Partnership deals can carry unexpected federal tax consequences, from how a transaction is classified to how a recent capital contribution can turn long-term gain into short-term gain, panelists said at the Philadelphia Tax Conference October 30.
The session, on common pitfalls under Subchapter K, was part of the conference hosted by the Villanova University Graduate Tax Program.
Continuation or merger
Before the Tax Cuts and Jobs Act, P.L. 115-97, repealed the technical termination rule, practitioners knew a partnership terminated when all its interests were sold, said Eric B. Sloan, a partner at Gibson Dunn. Whether it survived “was not a question that people asked themselves,” he said.
Matthew J. Donnelly, a partner at Kirkland & Ellis, described a deal in which a newly formed buyer limited liability company (LLC) purchases 100% of the equity of a target LLC. In corporate form, the target becomes a wholly owned subsidiary of the buyer. For tax purposes, though, it is a disregarded entity, and the buyer is treated as the continuation of the target partnership, he said.
The deal starts with two partnerships and ends with one, yet most practitioners have concluded it isn’t a merger under IRC § 708(b)(2)(A), Sloan said, because the buyer was formed for the transaction and hasn’t conducted any activities. The regulations under that provision “don’t define partnership merger, which is unhelpful,” he added.
Getting the classification right matters first for tax certainty, Sloan said, because “uncertainty is the enemy of tax planning.” A continuation also has advantages for buyers. The deal is treated as the buyer’s partners purchasing interests in the target for cash, so they get a basis adjustment under IRC § 743(b) and “the entire benefit of the step up.”
Practitioners then apply the anti-churning rules of IRC § 197(f)(9) solely by reference to the relationship between the partners, “so it simplifies everything,” Sloan said. On the sell side, gain falls under IRC § 751(a), which he called “a lot simpler” than § 751(b).
Conversions where ‘nothing happened’
Sarah Brodie, a principal at EY, flagged another trap in Rev Rul 84-52, 1984-1 CB 157. Suppose a partnership changes the state where it is organized and nothing else changes. Many people, herself included until about a year ago, would have said “[l]iterally nothing happened,” she said.
The ruling, however, treats that change as a contribution under IRC § 721, she said, so practitioners should at least consider it before making any change to a partnership, whether converting a general partnership into a limited partnership or moving it to another state or country.
Sloan, recalling that the ruling involved a general partnership becoming a limited partnership, called it “just wrong.” As he understood it, the IRS was looking for a nonrecognition provision, “and that’s fair,” he said.
But if a conversion really is a contribution, he noted, then IRC § 704(c), the disguised sale rules, and the anti-mixing bowl rules come into play. He also questioned whether moving from a Delaware LLC to a Wyoming LLC is even a realization event, though he allowed he could be wrong.
More broadly, Sloan advised practitioners to “put the tax treatment provisions in the agreement” and make sure the tax preparers are on board. Otherwise, “people will forget, and it will get misreported, and then it’ll be an unhappy day when you’re trying to sort it out with the IRS,” he said.
Split holding periods add short-term gain
Brodie described what she called an “absolutely bonkers” holding period rule. In her example, partners contribute $100 to an LLC in 2021 and another $100 in 2026, and a buyer pays $500 for all the interests later in 2026.
The partners have held their interests since 2021, but because the second contribution came less than a year before the sale, some of their long-term capital gain becomes short-term on a proportionate basis, Brodie said. She called the result a “really ridiculous and unfavorable conversion to short-term gain.”
Donnelly called it “a particularly gruesome rule” and said that for a taxpayer who cares about the three-year holding period under IRC § 1061, “this could potentially bite you.” The solution, “if there is one,” is to be careful about who makes the contribution, he said. Because the determination is made partner by partner, he explained, another entity or an affiliate could make the later contribution.
Sloan said the examples in Reg. § 1.1223-3 make clear that the rule applies even to pro rata contributions, which he found “really surprising.” The regulations offer “a little bit of a workaround,” he said, because a cash distribution can essentially reverse the contribution. A partnership could borrow $100 and distribute it in connection with the sale. That “washes out, cleanses that bad contribution,” he said, and the partners “should be okay.”
For more on the treatment of continuing partnership as a resulting partnership following a merger, see Checkpoint’s Federal Tax Coordinator 2d ¶ B-4306.
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