Allocations after an ownership change.

The rules governing allocations of income, gain, loss, deduction and credit for a partnership experiencing ownership changes involving a closing of a tax year are quite clear. But ownership changes not involving a closing of the tax year trigger unclear and ambiguous interpretations of the allocation rules, resulting in a patchwork of inconsistent answers. This article explains the types of events that trigger closing of the tax year, the types of events that do not and the available allocation methods.

The Code provides a framework of rules governing allocations for changes in partnership ownership interests. Secs. 706(c)(2)(A) and 708(b) describe the change-of-ownership situations that require a closing of the partnership's tax year. In such cases, income, gains, losses, deductions and credits are allocated between the remaining and outgoing or incoming partners. The "closing" statutes have remained fairly constant since 1954; the associated allocation methods have not changed since 1956. For ownership changes not covered by these Code sections (i.e., ownership changes not triggering a closing of the partnership tax year), existing commentary offers inconsistent treatment of allocation issues, often based on regulations, rulings and cases that preceded the enactment of Sec. 706(d) by Section 72(a) of the Tax Reform Act of 1984 (TRA '84). However, because Sec. 706(d) provides clear guidance, it should prevail.

This article discusses the statutory framework governing allocations on changes in partnership ownership interests, and how the allocation rules work. It also briefly discusses some of the pre-TRA '84 rules that applied to ownership changes not resulting in a closing of the partnership's tax year, and explains when these rules should no longer apply.

What Is a Partnership?

To be subject to the partnership taxation rules (including the allocation issues discussed in this article), an entity must fall within the Code's definition of "partnership." With the increased popularity of limited liability companies (LLCs) and other types of state-law-defined entities, the classification issue has become more problematic, but has been ameliorated by the "check-the-box" regulations.(1)

The overall effect of the check-the-box regulation is that a business entity not a trust or a corporation per se is an "eligible entity." An eligible entity with two or more members may elect to be classified and taxed either as a partnership or a corporation. Most entities that are partnerships under state law (e.g., general partnerships, limited partnerships and limited liability partnership), as well as LLCs, will be classified by the Regs. Sec. 301.7701-3(b)(1)(i) default rule as partnerships for Federal income tax purposes.

Closing Events

The Code defines the events that came a closing of the partnership tax year. If a closing event occurs, an allocation of income between partners holding an interest during the tax year is required. (Other ownership changes do not lead to closure yet require allocation, as discussed below.)

When Is Closing Required?

Sec. 706(c)(1) provides a general rule that, except in the case of partnership termination (as defined in Sec. 708(b)) and except as provided in Sec. 706(c)(2)(A), a partnership's tax year does not close as the result of a partner's death, entry of a new partner or the liquidation, sale or exchange of a partner's interest. Sec. 706(c)(2)(A) states that a partnership tax year closes as to a partner whose entire partnership interest terminates (whether by reason of death,(2) liquidation or sale or exchange of interest or otherwise). Sec. 706(c)(2)(B) provides that a partnership's tax year does not close as to a partner who sells or exchanges less than his entire interest or whose interest is otherwise reduced. While a Sec. 706(c)(2)(A) closing affects only the partner(s) involved, Sec. 708(b) applies to the entire partnership.

Additionally, Sec. 708(b)(1) provides that a partnership terminates if (1) business is no longer carried on by any of the partners or (2) there is a 50% or more sale or exchange of the total partnership capital and profits interest within a 12-month period.

If a partnership does not terminate, but a change occurs in any partner's interest during the partnership's tax year, all partners' distributive shares are determined under Sec. 706(d)(1), by taking into account their varying interests in the partnership during the year (varying interests rule).

Effects of Closing

The consequences of closing a partnership tax year are twofold: allocation occurs and the partnership tax year-ends for the affected partner(s). Sec. 706(a) and Kegs. Sec. 1.706-1(c) (2)(ii) require the partner to include in income partnership items for his tax year within or with which his membership in the partnership ends. This rule applies if the partnership tax year closes at its normal year-end or under Sec. 708(b) or 706(c)(2)(A). Thus, if a partnership tax year ended Dec. 31, 1998, its 1998 income will be included on the tax return of any partner whose year ended on the same date or no later than Nov. 30, 1999.

Example 1: DKO partnership has three equal partners and a December 31 year-end. D's tax year ends January 31, K's tax year ends June 30 and O's tax year ends November 30. DKO's income for the year ended Dec. 31,1999 is $99,000. Each partner reports $33,000 for his respective year-end in 2000; D reports his share on his return for the year ending Jan. 31, 2000; K, on his return for the year ending June 30, 2000; and O, on his return for the year ending Nov. 30, 2000.

If there is a dosing event for a partner with a fiscal year, two periods of partnership income may be included in a single tax year of that partner.

Example 2: A's estate holds an interest in ABC Partnership. The estate's fiscal year ends July 31; ABC is a calendar-year entity. The estate's share of income from its ABC interest for the year ended Dec. 31, 1998 was $120,000. The estate sold its ABC interest on June 30,1999, when the estate's allocable share of ABC income was $60,000. The sale of the interest closed ABC's partnership year as to the estate, under Sec. 706(c)(2)(A). The estate has to include $180,000 of ABC income on its return for the tax year ended July 31,1999.

Planning tip: Had the estate sold less than its entire interest in ABC on June 30, 1998, the partnership year would not have closed as to the estate, under Sec. 706(c)(2)(B).

Example 3: The facts are the same as in Example 1, except that the estate sold only 90% of its ABC interest, and its share of ABC income from June 30,1999 to Dec. 31, 1999 was $1,000. The estate would report the $120,000 of 1998 partnership income in its fiscal year ended July 31, 1999, and $61,000 ($60,000 + $1,000) of 1999 partnership income in its fiscal year ended July 31, 2000. Accordingly, the estate/partner would be able to defer partnership income to a future tax year by purposely selling less than its entire partnership interest initially.

Whether the seller sells the remaining (minimal) portion of its interest in a later year to the same buyer or to another buyer, the concept is the same--to avoid closing the tax year so that the seller does not have to bunch more than one year of partnership income into a return.

As reflected in Examples 2 and 3 above, events that close a partnership tax year (under Sec. 706(c)(2)(A) or 708(b)) can lead to very different amounts of partnership income being reported in a partner's tax year than ownership changes not involving closing. Accordingly, careful attention is warranted as to which provision applies in a given situation.

Distribution of Interest

Sec. 761(e), added by TRA '84 Section 75(b), added distributions of 50% or more of a partnership's capital and profits interest as a closing event. Sec. 761(e) deems distributions of interests to be exchanges in applying Sec. 708. Accordingly, a distribution of 50% or more of total partnership interests will close the year for the entire partnership.

Termination

As was discussed, Sec. 708(b) addresses closing the partnership tax year for the entire partnership. The partnership terminates, and the partnership year closes, if the partnership goes out of business or 50% or more of the total interest in partnership capital and profits is sold or exchanged within a 12-month period. Under Regs. Sec. 1.708-1 (b) (1) (ii),"sale or exchange" includes a sale to a pre-existing partner, but excludes a disposition of partnership interest by gift, inheritance or liquidation.

If a partnership terminates by going out of business, a final return is fried for the year ending on the last day of business. Accordingly, the partnership final income might be reported in a different tax year of the partner than would have occurred using the partnership's pre-termination year-end. (This may cause "bunching" of two tax years of partnership income/loss into one year of the partner, as in Example 2 above).

If a partnership terminates due to a sale or exchange of 50% or more of its capital and profits interest within 12 months and two partnerships thereby result (e.g., Partnership 1, with 60% of the original capital and profits interest and Partnership 2, with the remaining 40%), the partnership that ends up with more than 50% of the original capital and profits interest (i.e., Partnership 1) is deemed a continuation of the original partnership, under Regs. Sec. 1.708-1(b) (2)(ii). The continuing partnership fries a return for the partnership tax year that has been divided (encompassing the income of both the "old" and "new" partnerships); its tax return must state that it is a continuation of the divided partnership. Any other succeeding partnership (i.e., Partnership 2) will be deemed a new partnership, and require a new Federal identification number, separate return filing, etc.

Allocation Methods

The methods for allocating partnership tax items are explained in Kegs. Sec. 1.706-1(c). This regulation was adopted in 1956; no amendments have been made since regarding allocation issues.(3) Except to the extent "closing" implies a posting of the partnership's accounting transactions up to the date of the triggering event, the Code does not address allocation methods. Accordingly, Kegs. Sec. 1.706-1(c) continues to be the authority for allocation methods when a partnership year closes. (Such reliance cannot be placed on the regulation's rules for nonclosing events, because the Code provisions have changed.) A discussion of the regulation's allocation methods for events causing closing of the partnership year follows.

Depending on the reason for the allocation, the method prescribed by Regs. Sec. 1.706-1(c)(2)(ii) will be either an interim closing of the books (IC method) or a choice between that method and (by partnership election) a proration based on the period the partnership interest is held by the old and new partners.(4)

Example 4: A sold his one-third interest in ABC Partnership to X on July 1, 1998. Under Sec. 706(c)(2)(A), ABC's year closed on that date as to A. According to ABC's June 30,1998 financial statements, A's share of ABC's taxable income was $60,000. The ABC interest held by A, then X, ultimately earned $90,000 of taxable income for the tax year ended Dec. 31, 1998. If ABC's taxable income is allocated under the IC method, A's share of ABC income for 1998 will be $60,000; X's share will be $30,000. Alternatively, if the proration method is used, A's share of ABC income will be $45,000; X's share will $45,000 ($90,000 divided by the half of the year the interest was owned by each partner).

Thus, the allocation method chosen can have, e a significant effect on the income recognized by the partners.

When a partnership tax year ends as a short year due to partnership termination (under Sec. 708(b)), the partnership books must be brought up to the point of termination and partnership income will be allocated under the IC method. However, if the year closes only as to a particular partner (under Sec. 706(c)(2)(A)), another alternative is available. Under Regs. Sec. 1.706-1(c)(2)(ii), instead of the IC method, the partner's share of items can be estimated using the proration method, as follows:

1. The outgoing partner is allocated a pro rata portion of the partnership's items for the entire tax year based on the number of days he was a partner.

2. The incoming partner(s) include in income the total of the particular share's items for the entire partnership year, as reduced by the portion allocated to the outgoing partner.

Alternatively, any reasonable proration method may be used (i.e., one based on other than the period held by partners owning the same interest during a tax year); however, the same method must be used for the outgoing and incoming partner(s).

The election to use a pro rata allocation must be agreed on by the partners. Presumably, this means all partners (including those outgoing or incoming) must agree to the departure from the use of the IC method. Although Regs. Sec. 1.706-1(c)(2)(ii) does not so state, it is logical that this agreement must be reached by the partners before the due date of the partnership income tax return.

Adopting the Regs. Sec. 1.706-1(c)(2)(ii) proration method avoids the time-consuming and perhaps expensive process of dosing the books when a partner exits the partnership mid-year, and can be beneficial.(5)

The partnership agreement should specify the method to be used for allocations when the partnership has a choice between the IC and the proration methods. For instance, if there are few partners, each with a significant ownership position, the IC method may be more appealing.

Alternatively, a partnership with several limited partners might find the proration method more beneficial, especially if it was expected that many partners would be transferring in and out of the partnership in any given year. Either decision would avoid the likelihood of a lawsuit to settle the issue at a later date.

Nonclosing Events

If there is a change in any partner's interest, Sec. 706(d)(1) requires allocation of partnership income, gain, loss, deduction or credit by an allocation method that takes into account the partners' varying interests. This all-encompassing provision (which applies to sales, exchanges, liquidations, distributions from estates, etc.) was enacted by TRA '84 Section 72(a). Before that, it was not clear which allocation provision applied to certain nonclosing changes in partnership interests. The absence of direction for certain changes in interest led to some rather odd allocation methods (by the IRS, taxpayers and courts) for dealing with these changes. The clear language of Sec. 706(d) fills the void; accordingly, many former interpretations no longer apply.

If the pre-Sec. 706(d) methods had been abandoned after the TRA '84, further discussion of them would not be needed, but they continue to appear in commentary.

New Code, Old Regs.

Since 1954, the allocation methods applying to nonclosing events have changed; these nonclosing events now include:

1. The sale, exchange or liquidation of less than a partner's entire interest in a partnership.

2. The introduction of a new partner, reducing the relative interests of the other partners.

3. The gift of a partnership interest.

4. The distribution of a partnership interest from an estate or trust.(6)

Sale/Exchange of Partial Interest

Regs. Sec. 1.706-1(c)(4) directs that a partner who sells or exchanges part of his interest, or whose interest is otherwise reduced (by an event other than a sale or exchange), includes in income an amount determined by taking into account his varying interests in the partnership during the partnership tax year. This treatment was codified by the TRA '84 enactment of Sec. 706(d).

Transfers by Gift

Regs. Sec. 1.706-1(c)(5) addresses allocations for transfers of partnership interests by gift. The gift of an interest does not close the partnership tax year; the share of the income up to the date attributable to the donor's interest is allocated to him under Sec. 704(e)(2).(7) This rule is still valid under the Code.

Distributions from Estate/Trust

Before the addition of death as a closing event by the TRA '97, if a partner died, none of the income prior to death was allocated to him; the entire income or loss for the year was allocated to the decedent's estate or other successor to the partnership interest. The same logic applied to the distribution of a partnership interest from an estate, under Regs. Sec. 1.706-1(c)(3), Example 3, but no longer applies after the enactment of Sec. 706(d). Such distributions now require application of the Sec. 706(d) varying interests rule. If the distribution is of 50% or more of the partnership's interests, closing will occur under Sec. 761(e).

Varying Interests Rule

The Sec. 706(d) varying interests rule focuses on a change in any partner's interest, rather than a list of various types of changes. Taxpayers can no longer argue that a particular type of change in interest does not require an allocation based on the varying interests rule.

However, Sec. 706(d) refers to regulations for allocations based on varying interests. Although these regulations have not yet been issued, the allocation methods offered by Regs. Sec. 1.706-1(c)--to the extent they are consistent with Sec. 706(d)--offer such guidance. That regulation describes how allocations based on varying interests are to be made when the partnership year doses as to a partner. In such cases, the partnership can use the IC method or the proration method. Because these methods are consistent with the intent of the varying interests rule of Sec. 706(d), they should apply to the nonclosing situations contemplated by that provision.

Does Sec. 706(d) Apply as Intended?

Commentators have suggested that Sec. 706(d) may not apply to all changes in partnership interests, despite the clear language applying the varying interests allocation rule to all ownership changes. They have suggested that although the statute contains no exceptions, the legislative history, of the TRA '84 did not intend to override certain previous rules. However, close examination of that history does not suggest that it is at odds with Sec. 706(d).

For instance, some commentators(8) still recommend applying Regs. Sec. 1.706-1(c)(3)'s "allocate everything to the final partner" (and nothing to the estate) approach for the distribution of a partnership interest from an estate. This conclusion is based on a comment in the TRA '84 Senate Report(9) that the Sec. 706(d) varying interests rule is not intended to override a "longstanding rule" The longstanding rule mentioned therein was Sec. 761(c), as discussed in Lipke.(10) Sec. 761(c), as interpreted by the Tax Court in Lipke, would allow a disproportionate allocation of losses among partners present throughout an entire tax year, resulting (in that case) in some partners reporting losses disproportionate to their partnership interests during the year. This shift in the allocation of losses for continuing partners does not violate the Sec. 706(d) varying interests rule, because Sec. 706(d) does not apply when partners do not change throughout a tax year. More importantly, the Tax Court concluded that partners admitted during the tax year were not permitted disproportionate allocations. Because Lipke, cited in the Senate Report, embraced the varying interests rule for situations involving partner changes, Sec. 706(d) should be interpreted comparably.

Conclusion

Since 1954, the methods for allocating income when a partner's tax year closed have remained unchanged; the events that trigger closing have also been fairly consistent. For changes in interests not resulting in a closing of the partnership tax year, the law has been less certain. Nevertheless, since the TRA '84 enactment of Sec. 706(d), uniform treatment to allocate income based on the varying interests rule is required when there are changes in ownership of a partnership interest during a tax year. Accordingly, if there is a change in a partner's interest, the "allocate everything to the final partner" approach or other disproportionate allocation methods no longer apply.

The two tables on p. 408 illustrate various events that result in changes in partnership interests, the Code sections that address these events and the corresponding allocation method. Exhibit 1 reflects events that result in a closing of the partnership tax year; Exhibit 2 reflects those events not resulting in a closing of the tax year. As previously mentioned, the allocation method will be based on the varying interests rule of Sec. 706(d) and, to the extent consistent with that provision, Regs. Sec. 1.706-1(c). The regulation specifies the IC method as the only available method in certain situations, and a choice of that method or the proration method in others.

Exhibit 1: Allocation-Closing events

Event                                          Code Section

Year closes for partnership:

Partnership goes out of business               708(b)(1)(A)
Sale or exchange of 50% or more
 of total interest in partnership
 capital and profits                           708(b)(1)(B)
Distribution from estate or trust of 50%
 or more of total interest in partnership      761(e)(1),
 capital and profits                           708(b)(1)(B)
Distribution from corporation or
 partnership of 50% or more of total
 interest in partnership capital and           761(e)(1),
 profits                                       708(b)(1)(B)
Year closes only for affected partner(s):
Partner disposes of entire interest by sale,
 exchange, liquidation or distribution         706(c)(2)(A)
Gift by partner of entire interest             706(c)(2)(A)
Partner dies                                   706(c)(2)(A)

                                               Allocation Method

Event                                          IC   IC or pro rata

Year closes for partnership:

Partnership goes out of business               X
Sale or exchange of 50% or more
 of total interest in partnership
 capital and profits                           X
Distribution from estate or trust of 50%
 or more of total interest in partnership
 capital and profits                           X
Distribution from corporation or
 partnership of 50% or more of total
 interest in partnership capital and
 profits                                       X
Year closes only for affected partner(s):
Partner disposes of entire interest by sale,
 exchange, liquidation or distribution
                                                          X
Gift by partner of entire interest                        X(11)
Partner dies                                              X(12)
Exhibit 2: Allocation-Nonclosing events

Event                                          Code Section

Sale or exchange of less than 50%
 of total interest in partnership capital
 and profits (and less than entire
 interest of selling partner)                  706(c)(2)(B)
Distribution from estate or trust of less
 than 50% of total interest in partnership
 capital and profits (and less than
 entire interest of distributing partner)      706(c)(2)(B)
Distribution from corporation or
 partnership of less than 50% of total
 interest in partnership capital and
 profits (and less than entire interest
 of distributing partner)                      706(c)(2)(B)
Partner liquidates less than entire interest   706(c)(2)(B)
Partner gifts less than entire interest        706(c)(2)(B)

                                               Allocation Method

Event                                          IC   IC or pro rata

Sale or exchange of less than 50%
 of total interest in partnership capital
 and profits (and less than entire
 interest of selling partner)                             X
Distribution from estate or trust of less
 than 50% of total interest in partnership
 capital and profits (and less than
 entire interest of distributing partner)                 X
Distribution from corporation or
 partnership of less than 50% of total
 interest in partnership capital and
 profits (and less than entire interest
 of distributing partner)                                 X
Partner liquidates less than entire interest              X
Partner gifts less than entire interest                   X

EXECUTIVE SUMMARY

* A partner's death triggers closing of the partnership tax year for partnership tax years beginning after 1997.

* While allocation of tax items between partners is generally achieved by use of the IC method, the partnership may be able to elect use of the proration method.

* A partnership terminates (and its tax year closes) if 50% or more of the total interest in partnership capital and profits is sold or exchanged within a 12-month period.

(1) Regs. Sec. 301.17701-1,-2 and 3 (TD 8697, 12/17/96); for a discussion, see Heller and Carnevalle, "Check-the-Box Final Regs. Simply Entity Classification," 28 The Tax Adviser 296 (May 1997).

(2) The Taxpayer Relief Act of 1997, Section 1246(a), added a partner's death as a reason for closing a partnership's tax year, effective for tax years beginning after 1997.

(3) TD 6175 (5/23/56); subsequent amendments in 1973 and 1987 did not address allocation issues.

(4) See Regs. Sec 1.706-1(c)(2)(ii); also Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976 (1976), at 1976-3 CB 106; H. Rep't No. 94-658, 94th Cong., 1st Sess. (1975), p. 816; and IR 84-129 (12/13/84).

(5) However, see Example 14 in text above as to how the pro rata method may distort the allocation of income between partners.

(6) However, see the discussion in the text above under "Distribution of Interest" for rules for a distribution of 50% or more of the total capital and profits interest of a partnership.

(7) Sec. 704(e)(2) requires such allocations to be in proportion to the respective capital interests of the donor and donee. This is a stricter standard than the "substantial economic effect" standard of Sec. 704(b).

(8) See , e.g., McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners (Warren, Gorham & Lamont, 3d ed., 1997 and Cum. Supp. No. 4), [paragraph] 11.03[1] and p. S11-1.

(9) S. Rep't No. 98-169, 98th Cong., 2d Sess. (1984), p. 219.

(10) Kenneth E, Lipke, 81 TC 689 (1983).

(11) See note 7.

(12) Under Sec. 1402(f), self-employment income must be allocated to the deceased partner pro rata, with the cutoff at the end of the month in which the partner died. All other tax items would be allocated between the decedent and his estate or other successor-in-interest either via the IC method or pro rata, at the option of the partnership, under Regs. 1.706-1(c)(2)(ii).

For more information about this article, contact Mr. Keene at [phone].

David Keene, CPA
Keene & Company, CPAs
Seattle, WA