Editor: Christine M. Turgeon, CPA
Determining when a partnership terminates is a fundamental question under Subchapter K. However, it can be difficult to determine whether a partnership that retains de minimis assets or performs administrative functions during its winding-up period terminates, particularly if such activities cross tax years. This item provides a brief overview of the relevant authorities and discusses the uncertainty for taxpayers.
Overview of authority
Sec. 708(a) provides that a partnership continues unless it is terminated. Sec. 708(b)(1) states that a partnership is considered terminated 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. Expanding on the statute, Regs. Sec. 1.708-1(b)(3)(i) provides that a partnership generally should not be treated as terminated until the winding up of the partnership's affairs is completed. Neither the Code nor the regulations define the winding-up period.
Additionally, outside Sec. 708, the regulations under Secs. 736 and 761 suggest that a partnership should not terminate until its last liquidating distribution is made. For example, a partnership interest is not liquidated until the final payment is made (Regs. Sec. 1.761-1(d)), and a two-person partnership is not considered terminated until the retiring partner's entire interest is liquidated (Regs. Sec. 1.736-1(a)(6)).
While the statutory language provides a straightforward rule — a partnership is terminated after it ceases its business operations and has wound up its affairs — the practical mechanics of a partnership winding up make this rule difficult to apply when any level of activity or partnership asset remains. Additionally, inconsistent application of this provision by courts adds to the confusion.
In Harbor Cove Marina Partners Partnership, 123 T.C. 64 (2004), the Tax Court applied Sec. 708 and held that a partnership was not terminated until all its assets were distributed. The court emphasized that even de minimis activities prevent a partnership from terminating, noting that the partnership's business operations were not completed as of the end of that year because a partner was legitimately challenging the procedures used by the managing general partner in winding up the partnership's business. Therefore, a resolution of that lawsuit could reasonably lead to the partnership's reporting in a subsequent year significant income, credit, gain, loss, or deduction. In addition, the court distinguished dissolutions under state law from actual terminations, finding the partnership's legal status under local law irrelevant to determining whether the partnership terminated under Sec. 708.
The Tax Court took the same bright-line approach in a tax shelter case, 7050, Ltd., T.C. Memo. 2008-112. The court concluded that an inactive currency account was enough to prevent the partnership from terminating, despite the taxpayer's assertion that the partnership's business had completely ceased operations and that he had received a liquidating distribution.
Conversely, other courts have rejected a bright-line approach and instead focused on when the partnership ceased its business operations. In an unpublished opinion, the Sixth Circuit in Goulder,64 F.3d 663 (6th Cir. 1995), held that a partnership had terminated in a prior year despite the retention of certain security deposits. The parties stipulated that the partnership did not operate or carry on any business, which the court found sufficient to hold that the partnership had terminated under Sec. 708. Further, the court stated that "there is no per se rule that the mere retention of certain assets or management of particular activities in anticipation of liabilities amounts to a continuation of a partnership. . . . To the contrary, those cases holding that a partnership remained active feature far more activity" (citing Barran, 334 F.2d 58 (5th Cir. 1964), and La Rue, 90 T.C. 465 (1988)).
The IRS appeared to straddle this same uncertain line as to when a partnership is considered to terminate under Sec. 708 in Letter Ruling 201244004. There, the IRS ruled that a partnership terminated when it sold all its assets but retained a portion of the cash proceeds in a liquidating trust to satisfy future contingent liabilities. The IRS cited both Harbor Cove and Goulder but did not explicitly distinguish them; however, the IRS noted specifically that the parties in Goulder stipulated the partnership did not operate or carry on "any business, financial operation or venture" after the year when the termination was deemed to occur. While unclear, this suggests that the IRS might apply the Goulder standard if the partnership undisputedly ceased its business operations.
As described above, the Code and regulations do not specify how much activity during a partnership's winding-up period could run afoul of the statutory termination requirement that "no part of any business, financial operation, or venture of the partnership" is carried on. To fill in the gap, the courts in Harbor Cove and 7050, Ltd. took a bright-line approach that would prevent a partnership from terminating for tax purposes until the moment it was completely dissolved, thereby extending the partnership's life in the case of de minimis activities or forgotten bank accounts. On the other hand, Goulder (and perhaps the IRS in Letter Ruling 201244004) applied a more flexible test that would treat a partnership as terminated when the business activities of the partnership had sufficiently ceased, notwithstanding the existence of de minimis activities.
Uncertainties in practice
The winding up of a partnership generally consists of a period during which the partnership makes its final distributions, satisfies its remaining debt, pays liquidation expenses, closes its accounts, and files its final tax return. The Sec. 708 regulations state that a partnership is not terminated until the winding-up period has completed, but they do not define when that period ends. Taking into account the authorities described above, taxpayers are left without clear guidance on how to determine when a partnership is terminated where, for example, administrative activities and de minimis accounts extend into new tax years.
Take, for example, the existence of an open bank account. The 7050, Ltd. opinion suggests that the mere existence of a bank account can cause the partnership to continue for tax purposes even though no business activities are being conducted. Under this view, post-final distribution escrow accounts, accounts payable holdbacks, payments to service providers, and similar items would, under a bright-line test, prevent a partnership from being considered terminated even when no business activities occur. Perhaps this view reflects a statutory preference for partnership continuations. But it also can create traps for the unwary, as taxpayers may not expect this result when the partnership has ceased its business operations and when a certain amount of planning, such as in Letter Ruling 201244004, might allow the taxpayer to achieve its desired result.
However, under the substance-based interpretation of Goulder, de minimis administrative items may not prevent the partnership from being viewed as terminated for tax purposes, provided the business operations have sufficiently concluded. This view would provide greater flexibility to taxpayers whose winding-up activities may extend beyond the cessation of the partnership's business and allow for leniency in performing administrative tasks without their timing having an effect on the underlying liquidation (e.g., timing of income items).
Although not discussed in the opinions cited above, the definition of a partnership set forth in Culbertson,337 U.S. 733 (1949),and Luna,42 T.C. 1067 (1964), also may be relevant in this context. Specifically, if the partners cease business operations and demonstrate an objective intent to no longer operate the partnership for the joint pursuit of profit, these authorities may support a position that the entity ceases to be a partnership for U.S. tax purposes as of the point the requisite intent can be established. This view more closely aligns with Goulder but perhaps is inconsistent with Sec. 708's continuation preference.
Taxpayers also face uncertainty if they wish to continue a partnership's tax existence after ceasing its business activity. In that case, a taxpayer may not have certainty, for example, as to whether retaining a bank account would be deemed sufficient to sustain the existence of the partnership under Sec. 708 and thus may need to continue to materially operate its business (e.g., try to collect on receivables) to accomplish its desired result.
From a taxpayer's perspective, this uncertainty can have a significant impact on the tax treatment of a partnership dissolution that goes beyond the determination of when to file the final tax return. A misunderstanding of the rules can lead to a material impact on the taxpayer, resulting in, for example, gain or loss being shifted to a subsequent tax year, resulting in less tax benefit. Given the importance of these issues, it is equally important that taxpayers be able to determine with certainty whether a partnership has terminated.
Uncertainty and challenges with either approach
The authorities on partnership terminations may leave taxpayers uncertain of whether a partnership has terminated for purposes of Sec. 708, which may have significant auxiliary tax consequences. The bright-line approach may seem relatively simple to apply but presents challenges to taxpayers in the context of administrative errors or prolonged windups. While the more flexible approach can provide leniency, it may be more difficult for taxpayers to navigate.
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 email@example.com.
Contributors are members of or associated with PricewaterhouseCoopers LLP.