Involuntary Exchange

There is a transaction known as an "involuntary exchange" - I think it's dealt with in IRC section 1033 - but based on your description of what happened with the "reorganization" of the master limited partnership, I seriously doubt that what you've described is a Section 1033 "involuntary exchange." Section 1033 is for casualty and condemnation gains and that kind of "out of your control" kind of stuff.

Maybe the preparers of the partnership's K-1 knew that there would be enormous amounts of ordinary income from recapture of some sort, and just didn't bother to explain it well enough. Give 'em a call.

Or, just look at the recent documentation from the MLP as step one.

While Congress changed ?1031, as far as I can tell they didn't change ?

351. If all the interests of a partnership were exchanged for interests in a corporation, and at the conclusion of that transaction those people owned at least 80% of the corporation at that time, it should be able to qualify as a tax free transaction.

Sounds like she was cashed out.

Er, maybe not. Maybe so.

It is highly likely it is correct. It sounds like what happened to the owners of the Kinder Morgan partnerships when KM converted to a corporation. Over the years, the MLP has been making cash distributions out of revenue to the limited owners. This was offset by various deductions available to the MLP... let's say an oil/gas. When the MLP becomes a C Corp., the transaction is treated as a sale. It is not a tax-free exchange. The limited owners will receive shares in the corporation. Those past deductions by the MLP get recaptured as ordinary income. For many limited owners, this can be a significant amount of ordinary income to declare. The offset is that the taxable amount forms the basis for the shares in the corporation. It is quite possible that an owner of the MLP has already had their basis reduced to zero and the sale triggers a whopping amount of ordinary income.

So why wouldn't section 351 apply?

Perhaps the deal didn't meet the requirement in section 351 that "immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation".

This could occur, for example, if more than one MLP was exchanged into one corporation, as each MLP must stand alone in its exchange into a corporation for this requirement to be met.

Kinder Morgan and the companies that are currently being rumored as considering this type of buyout are already big companies. During 2014 when Kinder Morgan bought out it's related MLPs, the MLP owners (there was more than one MLP involved) ended up with well less than 50% of the resulting company.

For the current case, if the transaction is a pure conversion that meets the 80% rule Section 351 could apply. The deductions the MLP took that get recaptured as ordinary income by the limited partners still have to be dealt with somehow. It wouldn't surprise me if the end result looks a lot like the buyout case and the limited partners still get a K-1 with ordinary income they need to pay taxes on.

Thanks. That makes sense.

So if I understand correctly, it's likely that over the time she's owned it, the portion of income that was taxable was reduced, and now it's being recaptured? Kind of like depreciation on real estate?

(She doesn't give a fig about cost basis since she's never planning to sell, and her kids will get a stepped-up basis.)

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