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Termination of a partnership.

Termination of a partnership has different meanings, depending on whether it is used in a legal or tax context. Under the Uniform Partnership Act, a change in the relation of the partners results in a legal dissolution or termination of the partnership. This can occur, for example, if the general partner is incompetent or bankrupt, withdraws from the partnership, or dies.

For tax purposes, a partnership terminates if:

* no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners, or

* within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.

There are two separate circumstances in which discontinuation of a business can terminate a partnership.

Only one partner continues to carry on the business.

The partnership stays in existence but does not engage in any business activity.

A sale or exchange of 50 percent or more of the total interest in partnership capital and profits also can terminate a partnership. Although the Internal Revenue Code refers to a sale or exchange, the Regulations explicitly provide that the partnership will terminate if sales of one or more partnership interests total 50 percent or more in any consecutive 12-month period.

A transactio. n may constitute a sale or exchange even if the transferee is not formally admitted as a partner under state law. Transfers to existing partners, as well as to outsiders, may constitute sales or exchanges for this purpose. Non-taxable exchanges, such as incorporation or mergers that are otherwise tax free, will constitute an exchange.

However, not every transfer or disposition of a partnership interest is a sale or exchange. The Regulations specifically provide that the following are not sales or exchanges:

A gift, bequest, or inheritance of a partnership interest.

Acquisition of a partnership interest by contribution of property to the partnership.

Liquidation of a partnership interest by the partnership.

Unfavorable consequences

A partnerships termination can have unfavorable (and favorable) tax consequences. Among the unfavorable consequences are:

* Reporting. More than 12 months of partnership income may have to be reported in a single tax year for partners with year-ends that are different from the partnership year-end.

On termination of a partnership, the partnerships tax year ends. A tax return must be filed within three and a half months after the close of the month of termination (exclusive of extensions). If some partners have a tax year different from the partnership(s, the tax consequences could be unfavorable.

For example, assume that a calendar-year partnership is terminated on September 30, 1990. A partner with a fiscal year ending on or after September 30 (but before December 31) would be required to include in income his or her share of partnership income for the 12-month period ending December 31, 1989, and for the nine-month period ending September 30, 1990.

Changes in depreciation methods. Assume that a partnership owns an office building that it acquired in 1985. The partnership currently depreciates the building over 18 years at an annual deduction of $3.5 million. The partnership terminates. As a consequence, it will have to depreciate the building over 31.5 years at an annual deduction of about $1.6 million, or less than half the previous deduction.

* Tax elections. In the event of an inadvertent termination, a partnership will have to make new tax elections. For example, if the partnership had made a Section 754 election (by which the basis of Partnership property is adjusted to reflect transfers of partnership interests), and the partnership terminates, the election is no longer in effect.

If the terminated partnership had a fiscal year that was grandfathered by the Tax Reform Act of 1986, the new partnership may be forced to adopt a different year end. In addition, a partnership can be assessed penalties for late filing of tax returns due to an inadvertent termination.

Avoiding the unfavorable

In many instances, proper planning can avoid the inadvertent termination of a partnership with unfaVOrable tax consequences. Partners have considerable flexibility to structure a withdrawal as either a sale or a liquidation of the partner's interest.

Structured as a liquidation of the partner's interest (with the partnership redeeming the partner's interest), a withdrawal may avoid treatment as a proportionate sale to the continuing partners-even if the continuing partners contribute funds to the partnership to liquidate the interest.

However, if a new partner is admitted to the partnership in connection with the liquidation of an interest, the Internal Revenue Service may assert what is known as the step-transaction doctrine to convert the liquidation into a sale of the interest to the new partner.

Here is another tax-planning opportunity: The IRS has ruled privately that a partnership is not terminated when a 50 percent partner initially sells a 49 percent interest, and, a year and a day later, sells the remaining one percent interest. Such a two-step sale may avoid termination.

In summary, proper planning can help partners to avoid the unfavorable tax consequences of an inadvertent termination of a partnership.

Reptinted from Kenneth Leventhal & Company's Real Estate Newsline.

William Braas is a senior tax manager in the Dallas office of Kenneth Loventhal & Company,
COPYRIGHT 1990 National Association of Realtors
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Braas, William
Publication:Journal of Property Management
Date:Jul 1, 1990
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