Partnership IDR restructuring is not a taxable exchange

Plain-English summary

A publicly traded partnership's corporate general partner held incentive distribution rights that entitled it to increasing shares of future profits and distributions. The partnership cancelled those rights and issued common units plus new, less valuable incentive distribution rights designed to produce the same distribution as before. Because the partnership's appreciated assets had not recently been revalued, the general partner's capital account initially would not have matched the capital accounts attached to other common units. A contribution by the general partner's corporate owner triggered a partnership revaluation, and existing built-in gain was sufficient to equalize the accounts without shifting capital from other partners. Chief Counsel advised that the restructuring merely readjusted partnership items among existing partners and caused neither a taxable exchange nor a taxable capital shift.

Ruling snapshot

• Question: Did the general partner recognize a taxable exchange when its incentive distribution rights were replaced with common units and reduced incentive distribution rights?
• Outcome: Advice given, no taxable exchange.
• Key authorities: IRC §§ 704 and 761(c); Treas. Reg. § 1.704-1(b)(2)(iv)(f); Rev. Rul. 84-52; Lipke v. Commissioner, 81 T.C. 689 (1983).

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201517006
Release Date: 4/24/2015
CC:PSI:01
POSTU-122684-12

UILC:    761.03-00, 704.01-00

 date:   October 09, 2014

   to:   Associate Area Counsel, (CC:LB&I:)
         (Large Business & International )

 from:   Chief, Branch 1
         (Passthroughs & Special Industries)

subject: Whether a publicly traded partnership’s restructuring of Incentive Distribution Rights
into common units was a taxable exchange.

This memorandum responds to your request for assistance. This advice may not be
used or cited as precedent.

LEGEND

Taxpayer = ------------------------------

Partnership = -----------------------

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

Date 2 = ----------------

Parent = -------------------------------

a = --

b = -----------

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c = -------------

d = -----------

e = ---------------

ISSUE

   Did a taxable exchange result when the general partner of a publicly traded

partnership restructured its interest in the partnership, including exchanging its Incentive
Distribution Rights for newly issued publicly-traded common units?

CONCLUSION

   No, under the facts described below, the restructuring of the general partner’s

interest in the partnership was not a taxable transaction.

FACTS

    Taxpayer, a corporation, is the general partner of Partnership, a publicly traded

partnership within the meaning of § 7704(b) that is treated as a partnership for federal
tax purposes through the operation of § 7704(c). Partnership was formed on Date 1,
and its original partnership agreement granted Taxpayer an a percent general partner
interest in profits, losses, and capital, and in addition granted Taxpayer certain
“Incentive Distribution Rights” (IDRs). The IDRs are a form of non-publicly-traded
limited partnership profits interest that did not carry any interest in partnership capital on
Date 1, but entitled Taxpayer to share in future partnership profits and quarterly
distributions. The original partnership agreement provided that, as Partnership’s total
quarterly distributions reached certain thresholds, distributions and income allocations
to Taxpayer under the IDRs increased, up to a maximum of b percent. Additionally, the
IDRs entitled Taxpayer to a share of Partnership’s proceeds on liquidation if
Partnership’s assets appreciated after Date 1.

   On Date 2, Taxpayer and Partnership consummated an exchange agreement

and amended the partnership agreement to replace Taxpayer’s IDRs with common
units and less valuable IDRs. Specifically, Taxpayer’s interest was restructured as
follows: Taxpayer continued to hold its a percent general partner interest; Taxpayer’s
old IDRs were cancelled; Partnership granted Taxpayer c newly-issued publicly-traded
common units; Taxpayer also received new, less valuable, IDRs containing higher
thresholds and a lower maximum (d percent rather than b percent). The terms of the
newly-issued IDRs and the number of newly-issued publicly-traded common units were
calculated to produce the same distribution to Taxpayer as the old IDRs had produced
the prior quarter.

  Although Taxpayer’s IDRs did not carry any capital interest on Date 1, by Date 2

Partnership had significant appreciation in its assets, and if Partnership were to have

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liquidated immediately before the Date 2 restructuring, a substantial amount of the
proceeds would have been allocated to Taxpayer under the old IDRs. However, before
Date 2, Partnership had not experienced a revaluation event in some time, and as a
result its significant unrealized appreciation in its assets had not been “booked-up” and
reflected in the capital accounts of its partners. Thus, Taxpayer’s capital account at the
beginning of Date 2 did not reflect Taxpayer’s full economic entitlements upon
liquidation. Thus, Taxpayer’s capital account with respect to its newly-issued publicly-
traded common units would have been below the capital account of the other publicly-
traded common units, which would have meant that Partnership’s publicly-traded
common units were no longer fungible. However, also on Date 2, Taxpayer’s corporate
owner Parent contributed approximately $e to Partnership in exchange for newly-issued
publicly-traded common units of Partnership. As a result of this contribution,
Partnership revalued its assets, crediting its partners’ capital accounts to reflect how its
built-in gain would be allocated if Partnership sold the assets. Partnership had sufficient
unbooked built-in gain to equalize Taxpayer’s capital account with respect to the c
newly-issued publicly-traded common units without needing to shift capital from other
partners or allocate extra taxable income to Taxpayer.

LAW AND ANALYSIS

    Section 704 provides in general that a partner's distributive share of income,

gain, loss, deduction, or credit shall be determined by the partnership agreement,
unless the partnership agreement does not address the allocation or the allocation lacks
substantial economic effect.

   Section 761(c) provides that for purposes of subchapter K, a partnership

agreement includes any modifications of the partnership agreement made prior to, or at,
the time prescribed by law for the filing of the partnership return for the taxable year (not
including extensions) which are agreed to by all the partners, or which are adopted in
such other manner as may be provided by the partnership agreement. In Lipke v.
Commissioner,1 the Tax Court interpreted §§ 704 and 761 in holding that changes to
the partners’ sharing ratios are permissible as long as the change is made within the
time prescribed by § 761 and the change is not attributable to a variation under § 706
(such as when a partner sells part of its partnership interest, is partially redeemed, or
makes an additional capital contribution). Absent a variation under § 706, the Tax Court
ruled that the partnership’s changes “constituted nothing more than a readjustment of
partnership items among existing partners which, by itself, is permissible.”2 The
principles of Lipke were adopted in the 2009 proposed § 706 regulations.3

   Rev. Rul. 84-52, 1984-1 C.B. 157, addresses the conversion of a four-person

state-law general partnership into a limited partnership in the same state, with two
1
81 TC 689 (1983).
2
Id. at 698.
3
Prop. reg. § 1.706-4(b)(1), 74 FR 17119, April 14, 2009.

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partners becoming limited partners and two partners becoming both limited and general
partners. Each partner's total percent interest in the partnership's profits, losses, and
capital remains the same. Rev. Rul. 84-52 concludes that the conversion of general
partnership interests into limited partnership interests will not cause the partners to
recognize gain or loss under §§ 741 or 1001. Rev. Rul. 95-37, 1995-1 C.B. 130, holds
in part that the federal income tax consequences described in Rev. Rul. 84-52 apply to
the conversion of an interest in a domestic partnership into an interest in a domestic
LLC. Rev. Rul. 95-55, 1995-2 C.B. 313, holds in part that that the consequences of
Rev. Rul. 84-52 apply to a conversion of a general partnership into an LLP.

    Section 1.704-1(b)(2)(iv)(f) provides rules for partnership revaluations of

property, and states in part that a partnership agreement may, upon the occurrence of
certain events, increase or decrease the capital accounts of the partners to reflect a
revaluation of partnership property on the partnership's books. Capital accounts so
adjusted will not be considered to be determined and maintained unless: (1) the
adjustments are based on the fair market value of partnership property on the date of
adjustment; (2) the adjustments reflect the manner in which the unrealized income,
gain, loss, or deduction inherent in such property (that has not been reflected in the
capital accounts previously) would be allocated among the partners if there were a
taxable disposition of such property for such fair market value on that date; (3) the
partnership agreement requires that the partners' capital accounts be adjusted for
allocations to them of depreciation, depletion, amortization, and gain or loss, as
computed for book purposes, with respect to such property; (4) the partnership
agreement requires that the partners' distributive shares of depreciation, depletion,
amortization, and gain or loss, as computed for tax purposes, with respect to such
property be determined so as to take account of the variation between the adjusted tax
basis and book value of such property in the same manner as under section 704(c); and
(5) the adjustments are made principally for a substantial non-tax business purpose-- (i)
in connection with a contribution of money or other property (other than a de minimis
amount) to the partnership by a new or existing partner as consideration for an interest
in the partnership, (ii) in connection with the liquidation of the partnership or a
distribution of money or other property (other than a de minimis amount) by the
partnership to a retiring or continuing partner as consideration for an interest in the
partnership, (iii) in connection with the grant of an interest in the partnership (other than
a de minimis interest) on or after May 6, 2004, as consideration for the provision of
services to or for the benefit of the partnership by an existing partner acting in a partner
capacity, or by a new partner acting in a partner capacity or in anticipation of being a
partner, (iv) in connection with the issuance by the partnership of a noncompensatory
option (other than an option for a de minimis partnership interest), or (v) under generally
accepted industry accounting practices, provided substantially all of the partnership's
property (excluding money) consists of stock, securities, commodities, options,
warrants, futures, or similar instruments that are readily tradable on an established
securities market.

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   The restructuring of Taxpayer’s interest in Partnership was a readjustment of

partnership items among existing partners, not a taxable exchange. Additionally, no
taxable capital shift occurred; although the restructuring of Taxpayer’s rights under the
partnership agreement was not a revaluation event under § 1.704-1(b)(2)(iv)(f)(5) and
did not itself affect Taxpayer’s capital account, Parent’s Date 2 contribution was a
revaluation event under § 1.704-1(b)(2)(iv)(f)(5)(i) and Partnership had sufficient
unbooked built-in gain in its assets to increase Taxpayer’s capital account with respect
to the newly issued common units without needing to shift capital from other partners.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS

    This writing may contain privileged information. Any unauthorized disclosure of

this writing may undermine the ability of the Internal Revenue Service to protect the
privileged information. If disclosure is determined to be necessary, please contact this
office for our views.

   Please call Benjamin Weaver at (202) 317-6769 or Wendy Kribell at (202) 317

5033 if you have any further questions.

                                     Sincerely,




                                     ________________________________
                                     David R. Haglund
                                     Chief, Branch 1
                                     Office of the Associate Chief Counsel
                                     (Passthroughs & Special Industries)