In our changing economy, mergers have become a common occurrence especially among large corporations. But what happens if partnerships wish to merge?
Can partnerships merge under the same rules as corporations? To find the answer we need to take a look at the partnership rules under Section 708 of the Tax Code.
In a merger involving two or more partnerships, the continuing partnership is one whose partners have retained a more than 50 percent capital and profits interest once the merger is final. If more than one of the merging partnerships meets the more than 50 percent test, then the partnership that contributed the greatest fair market value of assets is considered the continuing partnership.
If none of the merging partnerships meets the more than 50 percent test, all of the merging partnerships are deemed to have terminated and a new partnership is formed. A partnership merger can occur in one of two forms: "assets-over" or "assets-up."
"Assets-over" occurs when a terminating partnership is deemed to have contributed its assets and liabilities to the continuing partnership in exchange for an interest in the continuing partnership. Immediately thereafter the terminated partnership distributes its interests in the continuing partnership to its partners in the form of a liquidation. The continuing partnership retains the assets and liabilities at the same basis prior to the merger.
No gain or loss is recognized on the transaction unless there is a deemed distribution of liabilities or a decrease in "hot assets" (i.e. accounts receivable or inventory) due to the fact that the partners' relative percentage interest has changed. Moreover since the continuing partnership retains the same basis in the newly contributed assets and liabilities, there is no recognition of any built in gains under Section 704(c) of the Tax Code unless there is a subsequent distribution. The seven-year rule does not start over.
Alternatively, "assets-up" is when the terminating partnership liquidates and all of its assets are distributed to its partners. The partners would then contribute the assets to the continuing partnership and the continuing partnership would assume all of the terminating partnership's liabilities. In this form, a gain may be recognized upon liquidation and the basis of the assets and liabilities could change. This form will be respected if, upon liquidation, the partners of the terminating partnership take title to the assets and liabilities and then title is changed once again in the name of the continuing partnership.
These two forms are best illustrated by the following examples in the Section 708 regulations:
Example 1 - Assets-Over
A and B are partners in Partnership AB, with a capital and profits interest of 50 percent. C and D are partners in CD, with a capital and profits interest of 50 percent.
The two partnerships merge on September 30, Year 1, and form partnership ABCD.
After the merger, A and B each have capital and profit interests of 30 percent, and C and D each have capital and profits interests of 20 percent.
Since A and B together own an interest of more than 50 percent in the capital and profits of partnership ABCD, the resulting 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, year 1 -- the date of the merger. Partnership CD is then terminated as of that date.
Partnership ABCD is required to file a return for the taxable year January 1 to December 31, year 1, indicating thereon that, until September 30, year 1, it was partnership AB. Partnership CD is required to file a return for its final taxable year, January 1 through September 30, Year 1.
Example 2 - Assets-Up
Partnership X, in which A owns a 40 percent capital and profits interest and B owns a 60 percent interest, and Partnership Y, in which B owns a 60 percent capital and profits interest and C owns a 40 percent interest, merge on September 30, year 1.
The fair market value of X's net assets is $100, and the fair market value of Y's net assets is $200. Partnership X is engaged in an ongoing trade or business and has, as one of its assets, goodwill.
The merger is accomplished under state law by having Partnership X convey an undivided 40 percent interest in each of its assets to A and an undivided 60 percent interest in each of its assets to B, with A and B then contributing their interests in such assets to Y. Y also assumes all of the liabilities of X.
The resulting partnership is treated as a continuation of Y for federal income tax purposes, and X is treated as terminating in the merger. The form of the partnership merger is respected, so that X is treated as following the assets-up form for federal income tax purposes.
The tax year for merging partnerships is considered terminated as of the date of the merger. Therefore the terminating partnership will file a final tax return ending as of the date of the merger. The continuing partnership will file a tax return for the entire tax year and retains its employee identification number.
The partnership must disclose that it is a continuation of a merging partnership and list the names, addresses and EINs of all other partnerships involved in the merger. Moreover, it should include the partner's respective distributive share before, during and after the merger.
Thus when two partnerships merge "assets-over" may be the better choice if there is relatively little built in gain to be recognized. On the other hand, if there is inherent gain in the assets, and/or goodwill exists within the partnership, the "assets-up" merger may be best to write up the assets to FMV.
Alicia Koross, CPA, is a director in the tax and accounting department of Morrison, Brown, Argiz & Farra, LLP.
