Jennifer Ray is a principal and Dina Wiesen is a managing director in the passthroughs group of the Washington National Tax office of Deloitte Tax LLP. They thank Jenny Alexander and Ben Applestein for their helpful comments on earlier drafts of this article.
In this report, Ray and Wiesen argue that most partnership divisions in which taxpayers attempt to separate business lines, assets, or partners ought to be analyzed as happening in a bubble.
Copyright 2022 Deloitte Tax LLP.
All rights reserved.
Corporate conglomerates have recently been breaking up their businesses in high-profile transactions. In 2021 General Electric Co. announced it would spin off its healthcare, renewable energy, and power divisions over the next few years to create three investment-grade, independent companies. Johnson & Johnson plans to spin off its consumer health business from its pharmaceutical business. Many other corporations also have recently announced proposed spinoff transactions to focus attention on remaining business units and eliminate inefficiencies. Just like a company classified as a corporation for tax purposes, a company that is classified as a partnership for U.S. federal income tax purposes can realize the value in each piece of its business by splitting the whole into parts or dividing the partnership.
Despite being common business transactions, partnership divisions present unanswered questions for federal income tax purposes. Many of those open issues stem from the threshold issue of whether a partnership division is properly analyzed as occurring in an isolated moment in time regardless of what transaction steps occur later as part of the same plan. Analyzing the consequences of a division requires identification of the owners of the ultimate partnerships, but what should the timing be? Do partnership divisions happen in a “bubble” such that the numerical tests described below apply immediately after a potential division, or is it necessary to determine ownership after all the steps in an integrated transaction occur? Or does the answer depend on the transaction?
This report uses simple examples to examine whether a partnership division is properly viewed as happening in a bubble, focusing on situations that might otherwise involve transitory partners and transitory partnerships. It concludes that, in most situations, a partnership division ought to be viewed as occurring in a bubble.
I. Partnership Divisions — A Summary
A. Structure of Section 708
Partnership divisions, as well as continuations and mergers, are governed by section 708.1 Section 708(a) provides the general rule that a partnership is considered continuing if it is not terminated. Under section 708(b)(1) (formerly section 708(b)(1)(A)), a partnership is considered terminated only if 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.2
Under former section 708(b)(1)(B), a partnership could be terminated for federal income tax purposes even if it continued to conduct business, have multiple owners, and exist for legal purposes (a technical termination). In a technical termination, a partnership was considered terminated if within a 12-month period there was a sale or exchange of 50 percent or more of the total interests in the partnership’s capital and profits. Former section 708(b)(1)(B) was repealed for partnership tax years beginning after December 31, 2017.3
Section 708(b)(2) provides special rules for mergers and divisions. In the case of a merger of two or more partnerships into one partnership, the resulting partnership is considered a continuation of any merging partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership.4 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) will be considered continuations of the prior partnership.5
Both the merger and the division code provisions look to ownership to determine whether a partnership is continuing for federal income tax purposes and provide a continuation threshold of “more than 50 percent of capital and profits” of a partnership. The legislative history contains minimal discussion of these provisions, but it appears Congress was focused on situations in which the tax year of a partnership might be said to end.6 In other words, if at least 50 percent of the interests in capital and profits of a partnership changed in a transaction (or over the course of a year, in the case of a technical termination), Congress might have viewed that as an appropriate time to close the tax year of the partnership. The structure of section 708 suggests that mergers and divisions were to be evaluated standing alone (without regard to transfers of partnership interests that might happen in the same transaction). Former section 708(b)(1)(B) would govern the consequences of those additional transfers.
Attempting to discern the workings of these provisions is complicated by the repeal of the technical termination rule.7 Former section 708(b)(1)(B) signaled that Congress believed it was appropriate to treat a partnership as terminated if a specific amount of partnership interests changed hands within a 12-month period. The repeal of section 708(b)(1)(B) might be read to suggest that there is no threshold of ownership by “historic” partners necessary to have a partnership continuation.8 Does this, in turn, inform whether a partnership division happens in a bubble? As discussed below, whether a partnership terminates or continues has many other consequences, such as whether a new partnership continues to be subject to the tax elections and accounting methods of an old partnership.9 In evaluating the examples, it might be asked what results would be most appropriate in the context of the overall transaction.
B. The Division Regulations
As discussed, the statute provides one sentence on a partnership division and is limited to a determination of which partnerships are continuations of the original partnership. Before 2000, there was no other guidance on how to analyze a partnership division. The regulations finalized in 2000 filled that gap and provided detailed rules governing the form of a division and the tax consequences of the deemed steps undertaken in a division, but they left some basic questions unanswered.
The first question is, what constitutes a division? Section 708(b)(2)(B) and the regulations only apply if a division exists. Neither the code nor the regulations define a partnership division.10 Many practitioners conclude that a division occurs if a transaction causes one partnership to become two or more partnerships.11 This rudimentary definition is limited, however, by the requirement that for a division to exist there be at least two “resulting partnerships.”12 A resulting partnership is one that exists under local law as a result of the division and that has at least two partners that were partners in the prior partnership.13 This requirement often limits the transactions that might be considered a division.
For example, Partnership X owns all of a limited liability company, and an unrelated person contributes assets to the LLC, which causes LLC to become classified as a partnership for tax purposes. One partnership (X) has become two partnerships (X and LLC), but the transaction is not a partnership division because LLC’s members are Partnership X and the unrelated person, and neither Partnership X nor the unrelated person was a partner in Partnership X.
The preamble to the final division regulations14 also provides an example in which there are not two resulting partnerships. In that example, ABC partnership owns X business and Y business. A and B each own 20 percent of ABC, and C owns 60 percent. ABC distributes X business to C in liquidation of C’s interest in ABC. C then forms a partnership with D and contributes X business to the CD partnership. The preamble provides that this transaction is not a division because the CD partnership only has one partner (C) in common with the original ABC partnership. Thus, the CD partnership is not a resulting partnership. Notably, not only does the final CD partnership only have one partner in common with the original ABC partnership, but there is no point in the transaction at which D is a partner of a partnership with A or B.
Assuming a transaction is a division and results in two partnerships that each have at least two partners in common with the prior partnership, both partnerships existing after the division are resulting partnerships. Any resulting partnership is considered a continuation of the prior partnership if the members of the resulting partnership had an interest of more than 50 percent in the capital and profits of the prior partnership.15 More than one resulting partnership can be considered a continuation. Any resulting partnership that fails this 50 percent test is considered a new partnership.16 If members of a partnership that has been divided do not become members of a resulting partnership that is considered a continuation of the prior partnership, those members’ interests are considered liquidated on the date of the division.17
A partnership division can take two forms. The default rule is the “assets-over” form, in which the divided partnership contributes some assets subject to liabilities to a recipient partnership in exchange for interests in the recipient partnership, and immediately thereafter distributes the recipient partnership interests to some or all of its partners.18 The “assets-up” form is possible if a partnership distributes assets in a manner that causes the partners to be treated under applicable local law as the owners of those assets, and the partners contribute the distributed assets to one or more recipient partnerships in exchange for interests in the recipient partnerships.19
The form of the transaction generally will be respected if either the distributing partnership is a continuing partnership or none of the resulting partnerships are continuing partnerships.20 If the form of the transaction is respected, then the partnership that in form transferred assets is also treated as transferring assets for federal income tax purposes.21 If the division is formless or done in a way that the regulations do not recognize (for example, interests-over), or if the resulting partnership that in form transferred the assets is not a continuing partnership (and another resulting partnership is), the form is not followed.22 In those circumstances, a resulting partnership that is considered a continuation is deemed to transfer assets.23 The regulations can force incongruous treatment of a partnership division for local law purposes and federal income tax purposes. The tax fiction of a division may not follow the legal form.
Once the form of a division is identified, the tax consequences of the transaction follow. Every partnership division, regardless of form, involves a transfer to a partnership and a transfer from a partnership. While contributions to and distributions from partnerships generally are tax deferred under sections 721 and 731, respectively, subchapter K contains exceptions to those general rules that need to be analyzed in each partnership division. The division’s form — and, in fact, whether a division exists at all — often changes the anticipated subchapter K consequences.24
II. When Is a Division Analyzed?
The second question, and the topic of this report, is when to determine whether a transaction has given rise to a potential division. A simple example is provided to illustrate the question. As noted, the division regulations only apply if a transaction creates at least two resulting partnerships. At least two persons must be partners in both the prior and resulting partnerships.25 If the division regulations apply, the form of the division partially depends on which resulting partnership or partnerships are considered to be continuations of the original partnership. To answer these questions, it is necessary to know when ownership is measured — a topic on which there is little guidance. Consider the following example to see the ambiguities that arise.
Example 1: Entertainment LLC, which is classified as a partnership for federal income tax purposes, owns a TV and movie streaming service and a video game business. Jack and James each own 20 percent of Entertainment, and Catherine owns 60 percent.26 Management believes that the businesses will run more efficiently if separated, and Jack and James also wish to sell their interests in the businesses to Lily and Henry. To effectuate those objectives, Entertainment contributes the streaming business to a newly formed entity, Streaming LLC, and distributes the Streaming interests pro rata to Jack, James, and Catherine. Entertainment is renamed Gaming LLC. Immediately after, Jack and James sell their Streaming and Gaming interests to Lily and Henry. Is this a division? If so, what are the tax consequences?
If potential divisions are analyzed in a bubble so that the identification of the partners and the measurement of ownership are performed immediately after the distribution of the Streaming interests, both Streaming and Gaming are resulting partnerships, and both are continuations of Entertainment. In the moment after the distribution, all of Entertainment’s members (Jack, James, and Catherine) are also members of Streaming and Gaming. Thus, Streaming and Gaming are “resulting partnerships,” and they are also continuations because the requisite 50 percent threshold has easily been met. The tax fiction of the division would follow the legal form of the division (a contribution of assets to Streaming, followed by Entertainment’s distribution of the Streaming interests). Lily and Henry would purchase LLC interests in both Streaming and Gaming from Jack and James.
If potential divisions are not analyzed in a bubble, and the identification of the partners and measurement of ownership occur after the plan’s last step (once Lily and Henry own the former interests of Jack and James), then neither Streaming nor Gaming is a resulting partnership because neither has at least two members from Entertainment, the original partnership. Catherine is the only overlapping member. Therefore, there is no partnership division of Entertainment to which the division regulations could apply. In that case, it is not clear whether either Streaming or Gaming is a continuation of Entertainment. If the division rules do not apply, does the general continuation rule of section 708(a) apply, and if so, which partnership is the continuation?27 Streaming and Gaming both conduct part of Entertainment’s historic business in a partnership, and each continues to be owned 60 percent by a historic partner of Entertainment. Could both partnerships be continuations under the general rule? The answer to these questions might depend on the characterization of the transaction, which also is not clear. Is there first a deemed liquidation of Entertainment? If so, is the liquidation followed by the sale by Jack and James of their shares of the Entertainment assets to Lily and Henry, and a contribution of the applicable assets by Catherine, Lily, and Henry to Streaming and Gaming? Or is there a liquidation of Entertainment, followed by a contribution by Jack, James, and Catherine of the assets to Streaming and Gaming, followed by a sale of LLC interests by Lily and Henry? Alternatively, should Entertainment be deemed to distribute the assets of the streaming business to its members, followed by a sale of the streaming assets and Entertainment interests by Jack and James to Lily and Henry, and a contribution of the streaming assets by Catherine, Lily, and Henry to Streaming? Would the results be different if Lily and Henry had purchased the interests of Jack and James immediately before the distribution instead of immediately after?
III. Why Does It Matter?
This section discusses some reasons taxpayers might care whether a division happens in a bubble. In general, the conclusion that a division happens in a bubble provides certainty in planning. If a division does not occur in a bubble, taxpayers face a nightmare of potential recasts and uncertainty.
A. Anti-Deferral Rules
All partnership divisions involve a contribution of assets under section 721 and a distribution of assets under section 731. A divisive transaction that is not a “division” likely also involves one or more contributions and distributions. While contributions and distributions to partnerships are generally nonrecognition events, there are several exceptions. Often parties will want to structure a division to avoid gain under these exceptions to the extent possible.
The form of a division will determine the relevant assets that the partnership distributes to its partners. Depending on the facts, the mixing bowl rules (sections 704(c)(1)(B) and 737) can apply to trigger gain recognition regarding the assets that the divided partnership transfers in a partnership division. This gain recognition can occur if a partner has contributed appreciated property to the partnership within seven years before the division and that same property is distributed to a different partner, or the same contributing partner receives a distribution of different property.
In Example 1, different deemed transactions may give rise to different consequences under the mixing bowl rules if any of the members contributed appreciated assets to Entertainment in the prior seven years. If the division happens in a bubble, the legal form of the transaction will determine whether the streaming or gaming assets (or the partnership interests that are successor property to those assets) are distributed to the members. If the division does not happen in a bubble, depending on the characterization, it is possible that all the assets are distributed to all the members, or some of the assets are distributed to some of the members, without clear guidance on which occurs. If the division does not occur in a bubble, the deemed transactions could result in unplanned and undesired gain recognition to the members, including Catherine (who is not selling her interest).
The form of a division can also trigger gain recognition or income recharacterization under section 707 (if a distribution is deemed to be a disguised sale), section 751(b) (if a distribution causes a shift of ordinary income among partners), or section 731(c) (if there is a distribution of marketable securities).
B. Purchase of Assets or Interests?
If an interest in the business is sold to a new investor, the tax consequences of the sale (outlined below) differ depending on whether the investor purchases partnership interests or assets. To determine the tax consequences in Example 1, it must be decided whether Jack and James are respected as members in Streaming for a moment in time. If the transaction is not analyzed as a division in a bubble, depending on the deemed form, Jack and James could be viewed as selling operating assets instead of LLC interests. If there is a division in a bubble, and Jack and James are respected as owners of Streaming interests, they would be deemed to sell LLC interests.
A buyer may prefer a purchase of partnership interests to a purchase of assets. In a purchase of a partnership interest, if the partnership has a section 754 election in effect for the year of purchase (or there is a substantial built-in loss), the buyer receives a section 743(b) adjustment for its sole benefit (or detriment). If instead the buyer is deemed to buy assets and to contribute those assets to a new partnership, the full basis in those assets becomes common basis to be shared among all the partners. Whether the buyer receives the depreciation or amortization it expects will depend on the section 704(c) method the partnership selects regarding the assets contributed by the other partners. Often the buyer can be made whole only by receiving curative or remedial allocations from the partnership, which come at the cost of allocating fewer deductions or phantom income to the other partners.
The form of a transaction has other collateral consequences that may cause a buyer to prefer a purchase of a partnership interest to a purchase of the partnership’s assets. For example, it may make a difference for purposes of section 197 if the partnership owns intangible assets subject to the anti-churning rules. If an investor purchases a partnership interest and has a section 743(b) adjustment allocated to the partnership’s anti-churning intangibles, that basis adjustment generally is amortizable as long as the investor is not related to the seller of the partnership interest.28 On the other hand, if an investor purchases anti-churning intangibles and contributes those assets to a partnership that has a disqualified partner, the contributed intangibles are not amortizable in the partnership’s hands.29
From the perspective of the seller, the form of the transaction may affect the character and holding period of the gain recognized. For example, sections 1231 and 1239 apply differently to sales of assets and interests. Regarding holding period, the determination of whether gain is long-term or short-term generally depends on the holding period of the property sold. A partner often has a different holding period in its partnership interest than the partnership has in its assets. If a partner sells its partnership interest, generally the relevant holding period is that of the interest. On the other hand, if a partnership distributes an asset to a partner and the partner sells that asset, the partner’s holding period in the asset is based on the partnership’s holding period in the asset under section 735(b). Thus, if a partnership distributes short-term-holding-period assets to its partners, or divides by contributing the short-term-holding-period assets to a recipient partnership and then distributing those partnership interests, the partners will have a short-term holding period in the assets or recipient partnership interests, even if the partners had an entirely long-term holding period in their original partnership interests.30 In Example 1, depending on Entertainment’s holding period in its assets, the form of the transaction may affect whether the recognized gain or loss is short-term or long-term.
C. Tax Elections
Whether a division happens in a bubble determines which partnerships are treated as continuations of the original partnership. If a resulting partnership is treated as a continuation of the prior partnership, then the resulting partnership is subject to the tax elections that the prior partnership made, including a section 754 election to adjust the basis of partnership property.31 If the division in Example 1 does not happen in a bubble, both Streaming and Gaming may need to make a new section 754 election, if desired.
D. Employer Identification Numbers
The regulations provide that the divided partnership retains its employer identification number.32 For this purpose, taxpayers often want the legal form of the division to match the tax fiction, which frequently hinges on whether a division happens in a bubble. For example, if the division in Example 1 does not happen in a bubble, both Streaming and Gaming may have to acquire new EINs, which can be a burdensome and confusing process.33
E. Liability for Taxes on Audit
As a result of the changes made to the partnership audit rules under the Bipartisan Budget Act of 2015, a partnership can be subject to federal income tax on imputed underpayments unless the partnership makes a push-out election regarding the audit adjustments.34 New investors in a partnership are wary of inheriting pre-closing tax liabilities. The final BBA regulations provide guidance on partnerships that “cease to exist.”35 For this purpose, a partnership ceases to exist if the IRS determines that the partnership ceases to exist because it terminates within the meaning of section 708(b)(1) or because it does not have the ability to pay the tax for which it becomes liable. If the IRS determines that a partnership ceases to exist before any partnership adjustment takes effect, the partnership adjustment is taken into account by the partnership’s former partners.36 Thus, a partnership that ceases to exist is no longer liable for any unpaid amounts resulting from a partnership adjustment.37
The IRS has the power (but is under no obligation) to determine that the partnership has ceased to exist and may only make that determination if the partnership has terminated under section 708(b)(1) (or if the partnership is unable to pay the amount it owes under the BBA).38 Depending on how the transaction in Example 1 is analyzed (whether the division happens in a bubble), it is possible that both Streaming and Gaming are continuations of Entertainment or that neither is a continuation under section 708(b)(2). Even if neither is a continuation under section 708(b)(2), it is possible that one or both could be considered a continuation of Entertainment under section 708(b)(1). Regardless of which (if any) LLC is a continuation of Entertainment, the IRS could determine that Entertainment has not “ceased to exist” for purposes of the BBA — that is, the IRS may determine that Streaming or Gaming (or both?) is the successor to Entertainment for purposes of the BBA.39 From a potential investor’s perspective, the risk is that the IRS could assert an imputed underpayment against either Streaming or Gaming as a result of positions taken on Entertainment’s returns before the investor purchased interests in the entities.
IV. Divisions in a Bubble
A. Bubble Theory of Divisions
Section 708, the regulations, and the applicable legislative history and preambles are silent regarding when to identify the partners or when to measure a partner’s interest in capital or profits for purposes of determining whether a partnership division has occurred and its consequences.40 As discussed, there are at least two possibilities: Ownership for this purpose could be determined immediately after the division (in a bubble) or could be determined taking into account all of a plan’s steps (no bubble).
The weight of authority supports a theory that ownership generally is determined immediately after the division. Under this bubble theory, transfers after a division would be disregarded in measuring ownership for purposes of determining whether a partnership is a resulting partnership and whether a resulting partnership is a continuation of the prior partnership. The testing period would start with the division’s first step (the contribution in an assets-over division, or the distribution in an assets-up division) and end with the division’s second step (the distribution in an assets-over division, or the contribution in an assets-up division). Thus, any sales, exchanges, contributions, or distributions that caused the partners’ ownership percentages to vary in the prior partnership before the partnership division would be taken into account. Any of those transfers that happened after the division’s second step would not factor into the division analysis.
B. Statutory and Regulatory Support
A bubble theory for divisions is consistent with the structure of section 708. Before the Tax Cuts and Jobs Act, section 708 provided generally that a partnership would continue unless at least 50 percent of the interests in its capital and profits changed in a transaction (or over the course of a year, in the case of a technical termination). Congress included a 12-month window for measuring a technical termination under former section 708(b)(1)(B) but did not include any window for measuring ownership changes after a division. This suggests that a division itself should not cause termination of a partnership even if interests in a resulting partnership are sold immediately after the division. For example, the sale of 40 percent of Entertainment in Example 1 would not itself have caused a termination of Entertainment even before the technical termination rule was repealed (assuming there were no other transfers of at least 10 percent of the interests in Entertainment in the same 12-month period). Thus, it would be inconsistent with section 708 for the sale of interests to cause a termination of the partnership just because the assets were first divided into two partnerships. Put another way, the division in Example 1 is not an appropriate time to close the tax year of the partnership or allow one or both businesses to make different tax elections. After Congress repealed the technical termination rule, partnerships became even more difficult to terminate.
Also, the form-driven division regulations weigh in favor of analyzing a division in a bubble. The government recognized that different forms may have different consequences and decided that generally the form of an assets-over or assets-up division will be respected.41 The division regulations are focused entirely on the two steps of a division (a contribution followed by distribution, or distribution followed by contribution). They respect transitory ownership of property in determining the consequences of a division. For example, in an assets-over division, the divided partnership contributes assets to a new partnership and becomes a partner for a moment, even though the divided partnership distributes those interests to its partners as part of the same plan.42 In an assets-up division, the regulations provide that assets are respected as being distributed up “despite the partners’ transitory ownership of” the prior partnership’s assets if specific conditions are met.43 Respecting transitory partners and transitory ownership of property means respecting a momentary reality, which is consistent with analyzing a division as happening in a bubble no matter what transaction steps may come later. Thus, the fact that in Example 1 Jack and James hold interests in Streaming and Gaming for a short time ought not prevent them from being considered owners in both entities under the division rules. Further, although Jack and James each might be considered a transitory owner of Streaming as a legal entity, both are historic owners of the underlying streaming assets — that is, both have been members in an LLC (classified as a partnership) conducting the streaming business, and so it is appropriate to recognize them as members in Streaming and Gaming until Jack and James sell their interests.
Analyzing a division in a bubble is consistent with the way partnership continuations under section 708(b)(1) are viewed. Generally, a partnership continues (that is, does not terminate) even if it changes its name, domicile, or legal form. Many practitioners view partnership continuations as occurring in a bubble, by analogy to F reorganizations under section 368(a)(1)(F).44 One of the requirements of an F reorganization is that the same person must own all of a corporation’s stock in identical proportions before and after the F reorganization.45 Historically, and most recently in the final F reorganization regulations, the IRS and Treasury ignored events before or after the F reorganization for purposes of analyzing the F reorganization, thereby viewing F reorganizations as occurring in a bubble.46 The final F reorganization regulations provide that the testing window for the requirements for a “potential F reorganization” begins when the transferor corporation begins transferring (or is deemed to begin transferring) its assets to the resulting corporation, and ends when the transferor corporation has distributed (or is deemed to have distributed) the consideration it receives from the resulting corporation to its shareholders and has completely liquidated for federal income tax purposes.47 The IRS and Treasury added the concept of a potential F reorganization to the final F reorganization regulations “to aid in determining which steps in a multi-step transaction should be considered when analyzing a potential mere change of an F reorganization (that is, which steps are ‘in the bubble’).”48
It might be argued that a partnership division, which involves the formation of a new partnership, is not analogous to an F reorganization, but rather is analogous to a corporate spinoff transaction under section 355. Those rules, however, have specific time-based control requirements that begin before the spinoff date and extend past the spinoff date.49 Section 708(b)(2)(B), by contrast, imposes no time-centric requirements for a partnership division.
In Example 1, a bubble analysis determines whether a division exists at all. In Example 2, the transaction is a division regardless of when ownership is measured, but a bubble analysis will determine which partnership is a continuation of the original partnership.
Example 2: The facts are the same as Example 1, except immediately after the distribution of the Streaming interests, Lily buys Catherine’s interest in Gaming, and Jack and James do not sell their interests in either partnership. As a result, there are two partnerships that own the gaming and streaming businesses as separate businesses. Gaming is owned 20 percent by Jack, 20 percent by James, and 60 percent by Lily; Streaming is owned 20 percent by Jack, 20 percent by James, and 60 percent by Catherine.
In Example 2, after the sale, each of Gaming and Streaming is owned by at least two members of Entertainment. While Entertainment’s original members own Streaming, those original members only own 40 percent of Gaming. Thus, regardless of whether the division happens in a bubble, each of Gaming and Streaming should be a resulting partnership, and the division regulations will apply. The questions are, which partnership is a continuation of Entertainment, and what is the form of the division?
If the division happens in a bubble, then both Gaming and Streaming are continuations of Entertainment because Jack, James, and Catherine are members of all three partnerships immediately after the distribution of the Streaming interests. Therefore, the tax form of the division will follow the legal form — a contribution of assets by Entertainment to Streaming, followed by a distribution of the Streaming interests. After the division, Catherine sells her interest in Gaming. Because the technical termination rule has been repealed, Catherine’s sale of a majority interest does not cause Gaming to terminate.
If the division does not happen in a bubble and Lily’s ultimate ownership in Gaming is taken into account, then both Gaming and Streaming are resulting partnerships, but only Streaming is a continuation. Gaming is not a continuation because the 40 percent combined ownership of Jack and James is insufficient to meet the ownership threshold of the continuation rule. Thus, the tax form of the division would not follow the legal form. Instead, Entertainment would be treated as contributing the gaming business to a new partnership and distributing the interests to Jack, James, and Catherine. Presumably then Catherine would be treated as selling her 60 percent interest to Lily. Analyzing the transaction this way effectively allows a technical termination of Gaming, which could be interpreted as an end-run around Congressional intent in repealing the technical termination rule.
The better answer is to analyze the division in a bubble and to respect Catherine’s transitory ownership in Gaming and Streaming. Treating Gaming as terminated would be inconsistent with Congress’s repeal of the technical termination rule. Further, it would be odd to take into account Lily’s majority ownership in both Gaming and Streaming for division purposes without deeming Lily to have purchased an interest first. If Catherine first sold an Entertainment interest to Lily, and then Entertainment contributed the streaming business to Streaming and distributed Streaming interests to Catherine, Jack, and James, then both Gaming and Streaming would be resulting and continuing partnerships.
C. Antiabuse Rule
Further proof that the general rule is to analyze divisions in a bubble is the presence of the antiabuse rule in the division regulations. The antiabuse rule provides that if a division is part of a larger series of transactions and the substance of the larger series of transactions is inconsistent with following the form, the IRS may disregard the form and recast the larger series of transactions.50 While this antiabuse rule suggests that a division generally is viewed in a bubble, the rule leaves open the possibility that a division might not be treated as happening in a bubble. Consider the following example based on an example in the section 708 regulations.51
Example 3: Jack, James, and Catherine are equal members in Gaming. Lily and Henry are equal members in Streaming. James and Catherine want to exchange their interests in Gaming for all the interests in Streaming. Rather than exchanging their LLC interests, the five owners have Streaming merge with Gaming, and the surviving entity is renamed Entertainment. As part of the same plan, Entertainment divides by contributing the streaming business to Media in exchange for Media interests. Entertainment distributes those Media interests to James and Catherine in complete liquidation of their Entertainment interests.
The example in the regulations concludes that this transaction is in substance an exchange of interests in Gaming for interests in Streaming, not a merger followed by a division. Thus, the form is respected, and the transactions are recast in accordance with their substance as a taxable exchange of interests. This conclusion is also consistent with the structure of section 708 and the general bias toward partnership continuations. Before the transaction, two partnerships conducting two different businesses existed. After the transaction, there are still two partnerships conducting two different businesses. In substance, therefore, there was no merger (two partnerships becoming one) or division (one partnership becoming two). Rather, the transaction is more easily explained as an exchange of interests.
This antiabuse exception implies that as long as the form and substance of a transaction are aligned, a series of transactions is not taken into account in analyzing a partnership division. The question then becomes how to tell if a transaction’s form and substance indeed align. The step transaction doctrine asks a similar question. The successful invocation of the step transaction doctrine generally permits the IRS to ignore unnecessary steps in a transaction but generally does not permit the agency to reorder steps in a transaction in which the reordering is no shorter or more logical than the steps actually undertaken.52
Determining the substance of a transaction can sometimes be difficult in the division context. In Example 1, two things happened: A partnership divided its businesses into two legal entities, and two owners sold their investments to new investors. It is not clear that any particular order of steps is most consistent with the “substance.” Thus, the form should be respected. Both Jack and James begin with partnership interests and end with cash. Applying the theory of the antiabuse example, the simplest explanation for this is that they sold partnership interests to Lily and Henry. Either they sold interests before the division (in which case Lily and Henry’s ownership would be taken into account in applying the division rules) or they sold interests in resulting partnerships after the division. The conclusion that both Streaming and Gaming are continuations of Entertainment is consistent with section 708 (even the former technical termination rule). After the transactions, each partnership (Streaming and Gaming) still conducts part of the historic business of Entertainment and is still 60 percent owned by a historic partner of Entertainment. Thus, in Example 1, analyzing the division as occurring in a bubble follows the legal form the parties adopted and appears consistent with the policy of section 708.
D. Administrative Guidance
Finally, the IRS has implied that it analyzes partnership divisions in a bubble in a private letter ruling that respected the existence of a partnership division within a larger transaction, even though a resulting partnership merged with another partnership as part of the same plan. Consider the following example that is based on that letter ruling.53
Example 4: A large food business (OP) wants to acquire most of the operating assets (the wanted assets) from Entertainment. The Entertainment members will continue to own Entertainment’s remaining assets (in this case, the streaming business) in partnership form. To facilitate that transaction, Entertainment will divide into two partnerships: Entertainment and Legacy (defined below).
Entertainment contributes the wanted assets to a newly formed single-member LLC (Wanted). Entertainment forms another single-member LLC (Legacy) that in turn forms a single-member LLC (Mergerco). Entertainment distributes to its members all the interests in Legacy, causing Legacy to become classified as a partnership. Mergerco and Wanted merge, with Wanted surviving, and with Legacy owning all the Wanted interests.
Legacy contributes Wanted to OP in exchange for OP units and real estate investment trust shares. Legacy liquidates, distributing OP units to some Legacy partners and REIT shares to other Legacy partners. The historic members continue to hold Entertainment, which owns the streaming business.
In a similar transaction in LTR 201619001, the IRS concluded that there was a division of the original partnership (Entertainment in Example 4) followed by a merger of one of the resulting partnerships (Legacy) with OP. The IRS did not specify, but it appears that both resulting partnerships were treated as continuations based on the representation that both resulting partnerships had the same ownership as the original partnership. The division steps in the ruling do not follow a specified form (because the division resulted from a partnership’s distribution of a disregarded entity), and thus appear to be an assets-over division under the default rule.54 The representations also provide that Legacy owned assets with a net fair market value that exceeded the net FMV of Entertainment’s remaining assets. This representation suggests that the IRS applied the FMV tiebreaker rule to treat Legacy as the divided partnership, despite Entertainment’s being the historic state law entity.55 Thus, neither partnership formed in the division was transitory.
The guidance is significant because the IRS respected the partnership division, even though a subsequent step in the plan merged a resulting partnership out of existence. By looking to ownership immediately after Entertainment’s distribution of Legacy and by ignoring Legacy’s ownership after the merger, the IRS seems to have analyzed the division in a bubble.
V. Conclusion
Partnership divisions are common business transactions in which taxpayers attempt to separate business lines, assets, or partners. Despite the prevalence of partnership divisions in the marketplace, threshold tax questions remain regarding partnership divisions. Practitioners would welcome guidance from the government to clarify the definition of a partnership division and whether, as posited in this report, most partnership divisions ought to be analyzed as happening in a bubble.56
FOOTNOTES
1 The question also sometimes arises whether partnership mergers should be deemed to occur in a bubble, but this report does not discuss that question.
3 Tax Cuts and Jobs Act section 13504.
6 H.R. Rep. No. 83-1337 (1954); S. Rep. No. 83-1622 (1954). John H. Birkeland and Philip F. Postlewaite, “The Uncertain Tax Ramifications of a Terminating Disposition of a Partnership Interest — The Constructive Termination of a Partnership,” 30 Tax Law. 335, 340 (1977) (regarding the purpose of section 708: “Since a termination in most cases precludes further use of a fiscal year . . . the best indications are that Congress was primarily concerned with precluding use of the fiscal year election and its deferral potential.”).
7 For a discussion of whether the repeal of technical terminations changes the way partnership continuations and terminations are analyzed in common transactions, see Sara B. Zablotney, “A Rose by Any Other Name Might Cost You More: Form, Substance, and Business Transactions Under Subchapter K,” Taxes (Feb. 2020); New York State Bar Association, “Report on Partnership Terminations Following the Tax Cuts and Jobs Act” (Jan. 17, 2020); Jennifer Ray and Dina Wiesen, “Partnership Continuations After the Tax Cuts and Jobs Act,” Tax Notes Federal, Aug. 19, 2019, p. 1215.
8 The IRS is developing proposed guidance that will clarify how to apply the partnership termination rules post-repeal of the technical termination rule, according to an agency attorney. Kristen A. Parillo, “Guidance Will Address Post-TCJA Partnership Termination Rules,” Tax Notes Federal, June 20, 2022, p. 1903.
9 For a comprehensive overview of the consequences of a technical termination, see Eric Sloan, Mark Opper, and Teresa Lee, “Let’s Get Technical: Partnership Terminations,” Tax Notes, Oct. 15, 2012, p. 263.
10 Section 708(b)(2)(B); reg. section 1.708-1(d). The government made a deliberate decision not to define a partnership division. Preamble to T.D. 8925 (“The IRS and Treasury have decided not to provide comprehensive definitions of what is a partnership merger or division in these final regulations.”).
11 For an overview of partnership divisions, see, e.g., Sloan, “Partnership Mergers and Divisions: A User’s Guide,” in Practising Law Institute, Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 264-1 (2021); Barksdale Hortenstine et al., “Transactional Planning Under the Partnership Merger & Division Regulations,” in Practising Law Institute, Strategies for Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 155-1 (2020); Blake D. Rubin and Andrea M. Whiteway, “Creative Transactional Planning Using the Partnership Merger and Division Regulations,” in Practising Law Institute, Strategies for Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 150-1 (2020).
12 Reg. section 1.708-1(d)(4)(iv).
13 Id. Even if a transaction results in two partnerships that each have at least two partners in common with an original partnership, it is possible that the transaction is not a “division” for other reasons. The broader definition of division is outside the scope of this report.
14 T.D. 8925.
15 Reg. section 1.708-1(d)(1).
16 Id.
17 Id.
18 Reg. section 1.708-1(d)(3)(i).
19 Reg. section 1.708-1(d)(3)(ii).
20 Reg. section 1.708-1(d)(4)(i).
21 Id.
22 Id.
23 Id.
24 There are compliance considerations for a partnership division. For example, the regulations provide requirements for a resulting partnership’s tax return after a division that focus on the resulting partnership’s ability to retain the employer identification number of the prior partnership. Reg. section 1.708-1(d)(2)(i).
25 Section 708(b)(2)(B) (uses the plural phrase “the resulting partnerships”); reg. section 1.708-1(d)(4)(iv). See also preamble to T.D. 8925 (concluding that a transaction does not result in a partnership division if there is only one resulting partnership because of only one partner having overlapping ownership in the two partnerships in the example).
26 For simplicity, ownership interests in this report’s examples include interests in both the capital and profits of the partnership.
27 See, e.g., Rev. Rul. 66-264, 1966-2 C.B. 248 (finding that a partnership continued when three partners bought the assets and continued to conduct the business); Neubecker v. Commissioner, 65 T.C. 577 (1975) (holding that a partnership continued when two partners continued the business of a law partnership after it legally dissolved).
28 Section 197(f)(9)(E); reg. section 1.197-2(h)(12)(v)(A) and -2(k), Example 19.
29 Section 197(f)(2); reg. section 1.197-2(g)(2)(ii) and -2(k), Example 16. The rules on bonus depreciation also apply differently to purchases of assets and purchases of partnership interests.
30 For a discussion of holding period issues generally and in the context of partnership divisions, see Glen E. Goold and Steven R. Schneider, “Finding the Gold Nuggets in Partnership Holding Periods,” Taxes (Feb. 2003).
31 Reg. section 1.708-1(d)(2)(ii). However, a post-division election that is made by a resulting partnership will not bind any of the other resulting partnerships. Id.
32 Reg. section 1.708-1(d)(2)(i). See Matthew Lay and Michael Scaramella, “After Partnership Continuations, Conversions, and Terminations, Can the New Entity Use the Old Entity’s EIN?” J. Passthrough Entities (Nov.-Dec. 2017).
33 Analyzing a division in a bubble will not always prevent this problem of the tax consequences not following the legal form of the transaction. For example, a partnership’s distribution of a disregarded entity often leads to this problem of incongruent treatment between state law and tax law. For a discussion of the uncertain tax treatment of a distribution of interests in a preexisting disregarded entity by a partnership to its partners, see Lay, “Preexisting Disregarded Entities May Complicate Partnership Divisions,” J. Passthrough Entities (Nov.-Dec. 2009).
34 P.L. 114-74 (2015); see generally section 6226.
35 Reg. section 301.6241-3(b).
36 Reg. section 301.6241-3(a)(1).
37 Reg. section 301.6241-3(a)(2).
38 Reg. section 301.6241-3(a)(1) and (b).
39 Other commentators have requested guidance from the government to resolve these types of uncertainties that result from the interaction of partnership divisions and the BBA. See, e.g., Brad Kay and Robert Honigman, “Uncertainty in Partnership Tax Items After the BBA,” Tax Notes Federal, Aug. 2, 2021, p. 723; Andrew L. Lawson, “When Does a BBA Partnership Terminate?” 74 Tax Law. 465, 503-511 (2011). For a general description of the foot faults under the BBA’s cease-to-exist rules, see Kate Kraus, “The Push-Out Election and AARs Might Not Get You Back to Kansas,” Tax Notes Federal, Dec. 2, 2019, p. 1429; Iryna Malakhouskaya, “Note: The Partnership Audit Rules of 2015: The Implications for Misvalued Private Funds and New Partners,” 10 Colum. J. Tax. L. 227 (2019).
40 There are many questions regarding how to measure a partner’s share of a partnership’s capital or profits that are outside the scope of this report. See generally Sheldon Banoff, “Identifying Partners’ Interest in Profits and Capital: Uncertainties, Opportunities and Traps,” Taxes (Mar. 2007).
41 65 F.R. 1572 (Jan. 11, 2000). The preamble to the proposed merger and division regulations analogizes to partnership incorporations, in which different forms can have different consequences, and the form chosen by the taxpayer is respected. See, e.g., Rev. Rul. 84-111, 1984-2 C.B. 88.
42 Reg. section 1.708-1(d)(5), Example 4. This might be contrasted with other situations in which a transitory partner is suspected of not being a partner at all. Cf. The legislative history to section 707(a)(2)(A) (a recharacterization provision that can apply if a partner performs services for a partnership) provides a list of factors that Congress believed to be relevant in determining whether a partner is receiving an allocation and distribution in their partner capacity or a section 707(a)(1) payment. The second factor is whether the partner status of the recipient is transitory, because transitory partner status suggests that a payment is a fee when the partner provides services. S. Rep. No. 98-169, vol. 1, at 227 (1984).
43 Reg. section 1.708-1(d)(3)(ii)(A) and (B). Compare this with the general rule of evaluating a plan and disregarding transitory entities for federal income tax purposes. See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); Rev. Rul. 67-448, 1967-2 C.B. 144; Rev. Rul. 73-427, 1973-2 C.B. 301; Rev. Rul. 78-250, 1978-1 C.B. 83; Rev. Rul. 79-273, 1979-2 C.B. 125; LTR 9418030; LTR 9148041; TAM 200244009.
44 For a detailed discussion of partnership continuations and an articulation of how the bubble theory applies to partnership continuations, see Phillip Gall, “Nothing From Something: Partnership Continuations Under Code Sec. 708(a),” Taxes (Mar. 2017).
45 Reg. section 1.368-2(m)(1)(ii).
46 See, e.g., preamble to T.D. 9739; Rev. Rul. 96-29, 1996-1 C.B. 50, obsoleted by T.D. 9739; preamble to REG-106889-04 (citing Rev. Rul. 96-29); LTR 201107003; LTR 201033016; LTR 200937005.
47 Reg. section 1.386-2(m)(1).
48 Preamble to T.D. 9739.
50 Reg. section 1.708-1(d)(6).
51 Reg. section 1.708-1(c)(6)(ii).
52 See Esmark Inc. v. Commissioner, 90 T.C. 171 (1988).
53 LTR 201619001. See also LTR 201643016, LTR 201643017, LTR 201643018, and LTR 201643019.
54 Reg. section 1.708-1(d)(3)(i).
55 Reg. section 1.708-1(d)(4)(i). For a discussion of treating Legacy as the divided partnership, see, e.g., Mario Amaya-Lainez, “Rulings Shed Some Light on the Application of Partnership Merger and Division Rules, but Not a Roadmap,” The Federal Lawyer (Oct.-Nov. 2017); Arthur B. Willis, Postlewaite, and Jennifer H. Alexander, Partnership Taxation, para. 16.03 (8th ed. 2017 and supp. 2021).
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