Partnership Terminations

As the number of partnerships and LLCs taxed as partnerships increases, so too will the number that terminate due to failure or owner disagreement. The Internal Revenue Code contains only a simple statement about partnership terminations, but a recent case expands on that.

Robert Collins and several others formed Harbor Cove Marina Partners (HCMP) to acquire and run a marina. The partnership agreement provided that, upon termination, the partnership was to sell its assets and distribute the cash; it also gave the managing partner significant authority. After numerous disagreements, Collins and the managing partner decided to liquidate the partnership. But, instead of selling the assets, HCMP transferred them to another partnership and gave Collins cash equal to the assessed fair market value of his interest. Collins sued the managing partner to force a sale of the assets as stipulated in the partnership agreement.

While the suit was pending, the managing partner filed a final partnership return and sent Collins a form K-1 based on the actual cash distribution. Collins filed his tax return taking the position the partnership had not terminated, but the IRS said he had to file his return based on the form K-1 he received. Collins filed a suit in the Tax Court arguing the partnership had not terminated and his return was filed correctly.

Result. For the taxpayer. Although the taxpayer was not the tax matters partner, he was entitled to have the Tax Court adjudicate an issue involving a partnership item.

IRC section 708 provides for the termination of a partnership upon either of two events: No part of any business is being carried on by any of the partners or more than 50% of the interests in the partnership are sold within a 12-month period. The first event was before the court. Specifically, the IRS argued that since the business had ceased, the partnership had terminated. Collins argued that the partnership could not terminate until the procedure in the partnership agreement for termination was followed.

In analyzing the code section, the Tax Court noted that termination for tax purposes is not the same as termination for state law purposes. Under IRC section 708 the determination is a facts and circumstances test. In addition to restating the section 708 requirements, regulations section 1.708 includes a clarification that a termination will not occur until all the assets are distributed to the partners.

Several cases have examined this issue. They held that a partnership was not terminated even when it ceased its primary business if a nominal amount of business still was continued. For example, holding a note from the sale of partnership assets and collecting interest on it precluded termination, and so did discontinuing a business while maintaining the partnership for investment purposes.

Based on the above cases, the Tax Court concluded that HCMP’s failure to terminate the partnership under the procedure outlined in the partnership agreement with a resulting lawsuit were sufficient to prevent a termination even if no business was being conducted by the partnership. In other words, any activity or assets at the partnership level preclude a termination for tax purposes.

In the area of corporate taxation it is generally accepted that a corporation can be deemed to have completely liquidated even though it maintains its charter and a nominal amount of assets, provided it is not engaged in an ongoing business. The partnership rule is different; in addition to ceasing business, a partnership must continue to file tax returns as a going concern until it distributes all assets to the partners pursuant to the partnership agreement.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.