Partnership Mergers and Divisions

The IRS issued final regulations on the tax consequences of partnership mergers and divisions, effective Jan. 4, 2001 (TD 8925). A partnership could elect to apply these regulations as of Jan. 11, 2000 (the publication date of the proposed regulations).

The final regulations provide guidance on the form of a partnership merger or division that the Service will respect. Failure to structure the merger or division consistent with the regulations may cause the transaction to be taxable if its substance more closely resembles a sale or exchange of either a partnership interest or partnership property. The regulations provide that the partnership merger or division may be in either the assets-over form or the assets-up form.

Background—Partnership Mergers

Under Sec. 708, a partnership is considered as continuing if it has not been terminated. A terminated partnership is one in which no part of its business is continued by any of the partners in the partnership or, if within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. Sec. 708 provides two special rules for the continuation of a partnership on a merger or consolidation of two or more partnerships and on the division of a partnership.

When two or more partnerships merge or consolidate, under Sec. 708(b)(2)(A), the resulting (or continuing) partnership is a continuation of any merging or consolidating partnership, whose members own an interest of more than 50% in the capital and profits of the resulting partnership. If more than one of the merged partnerships meets the re-quirement under Sec. 708(b)(2)(A), the partnership credited with contributing the greatest dollar value of assets to the resulting partnership is the continuation partnership (Regs. Sec. 1.708-1(b)(2)(i)). If the members of none of the merging partnerships own more than a 50% interest in the capital and profits of the resulting partnership, all of the merged partnerships are terminated and a new partnership would result (Regs. Sec. 1.708-1(c)(1)).

Mergers—Impact of Final Regs.

In the assets-over form structure, a terminating partnership contributes its assets and liabilities to a resulting partnership in exchange for partnership interests in the resulting partnership. Immediately thereafter, the terminating partnership transfers the interest in the resulting partnership to its partners in liquidation of the terminating partnership (Regs. Sec. 1.708-1(c)(3)(i)). In the assets-up form structure, the terminating partnership distributes its assets and liabilities to its partners in liquidation of the partnership. The partners of the terminating partnership contribute the assets and liabilities to the resulting partnership in exchange for an interest in that partnership (Regs. Sec. 1.708-1(c)(3)(ii)).

Partnership Divisions

If a partnership divides into two or more partnerships, under Sec. 708(b)(2)(B), a resulting partnership with members who had a greater-than-50% interest in the capital and profits of the prior partnership is a continuation of that partnership. Other resulting partnerships that do not qualify as continuation partnerships are new partnerships (Regs. Sec. 1.708-1(b)(2)(ii)). If the members of none of the resulting partnerships owned an interest of more than 50% of the prior partnership's capital and profits, that partnership terminates and the resulting partnerships are new partnerships (Regs. Sec. 1.708-1(d)(1)).

Divisions—Impact of Final Regs.

In the assets-over form structure, certain assets and liabilities from a prior partnership are transferred to a resulting partnership in exchange for an interest in the resulting partnership. Immediately thereafter, the prior partnership distributes the interest in the resulting partnership to partners designated to receive interests in that partnership (Regs. Sec. 1.708-1(d)(3)(i)). In the assets-up form, the prior partnership distributes certain assets and liabilities to some or all of its partners. The partners then contribute the assets and liabilities to a resulting partnership in exchange for an interest in such partnership (Regs. Sec. 1.708-1(d)(3)(ii)).

Under Regs. Sec. 1.708-1(d)(5), Ex. 1, a partnership division requires that at least two partners of the prior partnership be partners of each resulting partnership that exists after the division.

Example: A, B and C are partners in ABC Partnership. C leaves the partnership, receiving property for his partnership interest. He contributes such property to CD Partnership (that C forms with D). The new partnership formed with D is a division from ABC Partnership.

Other Guidance on Form

The final regulations indicate that, unless a transaction in either a partnership merger or division is structured in the assets-up form, the transaction will be an assets-over form transaction, regardless of whether that form is followed (Regs. Sec. 1.708-1(c)(3)(i) and -1(d)(3)(i)). According to the IRS, a two-partnership merger cannot use both the assets-over form and the assets-up form. Divisions and mergers involving more than two partnerships may be structured such that one merger or division takes the assets-over form, while the other merger or division takes the assets-up form. In that case, the Service treats each merger or division independently.

Merger Buyout Rule

Under the final regulations, a resulting partnership can purchase the interest of one or more partners in the terminated partnership without causing the application of the disguised-sale rules. Without this provision, the disguised-sale rule would cause all the partners in the terminating partnership to recognize gain or loss on the transaction. Under Regs. Sec. 1.708-1(c)(4), the sale of all or part of a partner's interest in the terminated partnership to the resulting partnership that is part of a merger or consolidation is a sale of the partnership interest. The merger agreement must specify the purpose for the acquisition and the consideration paid, and the selling partner must (either prior to or contemporaneously with the transaction) consent to treat the transaction as the sale of a partnership interest.

As the buy-out is treated as a sale of a partnership interest, the resulting partnership inherits the capital account in the terminated partnership, as well as any Sec. 704(c) liabilities from the exiting partner. If the terminating partnership has a Sec. 754 election in place (or makes such election), the resulting partnership will have a special basis adjustment under Sec. 743 in the terminated partnership's property.

According to the Service, if exiting partners sell 50% or more of the interest in a terminating partnership under a merger buyout, because the buyout is deemed to occur immediately prior to the merger, a technical termination of the terminating partnership occurs immediately before the merger.

Tax Return Treatment

Merger or consolidation. Under Regs. Sec. 1.708-1(c)(2), the tax year for any merging or consolidating partnership considered terminated closes on the termination date (i.e., the merger or consolidation date). Accordingly, the terminating partnership files its final returns for the tax year ending on the termination date. The resulting partnership will file returns for the tax year of the merging partnership considered to be the continuing partnership. The resulting partnership retains the employer identification number (EIN) of the partnership deemed as continuing. Additionally, the return must disclose that the resulting partnership is a continuation of a merging or consolidating partnership, and include the names, addresses and EINs of the other merged or consolidated partnerships. The return must also include the partners' respective distributive shares for the periods prior to and including the merger or consolidation date and subsequent to that date.

Divisions. Under Regs. Sec. 1.708-1(d)(2), the resulting partnership treated as the divided partnership retains the EIN and prior partnership's tax year. The return filed for the resulting partnership must include the names, addresses and EINs of all resulting partnerships regarded as continuing (other than as the divided partnership), and disclose that the partnership is a continuation of the prior partnership. The return must indicate separately the partners' respective distributive shares for the periods prior to and including the division date and subsequent to that date. All other resulting partnerships deemed as continuing are new partnerships; accordingly, these partnerships must obtain new EINs and file separate returns for the tax years beginning on the day after the division. These returns also need to include the name, address and EIN of the prior partnership. All tax elections previously made by the divided partnership are binding on the partnership regarded as continuing. Subsequent elections made by a resulting partnership will not affect other resulting partnerships. (This issue is also discussed in Orbach and Heller, "Merger and Division Prop. Regs.," 31 TTA 854 (Dec. 2000).)

From Stephen R. MacNeil, J.D., CPA, MST, Columbus, OH