Structuring partnership mergers

Editor: Christine M. Turgeon, CPA

Because many companies operate in partnership form, mergers under Sec. 708(b)(2)(A) are common among today’s merger–and–acquisition deals. These transactions frequently occur when a private–equity (PE) buyer already holds a portfolio of companies operating in a similar line of business through a partnership.

When a PE buyer identifies a new target business operating as a partnership, an add–on acquisition of the target to the PE buyer’s existing portfolio commonly may be structured through a merger of the target partnership into the PE buyer’s holding partnership. These mergers often involve consideration of both cash and interests in the PE buyer’s existing holding partnership. If the deal is not carefully structured, however, tax implications could arise for the target partnership’s partners and the PE buyer.

This item provides an overview of potential issues to consider when structuring an acquisition of a partnership target through a partnership merger transaction.

Partnership mergers in general

Regs. Sec. 1.708–1(c) contains the regulatory framework for partnership mergers under Sec. 708(b)(2)(A), but neither the statute nor the regulations define what constitutes a merger. The statute and the regulations provide that if two or more partnerships merge into one partnership, the resulting partnership will be considered a continuation of the merging partnership if the continuing partners own an interest of more than 50% in the capital and profits of the resulting partnership.

If the resulting partnership can be considered a continuation of more than one of the merging partnerships, it will be considered the continuation of the partnership contributing the greatest fair market value (FMV) (net of liabilities), and any other merging partnerships will be considered terminated. If the members of none of the merging partnerships have an interest of more than 50% in the capital and profits of the resulting partnership, all the merged partnerships will be terminated, and a new partnership will result.

State law does not control which partnerships are treated as terminating and resulting; therefore, a transaction treated under state law as Partnership A transferring assets to Partnership B could be treated as the reverse (i.e., Partnership B transferring assets to Partnership A) for federal income tax purposes.

Merger forms

The regulations provide for two forms of mergers — assets–over and assets–up.

Assets–over: Under the assets–over form, the merged partnership that is considered terminated contributes all of its assets and liabilities to the resulting partnership in exchange for an interest in the resulting partnership, and immediately thereafter, the terminated partnership distributes interests in the resulting partnership to its partners in liquidation of the terminated partnership. Any partnership merger that does not undertake the assets–up form is treated as undertaking the assets–over form.

Assets–up: Under the assets–up form, the merged partnership that is considered terminated distributes all of its assets to its partners in liquidation of the partners’ interests in the terminated partnership, and immediately thereafter, the partners in the terminated partnership contribute the distributed assets to the resulting partnership in exchange for interests in the resulting partnership. This form requires the partnership to legally effectuate the transaction as prescribed (i.e., the partnership must legally transfer its assets to the partners, followed by the partners’ contribution of the assets to the resulting partnership).

The assets–over form is more prevalent because the assets–up form imposes the additional administrative burden of having to retitle assets in the name of the partners. Under one possible approach based on Regs. Sec. 1.708–1(c)(3)(ii), a series of actions that potentially could qualify under the assets–up form as a partnership legally transferring all its assets to its partners includes: (1) the partnership drops all of its assets and liabilities into a newly formed disregarded entity; (2) the partnership legally distributes that disregarded entity to its partners; and (3) the partners contribute their interests in the disregarded entity to the resulting partnership. However, the regulations do not specifically address this fact pattern.

Merger cash-out rule

The merger regulations contain a special rule (Regs. Sec. 1.708–1(c)(4)) in which a sale of all or part of a partner’s interest in the terminated partnership to the resulting partnership will be respected as a sale of a partnership interest (the merger cash–out rule). Under this rule, the following actions are deemed to occur:

1. The resulting partnership purchases interests in the terminating partnership from the selling partner immediately before the merger;
2. The terminating partnership contributes its assets and liabilities attributable to the nonselling partners to the resulting partnership in exchange for resulting partnership interests (creating transitory “hook ownership”);
3. Immediately thereafter, the terminating partnership distributes its interests in the resulting partnership to the nonselling partners; and
4. Simultaneously with step 3, the terminating partnership distributes assets attributable to the interests purchased by the resulting partnership from the selling partner to the resulting partnership.

The merger cash–out rule requires the merger agreement (or another document) to specify (1) that the resulting partnership is purchasing interests from a particular partner in the merging partnership and (2) the consideration transferred for each interest sold. In addition, the selling partner needs to consent to treat the transaction as a sale of the partnership interest. Provided the merger agreement satisfies these requirements, the merger cash–out rule will apply even if the cash consideration is received by the terminating partnership from the resulting partnership and distributed to the selling partner immediately before the merger (see Regs. Sec. 1.708–1(b)(5), Example (5)).

The preamble to the proposed regulations that introduced this provision (REG–111119–99) describes the purpose of the merger cash–out rule to permit the buyout of certain terminating partnership partners with cash from the resulting partnership and to permit other terminating partnership partners to continue in the business without recognizing gain under the Sec. 707(a)(2)(B) disguised–sale rules.

Tax considerations

Example 1. Assets–over merger without the merger cash–out rule: ABCD LLC is an operating business that was formed in 1990 and classified as a partnership for federal income tax purposes. ABCD has four equal partners, A, B, C, and D. The four partners have agreed for ABCD to be acquired by a PE buyer for cash and partnership interests in the PE buyer’s holding company partnership (PE Holdco). Collectively, the partners of ABCD will own 25% of the interests in the capital and profits of PE Holdco. In connection with the transaction, A and B desire to be completely cashed out of the business with cash from PE Holdco, while C and D desire not to recognize any gain from the transaction. The parties enter into a merger agreement and do not effectuate the legal transfer of assets from ABCD to its partners; therefore, the transaction will be treated as an assets–over merger.

ABCD first will be treated as contributing all its assets and liabilities to PE Holdco in exchange for PE Holdco interests and cash. The receipt of the cash will result in the transaction’s being bifurcated into part contribution under Sec. 721(a) and part disguised sale of assets between ABCD and PE Holdco under Sec. 707(a)(2)(B). The portion of assets treated as sold by ABCD to PE Holdco in the disguised sale is equal to the ratio of the cash received over the total FMV of the assets contributed to PE Holdco (sale percentage). The portion of the assets not treated as sold in the disguised sale will be treated as contributed by ABCD to PE Holdco in the merger.

ABCD will recognize gain for the portion of the transaction that is treated as a disguised sale. This gain is equal to the cash received less the tax basis in the portion of the assets attributable to the disguised sale (this tax basis amount is determined by taking the total tax basis in all the contributed assets and multiplying it by the sale percentage). The resulting gain will be allocated among all of ABCD’s partners under Sec. 704(b), which creates an unfavorable result for C and D because they will be allocated a share of this gain even though they are not cashing out in the transaction. PE Holdco will receive a cost basis under Sec. 1012 in the portion of the assets acquired. Any depreciation or amortization from the acquired assets will be common basis of PE Holdco and shared among all its partners. The antichurning rules under Sec. 197(f)(9) should be considered with respect to any purchased goodwill because C and D will continue to be partners in PE Holdco.

The assets that are not deemed sold will retain their characterization as contributed assets; therefore, Sec. 721(a) and its exceptions to nonrecognition treatment will need to be considered. In addition, the disguised–sale rules under Regs. Sec. 1.707–5 should be analyzed for any of ABCD’s liabilities assumed by PE Holdco.

A new forward Sec. 704(c) layer (i.e., an amount equal to the disparity between the tax basis and the FMV of ABCD’s contributed assets at the time of the merger) will be created with respect to ABCD’s Sec. 721(a) contribution to PE Holdco. A reverse Sec. 704(c) layer (i.e., an amount equal to the disparity between the tax basis and the increase in the FMV of PE Holdco’s assets since its formation or last Sec. 704(b) revaluation) from a Sec. 704(b) revaluation could occur at PE Holdco to lock in any unrealized gain or loss for the partners of PE Holdco immediately prior to the merger. The Sec. 704(c) method chosen to recognize the forward and reverse layers should be negotiated and modeled by both ABCD and PE Holdco.

Following the contribution, ABCD will distribute its interests in PE Holdco to C and D in liquidation. C and D will determine their adjusted basis in the PE Holdco interests received from ABCD under Sec. 732(b) and will step into the shoes of ABCD’s Sec. 704(c) forward layer under Regs. Sec. 1.704–3(a)(7). C and D also will need to consider potential implications under Secs. 704(c)(1)(B) and 737 if the ABCD assets that comprise the forward layer are distributed out of PE Holdco within seven years of the merger.

Example 2. Assets-over merger with the merger cash-out rule: What if the parties instead agreed to treat the transaction under the assets–over form and to apply the merger cash–out rule with respect to A’s and B’s interests?

First, PE Holdco will be treated as purchasing A’s and B’s interests in ABCD. A and B will determine the character of their gain or loss from the sale under Secs. 741 and 751. C and D will not recognize any gain or loss from the sale.

PE Holdco’s adjusted basis in ABCD will be determined under Sec. 742 (i.e., cost basis). If ABCD has a Sec. 754 election in effect or makes one in connection with the transaction, then PE Holdco will compute a Sec. 743(b) adjustment to its share of the adjusted basis of assets of ABCD. This Sec. 743(b) adjustment will be converted to common basis of PE Holdco following the liquidation of ABCD in subsequent steps; therefore, any depreciation or amortization related to the adjustment will be shared among all its partners.

If a PE sponsor desires a step–up that is not common basis, alternative acquisition structures would need to be considered (e.g., purchase partnership interests in ABCD, but ABCD remains in existence after the transaction). The antichurning rules under Sec. 197(f)(9) should be considered with respect to the purchased intangible assets because C and D will continue to be partners in PE Holdco.

ABCD then will be treated as contributing the assets and liabilities attributable to C’s and D’s interests to PE Holdco in exchange for PE Holdco interests. Following the contribution, ABCD simultaneously distributes (1) its interests in PE Holdco to C and D and (2) its assets attributable to the interests PE Holdco purchased from A and B in liquidation. C, D, and PE Holdco will determine their adjusted bases in the PE Holdco interests and ABCD assets received from ABCD, respectively, under Sec. 732(b). PE Holdco will consider its Sec. 743(b) adjustment in the ABCD assets when performing its Sec. 732(b) calculations under Regs. Sec. 1.732–2(b). The tax considerations for ABCD under Secs. 721(a) and 707, as well as the implications under Sec. 704(c) for both parties, should be the same as in the example without the merger cash–out rule.

Other considerations

Tax reporting: The tax year for any terminating partnership is closed on the date of the merger under Sec. 706(c)(2), and the terminating partnership is required to file its return ending on that date.

The resulting partnership is required to file its return for the partnership that is considered as continuing. The return should indicate that the resulting partnership is a continuation, retain the employer identification number (EIN) of the continuing partnership, and include the names, addresses, and EINs of any other merged partnerships. The return should include the distributive shares of the partners for the periods prior to, on the date of, and after the date of the merger.

Successor liability: There could be effects from the successor liability rules under the Bipartisan Budget Act of 2015 (BBA), P.L. 114–74. For instance, in the above example, C and D would be indirectly liable for any imputed underpayment (IU) of PE Holdco, even if it relates to a pre–merger tax year. In addition, notwithstanding that ABCD has terminated under Sec. 708, the IRS could attempt to assess and collect an IU of the ABCD legal entity for tax years prior to the merger when it was a regarded partnership under Regs. Sec. 301.7701–2(c)(2)(iii)(A)(1). All parties involved should be aware of these possibilities and negotiate BBA provisions in the transaction documents accordingly (e.g., request push–out elections under Sec. 6226 in the event of an IRS audit).

Accommodating all the parties

As illustrated by the examples, tax calculations and reporting of partnership merger transactions — especially those involving the merger cash–out rule — can be complex. When structuring a partnership merger transaction in part with cash proceeds, careful attention should be given to whether the merger agreement can satisfy the requirements of the merger cash–out rule so that all of the parties receive the desired tax treatment.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax 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 PwC US Tax LLP.