The first prong of the Sec. 708 termination rules provides that the termination of a partnership is triggered if (1) the partnership ceases all business activity or (2) the business of the partnership is no longer carried on in partnership form. The second prong involves technical terminations under Sec. 708(b)(1)(B), which may not involve discontinuation of the partnership's business. This column focuses on what happens when the partnership's business activities cease.Avoiding Discontinuation of a Partnership's Business
A partnership is terminated under Sec. 708(b)(1)(A) if no part of any business, financial operations, or venture of the partnership is carried on by any of its partners in a partnership. The courts have focused on the beginning phrase "no part." Interpreting this literally, they have gone so far as to state that a partnership is not terminated even though its sole assets are notes receivable arising from the sale of the partnership assets (Foxman, 41 T.C. 535 (1964), aff'd, 352 F.2d 466 (3d Cir. 1965)). When the books of the partnership are left open, holding the notes is considered part of the trade or business of the partnership and, therefore, the partnership is not terminated (see Baker Commodities, 48 T.C. 374 (1967), aff'd, 415 F.2d 519 (9th Cir. 1969), where a convalescent home was sold for a note, and the court ruled the partnership was not terminated by reason of the sale of the home).
In Harbor Cove Marina Partners, 123 T.C. 64 (2004), the IRS held that a partnership did not terminate where the controlling partner wound up the affairs of the partnership's business by using procedures contrary to those provided in the partnership agreement, another partner had sued to compel the use of the stated procedures, and a resolution of the lawsuit could reasonably lead to a significant difference in the taxable income of the partners.
The position of the courts that any partnership activity keeps a partnership from terminating, including the collection of notes receivable, gives practitioners a great deal of leeway in planning to avoid partnership terminations. However, it should be noted that the Sixth Circuit held that a partnership was terminated in the year that it ceased operations and distributed all of its properties with the exception of security deposits. These amounts were held until the following year when it was determined that the partnership's creditors did not have any legal claims over them. In this case, the partnership was considered terminated even though it had not distributed all of its assets (Goulder, No. 93-3832 (6th Cir. 1995)).
In a real-life situation, a court ordered all of a partnership's assets to be sold at a judicial sale to resolve litigation between the five equal partners. Three of the five partners bought all the assets and continued operating the business. The other two partners each received a share of the sales proceeds in exchange for their respective 20% partnership interest. In Rev. Rul. 66-264, the IRS concluded that this transaction did not cause a cessation of the partnership's business and a resulting termination of the partnership under Sec. 708(b)(1)(A). Therefore, for federal income tax purposes the transaction was not treated as a sale of all of the partnership's assets to the three continuing partners and a subsequent liquidation of the partnership, but was instead treated as a sale or liquidation of the partnership interests of the two exiting partners.Changes in Business Purpose
A change in a partnership's business purpose does not cause the partnership to terminate for income tax purposes. For example, a partnership does not terminate when it changes its business purpose from developing property to holding the property for investment purposes (Ginsburg, 396 F.2d 983 (Ct. Cl. 1968)). The holding of the property for investment purposes is sufficient to establish that the partnership remains in existence and does not terminate.
The courts have also held that the process of winding up a partnership is considered part of the partnership's business. In Sargent, T.C. Memo. 1970-214, the decision to liquidate a partnership was made in one year, and the final winding up of the partnership business occurred in the succeeding year. The Tax Court held the partnership was not terminated at the point when the decision was made to dissolve, but instead was terminated at the time of the final liquidating distribution.
Example. Continuing the partnership when the partnership's assets are sold: The H Apartments Limited Partnership, a calendar-year partnership, owns and operates the H Apartments. On Nov. 1, 20X1, the partnership sells the apartment complex for $5 million. The sales proceeds consist of a $750,000 down payment, a $2 million purchase money note, and the assumption of a $2,250,000 mortgage note. The purchase money note provides for a current market rate of interest and payments of principal as shown in the exhibit below. The partnership recognizes a $600,000 gain on the sale in 20X1. After the sale, the partnership's only asset will be the note receivable, and there will be no outstanding liabilities.
H Inc. owns a 50% interest in the partnership and reports on a Nov. 30 fiscal year. H Inc. is concerned the partnership may be terminated (because the partnership's business has ceased) before Nov. 30, 20X1, causing the corporation to have to report its share of gain in the fiscal year ending Nov. 30, 20X1.
Very little activity on the part of the partnership is necessary for a partnership to be considered to continue in business. The practitioner could recommend that the H Apartments Limited Partnership hold the note receivable, rather than distributing shares in the note to the partners. In fact, the buyer may insist on the partnership retaining the note so that he can make one payment to the partnership instead of multiple payments to the partners. The partnership should also keep its books and records open to indicate that the partners have no intention of terminating the partnership. Based on the existing statute, regulations, and court decisions, these steps should avoid the termination of H Apartments Limited Partnership.
Nontax Issues Arising From Discontinuation of a Partnership's Business
The date on which a partnership is considered terminated because of the discontinuation of business under the tax rules does not govern when it terminates under state law. Consequently, other nontax considerations should be addressed by partnerships discontinuing a business.
When the partnership discontinues its business, it can pursue two courses. One course is to dissolve the partnership, and the other course is to leave the partnership entity active (which would be the case if it continues to hold notes receivable as discussed in the example).
Partners will generally want to dissolve a partnership that discontinues its business. While practitioners frequently recommend that a corporation shell be maintained after discontinuation of a business, to provide some continuing degree of liability protection, a partnership provides no such protection (except for limited partners). To legally dissolve a partnership, a certificate of dissolution should be filed with the state of formation. The state will generally not issue the certificate until the partnership can provide documentation that it is current on all of its state tax liabilities. Most state laws provide that if a partnership notifies its known creditors in writing of the dissolution, the partners will be relieved of liability to those creditors after a short period. Frequently, state law also provides that if a partnership publishes a notice of dissolution, its liability to unknown creditors is relieved after a slightly longer period—usually two years.
If a partnership continues in existence after the cessation of its business, the partners will remain liable for partnership debts or claims against the partnership until the partnership is dissolved.
A partnership that is legally dissolving must address many administrative issues. The partnership may need to:
- Close accounts with any state agencies including the sales tax collection agency, the workers' compensation agency, the state employment tax agency, etc.;
- File final federal and state income, excise, sales tax, or other required returns;
- Cancel any business license registrations with a city or other entity;
- Notify states in which the partnership is registered to do business;
- Close all bank accounts;
- Notify creditors, as described above;
- Pay use tax on any assets converted to personal use;
- Pay transfer taxes, if any, on distributed assets and retitle assets;
- Cancel or renegotiate a transfer or substitution of the contracting party for contracts and leases into which the partnership entered;
- Pay off or renegotiate a substitution of the debtor for partnership loans; and
- Notify customers and vendors.
In some situations, a partner may pay off a partnership debt (whether or not a partner guaranteed it) as part of the winding up process or at some point after the termination of the partnership. The tax treatment of this type of payment depends on several factors. A payment at the time of winding up may be treated as a contribution to the partnership, increasing the contributing partner's basis and reducing his gain on termination of the partnership. Payment of a partnership debt subsequent to the year of termination will generally give rise to business or nonbusiness bad debt.
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 30th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, and Twila Bollinger, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.