Determining If a Technical Termination Occurs

Editor: Albert B. Ellentuck, Esq.

For tax purposes, the termination of a partnership or an LLC classified as a partnership (collectively referred to here as an LLC) is triggered if there is a sale or exchange of 50% or more of the total interests in the LLC's capital and profits within a 12-month period (Sec. 708(b)(1)(B)). This type of termination is frequently referred to as a "technical termination" since it is seldom the members' intent to actually terminate the LLC. When an LLC terminates under these provisions, its assets are considered contributed tax free to a new LLC (under Sec. 721), and the interests in the new LLC are then deemed distributed to the members of the old LLC (Regs. Sec. 1.708-1(b)(4)).

Under these rules, there is no deemed distribution of "old" LLC assets to the members and no deemed recontribution of the assets to the "new" LLC. As a result, the "new" LLC's basis in its assets is identical to the basis of the assets in the "old" LLC.

The LLC's tax year closes on the date of the termination and the creation of a "new" LLC for federal tax purposes. Consequently, the new LLC must make new tax elections and adopt new tax accounting methods. For example, the "new" LLC must make a Sec. 754 election to cover post-termination exchanges of LLC interests. However, any member-specific basis adjustments resulting from Sec. 754 elections made prior to the technical termination carry over from the "old" LLC to the "new" LLC (Regs. Sec. 1.743-1(d)). A member with a special basis adjustment in property held by an LLC that terminates under the technical termination rules will continue to have the same special basis adjustment with respect to property deemed contributed by the terminated LLC to the new LLC, regardless of whether the new LLC makes a Sec. 754 election.

In addition, if an LLC is terminated by the sale or exchange of an interest, a Sec. 754 election made by the terminated LLC that is in effect for the tax year of the terminated LLC in which the sale occurs, applies to the incoming member (Regs. Sec. 1.708-1(b)(5)).

To determine if an LLC terminates, the practitioner must determine whether an LLC interest was disposed of in a "sale or exchange" as defined in the Sec. 708 regulations. If so, did the sale or exchange result in 50% or more of the total interests in LLC capital and profits being sold or exchanged during a consecutive 12-month period?

Sale or Exchange Under the Technical Termination Rules

The regulations do not define a sale or exchange for applying the Sec. 708 technical termination rules but instead specify certain transactions that are deemed not to be sales or exchanges, including (Regs. Sec. 1.708-1(b)(2)):

  1. A disposition of an LLC interest by gift, bequest, or inheritance (al though the distribution of property from an estate to satisfy a pecuniary bequest is considered an exchange);
  2. The liquidation of an LLC interest; and
  3. The acquisition of an LLC interest by contribution of property to the LLC.

Three other types of transactions are excluded from sale treatment, although they are not specifically excluded from the definition of a sale or exchange in the regulations. They are (1) charitable contributions of LLC interests (Letter Ruling 8228094); (2) certain distributions from a trust or estate (Senate Finance Committee Report to the Tax Reform Act of 1986, P.L. 99-514); and (3) transfers between spouses incident to a divorce (Sec. 1041(b)(1)). Additionally, the IRS has indicated that the conversion of one type of LLC interest into another type of LLC interest with different rights, preferences, privileges, or restrictions will not cause a technical termination where the conversion does not change any member's share of LLC capital or liabilities (Letter Ruling 200345007).

Other transfers of an LLC interest probably will be treated as a sale or exchange for Sec. 708 purposes, such as (1) a sale or exchange to another member of the LLC (Regs. Sec. 1.708-1(b)(2)) and (2) any distribution of an interest in an LLC (such as by a corporation) (Sec. 761(e)). In the latter case, a distribution of the LLC interest either to a parent corporation or to an existing or newly formed subsidiary that causes the LLC to terminate (assuming 50% or more of the profit and capital interests are involved) can be used when termination is desirable, without changing the owner's economic position.

Determining If 50% or More of Capital and Profits Interests Have Been Sold or Exchanged

Sec. 708 provides that the sale or exchange of 50% or more of the total interests in LLC capital and profits within a 12-month period triggers the termination of an LLC. This rule can apply to a single transfer or a series of transfers within the 12-month period. The 12-month period can be a single tax year, or it can include portions of two tax years. For an LLC termination to occur, the interests transferred must constitute 50% or more of both LLC capital and profits. Therefore, if a member sells a 60% interest in profits but only a 40% interest in capital, the LLC does not terminate because of that event.

Under Regs. Sec. 1.704-1(e)(1)(v), a member's interest in LLC capital is based on the portion of LLC assets that would be distributed to the member upon his withdrawal from the LLC or the LLC's liquidation. This amount may not be readily determinable if, for example, (1) the LLC operating agreement provides for a guaranteed return on the capital of some members but not others; (2) there is a gain chargeback provision; or (3) members previously contributed appreciated property to the LLC (which may result in a special allocation of gain under Sec. 704(c)). Except in simple arrangements, the only method to accurately determine a member's capital interest is to calculate the amount of capital that would be distributed to the member upon liquidation after a hypothetical sale of all LLC property for fair market value.

As difficult as it is to determine a member's interest in capital, it is just as difficult-if not more so-to determine a member's interest in profits. While there is no guidance in the Code or regulations, the "2008 Changes to Form 1065—Frequently Asked Questions" section of the IRS website provides information for calculating a partner's or member's share of profit, loss, and capital if the partnership agreement or operating agreement does not express a fixed percentage. In such cases, the partnership or LLC may use a reasonable method in arriving at such percentages as long as the method is consistent with the partnership or operating agreement and is consistently applied. Some suggested methods are to calculate (1) the ownership of capital based on the percentage of year-end capital accounts; (2) the owner's share of profits based on the percentage of items that increased capital accounts during the tax year (other than contributions); and (3) the owner's share of losses based on the percentage of items that decreased capital accounts during the tax year (other than distributions). Presumably, these same methods would be available under Sec. 708(b)(1)(B).

Practitioners should consider documenting the method used in the LLC's records and tax workpapers. If a transferring member's interest in LLC capital or profits is close to 50% or the calculation of the member's interest could result in either a less-than-50% or a 50%-or-more interest in capital and profits, the practitioner should be sure to document the calculation of the capital and profits interest transferred. If the IRS applies a different method to determine the member's interest and arrives at a different ownership percentage, the issue becomes one of valuation.

Multiple Sales Within a 12-Month Period

The technical termination rules of Sec. 708 apply to all transactions within a consecutive 12-month period-not a calendar or tax year. This can make detecting a technical termination difficult for the practitioner. The transfer of multiple interests during the 12-month period causes an LLC termination on the date the total interests transferred (in both profits and capital) equal or exceed 50%. However, the sale of the same interest two or more times during a 12-month period is only counted once in determining if a technical termination has occurred.

Example 1: F , G , and H are equal one-third members in J Investors LLC, a calendar-year LLC classified as a partnership for federal taxes. On Oct. 15, year 1, F sells his one-third interest to K . There is no LLC termination since the interest sold is less than 50%. On Feb. 15, year 2, H sells her one-third interest to L . J will terminate on Feb. 15, year 2, since two-thirds of the interests in LLC capital and profits have been sold during a consecutive 12-month period. If K instead of H had sold his LLC interest to L on Feb. 15, year 2, J would not have terminated. This is considered to be the sale of the same interest twice and does not result in a termination (Regs. Sec. 1.708-1(b)(2)).

Practice tip: The technical termination rules highlight the importance of communication between LLC clients and tax practitioners. If a 60% member in a calendar-year LLC sells his interest on March 15, a short-year tax return for the LLC is due on July 15. (An extension to file the short-period return can be obtained.) If the practitioner does not learn of the sale until the client brings in his tax return information in January, the short-period return invariably will be filed late. To prevent any inadvertent terminations, the practitioner may suggest the inclusion of a clause in the LLC agreement prohibiting a transfer unless an opinion is obtained from counsel that the transfer will not cause a technical termination, or the entity acquiesces to the transfer. The practitioner might also consider suggesting the inclusion of a provision in the agreement requiring the selling member to notify the entity of the sale of an interest and providing that failure to notify either nullifies the sale or requires the selling member to indemnify the LLC for any costs it incurs as a result of the sale.

Effect of Tiered Ownership Structures

Under Regs. Sec. 1.708-1(b)(2), if an upper-tier LLC or partnership holding an interest in a lower-tier LLC or partnership terminates, the upper-tier entity is treated as exchanging its entire interest in the capital and profits of the lower-tier entity. The regulation goes on to provide that if the sale or exchange of an interest in an upper-tier partnership or LLC does not terminate the upper-tier entity, the sale or exchange is not treated as a sale or exchange of a proportionate share of the upper-tier entity's interest in the capital and profits of the lower-tier entity.

Example 2: A , B , C , and D are equal 25% members of E Investors LLC, which is classified as a partnership for federal tax purposes. E owns a 75% interest in the capital and profits of F Realty LLC. A sale by A and B of their interests in E ( A' s 25% plus B' s 25%) will cause that LLC to terminate. Since the sale of A' s and B' s interests terminates E , E is deemed to have sold its 75% interest in F , causing a technical termination of F , too.

This case study has been adapted from PPC's Guide to Limited Liability Companies, 19th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Fort Worth, Texas, 2013 (800-323-8724;


Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.
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