Section Partnership Mergers IRS Guidance: Avoiding ... · The converting entity must be a California Corp, LP or GP; or Foreign Corp, LLC, LP, GP or Other Business Entity;

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Structuring Section 708 Partnership Mergers Absent IRS Guidance: Avoiding Termination in Collapsing Transactions Assets‐Over vs. Assets‐Up Transactions, Maintaining Continuity of Interest, and Deferring Tax Recognition

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Entity Mergers and Conversions: State Laws and Tax Laws A merger involves two or more entities.

Interspecies mergers have become common.

A conversion involves only one entity converting into another type of entity. Interspecies conversions have also become common.


Entity Mergers and Conversions: State Laws and Tax Laws Prior to the availability of conversions, a

conversion to another business entity type was generally accomplished in two steps:

◦ (1) the new entity was formed (for example, an LLC);

◦ (2) the existing entity was merged into the new entity, with the new entity surviving.

This two-step merger had actual “steps.”

Today, two-step mergers are still possible, but one step conversions also exist.


Ease of Conversion (CA example) The ease of conversion is illustrated by the CA Secretary of State

website: http://www.sos.ca.gov/business-programs/business-entities/conversion-information/

If the converted entity will be a California LLC: The converting entity must be a California Corp, LP or GP; or Foreign Corp, LLC, LP, GP or

Other Business Entity; File Articles of Organization – Conversion (Form LLC-1A)(PDF - REV 01/2016); and The filing fee is $150 if a California Corp is involved; and $70 for all others. If the converted entity will be a California LP: The converting entity must be a California Corp, LLC or GP; or Foreign Corp, LLC, LP, GP or

Other Business Entity; File a Certificate of Limited Partnership – Conversion (Form LP-1A)(PDF - REV 01/2016); and The filing fee is $150 if a California Corp is involved; and $70 for all others. If the converted entity will be a Registered GP: The converting entity must be a California Corp, LLC or LP; or Foreign Corp, LLC, LP or Other

Business Entity; File a Statement of Partnership Authority – Conversion (Form GP-1A)(PDF - REV 01/2016);

and The filing fee is $150 if a California Corp is involved; and $70 for all others. If the converted entity will be a Non-registering GP: The converting entity must be a California Corp, LLC or LP; or Registered Foreign Corp, LLC,

LP or Other Business Entity; File a Certificate of Conversion (Form CONV-1A)(PDF - REV 01/2016); and The filing fee is $150 if a California Corp is involved; and $30 for all others. If the converted entity will be a Foreign Entity: The converting entity must be a California LLC or LP, or Registered California GP; File a Certificate of Conversion (Form CONV-1A)(PDF - REV 01/2016); and The filing fee is $30.


Entity Mergers and Conversions: State Laws and Tax Laws A mere conversion is not regarded as a merger

for tax purposes.

◦ Under state conversion statues, a simple filing may, in many instances, effect the conversion.

◦ The understanding of the tax consequences that occur is, nonetheless, essential, in understanding how one-step conversions are treated.

◦ Formless conversion statutes carry with them certain deemed steps, one must be aware of these steps and choose an alternative to the formless conversion if the deemed steps aren’t desirable under the specific facts.


Entity Mergers and Conversions

A series of Revenue Rulings address mergers and conversions involving partnerships and LLCs.

◦ Rev. Rul. 84-52, 1984-1 C.B. 157, conversion of a general partnership into a limited partnership.

◦ Rev. Rul. 95-37, 1995-1 C.B. 130, amplifies Rev. Rul. 84-52 and applies the same approach to the conversion of a domestic partnership to a domestic LLC that is classified as a partnership.Rev. Rul. 68-289, 168-1 C.B. 314 involves the mechanics of the merger of three partnerships in an assets over form.

◦ Rev. Rul. 99-5, 1999-1 C.B. 434, conversion of a disregarded entity into a partnership.

◦ Rev. Rul. 99-6, 1996-1 C.B. 432, conversion of a partnership into a disregarded entity.

◦ Rev. Rul. 84-111, 1984-2 C.B. 88, incorporation of a partnership. This Revenue Ruling is also the touchstone for the key constructs of how assets and liabilities are transferred, “assets over,” interests over” and “assets up.”


Incorporation of a Partnership

◦ Rev. Rul. 84-111 recognized that there were at least 3 ways for a partnership to convert to a corporation, each with unique tax consequences, it was the first detailed pronouncement on such steps.

◦ Situation 1. The partnership transfers all of its assets to a newly-formed corporation, in exchange for all the outstanding stock of the corporation and the assumption by the corporation of the partnership’s liabilities. The partnership then terminates by distributing all its stock to the partners of the partnership in proportion to their partnership interests. This is the so-called “assets over” approach.

◦ Situation 2. The partnership distributes all its assets and liabilities to its partners in proportion to their partnership interests in a transaction that constitutes a complete termination of the partnership under section 708(b)(1)(A). The partners then transfer all of the assets receive from the partnership to the newly-formed corporation in exchange for at he outstanding stock of the corporation and the assumption by the corporation of the liabilities that had been assumed by the partners. This is the so-called “assets up” approach.

◦ Situation 3. The partners transfer their partnership interests to a newly-formed corporation in exchange for the outstanding stock of the corporation. The exchange terminates the partnership and all of the assets and liabilities of the partnership become assets and liabilities of the corporation. This is the so-called “partnership interest transfer” approach.



◦ One of the most significant differences in the 3 approaches to incorporation of the partnership is in the basis of the shares received in the corporation

◦ Situation 1. In the “assets-over” approach, the basis of the shares received by the former partners is the basis of the assets contributed, less liabilities assumed by the corporation.

◦ Situation 2. In the “assets-up” approach, the outside basis of the partners in their partnership interest (less money received) becomes the basis of the assets distributed. Upon contribution of these assets, the former partner receives a basis in the shares received equal to the basis of the assets contributed, less liabilities assumed by the corporation. Note that the inside basis of the assets disappears, and the basis of the assets becomes the outside basis in the partnership interests. This construct is potentially of interest if there is a high outside basis and low inside basis.

◦ Situation 3. In the “partnership interest transfer” approach, the basis the former partner receives in their shares, is the adjusted basis of their partnership interest, less liabilities assumed by the corporation.



Electing Corporate Status Under the Check-the-Box Rules.◦ The “check-the-box” rules were promulgated after Rev.

Rul. 84-111◦ These rules permit an eligible entity to “check-the-box” or

elect an entity classification other than its default classification.

◦ A domestic LLC, with two or more members is a partnership under the default classification.

◦ If it elects to be a corporation, there is a series of deemed steps under section 301.7701-3(c)(l)(i).

◦ These deemed steps follow the “assets over” construct of Rev. Rul. 84-111.

◦ The following is deemed to occur: The unincorporated entity contributes all of its assets

and liabilities to the corporation in exchange for stock of the corporation;

Immediately thereafter, the unincorporated entity is liquidated, distributing the stock of the corporation to its partners.



The good news:

Conversions of pass-through entities into other pass-through entities are often tax-free.

◦ GP to LP (Rev. Rul. 84-52); LP to LLC (Rev. Rul. 95-37) conversions.

◦ These rulings hold that Section 721 applies and there is no gain or loss under Section 741 and Section 1001.

◦ The rulings provide that, because the business will continue and because a 721 transaction is not treated as a sale or exchange, there is no Section 708(b)(1)(A) or Section 708(b)(1)(B) termination.

◦ These rulings also provide that if liabilities shift, there will be deemed distributions under Section 752(b). This could happen, for example, in the shifting of liabilities if a GP converts to an LP or LLC.


Entity Conversions

Tax Treatment of a Conversion of General Partnership to Limited Partnership.

◦ Rev. Rul. 84-52, 1984-1 C.B. 157, addresses the conversion of a general partnership interest into a limited partnership interest as part of the conversion of the general partnership into a limited partnership.

◦ Rev. Rul. 84-52 provides that under Section 721, no gain or loss will be recognized to the partners (unless there is a deemed distribution of cash in excess of basis resulting from a shifting of liabilities). It holds, further, that the partnership is a continuing partnership under Section 708, and does not terminate. Thus, it keeps its EIN and elections, and the conversion is not treated as a merger.

◦ Rev. Rul. 84-52 provides, “If, as a result of the conversion, there is no change in the partners’ shares of [the Partnership’s] liabilities under section 1.752-1(e) of the regulations, there will ne no change to the adjusted basis of any partner’s interest in [the Partnership] and [the Partners] will each have a single adjusted basis with respect to each partner’s interest in [the Partnership] (both as limited partners and general partner) equal to the adjusted basis of each partner’s respective general partnership interest in [the Partnership] prior to conversion.”

◦ Rev. Rul. 84-52 further states, “If, as a result of the conversion, there is a change in the partners shares of [the Partnership’s] liabilities under section 1.752-1(e) of the regulations, and such change causes a deemed contribution of money to [the Partnership] by a partner under Section 752(a) of the Code, then the adjusted basis of that partner’s interest shall, under section 722 of the Code, be increased by the amount of such deemed contribution. If the change in the partners shares of liabilities causes a deemed distribution of money to a partner under Section 752(b) of the Code, then the basis of that partner’s interest shall, under section 733 of the Code, be reduced (but not below zero) by the amount of such deemed distribution, and any gain will be recognized by that partner under Section 731 of the Code to the extent the deemed distribution exceeds the total adjusted basis of that partner’s interest in [the Partnership].”

◦ Consequence There is no deemed distribution out of assets and no automatic gain, but the shifting of liabilities must be taken into account in determining whether there is, in fact, any gain to any partner or any change in partners’ bases.


Entity Conversions

Tax Treatment of a Conversion of General Partnership to Limited Partnership.

◦ 752(b) issue:

Assume A and B form general partnership, P, which has property with a FMV of 400, AB of 160 and liabilities of 200.

If the partnership converts from a general partnership to an LP and A is the general partner and B is the limited partner, the 160 is included entirely in A’s basis and none of the 160 is included in B’s basis.


Entity Conversions

Tax Treatment of a Conversion of a Domestic Partnership to a Limited Liability Company.

◦ Rev. Rul. 95-37, 1995-1 C.B. 130 amplifies Rev. Rul. 84-52 and applies the same approach as Rev. Rul. 84-52 to the conversion from a domestic partnership to a domestic limited liability company (“LLC”) that is classified as a partnership. The conversion is not treated as a merger.

◦ Rev. Rul. 95-37 provides similarly to Rev. Rul. 84-52 that the conversion is generally tax-free under Section 721 (rather than a sale or exchange) and provides that there is no termination of the partnership, and that it retains its EIN.

◦ Rev. Rul. 95-37 provides, more succinctly, that the key issue is whether and the extent to which partner’s shares of liabilities change, it provides, in pertinent part, “(3) if the partners’ shares of partnership liabilities do not change, there will be no change in the adjusted basis of any partner’s interest in the partnership, (4) if the partners’ shares of partnership liabilities change and cause a deemed contribution of money to the partnership under section 752(a), then the adjusted basis of such a partner’s interest will be increased under section 722 by the amount of the deemed contribution, (5) if the partners’ shares of partnership liabilities change and cause a deemed distribution of money by the partnership to a partner under section 752(b), then the basis of such a partner’s interest will be reduced under section 733 (but not below zero) by the amount of the deemed distribution, and gain will be recognized by the partner under section 731 to the extent the deemed distribution exceeds the adjusted basis of the partner’s interest in the partnership.”

◦ Consequence There is no deemed distribution out of assets and no automatic gain, but the shifting of liabilities must be taken into account in determining whether there is, in fact, any gain to any partner or any change in partners’ bases.


Entity Conversions

Formless Conversion: Treatment of Conversion of a Partnership or LLC to a Corporation Where The State Law Statute Does Not Define the Form of the Conversion.

◦ Where there is a formless conversion statute, Rev. Rul. 2004-59 provides for the same “deemed” steps as a check-the-box election under section 301.7701-3(c)(l)(i).

◦ The following is deemed to occur: The unincorporated entity contributes all of its assets and liabilities to the

corporation in exchange for stock of the corporation; Immediately thereafter, the unincorporated entity is liquidated, distributing the stock

of the corporation to its partners.

◦ Although Rev. Rul. 84-111 technically does not apply, this construct is the “assets-over” approach of situation 1 of Rev. Rul. 84-111.

◦ If treatment under a different construct of Rev. Rul. 84-111 is desired, use an alternative to a formless conversion statute.

◦ If the new corporation is going to elect Subchapter S treatment, does the momentary ownership of the stock by an ineligible shareholder (a partnership) prevent an immediate S election after the incorporation? No, see Rev. Rul. 2009-15. The same holds true whether the incorporation is made via a “check-the-box” election (Situation 1 of Rev. Rul. 2009-15) or via a formless conversion statute (Situation 2 of Rev. Rul. 2009-15).


Conversions vs. Mergers

Conversions are Not Mergers:

◦ A mere conversion of a partnership (for example a conversion of a GP to an LP or LLC under a state law conversion statute) is not regarded as a merger, even though it may be accomplished through a merger under state law.

◦ Thus, there is no terminating partnership and no continuing partnership. Rather, the converted entity is the same partnership as before the conversion. Elections remain the same and the EIN remains the same.



The bad news:

Conversions of C corporations or S corporations to LLCs or partnerships are taxable.

◦ S corp. to LLC: PLR 9543017.

◦ C corp. to LLC: PLR 9701029.

◦ Both are taxable, yet both can be easily accomplished under many states’ merger statutes.

◦ Special case: S corp. can merger into LLC tax-free, if the LLC immediately elects to be taxed as a corp. and elects S status. There is a PLR on this, which is occasionally incorrectly cited for the proposition that a conversion of an S corp. to an LLC is tax-free. It isn’t unless the LLC immediately elects S status. PLR 9409014. The LLC interests were distributed to parent under 332, 336, no gain or loss. PLR 9409014.


Conversion of an S corporation to an LLC.

◦ PLR 9543017 – The Conversion of an S corporation to an LLC is taxable.

◦ The PLR addressed the State law merger of an S corporation into an LLC, with the LLC surviving.

◦ The PLR provides that the merger of the S corporation into the LLC, with the LLC surviving is treated as the transfer of the S corporation assets to the LLC in exchange for the LLC’s assumption of the S corporation’s liabilities, followed by the S corporation’s receipt of an interest in the LLC, and the S corporation’s distribution of the LLC to its shareholders in complete liquidation of the S corporation.

◦ The PLR provides that no gain or loss will result to the S corporation or the LLC on the contribution of assets to the LLC, unless the S corporation receives a net decrease in liabilities exceeding its basis in the assets contributed under section 1.752-1(f) of the regulations (and provided that the LLC would not be treated as an investment company if it incorporated).

◦ The PLR provides, however, that the S corporation will recognize gain or loss on the distribution of the interest in the LLC to its shareholders in complete liquidation, as if the S corporation had sold the interest to its shareholders at the time of liquidation. The PLR provides that this gain or loss will be passed through to the S corporation shareholders under section 1366(a).

◦ Thus, a fairly simple merger or conversion, under State law, of an S corporation to an LLC is taxable under Section 331 to the extent the value of the interests in the partnership/LLC received exceeds the shareholder’s basis in the S corporation stock.

◦ If an S corporation is not desirable going forward, there are at least two alternatives to converting the entire S corporation, including having the S corporation become a member in a lower-tier LLC, or a multi-step transaction described later.


Conversion of a C corporation to an LLC◦ PLR 9701029 – The conversion of a C corporation to an LLC is taxable.

◦ The PLR addressed the State law merger of a C corporation into an LLC, with the LLC surviving.

◦ This PLR follows the some construct as PLR 9543017, the merger of the C corporation into the LLC, with the LLC surviving is treated as the transfer of the C corporation assets to the LLC in exchange for the LLC’s assumption of the C corporation’s liabilities, followed by the C corporation’s receipt of an interest in the LLC, and the C corporation’s distribution of the LLC to its shareholders in complete liquidation of the C corporation.

◦ This liquidation is taxable under section 331.

◦ The C corporation will recognize gain or loss on the distribution of the membership interests in the LLC to the shareholders as if the interests had been sold to the shareholders for its fair market value.



An easy way of thinking of conversions and mergers is to break them down into different categories.

Mergers or conversions of pass-through entities:◦ GP to LP (Rev. Rul. 84-52); LP to LLC (Rev. Rul. 95-37) conversions.◦ Pass through mergers. Section 708(b)(2)(A); Treas. Reg. Section 1.708-1(c)

(coming up).

Mergers or conversions that are for tax purposes, only.◦ Disregarded entity to a partnership (Rev. Rul. 99-5)◦ Partnership to a disregarded entity (Rev. Rul. 99-6)◦ Check-the-box

Incorporation. ◦ Rev. Rul. 84-111◦ Incorporation is also the treatment of conversion of an LLC to an S corp. or

C corp.

Corporation to pass-through. ◦ PLR 9543017, S corp. to LLC; PLR 9701029, C corp. to LLC



The more complicated analysis: Mergers of two or more pass-through entities.

The corporate tax rules on mergers are very form-driven.

◦ There are certain detailed requirements for different types of Mergers under Section 368.

Type A reorgs are fairly flexible, with up to at least 50% boot permitted. Type B reorgs carry more requirements, as do Type C and D reorgs. Type E and F reorgs are generally single-entity reorgs, Type G is

bankruptcy.

◦ Even the Section 351 rules require an 80% control group obtaining their interest for property, and gain can be recognized where liabilities exceed basis of the property contributed under Section (c).

◦ In contrast, the rules of Subchapter K, the partnership rules, contain very little guidance on partnership mergers. Section 708(b)(2)(A) addresses which partnership, if any, is treated as a continuation of any merging or consolidating partnership, but it does not contain detailed rules on partnership mergers.



In a merger, the deemed tax steps and the steps occurring under state law can differ.

This can result in one entity surviving for state law purposes, while a different entity is deemed to survive from a tax law perspective.

A “worst case scenario” is that because cross-specie mergers and conversions are deceptively simple under state law, tax considerations may be addressed late in the process, or not at all. This could result, for example in an entity conversion being undertaken that is taxable.

Even apart from this simplistic problem that could occur where there is little legal guidance, there are more sophisticated situations in which there could be gain resulting from the shifting of liabilities, or 704(c) or 737 “mixing bowl” rules.


Partnership Rules vs. Corporate Tax Rules

The only specific section of the Code dealing with partnership mergers is Section 708(b)(2)(A). Treas. Reg. Section 1.708-1(c) also addresses partnership mergers.

There are two types of partnership terminations, an “actual termination” under Section 708(b)(1)(A) and a “technical termination” under Section 708(b)(1)(B).

Section 708(b)(2)(A) provides which partnership, if any, is treated as “continuing.” Section 708(b)(2)(A) provides,

“In the case of the merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of this section, be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership.”



Unlike the corporate rules, there are no specific forms of partnership mergers afforded tax-free treatment.

Any partnership merger is tested under the normal partnership rules, including Section 721, 722, 723, 731, 751, and Section 704 and Section 737. Rev. Rul. 2004-43 contains examples re 704(b) gain and 737 mixing bowl rules.

The partnership rules are, in general, more flexible than the corporate rules.

◦ There is no requirement for a “control group” akin to Section 351, indeed a contribution of property to a partnership is generally tax-free irrespective of the percentage of interest received in exchange for the property.

◦ The contribution of liabilities to a partnership is not tested against basis of the property contributed like Section 351, but liabilities assumed and relieved must be netted and tested under Section 752(b) and a net reduction in liabilities is a deemed distribution of cash.

◦ Even with a deemed distribution of cash (resulting from a net reduction in liabilities), there may not be gain, since a partner only recognizes gain on an actual or deemed distribution of cash if it exceeds the partner’s adjusted basis in the partners’ partnership interest.



Partnership AB, in whose capital and profits A and B each own a 50-percent interest, and partnership CD, in whose capital and profits C and D each own a 50-percent interest, merge on September 30, 1999, and form partnership ABCD. Partners A, B, C, and D are on a calendar year, and partnership AB and partnership CD also are on a calendar year. After the merger, the partners have capital and profits interests as follows: A, 30 percent; B, 30 percent; C, 20 percent; and D, 20 percent. Since A and B together own an interest of more than 50 percent in the capital and profits of partnership ABCD, such partnership shall be considered a continuation of partnership AB and shall continue to file returns on a calendar year basis. Since C and D own an interest of less than 50 percent in the capital and profits of partnership ABCD, the taxable year of partnership CD closes as of September 30, 1999, the date of the merger, and partnership CD is terminated as of that date. Partnership ABCD is required to file a return for the taxable year January 1 to December 31, 1999, indicating thereon that, until September 30, 1999, it was partnership AB. Partnership CD is required to file a return for its final taxable year, January 1 through September 30, 1999. Example 1, Treas. Reg. Section 1.708-1(c)(5), Example 1.



Mechanics of Continuation Assets-Over Form.◦ A partnership merger is treated as an “assets over”

transfer, unless specifically structured as “assets up.” Treas. Reg. Section 1.708-1(c)(3).

◦ In the assets-over form, assets of the terminated partnership are treated as contributed to the continuing partnership, in exchange for an interest in the “resulting partnership,” and, immediately thereafter, the terminating partnership is treated as distributing the interest in the resulting partnership to its partners in liquidation of the terminated partnership.

◦ An assets-up form can be selected. A transitory distribution of assets to partners, followed by a recontribution is respected, despite the transitory ownership. Treas. Reg. Section 1.708-1(c)(3)(ii). But, note Example 6 of Treas. Reg. Section 1.708-1(c)(6)(ii).

◦ If certain requirements are met, a sale by a partner in a terminating partnership to a resulting partnership will be respected. Treas. Reg. Section 1.708-1(c)(4).


Entity Conversions

So, are all mergers between partnerships and partnerships or LLCs taxed as partnerships tax-free?

No!

◦ There are potential shifts in liabilities. The 752(b) rules net these and only a net reduction with a deemed distribution in excess of basis triggers gain, but shifting will impact basis, even if it doesn’t exceed basis.

◦ 704(c) and 737 can trigger gain, even when there is no actual distribution. Rev. Rul. 2004-43.


Assets-Over

P1

Terminating

P2

Continuing

P1 contributes all assets and liabilities in P2, in exchange for an interest in P2

P1 distributes the interests in P2 to A and B and terminates

Assets andLiabilities

Interests inP2

1

2

A B C D

1

Interests inP2

2

Treas. Reg. Section 1.708-2(c)(3)(i)


Assets-Over

P1

Terminating

P2

Continuing

Sections 721, 722, and 723 apply. The tax basis of the assets contributed thus generally remains the same as prior to contribution.Sections 704(c)(1)(B) and 737 do not apply.

Assets andLiabilities

Interests inP2

A B C D

1

Interests inP2

2

Treas. Reg. Section 1.708-2(c)(3)(i)


Assets-Up

P1 P2

P1’s assets are distributed to A and B in liquidation of P1

A and B contribute assets to P2

1

2

A B C D

1

Treas. Reg. Section 1.708-2(c)(3)(ii)

Assets

Assets

2


Assets-Up

P1 P2

The assets are distributed, with their bases determined under Sections 732(b) and (c) on distribution, and then 723 on contribution. Basis in the assets will thus change based on “outside basis.”

Sections 704(c)(1)(B) and 737 apply.

A B C D

1

2

Treas. Reg. Section 1.708-2(c)(3)(ii)

Assets

Assets



Continuation of the Partnership◦ Section 708(b)(2)(A) dictates which partnership continues and which

terminates.

◦ Rev. Rul. 68-289, 1968-1 C.B. 314 provides that the partners in the non-continuing partnership are treated as contributing all of their assets and liabilities to the continuing partnership, in exchange for an interest in the continuing partnership. (“Asssets-Over”). Rev. Rul. 90-17 provides similarly.

◦ If partners of one of the merging partnership do not own more than 50% of the capital and profits of the resulting partnership, there is no continuing partnership, rather both are new partnerships.

◦ Rev. Rul. 68-289, 168-1 C.B. 314 involves the mechanics of the merger of three partnerships in an assets over form.

◦ If there is more than one continuing partnership, then there are rules as to which resulting partnership is treated as the continuing partnership. Rev. Rul. 77-458, 1977-2 C.B. 220. Which continues depends upon the FMVof the assets contributed. The partnership with the highest FMV of assets is treated as the continuing partnership.



Why is it important which partnership (if any) is treated as continuing?

◦ Elections of the continuing partnership remain in place.

◦ The EIN of the continuing partnership remains the same.

◦ Which partnership “continues” determines the construct of the transaction for tax purposes, that is which partnership is treated as contributing assets and which partnership is treated as distributing assets.



There could be no continuing partnership or there could be more than one continuing partnership.

◦ If partners of one of the merging partnership do not own more than 50% of the capital and profits of the resulting partnership, there is no continuing partnership, rather both are new partnerships.


Partnership Rules vs. Corporate Tax Rules The partnership that continues for tax purposes could differ from

the partnership that continues under state law. Treas. Reg. 1.708-1(c)(5), Example 2.

(i) Partnership X, in whose capital and profits A owns a 40-percent interest and B owns a 60-percent interest, and partnership Y, in whose capital and profits B owns a 60-percent interest and C owns a 40-percent interest, merge on September 30, 1999. The fair market value of the partnership X assets (net of liabilities) is $100X, and the fair market value of the partnership Y assets (net of liabilities) is $200X. The merger is accomplished under state law by partnership Y contributing its assets and liabilities to partnership X in exchange for interests in partnership X, with partnership Y then liquidating, distributing interests in partnership X to B and C.

(ii) B, a partner in both partnerships prior to the merger, owns a greater than 50-percent interest in the resulting partnership following the merger. Accordingly, because the fair market value of partnership Y's assets (net of liabilities) was greater than that of partnership X's, under paragraph (c)(1) of this section, partnership X will be considered to terminate in the merger. As a result, even though, for state law purposes, the transaction was undertaken with partnership Y contributing its assets and liabilities to partnership X and distributing interests in partnership X to its partners, pursuant to paragraph (c)(3)(i) of this section, for Federal income tax purposes, the transaction will be treated as if partnership X contributed its assets to partnership Y in exchange for interests in partnership Y and then liquidated, distributing interests in partnership Y to A and B.



Special Problems.

◦ Rev. Rul. 2004-43, 2004-4 C.B. 842 addresses 704(c)(1)(B) and 737(b).

In an “assets-over” construct, the seven year holding period does not restart. Treas. Reg. Section 1.704-4(c)(4).

◦ If partnerships are merged, there may be accounting method issues. Merging a cash method and an accrual method partnership can

present problems with cash method accounts receivable. If the surviving partnership is on the accrual method, cash

method accounts receivable income would be charged back under Section 704(c) when collected to the partners of the cash method partnership that contributed the cash method accounts receivable.


Cross-border Considerations

◦ Any time a merger or conversion is cross-border (a U.S. entity into a foreign entity or a foreign entity into a U.S. entity) there are additional considerations.

◦ Even if the conversion to a foreign corporation could otherwise be done tax-free, section 367 would need to be considered.

◦ Conversion into a foreign pass-through was generally simpler, under Section 721, but Notice 2015-54 means that there are tax consequences. For certain property with “built-in gain property” (Section 721(c) property) the “remedial method” is required and “acceleration events” accelerate gain. Effective for transfers occurring on or after August 6, 2015 (when the Notice was issued).

September 28, 2016

Joseph C. MandarinoSmith, Gambrell & Russell, LLP

Promenade II, Suite 31001230 Peachtree StreetAtlanta, Georgia 30309

www.sgrlaw.com404‐815‐3685

Partnership Mergersunder Section 708

Partnership MergersTax Treatment vs. State Law

• IRC does not define a partnership merger.

• Some state law regimes permit mergers and conversions.

• Some of transactions that occur under these merger or conversion statutes are not treated as mergers for tax purposes.

• Some transactions that occur outside the state law merger and conversion regimes are treated for tax purposes as partnership mergers.

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Example: State Law Change of Form

• A common state law transaction is to convert one type of entity into another.

• For example, the partners of a limited partnership may want to convert that entity into an LLC.

• Similarly, the partners of an entity in one state may want to convert it into an entity under another state.

• This can be accomplished by merger in certain states, although increasingly these changes can be effectuated in a single step through a conversion statute.

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• Because there is only one partnership at the beginning and end, the IRS takes the view that there has been no partnership termination and the partnership merger rules do not apply. The ending entity retains the TIN of the beginning entity, there is no truncation of the tax year, etc.

• Moreover, the IRS takes the view that the form of transaction under state law does not matter (i.e., merger vs. conversion vs. assets over vs. assets up). Rev. Rul. 95‐37.

43

Example: State Law Change of Form

43

Step 1: Starting Position

44

Y

50%50%

X

Oldco(state Z limited partnership with

significant assets)

44

Step 2: Form Newco

45

Y

50%50%

X

Newco(Delaware LLC with no assets)

45

Step 3: State Law Merger

46

50%

X

Oldco

Y

50%

Y

50%

Newco

X

Oldco merges into Newco

under state law with Newco

surviving

46

50%

Step 4: Ending Position

47

Y

50%50%

X

Newco(Delaware LLC with assets of

Oldco)

47

Merger Only for State Law

• Oldco and Newco are the same partnership for tax purposes.

• As noted, tax year does not close and TIN does not change.

• But, the transfer from an LP to an LLC may have collateral consequences. For example, the allocation of liabilities to each member may change.

• Generally, the reduction in liabilities to a member is treated is as a deemed distribution. In certain circumstances, that can trigger gain.

4848

Alternative Transactions

There are at least five ways to accomplish this type of entity‐to‐entity change in form:

• state law merger of Oldco into Newco

• state law conversion of Oldco into Newco

• X and Y contribution their interests in Oldco to Newco and then Oldco liquidates

• Oldco contributes its assets to Newco in exchange for interest in Newco which Oldco then distributes to X and Y in a liquidating distribution (“Assets Over”)

• Oldco distributes its assets to X and Y who then contribute the assets to Newco (“Assets Up”)

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Partnership Mergers and Divisions

• From the IRS perspective, all five are equivalent in this context (entity‐to‐entity).

• The partnership merger rules are really set up for transactions in which there are two or more partnerships to start with and at least one is terminated in the transaction.

• The partnership division rules are in some ways analogous to the partnership merger rules and apply where there is one partnership to start with and at least two at the end of the transaction.

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Partnership Mergers

• A transaction that is subject to the partnership merger rules will involve a combination of distributions and contributions.

• Distributions and contributions are much more likely to be tax‐free under the partnership tax rules than are the counterparts under the corporate tax rules.

• For this reason, the partnership merger rules are much simpler than the corporate tax merger rules.

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Partnership Mergers ‐‐ Distributions

Notwithstanding this simplicity, there are several exceptions to the tax‐free distribution rules that may impact our analysis:

• distributions of cash and marketable securities in excess of basis

• deemed distributions associated with changes in allocations of liabilities

• a change in ownership of hot assets

• the disguised sale rules

• the mixing bow rules

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Section 708• Section 708 contains the only IRC rule for partnership

mergers.

• Primarily, this rule is meant identify the survivor of a partnership merger.

• Section 708 does not address other consequences or even define what is a partnership merger.

• Part of this disconnect is that Section 708 predates the enactment of state merger and conversion statutes. Before those regimes, partnership “mergers” were effectuated by contributions and distributions.

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General Rule

“In the case of the merger or consolidation of two or more partnerships, the resulting partnership shall . . . be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership.”

Code § 708(b)(2)(B).

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Example 2

• Blueco and Redco merge under state law.

• Blueco has two owners, A and B.

• Redco has two owners, C and D.

• Redco is the survivor of the merger.

• Under the merger agreement, C and D each end up with 30% of the capital and profits of Redco, for a total of 60%. A and B each end up with 20% of the capital and profits of Redco, for a total of 40%.

5555

Example 2

• The owners of Redco end up with more than 50% of the capital and profits of Redco.

• Thus, Redco is the survivor and Blueco is terminated

• Blueco’s tax year ends, files a short year tax return.

• Redco retains its TIN and continues its tax year (no truncation).

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Example 3

• Same facts, but A and B each end up with 30% of the capital and profits of Redco, for a total of 60%.

• Thus, the owners of Blueco end up with more than 50% of the capital and profits of Redco.

• Thus, Blueco is the survivor for tax purposes even though it terminates under state law.

• Redco is terminated for tax purposes, its tax year ends, and files a short year tax return.

• The state law entity that is Redco survives, but now has Blueco’s TIN. Blueco’s tax return will be under the legal name of Redco, but will indicate that it is the continuation of Blueco.

5757

Example 3

• This result is counterintuitive, but can assist in planning.

• For example, it may be very important that Blueco’s TIN be retained. Blueco could be a medical provider and its TIN may be useful for billing and other purposes.

• Similarly, it may be very important that the state law entity that is Redco continue in existence even though it terminates for tax purposes. For example, Redco may be a party to several contracts that cannot be assigned or assumed without the counterparty’s permission.

5858

Multiple Survivors?• There could be a situation in which owners of two or

more partnerships end up with more than 50% of the resulting partnership.

• This can occur because of cross ownership.

• For example, if A and C in the prior examples were the same individual, both sets of partners would qualify as owning more than 50% of Redco at the end of the transaction.

• In that case, the regulations provide a tie‐breaker: the surviving partnership is the one that had that largest net value of assets.

5959

No Survivors?• There could also be a situation in which no owners of any of

the combining partnerships end up with more than 50% of the resulting partnership.

• This can occur if there are more at least three combining partnerships.

• For example, if in the prior examples E and F owned Greenco, and Greenco also combined into Redco, and each of A, B, C, D, E and F received 16.6% of Redco after the combination, then no combining partnership’s owners would end up with more than 50% of the resulting partnership.

• In that case, all the merging partnerships are deemed to terminate and there is no survivor.

• Thus, all three partnerships would have short year tax turns, and the state law entity that is Redco would need to obtain a new TIN.

6060

Form of Transaction• The 708 rules contemplate only two forms of mergers:

– The assets over transaction is the default form.

– The assets up transaction is the one exception.

• Thus, unless the transaction is actually structured as an assets up merger, the transaction will be treated as an assets over merger regardless of how it is structured for state law purposes.

6161

Assets Over – Tax Treatment• In an assets up transaction, the steps are as follows:

– The terminated partnership contributes all of its assets and liabilities to the surviving partnership in exchange for interests in that partnership

– Immediately after, the terminated partnership distributes these interests to its owners in a liquidating distribution

• Note that the identification of the terminated partnership and the surviving partnership are based on the 708 rules –thus, a partnership that actually terminates under state law could be the survivor and vice versa.

6262

Assets Up Form• In an assets up transaction, the steps are as follows:

– The terminated partnership distributes all of its assets and liabilities to its owners in a liquidating distribution

– Immediately after, the owners of the terminated partnership contributes these assets and liabilities to the surviving partnership.

• Note that there may be a benefit to this form if the owners of the terminated partnership have a higher outside basis than inside basis.

• Again, a partnership that actually terminates under state law could be the survivor and vice versa.

6363

Form Confusion• The definition of the assets up transaction depends on

the identification of the terminated and surviving partnerships.

• Sometimes the parties may intend to structure an assets up transaction but the terminated and surviving partnerships are not identical to the state law counterparts.

6464

Form Confusion• For example, assume a combination of Blueco and

Redco as an assets up transaction.

• Assume Blueco distributes its assets to A and B, and A and B end up with more than 50% of Redco.

• Thus, Redco is the terminated partnership.

• As a result, the distribution from Blueco to A and B is not a distribution from the terminated partnership and tis transaction would instead be treated as an assets over transaction for tax purposes.

• This may be undercut the intent of the parties.

6565

Equivalent Transactions

66

W

Oldco

X Z

Newco

Y

66

Seven Equivalent Transactions per IRS• state law merger of Oldco into Newco

• state law merger of Newco into Oldco

• contribution of interests in Oldco to Newco

• contribution of interests in Newco to Oldco

• contribution of assets of Oldco to Newco for Newco interests that are distributed to Oldco’s owners

• contribution of assets of Newco to Oldco for Oldco interests that are distributed to Newco’s owners

• distribution of assets to of survivor to survivor’s owners with immediate contribution to terminating partnership (“failed” assets up)

All of these are treated as assets over transactions.

6767

Assets Over – Partial Sale Variation

• Under certain circumstances, partners of the terminated partnership in an assets over transaction can be treated as selling their interests to the surviving partnership.

• This rule helps the other partners of the terminated partnership avoid having to recognize taxable gain.

• This rule is often coupled with a cash distribution to the selling partners.

6868

Disguised Sale Rules

• A contribution to a partnership that otherwise qualifies as tax‐free can be taxable if it violates the disguised sale rules.

• The disguised sale rules apply to contributions of property or cash by a partner to a partnership that can be tied to a transfer of property or cash by the partnership to the same partner.

• Note that these rules will also convert an otherwise tax‐free distribution of property by the partnership to a member into a taxable event.

69

Disguised Sale Rules• Three conditions must be met:

– there is a transfer of cash or property by a partner to a partnership;

– there is a transfer of cash or property by the partnership to the same partner; and

– the transfers, when viewed together, are properly characterized as a sale or exchange of property.

70

Disguised Sale Rules• The last factor is the most difficult part of the analysis.

Generally, this is a facts‐and‐circumstances determination. However, the applicable regulations provide an important presumption:

– A distribution that occurs within two years of a property contribution is deemed to result in a disguised sale.

71

Disguised Sale Rules ‐ Example• X and Y form a Newco LLC by contributing a variety of assets. Later, at

time when Newco is worth $1 million, Z contributes $500,000 for a one‐third interest. On the next day, Newco distributes assets to Z worth $250,000.

• Here, one member – Z – contributes cash or property (i.e., $500,000 in cash) and there appears to be a related transfer of cash or property back to Z (i.e., assets worth $250,000).

• This may be treated as a disguised sale. Accordingly, Newco will be required to recognize gain (if any) on the transfer of assets worth $250,000 to Z. (Such gain would likely be allocated to X and Y under the 704(c) rules as it would be attributable to appreciation prior to the time of Z’s entry into the LLC.)

72

Disguised Sales of Partnership Interest

• The statute also provides that a distribution of partnership interests could be subject to the disguised sale rules.

• The IRS initially proposed regulations on disguised sales of partnership interests in 2004, where they were met with almost universal criticism.

• The IRS withdrew the regs and advised taxpayers to look to statutory language, case law and legislative history.

• The statute contains little guidance, the cases are all over the map, and the legislative history show some willingness to overrule the case law, but delegated this to regulations.

73

73

Mixing Bowl Rule 1:Distribution of Property to Different

Partner within 7 Years• Specific fact pattern:

– if one party contributes property to the partnership;

– the property is distributed to a different partner; and

– the distribution occurs within 7 years of the contribution

• then the distribution is treated as a deemed sale of the property and the contributing partner is required to recognize gain.

74

• The amount of gain is the amount that would have been allocated to the partner by virtue of the 704(c) rules (i.e., the difference between the FMV of the property and its tax basis at the time of contribution).

• Note that the contributing partner is only required to recognize its 704(c) amount, not the full amount of the inherent gain.

75

Distribution of Property to Different Partner within 7 Years

Mixing Bowl Rule 2:Distribution of Property to Same Partner

within 7 Years

• §737 rules provides that:

– if a partner contributes appreciated property to a partnership;

– other property is distributed to the same partner; and

– the distribution occurs within 7 years of the contribution

• then the contributing partner is required to recognize gain.

76

Mixing Bowl Rules and Assets Up

• Note that because of its form, the mixing bowl rules may apply to a combination that is treated as an assets up transaction for 708 purposes.

• This is not the case for a combination treated as an assets over transaction.

77

Investment Credit Recaptureand Assets Up Form

• An assets over transaction generally will not trigger any investment tax credit recapture.

• In contrast, in the assets up form, the investment credit recapture rules will be triggered.

78

Partnership Divisions

• Section 708 also provides guidance on so‐called partnership divisions. Like partnership mergers, there is no definition of a partnership division.

• In general, it is a transaction in which part of the assets of an existing partnership are transferred into a new partnership, yielding two or more partnerships after the transaction.

• So like the approach to partnership mergers, partnership divisions generally involve contributions and distributions.

• The rules under 708 generally aimed at determining if there is a continuing partnership.

79

Partnership Divisions

• Because 708 only governs which entity is deemed to be the survivor of a division, it does not address other consequences.

• So, as with partnership mergers, the contributions and distributions that effectuate a division are given independent significance.

• Thus, to the extent the contributions and distributions are tax‐free, the division will be tax‐free.

80

Survivor – General Rule

“In the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) shall, for purposes of this section, be considered a continuation of the prior partnership.”

Code § 708(b)(2)(B).

81

Survivor Rules• More than one partnership can be treated as a continuation

of the original partnership.

• In that case, each is bound by the partnership elections of the original partnership and the tax returns of each must state that it is a continuation of the original partnership.

• But, only one of these continuing partnerships takes the TIN of the original partnership and is deemed to retain the assets that it holds at the end of the division (rather than receiving assets).

• This partnership is called the “divided partnership”

82

Survivor Rules• Any partnership that does not constitute a continuation of

the original partnership is treated as a new partnership.

• If no resulting partnership is treated as a continuation of the original partnership, then the original partnership is treated as terminating in the division transaction.

• If a partner of the original partnership does not end up as a partner of the continued partnership, her interest is treated as liquidated in the division transaction.

83

Division Definitions• “Prior Partnership” – the state law entity that existed prior

to the division – there will be only one of these

• “Resulting Partnership” – any state law entity that exists after the division and has at least two partners who were partners of the Prior Partnership – often two or more of these

• “Divided Partnership” – the partnership that is treated (for tax purposes) as transferring assets and liabilities to the Recipient Partnership in the division transaction ‐‐ there will be only one of these

• “Recipient Partnership” – the partnership that is treated (for tax purposes) as receiving assets and liabilities from the Divided Partnership in the division transaction – at least one of these

84

Form of DivisionAs with the partnership merger rules, the division rules contemplate only two types of divisions:

• Assets Over

– An existing partnership transfers some portion of its assets and liabilities to a new partnership in exchange for ownership of that partnership

– The existing partnership then distributes interests in the new partnership to some or all of the existing partnership's owners

• Assets Up

– An existing partnership distributes some or all of its assets and liabilities to some or all of its owners

– The receiving owners then contribute the assets and liabilities to one or more new partnerships

85

Form of Division• Unless the form of the transaction is an assets up

transaction, all other formats are treated as assets over divisions for tax purposes.

• As with merger counterpart, there can be some confusion as to which type of transaction has occurred.

• Once the analysis settles on a type of transaction, then the issues raised by the contributions and distributions within that format have to be addressed.

86

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Documents

Section Partnership Mergers IRS Guidance: Avoiding ... · The converting entity must be a California Corp, LP or GP; or Foreign Corp, LLC, LP, GP or Other Business Entity;