Working Your Way through the Maze of Technical Terminations
During the course of business, exchanges and sales of partnership interest are not uncommon. These transactions have little or no effect on business operations. However, when there is a sale or exchange of 50% or more of a capital and profit interest within a 12-month period, a technical termination may occur. This can be based on a single transaction or multiple transactions during the period. It should be noted that the 12 months addressed in the law are not based on a calendar year. Therefore, care must be taken when analyzing whether a technical termination transpired, and taxpayers/practitioners may need to review a two-year period when making this determination.
Technical terminations are a product of federal tax law. In general, the event does not cause an actual legal termination of the entity. Therefore, the entity will continue operating under the original EIN (Employer Identification Number). The tax year closes on the date that the technical termination occurred, and restarts the next day with the new ownership in place.
Not every 50% change of ownership results in a technical termination. The following events are excluded:
- A disposition of a partnership interest by inheritance, bequest or gift.
- A liquidation of a partner’s interest via retirement payments from the partnership, rather than a sale of the exiting partner’s interest.
- The acquisition of a partnership interest via a contribution of property to the partnership.
Consequences and Benefits
Technical terminations have both positive and negative ramifications. Some of the benefits include making new elections, such as the following:
- IRC Section 754 Election.
- Change in accounting methods.
- New tax year.
- Alternative depreciation methods.
In regard to depreciation, since depreciable property is deemed transferred from the old partnership to the new partnership, the assets are considered newly acquired property. Therefore, depreciation starts over for the assets deemed transferred. The assets are transferred at the net book value at the date of the termination. For example, a commercial building with a cost basis of $500,000 and accumulated depreciation of $15,500 as of the date of termination would begin depreciating the remaining net book value of $484,500 over the next 39 years. This is a consequence that is often overlooked and usually has a less than desirable outcome.
The new partnership can also elect to amortize start-up and organizational expenses incurred after the change in ownership. In contrast, the termination does not cause amortization of Section 197 intangible assets to start over. Nor can the remaining unamortized basis of start-up costs or organization expenses be written off. These must continue to be amortized as if the termination had not occurred.
Tax filers must remember that the termination requires two short-year tax returns to be filed. The date of the termination is considered the close of the tax year for the first return. That tax return will be due 2.5 months following the end of the month during which the termination occurred. If unaware of this, an extension may be missed and the entity could be subject to late filing penalties. If the partnership has a large number of partners, the penalties could add up to a significant amount ($195 per partner per month for a maximum of 12 months). There is also a penalty for failure to furnish complete and accurate Schedule K-1s to partners on a timely basis. That penalty can be $260 for each failure per K-1, up to a maximum of $3,193,000.
Not only does the practitioner need to be aware of the IRS filing requirements, many states also require a separate extension for the short-period returns. In particular, the State of New York has stiff late filing penalties and the NY Department of Taxation and Finance is not very flexible when it comes to abating these penalties.
When it has been determined that a technical termination has occurred, it is necessary that the first short-period return has both the final year and the technical termination boxes checked on page one of Form 1065. Since the old partnership was deemed to contribute all of its assets and liabilities to the new partnership, the first short-period return will have a zero ending balance sheet. A statement should be attached to the tax return explaining the transaction that caused the termination. This statement should also reflect what the ending balance sheet looked like immediately prior to the transaction. The first period return’s Schedules K-1 capital accounts will be zeroed out, and the final K-1 box should also be checked.
The second short-period return will have the both the initial return box and the technical termination boxes checked on page one of Form 1065. The beginning balance sheet on the second return should reflect what would have been the ending balance sheet prior to the termination. It is suggested that a statement be included with the Schedules K-1 to inform the partner that a technical termination had occurred and that two short-period K-1s may be received for the affected tax year.
The following statement should be attached to both short-period tax returns:
Pursuant to IRC Sec. 708(b)(1)(B) and the regulations thereunder, XYZ Partnership terminated on date. On that date, Joe Partner (Tax ID) sold X% ownership interest in the partnership’s capital and profits to Sam Partner (Tax ID). This disposition resulted in a sale or exchange of 50% or more of the total interests in the partnership’s capital and profits during a 12-month period. This resulted in a new partnership for federal income tax purposes, which began on date. (Note: the new partnership retains the same federal tax identification number.)
Please note, judgment is required in determining whether a technical termination occurred. This is especially true when a series of sales or transfers of ownership occurs over a period of time. The IRS may look at various transactions together to determine whether the step transaction doctrine should be applied. This could result in unintended consequences. It is imperative to have an open dialogue to ensure that tax advisors are kept abreast of any contemplated changes of ownership. As always, it is better to be proactive rather than reactive.
This is a very brief overview of the technical termination issues addressed by IRC Code Section 708. A more complete review of the relevant regulations and related literature is required should a possible termination transaction occur.