The Partnership “Technical Termination” Trap

By Vadim Blikshteyn, Holtz Rubenstein Reminick LLP, New York City

Editor: Alan Wong, CPA

Partners & Partnerships

Given the expiring gift tax rules and uncertain economic climate, many U.S. taxpayers are either selling family businesses to a trust for the benefit of their children or selling them to pay down debt. Unknown to the sellers, and at times their advisers, are the tax consequences associated with disposing of a controlling partnership interest.

A sale or exchange of 50% or more of the total interest in a partnership’s capital and profits within a 12-month period causes the tax year of the partnership to close (Sec. 708(b)(1)(B)). This is commonly known as a “technical termination.” In a technical termination, the partnership’s tax year closes on the date of the sale or exchange, but the partnership continues as a legal entity with the same employer identification number.

A partnership undergoing a technical termination should review all the elections the old partnership made and decide whether the new partnership should renew or forfeit any previously irrevocable elections. Tax practitioners should also be aware of the various reporting requirements involved in preparing two short-year tax returns for a partnership undergoing a technical termination and the tax treatment of certain capitalized intangible assets upon partnership termination. If a technical termination results in late filing of the partnership’s tax return for the short year, the penalties that may apply can be severe. Those penalties are discussed below.

Triggering a Technical Termination

Many transactions involving partnership interests can cause a technical termination of a partnership. However, a partnership interest that is disposed of by gift or devise is not counted as a transaction that determines whether a technical termination has occurred (Regs. Sec. 1.708-1(b)(2)). Partner contributions that result in a change of partnership ownership, unless they are part of disguised sales, are also not included in the determination of whether a technical termination has occurred. Additionally, a partnership interest that is sold to another partner and then resold to another party is only counted once toward the determination of whether a 50% or more change in partnership capital and profit has occurred (Regs. Sec. 1.708-1(b)(2)).

Example 1: Partner A sells his entire 40% interest in partnership ABC to Partner B and as a result increases Partner B’s interest in partnership ABC to 45%. If two months later Partner B sells a 40% interest to Partner C, this does not cause a technical termination since only one 40% interest was sold within a 12-month period.

Example 2: Assume the same facts as in the previous example except that one month later, Partner D is admitted into ABC partnership with a 30% interest after he contributes $300,000, and two months later Partner D receives a distribution of $300,000. This disguised sale triggers a technical termination because a 70% change in partnership capital and profit has occurred.

Tax Consequences and Potential Benefits

When a partnership undergoes a technical termination, there is a deemed transfer of assets and liabilities from the “old” partnership to the “new” partnership in exchange for an interest in the new partnership (Regs. Sec. 1.708-1(b)(4)). Depreciable property deemed transferred from the old partnership to the new partnership is considered newly acquired property, and, as such, depreciation is restarted on the remaining basis the old partnership had in these assets (Sec. 168(i)(7)). Therefore, the new partnership may choose to depreciate property under a new depreciation method. Qualified property or 50% bonus depreciation property is eligible for an additional 50% bonus depreciation deduction in the first tax year of the new partnership (Regs. Sec. 1.168(k)-1(f)(1)(ii)).

The new partnership that is formed can decide whether to elect previously irrevocable elections such as the Sec. 754 election. The new partnership can choose its own inventory method, accounting method, and tax year end. However, some aspects of the terminated partnership’s elections carry over to the new partnership. Whether or not the new partnership decides to make a Sec. 754 election, existing Sec. 743 basis adjustments in property held by the old partnership that technically terminated retain their Sec. 743 basis adjustments in the new partnership (Regs. Sec. 1.743-1(h)(1)).

Additionally, the newly formed partnership can elect to amortize organizational or startup costs that may have been incurred after the change in ownership that caused the technical termination. Since the old partnership is considered to have terminated for federal income tax purposes, there is a question whether the unamortized portion of organizational and startup costs can be written off when the old partnership terminates. Similar to that of organizational and startup costs, it also may be reasonable to assert that the capitalized syndication costs of the old partnership can be written off upon termination. The AICPA has requested clarification from Treasury and the IRS in comments on these matters in response to Notice 2012-25 (Letter from the AICPA Tax Executive Committee, Recommendations for the 2012–13 Guidance Priority List (May 1, 2012)).

Tax Return Reporting

The partnership undergoing a technical termination has to file two short-year returns, and the date of the transaction involving a sale or exchange of partnership interest that triggers a technical termination becomes the close of the tax year for the old partnership. A partnership tax return is due 3½ months following the end of the month during which a partnership terminates. A separate extension can be filed to extend the due date of each respective short-period return by an additional five months.

The tax return of the old partnership should have the technical termination and final return boxes checked. Since, upon the technical termination of a partnership, it is deemed that the old partnership contributes all of its assets and liabilities to the new partnership, it is recommended that the ending balance sheet of the old partnership be zeroed out. A statement should be attached to the tax return explaining the transaction(s) that triggered the technical termination and showing what the ending balance sheet was immediately prior to the partnership termination. The Schedules K-1 of the partners of the old partnership should reflect zero ending capital accounts and should be marked final. The IRS K-1 instructions also state that once a partnership terminates, the ending percentages of each partner immediately before partnership termination should be reflected on Item J of each partner’s Schedule K-1.

Similar to the old partnership tax return, the new partnership tax return should have the technical termination and initial return boxes checked. The beginning balance sheet should reflect the balance sheet of the old partnership immediately before termination. Similarly, the beginning capital on Schedule M-2 of the new partnership tax return should reflect what the ending capital on Schedule M-2 of the old partnership was immediately before its termination. The Schedules K-1 of the partners of the new partnership should have their beginning percentages in Item J be consistent with the ending percentages on the Schedules K-1 of the old partnership, and beginning capital on Item L of their respective Schedules K-1 should reflect their ending capital accounts immediately before the old partnership’s termination.

It is also advised that each Schedule K-1 of the old and new partnership contain a statement that notifies the partners that a technical termination has occurred and that they will be receiving two short-year Schedules K-1. Furthermore, it is important to include in an attached Schedule K-1 statement the continuing partner’s proportionate share of any Sec. 754 adjusted basis property that will carry over to the new partnership from the terminating partnership.

Failure to File: Penalties and Other Drawbacks

Tax practitioners are advised to contact their clients during the tax year, as clients may not be aware that a technical termination in their partnerships may have occurred and that they may be exposed to various penalties. Taxpayers failing to file a timely partnership return may be subject to failure-to-file penalties, penalties for failure to furnish payee statements, and failure to take advantage of various timely tax elections.

The failure-to-file penalty (if reasonable cause cannot be established) is $195 for each month the partnership fails to file a timely tax return, multiplied by the number of partners in the partnership (Sec. 6698). The accrual of the failure-to-file penalty is limited to a period of 12 months. The penalty for failure to furnish a payee statement is $100 for each Schedule K-1 that is not timely or properly filed, but the total penalty cannot exceed $1,500,000 (Sec. 6722). It is also important to note that there may be significantly higher penalties for failing to timely file specific tax forms such as Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; Form 8938, Statement of Specified Foreign Financial Assets; Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), and other forms. Due to the exposure to punitive financial and potentially criminal penalties for willful disregard of filing requirements, it is important for all tax practitioners to educate clients about the potential pitfalls of technical terminations and the importance of tax planning for their partnerships.


Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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