One of the provisions included in the House version of the tax reform bill H.R. 1 is the repeal of the technical termination of partnerships rule (IRC Section 708(b)(1)(B)) for years after 2017. What are the pros and cons of this possible change?
For federal income tax purposes, under the current system, a technical termination occurs when there is a sale or exchange of 50% or more of the interests in a partnership’s profits and capital in a 12-month period. The old partnership is treated as concluding, and a new partnership using the same EIN is then formed.
Short period returns
The most obvious consequence of a mid-year technical termination is the requirement for two short period returns: a final return for the pre-termination partnership, and an initial return for the post-termination partnership. This means additional work for the partnership and the compliance team. In some cases, the return preparer is not notified of the termination soon enough to timely file the final return. As a result, IRS notices are received on one or both short period returns, requiring even more time and effort to abate the assessed penalties. Under the proposed system, only one return would be filed per year, eliminating these potential compliance headaches.
Depreciation and cost segregations
Perhaps the most onerous of the technical termination rules under current law is the treatment of fixed assets. Due to a specific exception under IRC Section 168(i)(7) to the general “step into the shoes” rule of contributed property, all depreciable property retained by the new partnership is considered newly placed into service. This means that the clock is restarted with respect to depreciation periods, methods, and conventions, and, generally, depreciable lives are lengthened. And there is another, less apparent consequence relating to depreciable property. Cost segregation studies have become a popular option for property owners seeking to utilize the shorter lives available for Section 1245 property. However, due to specific rules relating to the deemed cessation of the partnership’s trade or business, cost segregations are not valuable to a terminated partnership unless new buildings are placed into service. Because the partnership will not terminate under the proposed system, partnerships can benefit, both from not restating assets in the year of the sale or exchange, and by utilizing cost segregation studies throughout the life of the partnership.
Accounting methods and elections
Another possible change that must be considered is that, under the current system, partnership accounting methods and elections are reset after a technical termination. In other words, the new partnership has another opportunity to choose elections that are beneficial to its operations. An important consideration is the Section 754 election. Under current law, this election, used to adjust an incoming partner’s basis in his partnership interest to his portion of the partnership’s basis in its assets, was almost always made when beneficial for the incoming partner in a more than 50% sale or exchange. This is because the election “reset” with the initial return of the new partnership, and therefore only affected the single transaction. Under the proposed rules, with no termination, a Section 754 election, once made, would remain in force throughout the life of the partnership. This means that for every sale or exchange (and certain distributions) the basis adjustment rules would need to be applied, whether beneficial to the partners and partnership or not. This could result in significant additional compliance.
In general, the repeal of the technical termination rules should be seen as favorable; however, care must be taken with elections in order to avoid hidden traps and unintended consequences. If you have questions, contact your CSH advisor.