Partnership Structural Changes: Deductibility of Expenses

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

Partnerships may be divided, combined, or otherwise restructured in order to meet a taxpayer’s goal of asset protection, succession planning, or wealth preservation. To complete the restructuring, the taxpayer will usually incur significant legal and accounting fees. These expenses likely comprise a combination of capital and deductible expenses, depending on the particular circumstances surrounding the restructuring.

Regs. Sec. 1.263(a)-5(a) requires a partnership to capitalize expenses paid to facilitate its restructuring, recapitalization, or reorganization. Sec. 709 carves out an exception to this rule and allows the partnership to deduct certain expenses incurred in the organization and creation of a new partnership. Consequently, it becomes important to determine whether the restructuring transactions create a new partnership or simply continue the original partnership. This item examines several partnership restructuring transactions and discusses the circumstances in which a restructuring expense can be deducted and amortized under Sec. 709 or must be capitalized under Regs. Sec. 1.263(a)-5(a).

Regs. Sec. 1.263(a)-5 Capitalization Requirement

In relevant part, Regs. Sec. 1.263(a)-5(a) requires the taxpayer to capitalize expenses incurred to facilitate (1) a restructuring, recapitalization, or reorganization of a business entity’s capital structure; (2) a Sec. 721 transfer; and (3) a formation or organization of a disregarded entity. The regulations explain that an amount is paid to facilitate one of the above transactions if, based on the facts and circumstances, it is “paid in the process of investigating or otherwise pursuing the transaction” (Regs. Sec. 1.263(a)-5(b)). The fact that an amount would (or would not) have been paid but for the transaction is relevant but does not determine the issue of whether an amount facilitates a transaction (Regs. Sec. 1.263(a)-5(b)). Regs. Sec. 1.263(a)-5(d) contains an exception for de minimis costs and states that amounts paid in the process of investigating or pursuing one of the above transactions will be treated as an amount that does not facilitate a capital transaction if, in the aggregate, the amounts do not exceed $5,000. Nevertheless, the taxpayer may still elect to capitalize de minimis costs under Regs. Sec. 1.263(a)-5(d)(4). Notwithstanding Regs. Sec. 1.263(a)-5(a), a partnership may still deduct certain expenses paid to facilitate its structural change if the deduction is specifically provided for by another provision of the Code (Regs. Sec. 1.263(a)-5(j)).

Sec. 709 Organizational Expenses

Sec. 709(b)(1) allows a partnership to deduct organizational expenses up to $5,000 (reduced by the amount that the expenses exceed $50,000) in the year in which the partnership begins an active trade or business. The partnership may then amortize any remaining organizational expenses over 180 months (Sec. 709(b)(1)). Sec. 709(b)(3) defines organizational expenses as expenditures that are (1) incident to the creation of a partnership; (2) chargeable to the partnership’s capital account; and (3) of a character that, if expended incident to the creation of a partnership having a limited life, would be amortizable over such life. In addition, the partnership must incur the expense at a reasonable time before the partnership begins business and before it files its first return (Regs. Sec. 1.709-2(a)). The regulations specify several organizational expenses, including legal fees for services incident to the organization of a partnership, such as preparation of a partnership agreement; accounting fees incident to the organization of the partnership; and filing fees (Regs. Sec. 1.709-2(a)).

Partnership Recapitalization

The IRS has determined that a partnership recapitalization does not terminate the existing partnership or create a new partnership. Under Sec. 708(a), an existing partnership is considered continuing if it is not terminated. In general, a partnership terminates only if:

• No part of the partnership’s business, financial operation, or venture continues to be carried on by any of its partners; or
• There is a sale or exchange of 50% or more of the partnership’s capital and profits interest (Sec. 708(b)(1)).

In Rev. Rul. 84-52, the IRS considered the tax treatment of a recapitalization in which a general partnership interest was converted to a limited partnership interest. The Service treated the transaction as a Sec. 721 contribution of general partnership interests to a limited partnership in exchange for limited partnership interests and concluded that the transaction did not constitute a sale or exchange for purposes of Sec. 708(b) because (1) the partnership’s business would continue after the conversion and (2) the transaction was governed by Sec. 721. The IRS later applied the same analysis to the conversion of a general partnership into a registered limited liability partnership and the conversion of a general partnership into a limited liability company taxed as a partnership (Rev. Ruls. 95-55 and 95-37).

Because the exchange of interests in a partnership recapitalization does not constitute a sale or exchange for purposes of a Sec. 708(b) partnership termination, Sec. 708(a) treats the existing partnership as continuing. Thus, a partnership recapitalization does not result in the creation of a new partnership. Consequently, the post-recapitalization partnership cannot deduct the costs associated with its organization under Sec. 709. Instead, the partnership must capitalize these expenses under Regs. Sec. 1.263(a)-5(a)(4) or (5).

Partnership Mergers and Consolidation

Depending on the particular facts, a partnership resulting from a merger or consolidation will be treated as either a new partnership or the continuation of one of the merged partnerships. When two or more partnerships merge, the merging partnerships terminate unless their members receive an interest of more than 50% in the capital and profits of the resulting partnership (Sec. 708(b)(2)(A) and Regs. Sec. 1.708-1(c)(1)). If the members of more than one of the merging or consolidating partnerships receive a greater than 50% interest in the resulting partnership, the continuing partnership is the partnership with the greatest net fair market value of assets (Regs. Secs. 1.708-1(c)(1) and (5), Example (1)). If none of the members of the merging or consolidating partnerships receives a greater than 50% interest in the resulting partnership, the resulting partnership is new (Sec. 1.708-1(c)(1)). Based on these rules, the resulting partnership may deduct and amortize its organizational expenses under Sec. 709 only when the merging or consolidated partnerships terminate and the resulting partnership is treated as a new partnership.

Example 1: A and B each own a 50% interest in the capital and profits of partnership AB, while C and D each own a 50% interest in the capital and profits of partnership CD. AB and CD merge to form partnership ABCD. After the merger, the partners have capital and profits interests in ABCD as follows: A, 30%; B, 30%; C, 20%; and D, 20%.

Given that A and B together own a greater than 50% interest in the capital and profits of partnership ABCD, ABCD is considered a continuation of partnership AB. Since ABCD is treated as a continuation of AB, the merger did not result in the creation of a new partnership. Consequently, ABCD is not eligible to deduct the costs associated with its organization under Sec. 709. These expenses must be capitalized under Regs. Sec. 1.263(a)-5(a)(4).

Example 2: Assume the same facts as in Example 1, except after the merger the partners each have a 25% capital and profits interest in ABCD. AB and CD terminate because neither A and B together nor C and D together have an interest greater than 50% in ABCD. Since both AB and CD terminate, the merger results in a new partnership. As a new partnership, ABCD can take advantage of the deduction and amortization provisions of Sec. 709. Still, ABCD must capitalize expenses of a nature that are beyond the scope of Sec. 709.

Partnership Division

As with mergers and consolidations, the partnerships resulting from a division can be a combination of new partnerships and/or continuations of the divided partnership, depending on the particular circumstances. When a partnership divides, the partnerships existing after the division are resulting partnerships if they have at least two members who were members of the divided partnership (Regs. Secs. 1.708-1(d)(1) and (d)(4)(iv)). The partnerships resulting from the division are continuations of the divided partnership if its members had a greater than 50% interest in the divided partnership’s capital and profits (Sec. 708(b)(2)(B)). Otherwise, the resulting partnerships are new (Regs. Sec. 1.708-1(d)(1)). As with merger and consolidation transactions, the new partnerships resulting from a division are eligible to deduct and amortize their organizational expenses under Sec. 709.

Example 3: Partnership ABCDE operates a citrus business. Before the division, the members have capital and profits interests in ABCDE as follows: A, 40%; B, 20%; C, 10%; D, 10%; and E, 20%. The members divide the business into its three distinct components. AB operates the farming business, CD operates the citrus processing business, and E operates the consulting business as E LLC, a single-member LLC. E later joins F to form EF LLC.

Both AB and CD are resulting partnerships because they contain two members of ABCDE; however, AB is the only continuing partnership because A and B together owned a greater than 50% interest in ABCDE’s capital and profits. As a continuing partnership, AB is not eligible to deduct the costs to facilitate its organization under Sec. 709; it must capitalize these expenses under Regs. Sec. 1.263(a)-5(a)(4). In contrast, C and D together owned less than a 50% interest in ABCDE’s capital and profits, so CD is treated as a new partnership. As such, it may deduct its organizational expenses under Sec. 709.

E is not a resulting partnership because it contains only one member of ABCDE. Further, as a single-member LLC, E is a disregarded entity and is unable to deduct its organizational expenses under Sec. 709. Later, when E joins F to create a new partnership, EF LLC can take advantage of Sec. 709.

Conclusion

The language in Regs. Sec. 1.263(a)-5 is quite encompassing as to the capitalization of expenses incurred to facilitate a change in the capital structure of a business entity. Still, partnership structural transactions can be highly fact specific, so the taxpayer may find relief from capitalization in other Code provisions, such as Sec. 709. Consequently, the actual tax treatment of expenses incurred during a partnership’s change in business structure will vary depending on the nature of the particular transaction. Practitioners should carefully consider Sec. 709 and other deduction provisions, as well as the nature of the transaction, when determining how to allocate expenses incurred in partnership restructuring transactions.

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EditorNotes

Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com