The BBA’s ‘ceases-to-exist’ rule in partnership termination transactions

Editor: Christine M. Turgeon, CPA

Under the centralized partnership tax audit regime enacted as part of the Bipartisan Budget Act of 2015 (BBA), P.L. 114-74, the IRS now has authority to determine, assess, and collect tax on partnership underpayments at the partnership level. As a result, a buyer of a partnership interest faces potential tax exposure related to uncertain tax positions for preacquisition tax years that did not exist under the prior TEFRA (Tax Equity and Fiscal Responsibility Act, P.L. 97-248) audit regime. 

To mitigate risks related to tax liabilities for preacquisition periods, a buyer of a partnership interest could obtain some form of protection by negotiating either full indemnification for preacquisition taxes or, at a minimum, the contractual agreement of the seller to cooperate in making a “push-out” election under Sec. 6226. This election, which is required to be made within 45 days of the date that the IRS issues a notice of final partnership adjustment, ensures that any preacquisition taxes are borne by the historic partners. 

The termination of a partnership for federal income tax purposes generally has no impact for purposes of the BBA audit rules. However, if the acquired partnership is terminated in a subsequent tax year and the IRS determines under Sec. 6241(7) that the partnership “ceases to exist” for purposes of the BBA audit rules, then, absent a full tax indemnity, a buyer would be liable for any resulting underpayment of tax for a preacquisition tax year, notwithstanding having negotiated for push-out protection. 

In addition, in some transactions in which a buyer may desire to purchase all the partnership interests, the buyer may have to purchase a combination of unblocked partnership interests and the stock of a corporate-blocker partner. This would result in the partnership continuing in existence after the purchase. If the buyer later terminates the partnership by collapsing the ownership under a single entity, the partnership would terminate for federal income tax purposes under Sec. 708(b)(1). 

This item provides a brief overview of the “ceases-to-exist” rule in the context of partnership acquisitions in which a partnership may terminate under Sec. 708(b)(1) and discusses some practical solutions that a buyer may want to consider when purchasing partnership interests to avoid potential pitfalls under the rule. 

Overview of the ceases-to-exist rule 

Under Regs. Sec. 301.6241-3(b)(1), a partnership ceases to exist if the IRS determines that the partnership terminates within the meaning of Sec. 708 or because the partnership is unable to fully pay any underpayment amount due. During the examination process, the IRS may make the ceases-to-exist determination regardless of whether the partnership terminates for federal income tax purposes. 

Under Regs. Sec. 301.6241-3(a) (1), if the IRS determines a partnership ceases to exist before any partnership adjustment takes effect, the partnership adjustment is accounted for by the former partners as if the partnership had made a push-out election under Sec. 6226. Under Regs. Sec. 301.6241-3(d), when the partnership ceases to exist because the partnership terminates within the meaning of Sec. 708, the former partners are the partners during the last tax year that the entity filed a partnership return. While the question of how the IRS will exercise its discretion remains unclear, a ceases-to-exist determination is more likely to occur when the IRS finds that collecting from the entity itself is highly unlikely. 

Effect of ceases-to-exist determinations on partnership acquisitions 

The ceases-to-exist rule can result in surprising outcomes for the acquisition of target entities in partnership form, depending on whether a buyer acquires all the partnership interests directly or acquires ownership through a direct purchase of all the unblocked partnership interests and a purchase of all the stock of a corporate blocker partner, which is common in partnership acquisitions involving private-equity sellers.

Acquisition of all partnership interests: When a buyer acquires all the partnership interests of a target partnership in a Rev. Rul. 99-6 transaction, the termination of the target’s status as a partnership for U.S. federal income tax purposes and the effect of a push-out election could, considering the ceases-to-exist rule, be effective in shielding the buyer from liability for prior-year underpayments arising from the target entity. 

If a ceases-to-exist determination is made, any underpayment of tax is taken into account by the former partners (i.e., either partners from the underpayment tax year or the final year that the entity was a partnership), whether or not a push-out election is made. Because the buyer acquired all the partnership interests in the Rev. Rul. 99-6 transaction, the buyer would never be considered a partner and, therefore, would not be a partner in the final partnership return. Thus, only the sellers would be considered as former partners. 

However, if the IRS does not determine that the partnership ceases to exist for partnership audit purposes under Regs. Sec. 301.7701-2(c)(2)(iii) (A), the tax liability would stay at the now-disregarded entity, which is fully owned by the buyer. As such, a buyer would receive liability protection for any underpayment of tax for a preacquisition tax year only if the seller cooperates in the process of ensuring the partnership representative makes a push-out election. 

Acquisition of partnership interests and corporate partner’s stock: In other cases, to acquire the target partnership, a seller may require a buyer to purchase the stock of a corporate partner in addition to all the unblocked partnership interests. This transaction would mean that the partnership would remain in existence after the acquisition.

Then, if the buyer is a corporation, it may want to determine whether it should collapse the partnership’s ownership into a single partner, thereby terminating the partnership to avoid the administrative burden of maintaining it. This situation presents a potential trap for the unwary, especially if a push-out election is expected to provide protection against an IRS adjustment resulting from an imputed underpayment for a preacquisition tax year. 

If the buyer were to terminate the partnership in a post-acquisition tax year and if a ceases-to-exist determination is made, under Regs. Sec. 301.6241-3(d)(2), the buyer would be considered the former partner of the unblocked interests it acquired directly, because the partnership remained in existence post-acquisition. Additionally, the corporate partner, now owned by the buyer, would be a former partner as well. Therefore, the buyer would be liable for the entire imputed underpayment, even if it relates to a preacquisition period, regardless of whether a push-out election is made. 

To avoid this potential pitfall, the buyer could terminate the partnership in the tax year of the acquisition so that the sellers would be treated as former partners and have any potential imputed underpayment for a preacquisition year pushed out to them as the historic tax partners. However, this step could be difficult to accomplish if the acquisition happens close to the end of the partnership’s tax year. Additionally, when an underpayment is assessed in the tax year of the acquisition, both the buyer and the seller may be treated as former partners. Alternatively, the buyer could wait to terminate the partnership until after the statute of limitation on the assessment of tax has expired for the acquisition tax year. 

If a ceases-to-exist determination is not made, the underpayment again would stay at the entity unless the seller cooperates in making a push-out election to the historic partners. The buyer also would bear the tax costs for any imputed underpayment adjustment pushed out to the corporate partner, because the buyer would be the owner of that entity. To provide protection for the corporate blocker partner’s share of the adjustment, a buyer could negotiate for a tax indemnity because a push-out election would provide no protection to a buyer that must purchase the stock of a corporate partner. 

Negotiations in light of ceases-to-exist determination uncertainty 

While Treasury states that the regulations “make the ceases-to-exist rules more administrable for the IRS by eliminating any confusion about whether a partnership has ceased to exist” (T.D. 9844, Supplementary Information: Summary of Contents and Explanation of Revisions (preamble), §10.B.i), questions remain as to the circumstances in which the IRS would make a ceases-to-exist determination and how a buyer and seller should negotiate in light of this uncertainty. A buyer may point to the unfairness of holding a newcomer to the partnership liable for underpayment amounts arising from before their ownership as being in tension with other aspects of the Code. Nonetheless, the preamble points out that “the core feature of the centralized partnership audit regime is to provide a centralized method of examining items of a partnership” and that the centralized audit regime “results in efficiencies because one proceeding can be conducted that will bind all partners and the partnership” (id., §1). 

The BBA audit rules’ goals of administrative ease and ability to collect at the partnership level allow the IRS to exercise its discretion to make a ceases-to-exist determination if the partnership is unable to fully pay any underpayment amount due. Thus, a seller may point to the buyer’s ownership of the target partnership with presumably profitable operations as a more evident indicator of the entity’s ability to pay. In addition, a seller may note the process of open access and due diligence during negotiation that allowed the buyer to vet the potential existence of an underpayment amount in a prior year and negotiate for a purchase price reduction or an indemnification as a result. Thus, a buyer, in a sense, acquires the target on an “as-is” basis, and any subsequent underpayment amount could be characterized as a failure of the buyer’s due diligence. 

Considerations 

Along with indemnification and push-out elections, a buyer may seek protection through representation and warranty insurance, which can serve as a third-party indemnification against unforeseen liabilities in transactions and is becoming more common in market practice. A buyer also may try to implement a purchase price adjustment or suggest alternative structuring to facilitate the target acquisition if the buyer could be liable for preacquisition underpayments of tax. 

In light of the ceases-to-exist rule, the scope and accuracy of due diligence become pertinent, especially when buyers cannot negotiate for more explicit indemnity protection. Additionally, the rule illustrates potential negative tax consequences resulting from a seemingly innocuous tax-free transaction that collapses the partnership to avoid the administrative burden of operating as a partnership. 

Editor Notes

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 Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PricewaterhouseCoopers LLP.