A partnership can terminate for federal income tax purposes without the partners knowing it. This is called a technical termination, and can expose the partnership to costly late-filing penalties.
What is a technical termination?
Technical terminations apply to businesses which are taxed as partnerships, which includes some LLCs. If your business files a Form 1065, this issue applies to you. If you file Form 1120 or Form 1120S, you’re not subject to technical terminations.
A technical termination of a partnership occurs when 50% or more of the partnership’s capital and profits interests are sold or exchanged within a 12-month period.
Example 1
Jerry, George and Elaine are partners in Vandalay Industries LLC, which is taxed as a partnership and is on a calendar year end. Jerry owns 60% of the capital and profits interests, and George and Elaine own 20% each. On May 1, 2013, Kramer purchases Jerry’s entire interest in the LLC. Since 50% or more of the capital and profits interest were sold or exchanged, the partnership was technically terminated on May 1, 2013.
A technical termination can result from multiple sales, even if they span multiple tax years. It can also result from sales by different partners.
Example 2
Assume the same ownership as in Example 1. On December 15, 2012, Kramer buys 2/3 of Jerry’s interest, i.e. 40% of the total ownership. On May 1, 2013, Newman purchases Elaine’s entire 20% interest. A technical termination occurs on May 1, because 50% or more of the capital and profits interest were sold within a 12-month period.
Consequences of a technical termination
General tax treatment
When a technical termination occurs, the the interests in the old pre-termination partnership are exchanged tax-free for interests in the new partnership. The “outside basis” of the continuing partners are the same in the new partnership as it was in the former partnership. The new partnership’s basis in its assets (inside basis) is the same as in the old partnership. The holding period of assets in the new partnership includes the holding period of those assets by the former partnership. These aspects of the technical termination are usually neutral from a tax perspective.
Depreciation methods
Depreciable property owned by the partnership is considered to be newly placed into service by the new partnership. This can be very unfavorable.
Example 3
Vandalay Industries, LLC had placed a commercial building which cost $395,000 into service on January 1, 2001. Commercial buildings have a tax depreciation life of 39.5 years, so Vandalay took a $10,000 depreciation deduction on its tax return each year.
Vandalay had a technical termination on January 1, 2013. The net value of the building on that date was $275,000 (cost of $395,000 less 12 years of depreciation at $10,000/year). The new partnership is deemed to have newly placed the building in service on January 1, 2103.This restarts the depreciation clock at 39.5 years. Vandalay now gets an annual depreciation deduction of only $6,962 ($275,000 remaining basis divided by 39.5 years).
Partnership tax year and late filing penalties
Technical terminations frequently trigger penalties for late filing of the old partnership’s final return. The old partnership’s tax year closes on the date of the technical termination. This means that the old partnership’s final tax return is due 3-1/2 months following the end of the month in which the partnership terminated. The penalty for late filing of a partnership return is $195 per month, per partner.
Example 4
Same facts as in Example 1, except the technical termination occurs on February 15, 2013. The final tax return of the old partnership is due 3-1/2 months following the end of the month in which the partnership terminated, i.e. June 15, 2013. The partnership doesn’t inform its tax preparer of the ownership change until the following January, and the final return is filed on February 15, 2014. The penalty for late filing is $4,680 (8 months late X 3 partners X $195).
Tip: Be sure to promptly inform your tax advisor of any ownership changes in your partnership.
Tax elections and accounting methods
The new partnership chooses its own tax accounting methods, year-end, and tax elections. These do not carry over from the old partnership.
Tip: In some circumstances a planned technical termination can be used to cure a missed or detrimental election. For instance, if a partnership eligible for the cash method of accounting inadvertently elects the accrual method and other relief isn’t available, a technical termination would allow the new partnership to elect the cash method.
EIN
The employer identification number (EIN) of the partnership is not changed by the technical termination. You are not required to apply for a new EIN.
Creation of a disregarded entity
A partnership must have two or more partners or members. If ownership changes result in only one surviving owner, the entity becomes a single member LLC or a sole proprietorship for tax purposes. This can happen with or without a technical termination.
Example 5
Same ownership as in Example 1. On May 1, 2013, Jerry buys out George and Elaine’s entire interests, leaving Jerry as the sole owner. A technical termination has not occurred, as only 40% of the capital and profits interests were exchanged. However, since there is only one survivng member, Vandalay becomes a single-member LLC for tax purposes. Its activity From May 1, 2013 forward is reported on Schedule C of Jerry’s Form 1040.
What is a sale or exchange?
A technical termination is triggered by the sale or exchange of 50% or more of the partnership’s capital and profits interests. The regulations and other available guidance do not explain what constitutes a sale or exchange, but rather specify that certain transactions are deemed not to be sales or exchanges for this purpose:
- Disposition of an interest by gift, bequest, or inheritance
- Liquidation of an interest (i.e. “retirement payments” made by the partnership in exchange for a retiring parnter’s interest)
- Acquisition of a partnership interest by contribution of property to the partnership
- Charitable contributions of partnership interests
- Transfers between spouses or former spouses incident to divorce
Note: This post briefly discusses some basic points of technical termiantions. Partnership taxation can be very complex. As always, be sure to consult your tax advisor.
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