Redemptions in Conjunction with Partnership Mergers Can Create Unexpected Tax Consequences

By Howard Wagner, CPA, Louisville, KY, and Kevin Staton, CPA, Lexington, KY

Editor: Frank J. O'Connell, Jr., CPA, Esq.

The IRS has provided a road map for partnership mergers or consolidations in Regs. Sec. 1.708-1(c). When two or more partnerships merge or consolidate into a single partnership, the resulting partnership is, for purposes of Sec. 708, considered a continuation of any partnership whose members retain an interest of more than 50% of the capital and profits of the resulting partnership. In a partnership merger in which some or all members of the terminated partnership receive cash for their interests, planning is necessary to prevent the continuing members of the partnership from recognizing gain on the transaction.

Mergers and Consolidations

The general rules cover a large majority of partnership mergers. In some cases the partnership that results from a merger of multiple partnerships can be considered a continuation of more than one of the partnerships. In that case, the partnership is considered to be the continuation of the original partnership whose contribution of assets represents the greatest fair market value (FMV), net of liabilities, to the resulting partnership. All other partnerships considered to be merged or consolidated in this process, but not continuing, should be considered terminated on the date of the merger. If none of the members of the merging or consolidating partnerships holds a greater-than-50% interest in the capital and profits of the resulting partnership, all merging partnerships are considered terminated and the resulting partnership is a new partnership. When filing the tax return for the continuing partnership, Regs. Sec. 1.708-1(c)(2) outlines the various disclosures that must be included with the resulting partnership tax return.

A merger or consolidation of partnerships may take one of two forms provided by the regulations: the “assets-over” form or the “assets-up” form. The assets-over form is the default for a partnership merger or consolidation.

Assets-over: The assets-over form requires the merged or consolidated partnership that is considered terminated to contribute all of its assets and liabilities to the resulting partnership in exchange for an interest in the resulting partnership, and, immediately thereafter, the terminated partnership distributes interests in the resulting partnership to the members in complete liquidation of the terminated partnership.

Assets-up: The assets-up form requires the terminated partnership to distribute all of its assets to the members, such that the members will be treated under the laws of the applicable jurisdiction as the owners of the assets, in liquidation of the members’ interests in the partnership; immediately thereafter, the members in the terminated partnership contribute the distributed assets to the resulting partnership in exchange for interests in the resulting partnership. Although there is a temporary ownership of the terminated partnership assets by its members, the form of the merger or consolidation will be respected for federal income tax purposes as long as the members complete the steps involved in the assets-up form. It should be noted that the IRS has taken the position that, although the conveyance of ownership in the partnership’s assets to the partners is imperative under the assets-up form, it should not be necessary for the partners to actually assume the liabilities of the partnership in order to follow such form.

Tax Consequences

When determining which form to use for a partnership merger, many factors should be considered. The tax results vary drastically depending on which form the transaction takes. For example, under the assets-over form, the partnership’s tax basis in the assets contributed to the resulting partnership is determined under Sec. 723 and should be generally unchanged by the transaction. Under the assets-up form, the basis of the assets of a terminating partnership is first determined under Secs. 732(b) and 732(c) on distribution to the partners, and the partnership then computes its basis under Sec. 723 on contribution to the continuing partnership. In addition, the choice of form will cause Secs. 704(c)(1)(B) and 737 to apply in different manners. Under the assets-up form, both sections are applicable if any assets distributed to the partners were previously contributed to the distributing partnership within seven years of the distribution. Under the assets-over form, neither Sec. 704(c)(1)(B) nor 737 applies. However, the deemed contribution of assets from a terminating partnership to the resulting partnership may create a new layer of Sec. 704(c) gain.

When the partners of the merged partnership desire to receive some portion of the merger consideration in cash, the disguised-sale rules of Sec. 707 will govern the treatment of the cash received. Generally, when a partner contributes property to a partnership and concurrently receives a distribution of cash from the same partnership, the transaction will be bifurcated for federal income tax purposes. In these cases, the transaction will be treated as partially a contribution to the partnership under Sec. 721 and partially a sale of assets.

Example 1: X, Y, and Z want to form a partnership. X and Y each contribute $1,000 in cash. Z contributes land with an FMV of $1,000 and a tax basis of $200. Immediately after the formation of the partnership, Z receives a cash distribution of $400. Under the disguised-sale rules, Z will be treated as selling a portion of the property to the partnership. Z’s deemed sales proceeds will be $400, the cash received. The amount of basis applied to the sale will be $80 ($400 cash received / $1,000 total contribution @ $200 basis), resulting in a gain to Z of $320.

The same disguised-sale rules would apply in the context of a partnership merger when one of the partners of the merged partnership wants to receive cash rather than a continuing interest in the merged partnership.

Example 2: Partnership ABC has three members, each with a 1/3 interest in capital and profits. The only asset of the partnership is land with an FMV of $1,500 and a tax basis of $300. ABC merges into Partnership DE in an assets-over merger. DE has two members with equal shares of profits and capital. DE’s only asset is land, with an FMV of $2,000 and a tax basis of $1,000, and cash of $500. In both cases, the partners’ inside basis in partnership assets is the same as their outside basis in their partnership interests. Because DE’s partners will represent more than 50% of the value of the remaining partnership, DE will be deemed to continue in existence and ABC will terminate under Sec. 708(b)(1)(A).

In the course of the merger negotiations, A indicates that he does not want to continue as a member of the merged partnership. ABC does not have the cash to redeem A, but DE does and agrees to provide the cash to ABC to redeem A. In the assets-over merger, ABC receives and distributes $500 cash to A and interests in partnership DE to B and C.
Under the disguised-sale rules, ABC will be treated as entering into a disguised sale to the extent of cash received in the merger. ABC will recognize a gain of $400. As in Example 1, the $500 cash received will be treated as sales proceeds, and the basis applied to the sale will be $100 ($500 cash received / $1,500 total contribution @ $300 basis). Under Sec. 707, A, B, and C will pay tax on the gain from the disguised sale even though the cash was used to redeem the interest of A.

However, help is available. The partnership merger regulations provide a special rule available in assets-over mergers. Regs. Sec. 1.708-1(c)
(4) provides that, in an assets-over merger, the sale of all or part of a partner’s interest in the terminated partnership will be respected as a sale of a partnership interest under the following circumstances:

  1. The merger agreement (or another document) specifies that the resulting partnership is purchasing interests from a particular partner in the merging or consolidating partnership and the consideration that is transferred for each interest sold; and
  2. The selling partner in the terminated partnership, either prior to or contemporaneous with the transaction, consents to treat the transaction as a sale of the partnership interest.

Assume the same facts as the previous example but for the fact that the partnerships and A enter into the requisite agreements. The disguised-sale rules would not apply to ABC, and ABC will not recognize gain or loss on the transaction. A will be treated as selling his partnership interest to DE for $500 and will recognize gain of $400 ($500 proceeds less $100 basis in the partnership interest).

The special rule is needed only in the case of an assets-over merger; the mechanics of the assets-up merger will already yield this result. In the assets-up merger, each partner of the terminated partnership is treated as contributing its share of assets to the surviving partnership, so the receipt of cash by one of those partners will generally result in gain only to that partner.


Without careful planning, the remaining partners in a terminated partnership will recognize gain on the merger transaction when one of that partnership’s members receives cash for his or her interest.


Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.

Unless otherwise noted, contributors are independent members of Crowe Chizek.

If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

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