Technical Terminations: Tangible Personal Property Depreciation Issues

Editor: Mary Van Leuven, J.D., LL.M.

Technical terminations of partnerships under Sec. 708 (b)(1)(B) and its regulations create numerous issues as to the proper tax treatment of depreciable tangible property owned by the terminating partnership, particularly when changing its accounting method for such property. Under Regs. Sec. 1.708-1(b)(1)(iv), the new partnership retains the terminating partnership’s basis in depreciable property. However, depreciation on such property “starts over” for the new partnership (i.e., it has to be depreciated by the new partnership as if acquired from a third party for the amount of the carryover basis).

Technical Termination

Sec. 708(b)(1)(B) provides that a partnership is considered terminated if, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. Regs. Sec. 1.708-1(b)(4) provides that, if a partnership is terminated by a sale or exchange of an interest, the following are deemed to occur:

1. The terminated partnership transfers all of its assets and liabilities to a new partnership in exchange for an interest therein.
2. Immediately thereafter, the terminated partnership distributes an interest in the new partnership to the purchasing partner and the other remaining partners in liquidation of the terminated partnership, either for the continuation of the new partnership’s business or its dissolution and winding up.

Deemed Asset Transfer

Sec. 168(i)(7) generally provides that, for transactions covered by Sec. 332, 351, 361, 721 or 731, or for transactions between consolidated group members, the transferee will be treated as the transferor for purposes of computing the depreciation deduction, to the extent of any carryover basis. However, this does not apply in the case of a partnership termination under Sec. 708(b)(1)(B). Thus, depreciable tangible property transferred from a terminating partnership to a new partnership as part of a technical termination under Sec. 708(b)(1)(B) must be depreciated as if it were acquired from a third party. The property’s basis will be the same in the new partnership as it was in the terminating partnership. This basis must be depreciated over the full recovery period applicable to the class of property to which the transferred property belongs in the new partnership’s hands, using the applicable depreciation method and convention.

Disposition of property: For a terminating partnership, the transfer is considered a disposition of the property; under Sec. 168(d), the disposition will be deemed to occur at the time prescribed by the applicable convention for the property (i.e., half-year, mid-month or mid-quarter). The disposition date would need to be determined consistently with the length of the terminating partnership’s tax year; see Rev. Proc. 89-15. Also, under Temp. Regs. Sec. 1.168(d)-1T(b)(3)(ii), property placed in service by the terminating partnership during the year of termination would generally not be allowed depreciation in that tax year.

The treatment is different for amortizable intangible property. Sec. 197 contains rules similar to those in Sec. 168(i)(7), but does not contain an exception for Sec. 708(b)(1)(B) terminations. Thus, the transfer of a Sec. 197 intangible from a terminating partnership to a new one results in the latter “stepping into the shoes” of the terminating partnership and continuing to amortize the property as if no transfer had occurred. 

Depreciable Property Held by the Terminating Partnership

As discussed, the rules are fairly straightforward for the treatment of depreciable property held by a partnership at the time of a technical termination. Issues arise when the depreciable property is being depreciated in the terminating partnership’s hands using an erroneous method. That method may be corrected before the termination through an accounting-method change, or after the termination by the new partnership’s adoption of proper methods. If depreciation methods are changed before the termination, a Sec. 481(a) adjustment will be recognized by the partners of the terminating partnership, and the new partnership will have (more or less) a carryover basis in its assets. Depending on the amount of depreciable property subject to the method change, this could have a large effect on the economics of the transfer of partnership interests.

An accounting-method change from an improper method of depreciation that resulted in under-or over-depreciation of an asset can be made under the automatic-consent provisions of Rev. Proc. 2002-9, Appendix Section 2.01 (as modified by Rev. Proc. 2007-16), unless such change is specifically excluded. Depreciation method changes excluded from Rev. Proc. 2002-9 may be made under Rev. Proc. 97-27.

Sec. 481(a) adjustments: Under both procedures (as modified by Rev. Proc. 2002-19), any Sec. 481(a) adjustment (i.e., the cumulative difference between the depreciation actually taken under the improper method and the depreciation that should have been taken had the proper method been in effect) required to effect the accounting-method change that results in an increase in taxable income, must be recognized ratably over four tax years (including short tax years, if any), unless otherwise provided. A Sec. 481(a) adjustment resulting in a decrease in taxable income must be recognized in the tax year of change.

Also under both procedures, the accounting-method change is deemed to occur on, and the Sec. 481(a) adjustment is computed as of, the first day of the tax year of change. In addition, the property subject to the accounting-method change must be owned by the taxpayer as of the first day of the tax year of change.

Acceleration: Rev. Procs. 2002-9 and 97-27 contain identical acceleration provisions for the Sec. 481(a) adjustment. The adjustment will be accelerated when a taxpayer ceases to engage in the trade or business or terminates its existence. In such case, the taxpayer must take the remaining balance of any Sec. 481(a) adjustment from said trade or business into account when computing taxable income in the tax year of the cessation or termination. Under the procedures, a taxpayer has ceased to engage in a trade or business if the operations of the trade or business cease, or substantially all of the assets are transferred to another taxpayer. Examples include the contribution of the assets of a trade or business, to which the Sec. 481(a) adjustment relates, to a partnership.

A partnership experiencing a technical termination under Sec. 708(b) (1)(B) may request permission to change its accounting method for depreciable property in the termination year for any improperly depreciated property owned as of the beginning of that tax year. If the change results in a negative Sec. 481(a) adjustment (i.e., a decrease in taxable income), the partnership will recognize the entire adjustment in the tax year of change under the normal provisions of Rev. Proc. 2002-9 or 97-27. If the change results in a positive Sec. 481(a) adjustment (i.e., an increase in taxable income), the termination should be considered an acceleration event, so that the terminating partnership will recognize the entire Sec. 481(a) adjustment.

If the terminating partnership changes its accounting method for depreciable property before the technical termination, the new partnership’s carryover basis in the property is affected (whether positively or negatively) by the Sec. 481(a) adjustment. If the terminating partnership does not change its depreciation methods for improperly depreciated property before the termination, the new partnership can adopt proper methods for the property on its initial income tax return, without the need for an ac-counting-method change. This effectively results in the new partnership’s recognition of Sec. 481(a) adjustment amounts (relating to the correction of the terminating partnership’s erroneous depreciation methods) over the property’s proper recovery period.    

EditorNotes

Mary Van Leuven, J.D., LL.M. is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC.

Unless otherwise indicated, contributors are members of or associated with KPMG LLP. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

© 2007 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

If you would like additional information about these items, contact Ms. Van Leuven at mvanleuven@kpmg.com.