Notable tax implications of partnership terminations and structural changes

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1 from Private Company Services Notable tax implications of partnership terminations and structural changes June 9, 2015 In brief The determination of whether a partnership terminates for federal tax purposes is governed by the rules found in Section 708 and the related regulations. Under these rules, a partnership may terminate for federal tax purposes even though it continues for legal purposes. For example, certain sales or exchanges of 50% or more of the interests in capital and profits of a partnership within a 12-month period can result in a technical termination for federal tax purposes. In other instances, a partnership may continue for federal tax purposes even though its legal form or structure has changed, like in a merger, consolidation, or division. Partners should be aware of the types of transactions that may cause a partnership to terminate, as well as the resulting tax consequences, in order to help ensure compliance with relevant reporting requirements. In detail When is a partnership terminated? Under Section 708(a), an existing partnership is considered as continuing if it is not terminated. In general, a partnership terminates when: (1) no part of the business, financial operation, or partnership venture is carried on by any of the partners in a partnership (Section 708(b)(1)(A)); or (2) there is a sale or exchange of 50% or more of the interests in capital and profits of the partnership within a 12-month period (Section 708(b)(1)(B)). What are the types of partnership terminations? A partnership termination is either an actual termination or a technical termination. An actual termination often is more straightforward and easier to identify than a technical termination. Actual terminations A partnership terminates under Section 708(b)(1)(A) when the business, financial operation, or venture of the partnership is no longer carried on by any of the partners in the partnership. In other words, a partnership terminates when its business is completely wound up, which includes the distribution of the assets to the partners. Even a minimal amount of continuing business or financial activity may prevent a partnership from terminating. For example, a partnership may continue to exist even though the only remaining activity is the collection of outstanding receivables. Because a partnership requires at least two partners for federal tax purposes, a Section 708(b)(1)(A) termination also occurs when 100% of the partnership interest is held by one partner. If there is only one partner remaining, the partnership automatically terminates (Reg. sec (b)(1); Rev. Rul. 99-6, C.B. 432).

2 Following a Section 708(b)(1)(A) termination, the partnership is required to file Form 1065, U.S. Return of Partnership Income, for the period ending on the date of termination. Box 2 under Item G on Form 1065 must be checked, indicating that it is a final return. Technical terminations Identifying a technical termination A partnership also terminates when there is a sale or exchange (whether taxable or nontaxable) of 50% or more of the interests in both capital and profits of the partnership within a 12- month period (Section 708(b)(1)(B)). For example, a sale or exchange of 65% of a partnership s capital and 35% of its profits during a 12-month period does not result in a technical termination. This measurement period refers to 12 consecutive months that may or may not coincide with a calendar year or the partnership's tax year. When interests are sold or exchanged on different dates, the percentages are added together to determine whether a sale or exchange of 50% or more of the partnership capital and profits has occurred. However, the sale or exchange of the same interest multiple times within a 12-month period is counted only once. A disposition of a partnership interest by gift, bequest, or inheritance, or the liquidation of a partnership interest, generally is not a sale or exchange for this purpose. Neither are the transfers of partnership interests to persons contributing property to the partnership in exchange for such interests. Example: Cathy and Darcy are partners who share equally in the capital and profits of CD Partnership. On October 12, 2013, Cathy sells 60% of her partnership interest to David (i.e., David acquires a 30% interest in CD). On January 27, 2014, Darcy sells 60% of her interest in CD to Adam (i.e., Adam acquires a 30% interest in CD). The partnership terminates on January 27, 2014 because there was a sale of 50% or more of the interests in capital and profits within a 12-month period (but once the 50% threshold is met, and a technical termination is triggered, the 12-month period restarts). However, if David rather than Darcy had sold the 30% interest to Adam on January 27, 2014, there would have been no termination event because the transfer of the same 30% interest from Cathy to David to Adam would be counted only once during that 12-month period. Observations: It may be possible to structure the sale of a significant partnership interest without triggering a technical termination by dividing the sale into two sales that are more than 12 months apart (PLR ; see also PLR , PLR , and PLR ). If doing so is not feasible under the circumstances, consideration should be given to structuring the sale just before the close of the last day of the partnership s tax year to ease the compliance burden associated with the technical termination. Determining a partner s interest in capital and profits is not always a straightforward exercise. For example, if a partnership agreement provides a partner with a preferred return of income, the partners profits interests at any moment in time could differ markedly from what the partners expect their share of profits to be over the life of the partnership. Mechanics of a technical termination Regulations under Section 708 describe the transactions that are deemed to occur upon the technical termination of a partnership. First, the old partnership is deemed to contribute all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership. Immediately thereafter, the old partnership makes a liquidating distribution of the interest in the new partnership to its partners (including the purchasing partner) in proportion to their respective interests. The new partnership s basis in its assets is the same as the old partnership s basis in its assets, and there is a continuation of existing Section 704(c) allocations. Observation: If the sale or exchange of an interest in an upper-tier partnership that holds an interest in a lower-tier partnership results in a termination of the upper-tier partnership, the upper-tier partnership is treated as exchanging its entire interest in the capital and profits of the lower-tier partnership, which potentially could result in a termination of the lower-tier partnership. For example, if there is a termination of an upper-tier partnership, and the upper-tier partnership owns 50% or more of the capital and profits interests of the lower-tier partnership, the termination of the upper-tier partnership will cause a termination of the lower-tier partnership. Filing requirements after a technical termination The old partnership is required to file Form 1065 for the period ending on the date of termination. Boxes 2 and 6 under Item G on Form 1065 must be checked, indicating that it is a final return related to a technical termination. Observation: If a technical termination is overlooked, or the due date for the resulting short period return (including extension) is not identified correctly, a penalty may be assessed against the partnership for failure to timely file Form The penalty is equal to $195 per partner for each month (or part month) the 2 pwc

3 failure continues, for a maximum of 12 months. A penalty also may be assessed for failure to complete and provide Schedule K-1 to each partner when due. In this case, the penalty is equal to $100 for each Schedule K-1 up to a maximum penalty of $1.5 million for all failures. Failure to file certain other partnership forms may compound the late filing penalty issue. The new partnership is required to file Form 1065 for the period beginning the day after the termination. Boxes 1 and 6 under Item G on Form 1065 must be checked, indicating that it is an initial return related to a technical termination. The new partnership continues using the employer identification number (EIN) of the old partnership. Observations: The old partnership s tax year closes on the date the partnership terminates. The tax year of the new partnership may be different depending on the tax year of the majority partner (i.e., the required tax year). Thus, if the new partnership has a new majority partner with a different tax year than the old partnership, the new partnership would have to adopt a new tax year. Other considerations after a technical termination As the technical termination is deemed to result in the creation of a new partnership, the new partnership is not required to use the same accounting methods as the terminated partnership and generally may adopt new accounting methods without obtaining IRS consent (Reg. sec (a)(2)). However, as outlined below, there are several considerations that the old and new partnerships should take into account with respect to accounting methods. Although a technical termination does not change the partnership s basis in its assets, the step-in-the-shoes rule under Section 168(i)(7) specifically excludes technical terminations, and thus the remaining tax basis of depreciable property must be recovered over a new depreciable life using new accounting methods. Further, property qualifying for bonus depreciation that is placed in service during the tax year of a technical termination is treated as originally placed in service by the new partnership on the date the property is contributed by the terminated partnership. Accordingly, the entire amount of bonus depreciation is allocated to the new partnership (i.e., the terminated partnership cannot claim any of the bonus depreciation even though it placed the property in service). The old partnership also needs to consider the loss of depreciation deductions for assets placed in service during the year of the termination since the depreciation allowance is not available for assets placed in service and disposed of in the same tax year. In contrast, a technical termination does not cause amortization under Section 197 to restart. The Section 197 regulations provide that the carryover basis rules apply (Reg. sec (g)(2)(iv)). Furthermore, if a partnership that has elected to amortize start-up expenditures under Section 195(b), or organizational expenses under Section 709(b)(1), experiences a technical termination, the new partnership must continue to amortize those expenditures over the remaining portion of the amortization period adopted by the old partnership. The unamortized balance may not be deducted currently. Other accounting method considerations for the terminated partnership include the potential recognition of any advance payments previously deferred under Reg. sec and Rev. Proc , the acceleration of the remaining balance of any Section 481 adjustment (created as a result of a change in accounting method) into the year of termination since the partnership is treated as ceasing to engage in a trade or business, as well as short-year return considerations (e.g., the ability to deduct liabilities accrued as of the date of the termination, calculation of the depreciation deduction, the ability to deduct prepaid expenses, etc). Additional accounting method considerations for the new partnership include the requirement to make new elections, including certain elections available under the tangible property regulations (e.g., de minimis, partial dispositions), a new last-in, first-out (LIFO) election, etc. If the old partnership has in effect (or makes) a Section 754 election for the period ending on the date of termination (or if the new partnership makes a Section 754 election for the period beginning the day after the termination), the purchasing partner will be entitled to adjust its share of the new partnership s asset basis. Observation: With respect to the deduction for domestic production activities under Section 199, the rules generally provide that in connection with contributions to partnerships under Section 721, the activities of the new partnership do not include the activities of the terminated partnership. However, in the case of a technical termination, the new partnership is treated as performing the activities performed by the terminated partnership. What are the types of partnership structural changes? Partnership structural changes may occur in a partnership merger or consolidation, or in connection with a partnership division. In these instances, a partnership may continue for federal tax purposes even though its legal or structural form has changed. 3 pwc

4 Partnership mergers or consolidations Identifying the continuing partnership in a merger or consolidation In general, if two or more partnerships merge or consolidate, the resulting partnership is considered a continuation of the merging or consolidating partnership whose partners have more than a 50% the resulting partnership (Section 708(b)(2)(A)). Any other merging partnerships are terminated. If the resulting partnership can be considered a continuation of more than one merging or consolidating partnership, the partnership that contributed assets having the greatest fair market value (net of liabilities) to the resulting partnership is considered the continuing partnership. Alternatively, if none of the partners have more than a 50% the new partnership, all of the merging or consolidating partnerships are terminated and a new partnership is created. Example: Partnership AB (with partners Annie and Bobby) and Partnership BC (with partners Bobby and Cathy) merge to form Partnership ABC (with partners Annie, Bobby, and Cathy). The net value of the property contributed by Partnership AB is $4,000 and the net value of the property contributed by Partnership BC is $8,000. After the merger, Bobby owns 55% of the profits and capital of Partnership ABC. Although initially either Partnership AB or Partnership BC could be viewed as the continuing partnership (because Bobby, who is a partner in both, has more than a 50% the resulting partnership), Partnership BC will be viewed as the continuing partnership because it contributed a higher net value of assets to the resulting partnership. Mechanics of a partnership merger or consolidation The default form for a partnership merger is the assets-over form. An assets-up partnership merger also will be respected for federal tax purposes, provided the terminated partnership distributes all of its assets to the partners in liquidation of the partners interests (in a manner that causes the partners to be treated as owners of the distributed assets under the laws of the relevant jurisdiction), and immediately thereafter the partners contribute the assets to the resulting partnership. In an assets-up merger, the resulting partnership will have a basis in the contributed assets equal to the basis of the assets in the hands of the contributing partners and any Section 704(c) built-in gain or loss will be re-determined at the time of the contribution. Observation: If a partnership merger takes the form of anything other than assets-up or assets-over (e.g., the partners transfer their interests in the terminated partnership to the resulting partnership as part of the merger or consolidation), then, for federal tax purposes, the merger will be considered an assets-over merger. Filing requirements after a partnership merger or consolidation The merging or consolidating partnerships that are terminated are required to file Form 1065 for the period ending on the date of termination (i.e., the date of the merger or consolidation). Box 2 under Item G on Form 1065 must be checked, indicating that it is a final return. The resulting partnership is required to file Form 1065 for the tax year of the merging or consolidating partnership that is considered as continuing. It retains the EIN of the merging or consolidating partnership that is considered as continuing. The return must indicate that the resulting partnership is a continuation of that partnership. The return also must include the names, addresses, and EINs of the other merged or consolidated partnerships. Other considerations after a partnership merger or consolidation Currently, there is no statutory guidance regarding the accounting method considerations in partnership mergers. However, government officials on a panel at the American Bar Association (ABA) Section of Taxation meeting recently stated that they believe the Section 721 principles for a contribution of assets to an existing partnership apply to these transactions. Under that approach, the accounting methods of the continuing partnership would survive and the partnership would take a carryover basis in the transferred assets and assumed liabilities. If the accounting methods are changed, the transferred assets and liabilities may need to be accounted for consistently with the old methods of the terminated partnership(s) in order to prevent the duplications or omissions that could arise from the adoption of new methods without a cumulative catchup adjustment (i.e., Section 481(a) adjustment). However, the step-into the shoes rule under Section 381(c)(6) would apply to depreciable property, and thus the tax basis of the property would be recovered over the remaining recovery period using the same depreciation methods as the merged partnership(s). Newly acquired assets and liabilities after the transaction would be accounted for using the continuing partnership s methods. Observation: The continuing partnership generally would have to request the consent of the commissioner and file a change in 4 pwc

5 method of accounting in order to change any of the surviving accounting methods. Any pre-existing election of a continuing partnership will remain in effect and any pre-existing elections of a terminated partnership would come to an end. Partnership divisions Identifying the continuing partnership in a partnership division In general, transactions that result in a single partnership becoming more than one partnership are treated as a division if at least two members of the single, prior partnership become members of more than one of the resulting partnerships. If a partnership is divided into two or more partnerships, each of the resulting partnerships generally is considered to be a continuation of the prior partnership if its partners had more than a 50% interest in the capital and profits of the prior partnership (Section 708(b)(2)(B)). Any other resulting partnerships are not considered a continuation of the prior partnership, but, instead, are considered new partnerships. If partners in a partnership that has been divided do not have an interest in a resulting partnership, their interests are considered liquidated on the date of the division. Example: Partnership ABCD (with partners Annie (40%), Bobby (20%), Cathy (20%), and David (20%)) divides into Partnership AB (with partners Annie and Bobby) and Partnership CD (with partners Cathy and David). Because the partners in Partnership AB had more than a 50% Partnership ABCD (60%), Partnership AB will be viewed as the continuing partnership. Partnership CD will be viewed as a new partnership. The divided partnership is the partnership that is treated as having transferred its assets and liabilities to the recipient partnerships. If only one of the partnerships resulting from the division is treated as continuing, then it is treated as the divided partnership. If a partnership divides into two or more partnerships without undertaking a form that is recognized under the regulations, or the resulting partnership that (in form) transferred the assets and liabilities is not considered a continuation of the prior partnership, and more than one resulting partnership is considered a continuation of the prior partnership, the continuing resulting partnership with assets having the greatest fair market value (net of liabilities) will be treated as the divided partnership. In the example above, Partnership AB is viewed as the divided partnership. Mechanics of a partnership division A partnership division can be undertaken using the assets-over or assets-up form. Consistent with partnership mergers or consolidations, if a partnership divides using a form other than assetsover or assets-up, it will be treated as undertaking the assets-over form. In addition, to the extent the only change in a partnership division is the form in which the partners hold property, and each partner's overall interest in the partnership property does not change, there generally is no new Section 704(c) determination. Filing requirements after a partnership division The divided partnership must file a partnership return for the tax year of the partnership that has been divided and retain the EIN of the prior partnership. The return should indicate that the partnership is a continuation of the prior partnership. Any other resulting partnerships that are regarded as continuing must file separate returns for the tax year beginning on the day after the division using new EINs. The same is true for any partnerships that are considered new partnerships. They also would need to check Box 1 under Item G on Form 1065, indicating that it is an initial return. Other considerations after a partnership division A partnership division generally is a continuation of the partnership, therefore, all existing accounting methods carry over. Any pre-existing election of a resulting partnership that is considered as continuing would remain in effect. A subsequent election by one of the resulting partnerships would not have an effect on the other resulting partnerships. The takeaway Partners should be aware of the types of transactions that may cause a partnership to terminate under Section 708, as well as the relevant short-year reporting requirements. Partners also should make sure they consider the merger and consolidation rules where multiple partnerships are combined into a single partnership and the division rules where a single partnership becomes multiple partnerships. Elections and accounting methods should be evaluated in connection with these types of transactions. Failure to consider any of these issues may result in adverse consequences or missed opportunities. 5 pwc

6 Let s talk For a deeper understanding of how these issues might affect your business, please reach out to one of the PwC professionals listed below, or your local PCS contact: Mergers & Acquisitions Federal Tax Services Private Company Services John Schmalz, Washington, DC (202) john.schmalz@us.pwc.com Monic Kechik, New York, NY (646) monic.kechik@us.pwc.com Gregg Muresan, Cleveland, OH (216) gregg.g.muresan@us.pwc.com 2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. SOLICITATION This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisor 6 pwc