any other provisions of the
Code and regulations or about the tax treatment of any conditions existing at the time
of, or effects resulting from, any transaction(s) that are not specifically covered by the
above rulings.

This ruling is limited to allocations of gain or loss from the sale or other disposition of
qualified financial assets made under §§ 704(b), 704(c)(1)(A), and 1.704-3(a)(6).
Specifically, no opinion is expressed concerning 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 contributed to X
by any owner other than the Owners described in this ruling. X must maintain sufficient
records to enable it and its Owners to comply with §§ 704(c)(1)(b) and 737.

Additionally, this ruling applies only to the contributions to X by the Owners for whom X
supplied specific information concerning the contributed assets as described above, and
not to any other contributions by the Owners or any other future owner.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.
PLR-102486-10 7

Pursuant to a power of attorney on file with this office, a copy of this letter is being
forwarded to X's authorized representatives.

                                    Sincerely,



                                    Melissa C. Liquerman
                                    Branch Chief, Branch 2
                                    (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes