Editor: Christine M. Turgeon, CPA
The issue of whether a partnership continues or terminates for U.S. federal income tax purposes frequently arises in restructuring transactions. In some instances, it may be desirable for a partnership to terminate rather than to continue in the context of a sale of the business or a restructuring transaction. For example, buyers may not want the partnership to continue if they do not want to inherit existing elections or Sec. 704(c) methods of the target partnership.
In other contexts, it may be desirable for the partnership to continue for U.S. federal income tax purposes through a restructuring because a termination would require a closing of the partnership's tax year, terminate existing tax elections and accounting methods of the partnership, and affect the depreciation of partnership property. A termination also would change the application of Sec. 163(j) and limitations on the deductibility of interest, affect partnership audits and litigation under the Bipartisan Budget Act of 2015, P.L. 114-74, and restart a seven-year window for purposes of the Sec. 704(c)(1)(B) and Sec. 737 mixing-bowl rules.
Continuity requirements
Ultimately, the tax consequences of a particular transaction — including whether a partnership continues or is terminated — depend on the application of Sec. 708(a), which simply provides that a partnership continues unless it is terminated. A partnership terminates for this purpose only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership (Sec. 708(b)(1)). Said differently, if any part of any business or venture of the pre-transaction partnership continues to be carried on by any partner in a partnership, the pre-transaction partnership continues for federal tax purposes under Sec. 708(a).
While the statutory language of Sec. 708(a) appears clear, the termination rule of Sec. 708(b)(1) lacks an identifiable quantum of continuity of interests and continuity of enterprise upon which a taxpayer can securely rely for tax planning purposes. Assume an existing partnership undergoes a restructuring transaction in which the interests of two partners are redeemed and the remaining two partners contribute their partnership interests to a newly formed partnership that continues the business of the pre-transaction partnership. Even though the new partnership embodies a different legal entity than the pre-transaction partnership, the pre-transaction partnership is not terminated and is deemed to continue under Sec. 708(a) because its business continues to be carried on by "any" of its partners in a partnership (Rev. Rul. 66-264). The statute does not identify a specific amount of continued ownership required to avoid a termination under Sec. 708(b)(1). Therefore, the result seems to be the same whether a 5% partner in the pre-transaction partnership or a 95% partner in the pre-transaction partnership continued as a partner in the new partnership.
If a partner in the pre-transaction partnership continues its interest in the new partnership indirectly (e.g., through ownership in another partnership), would the continuity-of-interest rule of Sec. 708(b)(1) be satisfied? The plain language of Sec. 708(b)(1) might not be construed to permit a partnership to be viewed as a continuation where the partners in the pre-transaction partnership are merely indirect partners in the post-transaction partnership. If a partnership could be treated as a continuation when any pre-transaction partner is merely an indirect partner in the post-transaction partnership, every contribution of assets into a lower-tier partnership might be deemed to result in the lower-tier partnership's being a continuation of the contributing partnership (and a continuation of itself if it was not newly formed). Thus, remote continuity could be viewed as insufficient for a partnership to continue under Sec. 708(a).
With respect to the continuity-of-business rule of Sec. 708(b)(1), the statute requires that "any of its partners" continue "any business, financial operation, or venture of the partnership" through a partnership. The provision contains no stated threshold or quantum of activity required to find a continuation of a pre-transaction partnership's business by a post-transaction partnership. Thus, it remains unclear whether an upper-tier partnership that continues to own an indirect interest in a post-transaction partnership that continues the business of the pre-transaction partnership would satisfy the statutory business-continuity requirement to support a continuation.
Some might view the Sec. 708(a) termination rule as based on the treatment of a partnership as an entity for U.S. federal income tax purposes. Under Subchapter K of the Code, for various purposes, a partnership is considered to be either an aggregate of its partners or an entity. Generally, Subchapter K adopts an entity approach with respect to transactions involving partnership interests (Rev. Rul. 75-62). Whether an aggregate or entity theory of partnerships should be applied under a specific Code section depends on which theory is deemed more appropriate to that section (S. Rep't No. 1622, 83d Cong., 2d Sess. 89 (1954), and H.R. Conf. Rep't No. 2543, 83d Cong., 2d Sess. 59 (1954); Casel, 79 T.C. 424 (1982)).
The continuation of a partnership under Sec. 708(a) depends on whether any business of the partnership is carried on by any of its partners in a partnership. Therefore, because Sec. 708(a) is an entity-oriented provision, an entity approach may be considered more appropriate (Rev. Rul. 87-51). This view could support an argument that the continuity-of-interest rule of Sec. 708(a) is satisfied only with respect to direct interests in a partnership retained by any partner in the pre-transaction partnership. This approach also might support an argument that the business-continuity requirement should be deemed satisfied only if the post-transaction partnership continues any business or enterprise of the pre-transaction partnership directly.
Planning considerations
Despite the absence of bright-line rules, a taxpayer could consider certain actions in seeking to mitigate the potential uncertainty in this area of U.S. federal income tax law and to support the desired U.S. federal income tax treatment of a specific transaction as either a continuation or termination of a partnership under Sec. 708 for U.S. federal income tax purposes.
Example: Partnership X, whose partners are P1 and P2, undergoes a restructuring in which P2 contributes its X interests to Partnership Y, a newly formed partnership, in exchange for Y interests. Partnership Y's partners include P3 and P4. Partnership Y contributes the X interests to Partnership Z, also a newly formed partnership, in exchange for Z interests. Partnership Z's partners are Partnership Y and Partner P4. Partnership Z purchases the remaining interests in Partnership X from P1 for cash. As a result, Partnership Z owns all interests in Partnership X, and Partnership Z continues the business of Partnership X following the restructuring.
Would Partnership X be considered terminated for U.S. federal income tax purposes under Sec. 708(b)(1) as a result of the restructuring? As discussed above, P2's remote continuity of interest in Partnership Z (through its interest in Partnership Y) may not be deemed sufficient to support a continuation under Sec. 708(a). Here, the parties to the restructuring intended for Partnership X to terminate under Sec. 708(a) for U.S. federal income tax purposes as a result of the transaction. While Partnership Z continues the business of Partnership X, none of Partnership X's partners are in PartnershipZ.
Because these rules are ambiguous, taxpayers might be able to structure their transactions in a manner to support arguments for the intended U.S. federal income tax treatment of a transaction, subject to general requirements around business purpose and economic substance. If the parties to the restructuring in the example above had intended for Partnership X to continue for U.S. federal income tax purposes, they could have (1) made P2 a direct partner in Partnership Z or (2) had Partnership Y continue the business of Partnership X by retaining the interests in Partnership X contributed by P2 and having Y acquire the remaining interests in Partnership X fromP1.
EditorNotes
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or christine.turgeon@pwc.com.
Contributors are members of or associated with PricewaterhouseCoopers LLP.
