Preface: Partnership mergers are sometimes applicable to improving business tax plans and tax filing efficiencies, and often encompass many taxation and legal issues that must be reviewed and evaluated with appropriate advice to ensure that the most appropriate decisions are chosen, with adherence to required guidelines. This blog outlines a general awareness of the major tax pertinent highlights.
Tax Laws of Partnership Mergers
Credit: Sauder & Stoltzfus, LLC
The general tax definitions of the partnership-merger rules do not define a “merger.” In general, however, one of the partnerships entering the merger will be the “continuing” partnership after the merger, and one of the partnerships will terminate; it will be the “dissolving” partnership.
In addition, a partnership merger, can also involve a conversion of the entity to an LLC in certain states. The tax ramifications of the conversion are beyond the scope of this blog.
An entity that is taxed as a partnership may combine with a like entity. The transaction that will be treated as a “merger” for purposes of the partnership-merger rules in one of several ways:
Assets-over. A partnership can transfer all its assets to another partnership in exchange for interests in that partnership. It then distributes the interests received to the members of the dissolving partnership. This form of merger is called “assets-over,” because the dissolving partnership’s assets are conveyed over to the resulting partnership.
Assets-up. The partnership can liquidate by distributing all its assets to its partners. They then contribute the assets to the resulting partnership. This form of merger is called “assets-up,” because assets are transferred “up” to the partners.
Interests-over. The partners in a dissolving partnership can transfer their interests to another partnership in exchange for its interests. The dissolving partnership then liquidates. This form of merger is called “interest-over.”
State-law merger. State-law entities that are taxed as partnerships can merge without using one of the forms listed above. They do so by merging under a state-law merger statute.
“Also, partnerships using the interest-over form are treated for tax purposes as following the assets-over form. Thus, as a practical matter, the only way that partners can avoid the application of the assets-over form is to use the assets-up form.”
When entities taxed as partnerships merge by a statutory merger, tax consequences are determined by treating the transaction as an assets-over transaction. Also, partnerships using the interest-over form are treated for tax purposes as following the assets-over form. Thus, as a practical matter, the only way that partners can avoid the application of the assets-over form is to use the assets-up form. To qualify as an asset-up form, the partnership assets must be transferred for state-law purposes to each of the partners. This may impose additional costs and risks on the partners.
Generally, which partnership is the continuing partnership for tax purposes is determined under one of two tests.
- Do the partners from one of the partnerships own (in the aggregate) more than 50 percent of the capital and profits in the resulting partnership? If so, the continuing partnership is the one that was previously owned by the majority of the partners.
- Do the partners in both of the former partnerships own more than 50 percent of the capital and profits in the resulting partnership? If so, the continuing partnership is the one credited with the contribution of assets having the greatest fair market value to the resulting partnership. Fair market value is net of liabilities.
“In fact, the continuing partnership for tax purposes may be the one that was merged out of existence for state-law purposes.”
Under these rules, it is not obvious which partnership in a state-law merger survives for tax purposes. In fact, the continuing partnership for tax purposes may be the one that was merged out of existence for state-law purposes. Now we will protract on the tax consequences of each transaction pertinent to a partnership merger.
Tax consequences to the dissolved partnership. The partnership that is deemed to terminate for tax purposes under the partnership-merger rules is treated as follows:
- The dissolved partnership is deemed to contribute its assets and liabilities to the continuing partnership in exchange for interests in the continuing partnership. In general, there is no gain or loss on the contribution.
- The dissolved partnership receives a capital account credit based on the amount of money contributed and the fair market value of property contributed, net of any liabilities.
- The dissolved partnership’s basis in the contributed assets carries over to the basis in the interests of the continuing partnership that it receives.
- The dissolved partnership’s holding period in the contributed assets tacks on to the holding period in the partnership interest received.
The dissolved partnership’s tax year terminates on the date of the merger.
Tax consequences to the continuing partnership. The partnership that is deemed to continue for tax purposes under the partnership-merger rules is treated as follows:
- The continuing partnership generally has no gain or loss.
- The continuing partnership takes a carryover basis in the assets of the dissolved partnership.
- The holding period of the assets of the dissolved partnership “tacks.” That is, the continuing partnership acquires whatever holding period the dissolved partnership had.
- The continuing partnership will generally step into the dissolved partnership’s shoes for depreciation and cost recovery of contributed assets of the dissolved partnership.
The dissolved partnership’s contributions of unrealized receivables, inventory, and built-in capital loss property will retain their character in the continuing partnership.
The continuing partnership’s tax year does not close.
The federal income tax return for the year of the merger must state that the partnership is a continuation of the merging partnership.The continuing partnership must retain the same employer identification number.
Tax consequences to the partners. The partners in a partnership merger are generally taxed as follows: In a dissolved entity they generally do not recognize gain or loss on the transaction”
A partner may, however, recognize gain or loss in certain instances. This usually occurs if the partner’s net share of liabilities allocated to the partner is reduced so there is a deemed cash distribution that triggers taxable gain.
The partners of the dissolved partnership step into the dissolved partnership’s shoes with respect to their shares of capital accounts.
The partners of the dissolved partnership generally will have the same adjusted basis in the continuing partnership that they had in the dissolved partnership.
The continuing partnership may have a Code Sec. 754 election (also known as a step-up in basis) in effect. If so, the partners of the dissolved partnership may receive a special basis adjustment in the assets of the continuing partnership. This adjustment extends as far as a partner’s basis in continuing partnership interests received differs from his basis in the continuing partnership’s assets.
Partnership mergers involve many tax specific issues that must be reviewed and evaluated to ensure that the best decisions are made. Please talks with an experienced tax advisor before commencing on a partnership merger.