The Division of a Partnership
The ABCs of a partnership division.
January 25, 2010
It is not hard to think of situations that involve the division of a partnership. For example, the conflict arising in a partnership owned by two families with different investment ideas can be resolved by dividing the partnership into two partnerships owned by each family.
The only provision in the Internal Revenue Code of 1986, as amended (the Code) on partnership division is Section 708(b)(2)(B). It provides that a “resulting partnership” the members of which own more than 50 percent of the capital and profits of the “prior partnership” shall be considered a continuation of the “prior partnership.” Treasury Regulation (“Regulation”) § 1.708-1(d)(4)(ii) defines “prior partnership” to be the partnership subject to division that exists under jurisdictional law before the division. Regulation § 1.708-1(d)(4)(iv) defines “resulting partnership” to be the partnership resulting from the division that exists under jurisdictional law after the division and that has at least two partners who were partners in the “prior partnership.”
Regulation § 1.708-1(d)(4)
Regulation § 1.708-1(d)(4) introduces two additional terms:
Example: Assume partnership ABC is owned 40 percent by A, 30 percent by B and 30 percent by C. The partners want to divide ABC into partnership AB — a continuing partnership and partnership AC — a continuing partnership. Regulation § 1.708-1(d)(4)(i) states that if the resulting partnership which, in form, transfers the assets and liabilities in connection with the division is a continuation of the prior partnership, then it will be treated as the divided partnership. Thus, assume that ABC forms new partnership AC, transfers assets to AC, distributes partnership interests in AC to A and C in exchange for all or part of their interests in ABC and renames itself AB. Because AB transferred the assets to AC, AB will be considered as the “divided partnership.” Regulation § 1.708-1(d)(4)(i) also provides that if the transfer of the assets is not by a resulting partnership, which is a continuation of the prior partnership and more than one resulting partnership is a continuation of the prior partnership, then the continuing resulting partnership with the assets having the greatest fair market value (net of liabilities) is treated as the divided partnership. There will be no “divided partnership” if none of the resulting partnerships have partners who owned more than 50 percent of the capital and profits of the prior partnership. In that case, the prior partnership will be considered to have liquidated.
Forms of Division
Only two forms of division are recognized under Regulation § 1.708-1(d): the assets-over form and the assets-up form. If the method of division is not specified, Regulation § 1.708-1(d)(3)(i) states that the form of division will be the assets-over form.
In an “assets-over form” in which at least one resulting partnership is a continuation of the prior partnership the divided partnership is considered to have transferred assets to the recipient partnerships in exchange for partnership interests in the recipient partnerships and then distributed those partnership interests to some or all of its partners in partial or complete liquidation of the partners’ interest in the divided partnership. Reg. § 1.708-1(d)(3)(i)(A). If none of the resulting partnerships are a continuation of the prior partnership, the prior partnership will be treated as contributing all of its assets and liabilities to new resulting partnerships in exchange for interests in the resulting partnerships; and, immediately thereafter, the prior partnership will be treated as liquidating by distributing interests in the new resulting partnerships to the prior partnership’s partners. Reg. § 1.708-1(d)(3)(i)(B).
In the “assets-up” form of division, the divided partnership distributes assets to some or all of its partners in partial or complete liquidation of the partners’ interest in the divided partnership and immediately thereafter, such partners contribute the distributed assets to a recipient partnership or partnerships in exchange for interests in such recipient partnership or partnerships. The form of partnership division will be recognized even though the distributee-partners’ ownership of the assets is transitory. Reg. § 1.708-1(d)(3)(ii)(A). If there is no continuing partnership, the prior partnership must liquidate under the applicable jurisdictional law. Treas. Reg. § 1.708-1(d)(3)(ii)(B).
Which Form Works Better?
Which partnership should be the divided partnership and which form of division to use may affect the divided or the recipient partnership’s basis in its assets (inside basis) and each partner’s basis in its partnership interest in the divided or recipient partnership (outside basis). Under Section 721, the tax basis of the recipient partnership interest to the divided partnership equals the tax bases of the assets transferred to the recipient partnership. Under Section 732(a), the tax bases of the recipient partnership, interest carries over to the partners of the recipient partnership if they are also partners in the divided partnership. In the above example, A is a partner in both the divided partnership (AB) and the recipient partnership (AC), so A’s tax basis in its AC partnership interest is 40 percent of the tax basis that AB has in its AC partnership interest. If the partners’ interests are liquidated in the divided partnership, under Section 732(b) the tax bases of partners in the divided partnership are substituted for the tax bases of the recipient partnership interest transferred to them by the divided partnership. C is a partner only in AC, so C has a substituted basis in its AC partnership interest equal to its tax basis in AB. Section 754 adjustments may be optional or mandatory.
Since a division involves a contribution and a distribution of property, gain or loss may be triggered by these transfers. For example, a distribution of marketable securities by the divided partnership may generate gain under Section 731(c). The disguised sale rules under Section 707(a)(2)(B) may apply because a partner of the divided partnership contributed assets within two years of the division. The anti-mixing bowl rules of Sections 704(c)(1)(B) and 737 may apply if contributed property is distributed to another partner or other property is distributed to a contributing partner within seven years of the date of division. Liability shifts may also occur.
Proper planning for the division of a partnership is not easy. It requires considering many parts of partnership tax law.
Janice Eiseman, JD/LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the law firm Morrison & Cohen LLP, in New York City.