Merging partnerships for tax savings.

Facts

The Blue Partnership has two equal partners and operates a manufacturing plant. In 1987, Blue purchased $1.25 million of equipment and claimed an investment tax credit (ITC) under a phase-in provision on its return. The fair market value (FMV) of this equipment is $1 million.

The Green Partnership is an equal partnership that is also engaged in manufacturing. Green purchased $500,000 of equipment more than five years ago, which has a current FMV of $200,000. Green also has $400,000 in cash and land with a $500,000 FMV.

Individuals Johnson and Olson are the only partners in both partnerships. The partners have decided to merge the two partnerships and have asked their tax adviser for advice in structuring the merger.

Issue

Will the Blue partners have to recapture ITC on the equipment purchased in 1987?

Analysis

In the merger of two or more partnerships, the resulting partnership is deemed to be the continuation of the premerger partnership whose members own more than a 50% interest in the capital and profits of the remaining partnership. If the resulting partnership could be considered the continuation of more than one premerger partnership, it will be deemed to be the continuation of the premerger partnership whose partners are credited with the contribution of the greatest dollar value of assets.

Regardless of the actual form that the merger takes, each partnership terminating as a result of a merger is treated as contributing its assets to the postmerger partnership (either the surviving partnership or a new partnership) and then liquidating. The terminating partnership is therefore deemed to distribute interest in the postmerger partnership to the partners of the terminating partnership.

This represents a different taxable event than the termination of a partnership under Sec. 708(b)(1)(B). The basis of the assets in the hands of the postmerger partnership is not determined under the distribution rules, but rather the postmerger partnership assumes the basis of the assets in the hands of the terminating partnership. Since the postmerger partnership receives a carryover basis in the assets, no ITC recapture is required. This treatment is substantially different from that resulting from Sec. 708(b)(1)(B)terminations.

Because the partners of both premerger partnerships wilt own more than 50% of the capital and profits of the remaining partnership, it will be the continuation of the premerger partnership whose partners contribute the greater value of assets. Therefore, Green will be deemed the continuing partnership and Blue will be deemed to contribute its assets to Green and then liquidate.

Conclusion

The Blue Partnership will not recognize any ITC recapture on the proposed merger with Green Partnership since the assets of Blue will have a carryover basis to Green.

Since ITC recapture (and depreciable basis, lives and methods) will not be an issue in structuring the merger, the tax adviser can determine which partnership survives the merger based on other factors, i.e., which partnership's accounting methods and elections should survive. Once it has been determined which partnership should survive, the taxpayers can often structure the merger to reach the desired result. Some methods of controlling which partnership survives the merger are:

1. Causing a distribution of assets by the partnership that must be terminated {thus reducing the value of its assets below the value of the assets of the partnership targeted to survive).

2. Having the partners of the partnership targeted to survive contribute additional assets to that partnership before the merger.

Variation

If the partners of none of the original premerger partnerships have more than a 50% interest in the capital and profits of the resulting partnership, all original partnerships are terminated and the resuiting partnership is considered to be a new partnership. This affords a planning opportunity if the partners do not wish to retain any of the original partnerships or their accounting methods, elections or other partnership attributes. In these situations, the merger can be structured in such a way that the partnerships receive no more than a 50% interest in the capital and profits of the resulting partnership.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Partnerships, 4th Edition, by Grover A. Cleveland, William D. Klein, Richard D. Thorsen and Philip H. Welch, published by Practitioners Publishing Company, Fort Worth, Tex., 1991.