Partnership terminations triggered by a change in form.
Electing out of partnership status
The partnership form no longer exists (for most purposes) if the partners elect not to be treated as a partnership. The Code permits limited classes of partnerships to elect out of taxation under the partnership rules (or out of selected portions of the partnership rules). The election out of partnership status is available only if the income of the partners can be adequately determined without computing the partnership's income and the arrangement is (1) an investing partnership, (2) an operating agreement, or (3) a securities syndicate (Sec. 761(a); Regs. Sec. 1.761-2).
Termination when only one partner remains
The partnership form also ceases to exist if a transfer of partnership interests occurs and only one partner remains. For example, a partnership terminates when a 60% partner acquires the interests of two other partners who each have a 20% interest in the partnership (Regs. Sec. 1.708-1(b)(1)). The partnership is terminated as of the sale date of the partnership interests. (However, a special rule applies upon the death of a partner in a two-person partnership. See the discussion below.) After the sale of the interests, the business is no longer carried on in a partnership form but rather is conducted as a proprietorship or branch (if the owner is a corporation, another partnership, or a multimember limited liability company (LLC)). A business can also cease to be a partnership if its assets are transferred to a trust or the business is incorporated.
Termination of two-partner partnership at one partner's death or retirement
Two-person partnerships necessitate careful planning to avoid inadvertent terminations. For example, a partnership will terminate if a buy-sell agreement is triggered upon the death of either partner. While such a buy-sell agreement may be appropriate for transfer of the partnership interest and income tax planning, the partners may not intend that the sale result in the termination of the partnership with its potentially adverse effects.
A termination can be avoided if the deceased partner's interest is transferred directly to a beneficiary or the estate of the deceased partner. If the successor in interest shares in the partnership profits after the death of the deceased partner, the partnership does not terminate (Regs. Sec. 1.708-1(b)(1)(i)). This rule applies even if the parties are engaging in negotiations to purchase or retire the interest held by the deceased partner's successor in interest.
Similarly, if one partner in a two-person partnership dies, the partnership is not terminated until the deceased partner's entire interest is liquidated (Regs. Sec. 1.736-1(a)(1)(ii)). Thus, the surviving partner is deemed to be operating a partnership for income tax purposes (though clearly not qualifying for such classification for state law purposes) as long as the partnership continues to make payments for his interest or as a share of partnership income to the deceased partner's successor in interest.
A practitioner should consider making the following recommendations to clients regarding two-person partnerships to ensure continuation of the partnership after the death of one of the partners:
* The partnership agreement or the liquidation agreement should indicate the interest of the deceased partner is to be retired by a series of liquidating payments made by the partnership. Ideally, the agreement should state the payments are made under Sec. 736;
* Upon the partner's death, the partnership books should reflect the elimination of the deceased partner's interest in capital and the establishment of a payable to the partner's successor in interest. All subsequent payments made to retire the interest should reduce the payable;
* Partnership returns should be filed as long as payments are being made to the deceased partner's successor in interest; and
* All payments for the deceased partner's interest in the partnership should be made from the business account of the partnership and not from the personal account of the remaining partner.
In some circumstances, it may not be desirable for the partnership to continue after a partners' death or retirement. For example, the remaining partner may want to terminate the partnership to avoid the costs of filing a tax return, complying with state filing requirements, and paying state license fees.
Sale of partnership interest that results in a single partner and resulting partnership termination
Based on the holding in McCauslen, 45 T.G. 588 (1966), and Rev. Ruls. 67-65 and 99-6, when a partnership terminates because a sale of partnership interests results in a single partner, the selling partner follows the normal rules for recognizing gain or loss on the sale of the partnership interest. But for the remaining (purchasing) partner, the partnership is deemed to have distributed all its assets to its partners in liquidation. The purchasing partner takes a carryover basis in the assets deemed distributed to him or her and is treated as purchasing the assets that were deemed distributed to the selling partner for an amount equal to the purchase price of the partnership interest. The purchasing partner's holding period for the assets deemed purchased begins on the day immediately following the date of sale. The holding period for the assets with a carryover basis (those deemed distributed to the purchasing partner) includes the partnership's holding period for those assets. The purchasing owner recognizes gain and assigns basis under the general rules that apply to liquidating distributions.
Example 1. Two-person partnership terminates after one partner sells interest to the other: J and B are equal partners in H Investors Partnership (HIP). J wants to liquidate his interest in HIP, so B decides to buy him out for $100,000.
J treats the transfer of his partnership interest as a sale. Accordingly, the difference between the sales price of J's interest and his basis is generally capital gain. If Sec. 751 hot assets are held by the partnership, the hot-asset rules in Sec. 751 may result in J's realizing ordinary income.
B is treated as if HIP had made a liquidating distribution of all its assets to J and B and, following the distribution, B purchased the assets deemed distributed to J. B's basis in the assets acquired by the deemed purchase of J's assets is the purchase price of $100,000. B's holding period for the assets deemed acquired from J begins on the day immediately following the date of sale. B must recognize gain on the deemed distribution of assets to her under the general rules (for example, gain would be recognized if B is deemed to receive cash in excess of the basis of her partnership interest). B's holding period for the assets deemed distributed includes the partnership's holding period for the assets.
Example 2. Partnership terminates at the sale of all partnership interests to one new partner: Assume the same facts as in Example 1, except a third party, A, purchases the interests in HIP owned by both B and J. J and B report gain or loss under the rules that generally apply to the sale of partnership interests. A, however, must determine the basis and holding period of HIP's assets as if HIP had made a liquidating distribution of its assets to J and B and, immediately following the distribution, A had acquired the assets from the partners. A's basis in the assets is his purchase price, and his holding period begins on the day immediately after the date of sale.
Sheila Owen, CPA
Sheila Owen, CPA, is a senior technical editor with Thomson Reuters Checkpoint. For more information about this column, contact email@example.com.
This case study has been adapted from PPC's Tax Planning Guide--Partnerships, 33d Edition (March 2019), by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, William R. Bischoff, and Cheryl McGath. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).
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|Publication:||The Tax Adviser|
|Date:||Oct 1, 2019|
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