Editor: Mo Bell-Jacobs, J.D.
Transactions between partnerships can result in situations where it may be unclear whether any of the partnerships involved terminate for federal tax purposes. Compounding this confusion is the disconnect between what may occur under state law and the fictional series of events deemed to occur for purposes of Subchapter K. These differences can lead to circumstances where a partnership may continue to exist for tax purposes even when it is dissolved under state law. This item discusses the rules and authorities related to partnership continuations and when they may apply.
When does a partnership continue? When does it terminate?
A partnership continues when it does not meet the definition of a termination under Sec. 708(a). A partnership terminates when no part of any businesses, financial operation, or venture of the partnership continues to be carried on by any of its partners in an entity taxed as a partnership (Sec. 708(b)). Consider the following example:
Example 1. “Drop down” continuation: A and B are the sole members of AB LLC, a limited liability company (LLC) taxed as a partnership. On April 30, 20X2, they transfer 100% of their units in AB to a new legal entity — CD LLC — in exchange for 100% of the units of CD. Immediately after the transaction, A and B are members in CD, which owns 100% of AB.
Although it appears that AB becomes a disregarded entity, the trade or business of AB continues to be carried on inside CD, which continues to be owned and operated by A and B. Since the reorganization of AB does not meet the definition of a termination, CD should be treated as a continuation of AB. A full-year partnership return is filed, as the restructure is disregarded for federal tax purposes (see Rev. Ruls. 84-52, 95-37, and 95-55). Going forward, A and B will file the return under the new business name CD LLC, but there is no requirement that the partnership obtain a new federal employer identification number.
Rev. Rul. 66-264
Partnership continuations may occur in more complex transactions than in Example 1.
Example 2. “Drop down” continuation of an operating partnership: A and B are members in OpCo LLC. The members are approached by Sponsor, a private-equity fund that is interested in acquiring a majority interest in OpCo. Sponsor forms NewCo LLC and funds it with cash. Immediately after the formation of NewCo, A and B contribute a percentage of their OpCo interests to NewCo in exchange for units totaling 10% of the value of NewCo. After the contribution, NewCo acquires the remaining partnership interests of OpCo from the members with cash. Following the transaction, NewCo is owned 90% by Sponsor and 5% equally byA and B. OpCo is owned 100% by NewCo.
This scenario is similar to Rev. Rul. 66-264, where a partnership with five owners sold all its assets pursuant to a court order. Three of the five partners funded a new partnership with cash and acquired the assets. The two exiting partners received cash. Since the newly formed partnership carried on the same business, the ruling held it was a continuation of the old partnership. The exiting partners were treated as selling their partnership interests to the continuing partners. The ruling echoes a fundamental principle of Sec. 708 — a partnership continues if it does not terminate.
In Example 2, there was a change in ownership but no substantial change to the underlying business activity. The business continues to be carried on by the original members in an entity taxed as a partnership. NewCo satisfies all the requirements for a “drop down” continuation. If NewCo is a continuation, a full-year partnership return is filed (presumably under the NewCo name), and A and B are deemed to sell 90% of their partnership interests to Sponsor.
Example 3. Comparison to Rev. Rul. 99-6: Assume the same facts as Example 2; however, the purchase agreement stipulates that the parties account for the transaction under Rev. Rul. 99-6, Situation 2.
The only factual difference here is the purchase agreement’s explicit application of Rev. Rul. 99-6. Under the Rev. Rul. 99-6 construction, NewCo would reflect the transaction as a purchase of a 90% fractional interest in each asset of OpCo for the cash purchase price. NewCo would take a carryover basis in the remaining 10% fractional interest of each asset contributed to NewCo by A and B.
It is not entirely clear whether Rev. Rul. 99-6 is intended to apply to a partnership continuation. The scope of the ruling is limited to transactions where a partnership terminates under Sec. 708(b)(1)(A) under two sets of specific factual situations involving a taxable acquisition. Neither situation discussed in the ruling addresses situations where Sec. 708(a) applies.
The underlying fundamentals of Rev. Rul. 66-264 and Rev. Rul. 99-6 seem somewhat mutually exclusive. Each ruling aligns better with a specific set of facts. To that end, where one applies, the other feels inherently less applicable. Nevertheless, it is not uncommon to see purchase agreements that contain an “intended tax treatment” section, which may specify that a transaction that would result in the continuation of a partnership be accounted for under the mechanics of Rev. Rul. 99-6. Although these provisions in agreements can provide directional guidance, the IRS is not bound by the parties’ agreed-upon treatment. Keep in mind that on examination the IRS may seek to recast a transaction based upon all relevant facts and circumstances.
Partnership continuations from mergers
Rev. Rul. 66-264 is helpful in summarizing the relevant rules and consequences of partnership “drop down” continuations. However, it has a narrow scope; not every transaction will fit within the ruling’s framework. Fortunately, an additional ruleset is available to look to for guidance where the ruling does not apply.
Example 4. Continuations between “old and cold” partnerships: A and B are equal members in AB LLC, a widget manufacturer. The members are approached by their largest competitor, CD LLC, with an offer to acquire their business. Under the agreement, CD will give A and B a cash payment equal to 80% of the value of AB and a rollover interest worth 20% of the total capital and profits of CD. Immediately after the transaction, AB will liquidate.
The consolidation of AB and CD appears similar to the facts of Rev. Rul. 66-264. Immediately after the transaction, A and B remain direct partners in a partnership that carries on the trade or business of AB. Given the similarities, it is not unreasonable to immediately assume CD is a continuation of AB. However, nuanced differences may change the analysis. Here, CD is an existing, “old and cold” partnership with its own widget fabrication trade. Does the existence of a CD trade or business create a need for further analysis?
The framework that makes the most sense to apply when evaluating a transaction where multiple “old and cold” partnerships become a single partnership is the merger rules of Regs. Sec. 1.708-1(c). If the merger rules apply, the determinations related to partnership continuations are made by reference to a set of mechanical rules. These rules determine which (if any) partnership is a continuation, based on the ownership of the post-merger partnership or on the net fair market value of the assets contributed by each of the consolidating partnerships. If none of the members of the consolidating partnerships own more than 50% of the capital and profits, both partnerships are deemed to terminate on the date of the merger, with the resulting partnership treated as newly formed.
In Example 4, A and B’s ownership in the capital and profits of the post-merger entity is only 20%. The remaining 80% is owned by CD’s historic partners. Under the merger rules, AB terminates in the transaction because AB’s partners own 50% or less of the capital and profits of the post-merger partnership. Since CD’s historic partners retain the remaining 80%, CD is the continuing partnership, which files a full-year return accordingly.
Example 5: Comparison to Rev. Rul. 99-6: Assume the same facts as Example 4, except the purchase agreement specifies Rev. Rul. 99-6, Situation 2, is intended to apply to the transaction.
Again, it is unclear if the application of Rev. Rul. 99-6 makes sense where partners of the target partnership continue to be partners in the acquiring partnership. The merger rules already discuss how to account for a consolidation of multiple partnerships. The transaction pattern that best fits Rev. Rul. 99-6 is one where there is no continuity of ownership in the continuing partnership. For example, if CD acquired 100% of the AB partnership interests for cash, then the transaction is consistent with Situation 2 of Rev. Rul. 99-6.
Determine which rules apply to the facts
Whether partnerships terminate or continue for federal tax purposes is not always cut and dried. The tax consequences of a transaction may not even align with state law. In addition, the fact patterns of a partnership continuation transaction may brush up against other rulings, so it is important to identify which set of rules best applies to an underlying transaction.
Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP. Contributors are members of or associated with RSM US LLP. For additional information about this item, contact Mike Laier, CPA (Mike.Laier@rsmus.com), Chicago.