Holding Period and Basis Considerations of Partnership Conversions

EXECUTIVE SUMMARY

• A conversion of an entity treated as a partnership to an entity treated as a sole proprietorship could come about when one partner purchases all the remaining outstanding ownership interests in a partnership or when all the partners of a partnership sell their interests to a single third party.
• A conversion of an entity treated as a sole proprietorship to a partnership could come about when a third party purchases a membership interest in a solely owned entity from the existing owner or when a third party contributes cash or property to a solely owned entity in exchange for an interest in the entity.
• Three transaction forms, which each result in different tax consequences, are available for incorporating a partnership.
• A partner typically exits a closely held partnership either by selling his or her partnership interest to the remaining partner or through a liquidation of the partner’s interest by the partnership.

It is common for owners of a business to conclude, at some point in the life of the business, that they must change the legal form of the entity through which the business has been conducted. While the legal process and attendant paperwork for implementing a change of entity form may draw most of the attention of business owners and their legal advisers, owners and advisers must also consider the tax consequences of the change.

For changes in entity form subsequent to formation, the tax consequences of the change depend on the entity’s federal income tax law status before and after the change. The exhibit on p. 156 presents the most common state law entities and the corresponding federal income tax law entities associated with the particular state law entities.

For example, the incorporation of a two-person limited liability company (LLC) could be viewed as a tax event (partnership into corporation) or a nontax event (corporation into corporation), depending on which federal income tax law entity status the entity chose at formation.

This article summarizes the tax consequences of entity changes involving the conversion to or from any entity treated as a partnership for federal income tax purposes (e.g., general partnerships, limited partnerships, LLCs with two or more members, and limited liability partnerships). Thus, the terms “partner” and “partnership” as used in this article include all state law entities treated as partnerships for federal income tax law purposes. The conversions discussed here include partnership to sole proprietorship, sole proprietorship to partnership, and partnership to corporation, with a focus on basis and holding period considerations, as well as gain or loss recognition, at conversion. The same issues are also discussed in the context of partnership sales and liquidations. In addition, tax planning considerations for these transactions are outlined.

Partnership to Sole Proprietorship

The conversion of an entity treated as a partnership for tax purposes to an entity treated as a sole proprietorship for tax purposes could come about when one partner of a partnership purchases all the remaining outstanding ownership interests in the partnership or when all the partners of a partnership sell their respective interests to a single third-party purchaser.

Example 1: AB is a two-member LLC treated as a partnership for tax purposes. AB has only long-term capital assets and no liabilities. The basis of AB’s assets is $10,000 and the fair market value (FMV) is $20,000. The two partners each own 50% of AB, and they each have a basis of $5,000 in their partnership interests. B purchases A’s 50% interest in AB for $10,000 and continues to operate AB as a single-member LLC.

Under general partnership tax rules, A’s sale of her partnership interest in AB to B could be viewed as (1) A’s sale and B’s purchase of a partnership interest, (2) a partnership termination (because there is only one owner after the sale), (3) a partnership distribution of the business’s operating assets to B, and (4) B’s contribution of the business operating assets to a sole proprietorship.¹ Under those general rules, (1) A would recognize a $5,000 gain on the sale of her partnership interest, (2) B would take a $10,000 basis (the amount he paid A) in the new interest, (3) B would recognize no gain or loss on the liquidating distribution of property from the partnership, (4) B would take a $5,000 basis in 50% of the property received in the liquidating distribution (his basis in his original interest immediately before the distribution) and a $10,000 basis in 50% of the property received (his basis in the new interest acquired from A), and (5) B’s holding period of all the property received in the distribution would include the time the property was held by the partnership.

Rev. Rul. 99-6² provides for a slightly different outcome in the disposition of an interest in an entity treated as a partnership for tax purposes. The ruling provides for asymmetric treatment of sellers and buyers: Sellers are treated as having sold their partnership interests, while buyers are treated as having purchased the seller’s share of partnership assets. While in almost all respects the tax consequences to the seller and buyer under Rev. Rul 99-6 are the same as when the general rules are applied, the revenue ruling does yield a difference in the holding period of assets for the buyer of the partnership interest.

With respect to the purchase by one partner of the other partner’s partnership interest, under Rev. Rul. 99-6, the following is the correct outcome: When B purchases all of A’s interest in the partnership for $10,000, the partnership is deemed terminated for federal tax purposes under Sec. 708 (b)(1)(A), even though for state law purposes B continues to operate the LLC (a state law single-member LLC). From A’s perspective, she is treated as having sold her partnership interest to B and recognizes a gain of $5,000 on the sale of her interest ($10,000 received from B – $5,000 basis in her interest). Because the partnership has no unrealized receivables or inventory items, the gain is treated as a capital gain. From B’s perspective, the partnership is deemed to have made a liquidating distribution of all its assets to A and B; following the distribution, B is treated as having acquired from A all the assets deemed to have been received by A in the liquidating distribution. Thus, B ends up with 100% of the partnership property, 50% of which came to B via a deemed partnership liquidating distribution and 50% via a deemed acquisition of A’s share of partnership property.

In the deemed liquidating distri-bution, B would recognize no gain or loss on the distribution ($5,000 basis of assets distributed to B – $5,000 basis of B’s partnership interest = $0 gain or loss). B’s basis in the partnership property deemed distributed would be the $5,000 basis of B’s partnership interest immediately before the distribution, reduced by the amount of money, if any, received in the distribution ($0), or $5,000. B’s holding period of the property received in the deemed liquidating distribution would include the time the property was held by the partnership, which was long term. With respect to B’s deemed acquisition of A’s share of partnership assets, Rev. Rul. 99-6 indicates that under the general rules, B’s basis in the partnership property acquired from A would be the amount paid to A ($10,000), but B’s holding period in the property received via the deemed acquisition of A’s share of partnership assets would begin the day after B is deemed to have acquired them from A. In other words, those assets would be treated as short-term assets.

After the acquisition, B’s basis in the assets is $15,000 ($5,000 carryover basis + $10,000 acquisition price paid), and B’s holding period would be long term for one-third of the assets and short term for two-thirds. Rev. Rul. 99-6 cites as authority McCauslen³ and Rev. Rul. 67-65,⁴ both of which involved a surviving partner’s purchase of the deceased partner’s partnership interest. In both instances, the surviving partner was treated as acquiring the deceased partner’s share of partnership assets, even though the acquisition took the form of an acquisition of the deceased partner’s partnership interest.

In the case of a single third-party purchaser’s purchase of the partnership interests of both partners of a two-member partnership, Rev. Rul. 99-6 again treats the sellers as having sold their interests while the buyer is treated as having purchased the sellers’ share of partnership assets.

Example 2: Assume the same facts as in Example 1, except that A and B each sell their entire interest in AB to E for $10,000, for a total sale price of $20,000. The partnership is deemed terminated for tax purposes under Sec. 708(b)(1)(A) even though E continues to operate AB as a single-member LLC, and A and B must report gain or loss on the sale of their partnership interests ($10,000 received from E – $5,000 basis in their respective partnership interests = $5,000 gain each). The AB partnership is deemed to make a liquidating distribution to A and B, in proportion to their respective interests, of all the partnership’s property, and E is treated as acquiring those partnership properties directly from A and B. E’s basis in the property deemed acquired is $20,000, the total amount paid to A and B, and E’s holding period for those assets begins on the day after the deemed acquisition from A and B.

Rev. Rul. 2001-61⁵ addresses a practical implementation issue when a partnership converts to a sole proprietorship. In that ruling, the IRS provided clarification on the continued or terminated use of an employer identification number (EIN) and a taxpayer identification number (TIN) in the case of an entity treated as a partnership for tax purposes that converts to a disregarded entity (i.e., sole proprietorship) for tax purposes. The Service held that the disregarded entity must continue to use the partnership EIN for employment tax purposes but must use the TIN of its owner for other tax purposes.

Sole Proprietorship to Partnership

Rev. Rul. 99-5⁶ provides guidance when an entity treated as a sole proprietorship for tax purposes (i.e., a sole proprietorship or single-member LLC) converts to a partnership for tax purposes (i.e., a partnership or a multimember LLC). Such a conversion could come about when a third party purchases a membership interest in an LLC from the existing sole member or when a third party contributes cash or property to a solely owned entity in exchange for an interest in the entity. Rev. Rul. 99-5 assumes that state law recognizes single-member LLCs but that single-member LLCs are disregarded entities for tax purposes (and thus are sole proprietorships for tax purposes). In general, Rev. Rul. 99-5 treats sellers as selling, and buyers as buying, assets rather than an interest in a partnership. Again, the revenue ruling addresses two different scenarios for the conversion of a single-member entity to a multimember entity.

Example 3: X is a single-member LLC that is treated as a sole proprietorship for tax purposes. X has only long-term capital assets and no liabilities. The basis of X’s assets is $10,000, the FMV of X’s assets is $20,000, and the single member, A, owns 100% of X. B purchases a 50% interest in X from A for $10,000.

Because X is treated as a sole proprietorship for tax purposes, A is treated as holding all of X’s assets (which are all capital or Sec. 1231 assets) directly. As a result of B’s purchase, A is treated as having sold a 50% interest in all of X’s assets, followed by A’s and B’s contribution of 100% of the assets to NX, LLC, a new partnership, in exchange for partnership interests. A recognizes a gain of $5,000 ($10,000 purchase price – $5,000 basis in one-half of X’s assets) on the deemed sale of a 50% interest in X’s assets to B. A and B do not recognize gain on the property’s contribution to NX in exchange for a partnership interest.

B’s basis in his 50% partnership interest equals the amount he paid to A in his deemed acquisition of one-half of X’s assets, or $10,000, and A’s basis in her 50% partnership interest equals 50% of the adjusted basis of the assets deemed held by A immediately before the sale to B, or $5,000. NX’s basis in the property contributed by A and B is equal to the adjusted basis of those properties in the hands of A and B immediately before the deemed contribution to the partnership, or $15,000 ($5,000 from A and $10,000 from B).

A’s holding period in her 50% NX partnership interest includes the time the assets contributed to NX were held by X (and deemed owned directly by her for tax purposes). B’s holding period in his 50% NX partnership interest begins the day after he acquires 50% of X’s assets from A. Partnership NX’s holding period for the contributed assets includes A’s and B’s holding periods for those assets.

Example 4: Under a second scenario, an unrelated third party, B, instead makes a capital contribution of cash to the single-member LLC X(treated as a sole proprietorship for tax purposes), owned by A, in exchange for a 50% interest, and the cash is used in the ordinary course of business (i.e., it is not distributed to the original single member A).

A is treated as contributing all of X’s assets to a new two-member LLC, NX (treated as a partnership for tax purposes), in exchange for a 50% interest. No gain or loss is recognized by either member as a result of the contribution of assets (by A) and cash (by B).

A’s basis in her partnership interest is equal to $10,000, the basis of the assets held by X, but is treated as directly owned by her immediately before B’s cash contribution. B’s basis in his NX partnership interest is equal to his basis in the contributed assets (cash of $10,000) at the time of conversion. NX’s basis in the contributed property is equal to the adjusted basis of that property in the hands of the contributing members before the conversion of the single-member LLC to a two-member LLC, or $15,000 ($5,000 from A + $10,000 from B).

A’s holding period in her NX partnership interest includes the holding period of the capital and Sec. 1231 assets contributed, which is long term. B’s holding period in his NX partnership interest begins the day after his cash contribution to NX. NX’s holding period for the assets contributed by A includes A’s holding period for those assets, which is long term.

Rev. Rul. 2001-61⁷ addresses an implementation issue when a sole proprietorship converts to a partnership. In that ruling the IRS held that, after the conversion to a partnership, the new partnership must continue to use the disregarded entity’s EIN for employment tax purposes.

Partnership to Corporation

Rev. Rul. 84-111⁸ describes three forms for the incorporation of a partnership: (1) partnership assets are transferred to a newly formed corporation in exchange for all of the outstanding stock of the corporation, followed by the stock’s distribution to the partners and the partnership’s liquidation, generally known as the “assets-over” method; (2) partnership assets are distributed to the partners in liquidation of the partnership, followed by the contribution of the assets to a newly formed corporation in exchange for its stock, generally known as the “assets-up” method; and (3) partnership interests are transferred to a newly formed corporation in exchange for its stock, resulting in the partnership’s termination, generally known as the “interests-over” method. In holding that the specific form of the incorporation used has differential effects as to basis, gains or losses, and holding periods, Rev. Rul. 84-111 supersedes Rev. Rul. 70-239.⁹ Under that earlier ruling, regardless of the method used by the taxpayer, all incorporations of partnerships were treated for tax purposes as if the assets-over method had been used.

Differences Between the Methods

In general, Rev. Rul. 84-111 applies the rules of subchapter C on transfers to corporations (i.e., Secs. 351, 358, and 362), the rules of subchapter K on partnership distributions, transfers of partnership interests, and the treatment of unrealized receivables, inventory, and liabilities (i.e., Secs. 732, 735, 741, 751, and 752), and the rules of subchapter P on the holding period of property (i.e., Sec. 1223) to each method of incorporation. As a function of the basis in and the holding period of the assets held by a partnership, the partners’ basis in and holding period for their interests, and the character of the assets held by the partnership, the partner, and the corporation, the tax consequences will vary under each method.

For example, when the partners’ basis in their partnership interests is equal to the partnership’s basis in its assets, regardless of the method used to incorporate the partnership, the corporation’s basis in the assets after the incorporation will be the same as the basis of the assets when held by the partnership. However, when the basis in partnership interests does not equal the basis of the partnership assets, differences will arise depending on which method is used.

Example 5: Partnership P has three equal partners, D, E, and F. P has only long-term assets and no liabilities, and it distributes no cash. The adjusted basis of P’s assets is $18,000 and their FMV is $60,000. D, E, and F have a long-term holding period for their respective partnership interests. D and E have a basis in their respective partnership interests of $6,000 each, while F has a basis in her interest of $8,000, for a total basis in partnership interests of $20,000. No election under Sec. 754 has been made, and neither the partnership nor the partners recognize gain or loss on the transfers to a controlled corporation.

After the incorporation, under the assets-over method, the corporation’s basis in the assets would equal $18,000, while the shareholders’ basis in their stock would equal $20,000. Under the assets-up method, the results would depend on whether F made a Sec. 732(d) election. With the election, the corporation’s basis in the assets would equal $20,000, the same as the shareholders’ basis in their stock. Without the election, the corporation’s basis in the assets would equal $18,000, while the shareholders’ basis in their stock would equal $20,000. Under the interest-over method, the corporation’s basis in the assets would equal the shareholders’ basis in their stock, or $20,000.

The tax consequences described in Rev. Rul. 84-111 are premised on the actual execution of all the steps inherent in the incorporation of a partnership, as a function of the method used. In Rev. Rul. 2004-59,¹⁰ the IRS provided guidance as to the tax treatment applicable to a partnership that converts to a corporation under a state “formless conversion” statute, which allows an entity to convert from one state law entity to another without the actual transfer of assets or interests. Because Rev. Rul. 84-1¹¹ applies only to actual transfers of assets or interests, taxpayers using a state formless conversion statute cannot rely on the ruling. In Rev. Rul. 2004-59, the Service held that the following steps are deemed to occur when a partnership uses a state formless conversion statute: The partnership contributes all its assets to a corporation in exchange for the stock; immediately thereafter, the partnership liquidates, distributing the corporation’s stock to its partners in a liquidating distribution. In reaching this conclusion, the Service relied on Regs. Sec. 301.7701-3(g)(i), which outlines the steps deemed to have occurred when an entity classified as a partnership elects to be classified as an association, and Sec. 7701(a)(3), which includes an association within the definition of the term “corporation.”

Although related to a corporation’s conversion to an LLC, Browning Ferris Industries, Inc.11 illustrates the deference given by the courts to the steps deemed to have been taken by taxpayers as part of entity conversions. In Browning, the court concluded that because the corporation was deemed to have terminated before filing a refund claim, the new LLC that took its place did not have requisite standing to file the refund claim for the now-defunct consolidated group. Thus, while formless conversions may have great appeal because of practical simplicity, taxpayers need to be aware of not only the tax consequences arising from the steps deemed taken but also those arising from an entity’s termination for tax purposes. In terms of tax consequences arising from the steps deemed taken, under the step transaction doctrine,¹² the general rules of subchapter C related to the tax consequences of incorporation and the general rules of subchapter K related to a partnership’s liquidation would apply to a formless conversion.

Planning Opportunities

Because the tax consequences of the partners, partnership, and the resulting corporation vary across the three methods for incorporating a partnership, taxpayers should compare the tax consequences of the three alternatives in order to identify the method that yields the most favorable tax outcome. The comparison should consider basis, holding periods, and character of assets or interests transferred. In addition, taxpayers in states where a formless conversion is available should compare the tax consequences of using the formless conversion with those arising under Rev. Rul. 84-111 from actual transfers of assets and interests.

For example, character considerations about corporate stock arise from Sec. 1244, which allows for ordinary treatment of a loss arising from the sale or worthlessness of small business stock. Since the original owner of the Sec. 1244 stock is the only taxpayer eligible to claim this ordinary loss, use of the assets-over method of incorporating a partnership would void the Sec. 1244 treatment. Because under the assets-over method the partnership serves as an intermediary owner in the process of transferring the stock to the former partners, the Sec. 1244 treatment is lost when the stock is transferred by the partnership to the partners. Sec. 1244 treatment is preserved with both the assets-up and interests-over methods because the partners take ownership of the stock directly in the exchange.

Partnership liabilities transferred as part of incorporation may also offer opportunities for planning. If, in addition to the assets transferred by the partnership, the corporation also assumes liabilities of the partnership, then under Sec. 357(a) the assumption will not taint an otherwise tax-free incorporation of a partnership, as long as the sum of the liabilities transferred does not exceed the adjusted basis of the assets transferred to the corporation. However, when the sum of the liabilities exceeds the adjusted basis of the assets transferred by the partnership to the corporation, Sec. 357(c)(1) requires the recognition of the excess as either ordinary income or capital gain.

An important exception to Sec. 357(c)(1) exists for certain obligations of a partnership. Under Sec. 357(c)(3)(A)(ii), partnership obligations for payments to a retiring partner or a deceased partner’s successor in interest (Sec. 736(a) payments) are not included in liabilities for purposes of Sec. 357(c)(1) and therefore cannot give rise to income on incorporation. This treatment allows for flexibility in planning payments to partners contemplating retirement in the period immediately before incorporation. In addition, since under Rev. Rul. 83-155¹³ Sec. 736(a) payments can be deducted by the newly formed corporation when paid, the anticipated tax rates of the remaining partners, the retiring partner, and the new corporation should be considered when planning the timing of the incorporation.

Care should be taken in timing the incorporation of a partnership with an existing active business. Sec. 482 allows the IRS to allocate income between or among taxpayers if the allocation is necessary to prevent the distortion of income or the evasion of income taxes. The IRS successfully applied Sec. 482 to the incorporation of a partnership when it concluded that the partnership had earned the income ultimately realized by the corporation. In Foster,¹⁴ income reported by four corporations on the sale of land developed by commonly controlled partnerships but transferred to the corporations after substantially all development was completed was reallocated to the commonly controlled partnerships. In the Service’s eyes, the partnerships had done everything necessary to create the potential for income recognition and could not avoid that recognition by arranging for the property to be in the hands of another taxpayer at the moment the income was recognized. By carefully planning the timing of the cessation of business activities in the partnership and the commencement of business activities in the corporation, incorporating partnerships should be able to avoid this type of problem.

Sales and Liquidations of Partnership Interests

When a partner desires to exit a closely held partnership, there are typically two ways to accomplish this: by selling the partnership interest to the remaining partner or by liquidating the exiting partner’s interest in the closely held partnership. Note that Rev. Rul. 99-6 applies when an exiting partner sells her interest to the remaining partner. Since the tax consequences of selling a partnership interest differ from those of liquidating a partnership interest (see below), parties must take care in drafting the transaction documents so that the intended form of the transaction will be respected. The courts have generally upheld the sale treatment of a transaction when the agreement between the parties contained the words “purchase” and “sale,”¹⁵ the agreement characterized the parties as the purchasing and selling partners,¹⁶ or the payments were made by the remaining partners to the selling partner.¹⁷ On the other hand, liquidation treatment resulted when the document between the parties used the terms “redemption,” “termination,” “liquidation,” or “retirement”¹⁸ or the agreement was between the partnership and the departing partner.¹⁹

When the parties have not exercised care in drafting agreements, the courts will draw their own conclusions as to the intended transaction type. For example, in Foxman,²⁰ a withdrawing partner reported amounts he received from a partnership as capital gain on a sale of his partnership interest to the two remaining partners. The remaining partners, however, considered the transaction a liquidation of the retiring partner’s interest and the partnership deducted a large portion of the payments as guaranteed payments. Based on the terms used in the agreement, the court ruled that a sale, rather than a liquidation, had occurred. Similar cases exist in which the court determined that the transaction type was different from the one intended by the parties, largely because of inconsistencies and/or unclear language in the transaction agreement.²¹ Taken together, the case law on this point suggests that if liquidation treatment and not sale treatment is desired, the agreement between the parties should make specific reference to Sec. 736 and payments should be made by the partnership to the exiting partner.

In general, the choice of exit method from a partnership gives rise to differences in the character of the gain or loss recognized by the exiting partner, the timing of the gain or loss, and the basis of partnership assets to the partnership. Liquidation treatment generally offers more flexibility to partners than sale treatment. In certain circumstances, this flexibility may make the choice of liquidation more desirable than a sale.

Liquidating payments are generally treated as the payment of a distributive share of partnership income if the amount is determined by reference to the partnership’s income; otherwise, the payment is considered a guaranteed payment.²² For example, if an exiting partner receives a lump-sum amount for her interest in partnership property plus a percentage of the entity’s net income for some years after retirement, the payments based on net income are treated as a distributive share of partnership income. The partnership may not deduct any portion of a payment characterized as a distributive share; it simply reduces the distributive shares of the continuing partners.²³ A payment that is a distributive share is included in the recipient’s income for the tax year in which or with which the partnership’s tax year ends.²⁴ A guaranteed payment, includible in the recipient’s income, is deductible by the partnership.

In certain cases, an exiting partner may desire certainty as to the amount of payments she will receive. For example, an exiting partner might wish to receive 20% of gross sales for a certain number of years after her retirement. The Tax Court has ruled that a payment based on a percentage of gross revenue paid to a general partner is a distributive share rather than a guaranteed payment.²⁵ However, the IRS has ruled that an allocation of gross income can be a guaranteed payment.²⁶

This ambiguity with respect to allocating gross income to an exiting partner may present a planning opportunity when a liquidation is undertaken. For example, if a retiring partner has received an investment tax credit through the partnership that is subject to recapture, she must recapture a portion of the credit to the extent that her proportionate share of the partnership’s general profits is reduced by more than one-third.²⁷ If the liquidating payments are characterized as a distributive share of general profits and do not reduce the exiting partner’s profits interest by more than one-third, the exiting partner has no recapture, but the liquidation payments continue at the agreed-on level. If the payments extend beyond the period of recapture, an exiting partner has a permanent tax savings. If, however, the partner decides to sell the interest, she would be subject to the full recapture at the time of sale, forgoing the potential permanent tax savings that would have been achieved if her exit had instead been structured as a liquidation.²⁸ Thus, carefully planning the timing of liquidating payments may be useful for minimizing the recapture on outstanding investment tax credits.

In addition, it is worth pointing out that partners may modify liquidation agreements involving distributive shares, a point of flexibility not available once a sale has been consummated. For instance, the IRS has indicated that a liquidation agreement involving continuing payments of a distributive share to a retired partner can be converted to an agreement providing guaranteed payments without adverse tax consequences to any of the parties.²⁹

Differences in the identification of hot assets should also be considered when evaluating the tax consequences of liquidations compared with sales of partnership interests. “Hot assets” include partnership unrealized receivables and substantially appreciated inventory.³⁰ Unrealized receivables are rights to payments arising from goods and services delivered or to be delivered (e.g., trade accounts receivable of a cash basis taxpayer and commissions receivable by a broker for sales under contract to be closed in the near future).³¹ Inventory includes stock in trade and any other property that would not be treated as a capital asset at sale.³² The deemed sale (arising from either the sale of a partnership interest or a liquidating distribution to a partner) of hot assets generally gives rise to ordinary income, while amounts in excess of the hot assets are generally treated as in exchange for a capital asset. In the case of the liquidation of an exiting partner’s interest, inventory items are treated as hot assets only if the aggregate FMV of all inventory items exceeds the partnership’s aggregate tax basis in the inventory by more than 20%. In the case of the sale of a partnership interest, there is no minimum threshold for purposes of classifying inventory items as hot assets; if the FMV of a particular inventory item exceeds its adjusted basis, then that inventory item is a hot asset. This difference makes it more likely that ordinary income (from treatment as hot assets) will arise in the case of sales of partnership interests than in the case of liquidations of partnership interests.³³

A final important point of difference between sale and liquidation treatment concerns timing. In a two-person partnership, liquidation of one partner’s interest defers termination of the partnership until the final liquidating payment is made, whereas immediate termination of the partnership occurs when one partner purchases the other’s interest.³⁴ Thus, the timing of one partner’s exit from a two-partner partnership could produce different results depending on whether the exit is in the form of a sale or a liquidation. In many cases, liquidation will afford greater flexibility as to the date of the partnership’s termination than does the sale of a partnership interest.

Summary

This article has discussed the tax consequences of entity changes involving conversions to and from entities treated as partnerships for federal income tax purposes and sales and liquidations of a partner’s interest in a partnership. Taken together, the complexity of the holding period, basis, and gain or loss recognition rules in this area suggests that contemplated transactions deserve thoughtful planning to ensure that taxpayers’ tax positions and attributes are maximized.

For more information about this article, contact Mr. Sousa at jonathan.sousa@rsmi.com or Prof. Weiden at kweiden@mail.fairfield.edu.

Notes

¹ It is worth pointing out that immediately after B purchases A’s partnership interest and before the termination, B holds 100% of the interests in AB, of which 50% is his original interest and 50% is the “new” interest acquired from A.

² Rev. Rul. 99-6, 1999-1 CB 432.

³ McCauslen, 45 TC 588 (1966).

⁴ Rev. Rul. 67-65,1967-1 CB 168.

⁵ Rev. Rul. 2001-61, 2001-2 CB 573.

⁶ Rev. Rul. 99-5, 1999-1 CB 434.

⁷ Rev. Rul. 2001-61, 2001-2 CB 573.

⁸ Rev. Rul. 84-111, 1984-2 CB 88.

⁹ Rev. Rul. 70-239, 1970-1 CB 74.

¹⁰ Rev. Rul. 2004-59, 2004-1 CB 1050.

¹¹ Browning Ferris Indus., Inc., and Subs., 99 AFTR 2d 2007-1312 (Fed. Cl. 3/2/07).

¹² See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); Packard, 85 TC 397.

¹³ Rev. Rul. 83-155, 1983-2 CB 38.

¹⁴ Foster, 80 TC 34 (1983), aff’d 756 F2d 1430 (9th Cir. 1985).

¹⁵ See, e.g., Emory, 374 FSupp 1051 (D.C. Tenn. 1972), aff’d, 490 F2d 208 (6th Cir. 1974); Foxman, 41 TC 535 (1964), aff’d, 352 F2d 466 (3d Cir. 1965).

¹⁶ See, e.g., Foxman, 41 TC 535 (1964); Boland, TC Memo 1972-233, aff’d in unpublished op. (3d Cir. 1974); IRS Letter Ruling 9715008 (4/11/97).

¹⁷ See, e.g., Karan, 319 F2d 303 (7th Cir. 1963); IRS Letter Ruling 9715008 (4/11/97).

¹⁸ See, e.g., Miller, 181 Ct. Cls. 331 (1967); Cooney, 65 TC 101 (1975); Stilwell, 46 TC 247 (1966).

¹⁹ See, e.g., Kelly, TC Memo 1970-250.

²⁰ Foxman, 41 TC 535 (1964).

²¹ See, e.g., Miller, 181 Ct. Cls. 331 (1967); Zager, TC Memo 1987-107.

²² Sec. 736(a).

²³ Regs. Sec. 1.736-1(a)(4).

²⁴ Sec. 702; Regs. Sec. 1.736-1(a)(5).

²⁵ Pratt, 64 TC 203 (1975).

²⁶ Rev. Rul. 81-300, 1981-2 CB 143; Rev. Rul. 81-301, 1981-2 CB 144.

²⁷ Regs. Sec. 1.47-6(a)(2).

²⁸ Id.

²⁹ IRS Letter Ruling 7814026 (1/5/78); IRS Letter Ruling 7939099 (6/28/79).

³⁰ Sec. 751(b).

³¹ Sec. 751(c).

³² Sec. 751(d).

³³ Sec. 751.

³⁴ Regs. Sec. 1.736-1(a)(6).