Nothing from Something: Partnership Continuations under ...

[Pages:89]University of Chicago 2016 Federal Tax Conference

Nothing from Something: Partnership Continuations under Section 708(a)

Phillip Gall Ernst & Young LLP

November 12, 2016

Nothing from Something: Partnership Continuations under Section 708(a)1

Don't be fooled by the insipid language of section 708(a): "GENERAL RULE.--For purposes of this subchapter [i.e., Subchapter K], an existing partnership shall be considered as continuing if it is not terminated." Tempting as it is to gloss over a provision that seems so painfully obvious,2 doing so ? as far as these things can go ? is perilous. More heft can be found in section 708(b), which provides that a partnership is considered as terminated (and thus not continuing), only if "(A) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (B) within 12month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits [(a "technical termination")]." Said another way, if any part of the business, financial operation, or venture of the partnership continues to be carried on by any of the partners in a partnership and there is not a technical termination, the partnership continues. What will become clear, if it is not already clear from the breadth of that statement, is that there are a lot of

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I would like to thank my colleague, Monisha Santamaria, for her tireless work and

enthusiasm in assisting me with this paper. I would also to thank my partners, Andy Dubroff,

David Franklin, Todd Golub, and Franny Wang, and my former partner, Don Turlington, for

their helpful comments and insights. A special thank you to Monte Jackel and Bob Crnkovich

for their blessings in my use of the title, despite the similarity to the title of their excellent article

on partnership conversions. See Monte A. Jackel and Robert J. Crnkovich, Partnership

Conversions: Making Something Out of Nothing, 123 Tax Notes 275 (July 20, 2009). All

section references are to the Internal Revenue Code of 1986, as amended (the "Code"), or the

regulations thereunder.

2

Section 708(a) has been said to "challenge[] the definition of `foreign corporation' for

simple-mindedness." Henry Jordan and Herman Schneider, New Developments and Existing

Problems in the Taxation of Partnerships and Subchapter S Corporations, 43 Taxes 366, 381

(1965). (Section 7701(a)(5) states (and stated in 1965): "The term `foreign' when applied to a

corporation or a partnership means a corporation or a partnership which is not domestic.")

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partnership continuations (sometimes referred to as "partnership F reorganizations"). Be forewarned, an appreciation for the scope of section 708(a) is a bit like being armed with Maslow's hammer.3

Many partnership continuations are readily apparent. For example, a partnership may continue notwithstanding the death or withdrawal of one of its partners; a partnership may continue notwithstanding a change in its place of organization or a change in the type of legal entity; and a partnership may continue notwithstanding the conversion of a partner's interest from a common interest to a preferred interest or other amendments to the partnership's operating agreement. However, partnership continuations are not always so easy to identify. For example, a transaction that is legally a sale or transfer of assets to a newly formed legal entity that has some unrelated members and other assets may be treated as a partnership continuation. In many cases, treating a partnership as continuing will result in a recast of the transaction to one that could have vastly different tax consequences than the form would produce. The stakes of whether a transaction results in a partnership continuation, therefore, involve not only administrative issues such as whether the partnership's year ends, its elections terminate, and its employee identification number ("EIN") should continue to be used, but also more substantive issues concerning the proper characterization of the transaction for U.S. federal income tax purposes. But the stakes don't end there.

After the transaction is recharacterized in a manner consistent with the continuation conclusion, a question remains as to the consequences, if any, to the continuing partners in the

3

See Abraham Maslow, The Psychology of Science: A Reconnaissance 15 (1966) ("I

suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a

nail.").

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continuing partnership: As a legal matter, such partners may own interests that have different legal and economic rights. Not only might that result in different sharing of partnership liabilities under section 752 (e.g., if a partner who was a general partner becomes a limited partner), different treatment for self-employment tax purposes due to the application of the exception under section 1402(a)(13) (e.g., again, if a partner who was a general partner becomes a limited partner), or the need to file a check-the-box election (e.g., if the default classification for the legal entity is not a partnership), but it also raises fundamental questions as to whether the transaction should be treated as a "tax nothing" or as a realization event.

This paper is divided into three parts. Part I addresses the background of partnership continuations, focusing on the history of section 708(a) and the relationship between partnership continuations, on the one hand, and partnership mergers and divisions, on the other hand. Part II reviews the continuation authorities and identifies partnership continuations and the resulting transactional recast in a variety of structures. Finally, Part III addresses the treatment of the continuing partners in the continuing partnership and argues in support of treating a partnership continuation as a "tax nothing," rather than as a realization event, for such partners.

I. Background of Partnership Continuations A. Section 708(a) History4

In 1919, the Treasury Department issued O.D. 228,5 a ruling that set the wheels in motion for the eventual enactment of section 708 in 1954. The ruling concludes that a short-period

4

See James E. Thomas, Continuity of Partnerships for Federal Income Tax Purposes, 40

ABA Journal 157 (Feb. 1954).

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1 C.B. 190 (1919).

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return is required when a partnership dissolves under local law upon the death of a partner, regardless of whether the partnership's business is continued by the remaining partners:

As the death or withdrawal of a partner ordinarily dissolves the partnership, a return would be required covering the period from the beginning of the partnership's taxable year to the date of its dissolution. If the business of the partnership is continued as such, a new accounting period would be established upon the necessary reorganization of the partnership, and its next return should cover the period from the date of reorganization until the end of the taxable year. Implicit in the conclusion in O.D. 228 was that the dissolution of a partnership under local law results in the termination of the partnership for U.S. federal income tax purposes.

Perhaps because O.D. 228 was issued while the nation was distracted by war, or perhaps because rulings did not have the same clout in 1919 as they do today, several contrary court decisions were later issued without even citing the ruling. In Tooke v. Commissioner6 and Reynolds v. Commissioner,7 which were companion cases, the issue was whether a partnership's year ended upon its dissolution under local law. Tooke and Reynolds were partners in two partnerships that each had a March 31 fiscal year. On September 30, 1922, both partnerships dissolved and their combined business was incorporated in a single corporation, the stock of which was issued to the two partners. The issue was whether the income of the partnerships from April 18 through September 30, 1922, was to be included in the partners' 1922 tax returns, which would be correct under O.D. 228, or their 1923 tax returns, as reported. The taxpayers' seemingly preposterous theory was that the partnerships' accounting periods did not end upon

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17 B.T.A. 690 (1929).

7

17 B.T.A. 693 (1929).

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The decisions use March 31 as the beginning date for the short periods.

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their incorporation; rather, they argued they were not required to include the partnerships' income in their returns until 1923, the year in which the partnerships' accounting periods would have ended. The crux of the argument was that, even though the partnerships dissolved and their businesses ceased to be conducted in partnership form, their accounting periods did not end. Although these cases should have been straightforward, particularly in light of O.D. 228, the court agreed with the taxpayers,9 and, more surprising, the Commissioner acquiesced.10

The Supreme Court entered the fray in Guaranty Trust Co. v. Commissioner,11 holding that a deceased partner's share of partnership income for 1933 includes his share of partnership income for its year ending on July 31, 1933, and for the period from August 1, 1933, to December 16, 1933, which was the date of the partner's death.12 Due to the taxpayer's death, the partnership dissolved under local law and an accounting was required. The taxpayer did not even try to contend, "nor could well do so,"13 that the short period ending on the date of death did not result in the end of the partnership's taxable year. Instead, the taxpayer argued that requiring both periods' income (over 16 months of income) to be included "offends against the

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The court relied on the decision in Bankers' Trust Co. v. Bowers, 295 F. 89 (2d. Cir.

1923), which held that an individual's death did not end his or her accounting period; rather, the

period continued for the full 12-month period. The Tooke court stated: "We are unable to see

why a different rule should apply in the case of the end of a partnership." 17 B.T.A. at 692.

10 1930 IX-1 C.B. 46 (acquiescing to Reynolds v. Commissioner); 1930 IX-1 C.B. 54 (acquiescing to Tooke v. Commissioner).

11 303 U.S. 493 (1938).

12 Although the partnership dissolved under state law upon the partner's death, the surviving partners agreed to continue the partnership's business until July 31 of the following year.

13 303 U.S. at 499.

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policy of the revenue acts to assess income taxes annually on the basis of twelve month periods,"

even though such income would then not be subject to tax in any other taxable year.14 The Court

rejected the taxpayer's argument because it believed the policy of requiring a partner to include

his share of partnership income for any partnership year ending with or within his year was

served as long as there was an accounting of such income by the partnership. Although the

Court did not cite O.D. 228, the decision is consistent with its conclusion.15

In Walsh v. Commissioner,16 the issue was whether the death of a partner, which the

parties agreed caused the partnership to dissolve under local law, resulted in the termination of

the partnership's taxable year for the surviving partners, thereby requiring such partners to

include their shares of the partnership's income for the short-period ending on the date of the

partner's death.17 The court noted a distinction under local law between the dissolution of a

partnership, which occurred on the death of a partner, and the termination of a partnership, which

14 303 U.S. at 497. 15 Under current law, a partnership's taxable year does not close for tax purposes upon the death of a partner. However, the result in Guaranty Trust Co. is now codified in section 706(c)(2)(A): "The taxable year of a partnership shall close with respect to a partner whose entire interest in the partnership terminates (whether by reason of death, liquidation, or otherwise)." 16 7 T.C. 205 (1946). 17 Specifically, the case involved two partnerships in which the decedent was a partner: One was a calendar-year partnership, and the other had a May 31 taxable year. The decedent died on July 7, 1939. The issue was relevant for a trust, which was a partner in both partnerships, that had an August 31 taxable year and for an individual whose husband was a partner in the partnership with the May 31 taxable year. For the trust, the stakes were whether it had to include its share of the calendar-year partnership's income from January 1 through July 7, 1939, in its return for its taxable year ending August 31, 1939, and its share of the May 31-year partnership's income from June 1 through July 7, 1939, in such return. For the individual, the stakes were whether her husband's share of the May 31-year partnership's income from June 1 through July 7, 1939, had to be included in the return for her taxable year ending December 31, 1939.

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occurred only after its affairs were wound up. The court concluded that the taxable year of the

partnership did not end for the surviving partners upon its dissolution.

After many years of inconsistent decisions, O.D. 228 was revoked in Rev. Rul. 144.18

Significantly, Rev. Rul. 144 de-links state law from the treatment of partnerships for tax

purposes:

[T]he term "partnership" for tax purposes is broader than the term under common law, the Uniform Partnership Act, or individual State laws. Accordingly, the Federal tax consequences of transactions involving partnerships and interests in partnerships will be determined on the basis of their substance and in accordance with the Federal tax laws without regard to the technical refinements of State laws.

Rev. Rul. 144 then focuses on the entity treatment of partnerships for tax purposes being

inconsistent with the notion that changes in the membership of a partnership should have an

impact on the partnership and, thus, concludes:19

[A] change in the membership of a partnership resulting from the death, withdrawal, substitution, or addition of a partner, or a shift of interests among existing partners does not, in itself, effect a termination of a partnership for Federal income tax purposes. Ordinarily, a partnership will be treated as continuing where the business of the partnership, or a substantial portion thereof, is continued. [Emphasis added.]

18 1953-2 C.B. 212. 19 The entity features of partnerships relied upon to establish that a partnership continues notwithstanding a change in membership were (i) the fact that a partnership has its own taxable year, (ii) the fact that under Walsh the taxable year of the partnership does not terminate upon the death of a partner insofar as the surviving partners were concerned, (iii) the fact that a partnership's basis in its assets is not affected by changes in membership, and (iv) the fact that a sale of a partnership interest is treated as a sale of a capital asset, distinct from the partner's interest in the partnership's assets. The ruling does note that the entity treatment of partnerships is not always appropriate: "It is not intended herein to state that a partnership is invariably to be treated as a unit intervening between a partner and partnership transactions and income [sic] for Federal tax purposes."

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