August 07, 2014
Did Your Partnership Technically Terminate for Tax Purposes? If So, What Are The Tax Consequences?
By Colleen McHugh
A technical termination of a partnership occurs when there is a sale or exchange of 50% or more of the total interest in the profits and capital of a partnership within a 12-month period.
For example, if John sells his 55% profits and capital interest in Partnership Z to Kelly, Partnership Z will technically terminate for tax purposes on the date of the sale because 50% or more of the profits and capital of the partnership was sold in a 12-month period.
Suppose, instead, that John sells his 40% profits and capital interest in Partnership Z to Kelly on 1/1/14 and Tom sells his 15% profits and capital interest to Nicole on 8/31/14. As a result of Tom’s sale, Partnership technically terminates on 8/31/14 for tax purposes because 50% or more of the profits and capital of Partnership was sold within a 12-month period.
There are some issues to consider if a partnership has a technical termination:
- The final year for the terminated partnership ends on the date of termination. The final return for the terminated partnership is due on the 15th day of the 4th month from the date of termination. Note that the “new” partnership uses the same EIN as the terminated partnership. It is important to keep track of sales and exchanges of interests in the partnership in order to ensure that a tax filing deadline will not be missed if there is a technical termination during the year.
- Potential tax year-end change. A partnership generally may not have a taxable year other than the majority interest taxable year, which is defined as the taxable year (if any) which, on each testing day, constituted the taxable year of one or more partners having (on such day) an aggregate interest in partnership profits and capital of more than 50%. Given that a technical termination results from a sale or exchange of an interest in the partnership, the “new” partnership may be required to change its year end if, for example, the terminated partnership is on a calendar year and the transferee partner, who is a majority partner, has a fiscal year end of 6/30.
- New elections must be made. Tax elections made by the terminated partnership are not applicable to the “new” partnership. As a result, the following elections may need to be made again by the “new” partnership: accounting method, inventory methods, and a Section 754 election.
- Restart of depreciation. The “new” partnership computes depreciation on property held by the terminated partnership as if the property was newly acquired by the “new” partnership. For example if a 15-year property held by the terminated partnership is in its 15th year of depreciation, the “new” partnership will now have to depreciate the remaining basis over 15 years.
- Treatment of start-up and organizational expenses. If the terminated partnership had elected to amortize its start-up expenditures or organizational expenses, the “new” partnership must continue to amortize these expenditures over the remaining portion of the amortization period. (Note that this rule only applies to partnerships that had a technical termination after 12/9/13.)
- Reliance on private letter rulings. Generally, the “new” partnership may not rely on any private letter rulings obtained by the terminated partnership. The “new” partnership will have to obtain new private letter rulings, if applicable.
- Tiered partnership technical terminations. A technical termination of an upper-tier partnership could cause a technical termination at a lower-tier partnership. For example, if Partnership A owns 50% or more of the profits and capital of Partnership B and Partnership A has a technical termination, then Partnership B will also have a technical termination.
There are significant consequences to partners (and LLC members) upon the transfers of ownership interests. The rules must be kept in mind as these entities grow and seek additional investors.