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Avoiding The Partnership Technical Termination Trap

Some families have been pleased about using partnership interests for wealth transfer during the recent market lows. Unfortunately, a few have been met with unwelcome surprises — five-figure bills penalizing the partnerships for filing late tax returns.

When a partnership is terminated, its final income tax return is due three and a half months from the date of termination. Unless the partnership happened to cease doing business on Dec. 31, this means that the final tax return is due sometime before April 15 of the following year. This can trip up general partners and advisors when a partnership continues operations but has triggered a provision in the Internal Revenue Code known as a technical termination.

A partnership or a limited liability company (LLC), which is taxed as a partnership, generally is terminated in one of two ways. It can undergo an actual termination, in which business operations cease and the partnership no longer exists; or it can experience a technical termination, in which the partnership’s activities are ongoing, but an event occurs that triggers the provisions under Section 1.708-1 of the Treasury regulations. These state that a technical termination of a partnership occurs if there is a sale or exchange of 50 percent or more of the total interest in the partnership’s capital and profits within a 12-month period. In cases where the partnership continues normal operations after the transfer, it may not occur to the general partner that a termination has taken place or to notify the partnership’s tax advisor immediately of the transaction causing the termination.

In many cases, the fact that there was a technical termination of the partnership isn’t discovered until its tax return is prepared the following year, well after the deadline. While this may seem like an understandable oversight, the penalties can be severe. The Internal Revenue Service charges a penalty of $150 per partner for every month that the tax return is late (limited to a maximum of 12 months). Many states have similar penalties. Depending on the number of partners, this can quickly add up to large bills from the taxing authorities.

One example involves a matriarch who owned a 60 percent interest in a family investment partnership with six other family members as partners. For estate-planning reasons, she sold her interest in the partnership to a trust in April 2010. Normal operations of the partnership continued after the transfer, but because it was in excess of the 50 percent threshold, a technical termination of the partnership was triggered. This was not discovered until April of the following year when the partnership’s accountant was filing the annual tax return, but by that point, the damage had been done — the partnership received a notice from the IRS assessing penalties and interest in excess of $12,000.

If the partnership had wanted to avoid the termination, the transaction could have been spread over more than 12 months. The matriarch could have sold less than 50 percent of her interest in April 2010 and waited 12 months before selling the remainder.

For purposes of the 50 percent threshold, however, a transfer of the same partnership interest multiple times during a 12-month period is only counted once. For example, had the matriarch sold 40 percent of the partnership interest to the trust, and six months later, the trust sold that same 40 percent interest to a third party, the total partnership interest transferred during the 12-month period would only be 40 percent for purposes of the technical termination rules.

In addition to a technical termination, another situation in which an entity will be deemed to terminate despite continuing operations occurs when a multi-member LLC becomes a single-member LLC. Multi-member LLCs are generally taxed as partnerships, whereas single-member LLCs are considered disregarded entities for tax purposes, with the sole member reporting the LLC activity on his personal income tax return. To illustrate, a father owns 25 percent of an LLC holding rental property, which is managed by his son, who owns the remaining 75 percent of the LLC. Because of depressed asset values and low interest rates, the father decides to sell his interest to the son in exchange for a promissory note. The son will pay the interest due on the promissory note from the cash flow of the rental property, then pay off the full loan balance when the real estate market has recovered and the rental property can be sold for a sizable gain. While the son will continue to operate the LLC as he always has, the LLC is deemed to have terminated on the day the father’s interest was sold to him, because it changed from a two-person LLC to a singlemember LLC. The final tax return for the LLC will be due three and a half months from the day the interest was sold to the son.

One bit of good news for those who find themselves dealing with this type of penalty assessment is that the taxing authorities have some flexibility to waive such penalties. In many cases, this can be addressed with a simple phone call to the IRS or state tax department explaining the administrative oversight. It is not uncommon for the authorities to waive all penalties and interest for the late filing of tax returns by first-time offenders. However, they are not required to do so, and it is unlikely an entity would receive a waiver if a previous tax return had been filed late or if there were any previous history of tax noncompliance. Absent the taxing authorities’ willingness to waive the penalties, the partnership would have to prove that it failed to file a timely return as a result of events meeting the reasonable cause criteria as defined in the Treasury regulations. A natural disaster or other non-preventable event would likely be reasonable cause, but simply being unaware of the partnership’s accelerated filing deadline would not qualify.

The regulations pertaining to partnership terminations are complex. Further complicating matters, federal and state law regarding partnership terminations may differ. It’s possible that a technical termination could occur under federal law, but not under state law. Other implications of technical terminations may need to be considered, such as partner capital account adjustments and potential capital gains for the partners. Professional advice should be sought any time a business owner believes he may be running afoul of the partnership technical termination rules. Failure to do so could result in a nasty — and expensive — surprise.

Client Service Manager David Walters, who is based in our Portland, Oregon office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 6, “Transfer Taxes,” and Chapter 5, “Estate Planning.”

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