You are the owner of a partnership and someone offers to buy your business or combine practices. This offer may be an incredible opportunity. While it may not be the main focus during negotiations, the tax implications of the reorganization or sale are important and can have a significant effect on your bottom line.
One of the key attributes of operating your business as a partnership or LLC is the flexibility it offers. From forming and funding your business to allocating income and distributions, a partnership allows owners a great deal of control over their business. A significant aspect to partnership flexibility is the concept of carryover basis. When assets are contributed to a partnership, the basis “carries over” to the entity. The business holds the same basis in the assets as the partner who contributed them, and generally no gain or loss is recognized. Likewise, when the partnership distributes assets, the partner maintains the same basis in the assets as the partnership prior to distribution. While there are some exceptions, most distributions of cash or property are tax free.
Partnership mergers can be thought of as a combination of contributions and distributions between the merging entities and partners. Because of this, they are typically non-taxable events. The two types of partnership mergers recognized by the IRS are assets-over form and assets-up form. In an assets-over merger, the terminating partnership contributes all assets and liabilities directly to the remaining partnership. In return, the remaining partnership distributes ownership to the terminating partnership which immediately distributes this ownership to its partners. Upon distributing this ownership in the remaining entity to the partners, the terminating partnership no longer retains any assets, liabilities, or equity and ceases to exist. In this type of merger, the basis of these items are unchanged and no gain or loss is recognized on the merger. The resulting basis for each partner will be equal to their basis before the merger plus or minus any adjustments resulting from a change in liabilities.
In an assets-up merger, the terminating partnership distributes all assets and liabilities to its partners who then contribute these items to the remaining entity in exchange for ownership. For the IRS to determine that an assets-up merger has occurred, the partnership must take all steps to convey the assets have been legally transferred to the partners before being transferred to the surviving partnership. In certain situations an assets-up merger allows partners to distribute assets in such a way to avoid or minimize gain recognition and produce a significant beneficial future tax result.
If any partner is bought-out under either type of merger, a taxable event occurs and the partner must calculate a gain or loss based on their tax basis. It is important to note that the tax basis is often different than the partner capital account on the books or on their K-1. The tax basis is calculated separately for each partner based on their total historical partnership activity:
+ Partner Contributions
+ Taxable Income
– Partner Distributions
– Taxable Loss/deductions
= Partner Tax Basis
When the partnership is sold, this basis will be used to determine the taxable gain or loss on the sale to be reported on the selling partner’s tax return. Other instances that may trigger a taxable event during a partnership merger include:
A distribution in excess of partner basis in the case of an assets-up merger
Mixing bowl distribution: A distribution of built-in gain assets to a partner within seven years of the partner’s contribution
A disguised sale: Significant or irregular distributions made in conjunction with the merger may be treated as a complete or partial sale of ownership
A partnership merger or sale is a complex situation with many factors that may affect your tax situation. If you are considering one of these options, we advise that you contact an experienced tax advisor. If you have any questions about this topic, or any other tax matters, please feel free to contact your L&B professional at (858) 558-9200.