Avoiding Pitfalls: Tax Due Diligence for Partnership Buyers
In Marcum’s May 2023 Beyond the Numbers article, “Tax Considerations in Middle Market Transaction,” we discussed the tax considerations for buyers and sellers in M&A transactions relating to corporate target companies. We continue our discussion on this topic as it relates to buyers and sellers of partnerships and limited liability companies classified as partnerships.
In an asset sale, the partnership (the seller) is treated as selling, and the purchaser is treated as buying the identified assets and liabilities of the partnership, including any intangible assets such as goodwill. The purchase price must be allocated to each of the asset classes and then to each of the assets within each asset class. It is generally allocated based on the fair value of the assets, all residuals being allocated to intangibles. However, the Internal Revenue Service (IRS) typically respects a purchase price allocation between an unrelated buyer and seller so long as they are not related. Accordingly, the buyer receives a stepped-up basis in the assets equal to the purchase price paid, creating a tax basis in goodwill and other identifiable intangible assets that the buyer can amortize on a straight-line basis over 15 years.
From the seller’s perspective, the partnership recognizes gain or loss on the sale of assets, which flows through to the partners on their K-1s. The character of the gain or loss depends on the assets sold and can be a combination of ordinary gain/loss and capital gain/loss. There is no entity-level tax at the partnership level on the sale of assets and no second layer of tax to the equity owners on any distribution of the purchase price proceeds.
The purchase of the partnership interests of a partnership can be more challenging depending on the portion of partnership interests acquired. The seller’s tax consequences are the same regardless of the amount sold. In either instance, the seller recognizes capital gain or loss equal to the difference between the purchase price and the adjusted tax basis in their partnership interests. The classification of gain or loss as between long-term capital gain (where the partnership interests are held for more than one year) and ordinary income depends on the underlying assets of the partnership. This is commonly known as the “hot” asset rule. Hot assets are generally defined as unrealized receivables (including depreciation recapture) and inventory. Any amount of the gain allocated to the sale of hot assets is characterized as ordinary gain and subject to ordinary income tax rates. Note that the result is the same when a partnership sells its inventory and fixed assets, and a cash-basis taxpayer collects its receivables in the ordinary course of its business.
The buyer’s tax consequences are where things become complicated. Regardless of whether the buyer acquires some or all of the partnership interests, the buyer’s tax basis in the acquired partnership interest (outside basis) is stepped up to equal the purchase price of such interest. However, the buyer’s basis in the partnership’s assets (inside basis) depends on whether the buyer acquired some or all of the partnership interests from the former partners. In acquiring 100% of the partnership interests, the former partnership now only has one partner, vis a vis the buyer. As a partnership must have more than one partner, it becomes an entity that is disregarded for federal income tax purposes. Under IRS guidance, the buyer is deemed to have purchased the partnership assets and, therefore, gets a step-up of the basis in the assets to the purchase price, including the creation of tax goodwill and other identifiable intangible assets, without needing an election.
If, however, the buyer acquires less than 100% of the partnership interests, the partnership status is unchanged, and the inside basis of the assets does not change. Consequently, there is a disparity between the buying partner’s inside and outside basis, which can create unfavorable economic results for the buying partner where the partnership owns substantially appreciated assets. This disparity can be alleviated by the partnership making a Section 754 election under the Internal Revenue Code (IRC). A Section 754 election allows new partners to equalize the inside basis of the assets to a new partner’s outside basis by stepping up (or stepping down) the partnership assets allocated to the new partner (not the existing partners), allowing the new partner the benefits of depreciation and amortization deductions that do not occur if the election is not made.
Partnership laws within the IRC are among the most complex, particularly in the context of M&A transactions. Therefore, it is essential to understand the composition of the partnership assets before the purchase or the sale of a partnership interest to determine whether unfavorable economic results to the seller or the incoming partner may occur.
It is a common belief for buyers of partnerships that tax due diligence on partnerships is not required for pass-through entities. Their rationale is that any taxes due to examination adjustments simply flow through to the partnership. While that may have been true in the past, as far as income taxes go, that is no longer the case under the centralized partnership audit regime, which became effective for tax years beginning in January 2018 under the Bipartisan Budget Act (BBA).
The BBA audit rules allow the IRS to assess and collect tax at the partnership level (rather than the historical partners) under certain circumstances. These changes may result in successor liability to the acquirer of partnership interests relating to any potential pre-acquisition tax deficiencies. This is true even where the buyer purchases 100% of the interest in a partnership, and the partnership becomes a disregarded entity. We recommend tax due diligence be performed subject to the BBA audit rules. Further, successor liability also exists for buyers of partnership interests relating to sales tax, property tax, payroll tax, and unclaimed property liabilities of the partnership, making due diligence imperative for these pass-through entities.