What are partnership or LLC reorganizations, and how will they be taxed?

When you first established your business, you knew your entity structure would dictate how you’d be taxed — so you made that decision carefully. The same level of strategic thinking should apply when you reorganize your business. Whether you are merging with another entity dividing the business, how you format the transaction will influence the tax outcomes.

What are partnership reorganizations?

In this article, when we refer to partnership reorganizations, we’re talking about both legal partnerships and LLCs that are taxed as partnerships. The following types of transactions could be considered partnership reorganizations:

• The merging of two different partnerships
• Splitting the business into two or more partnerships
• Transferring partnership interest to another partnership

These reorganizations are tax sensitive, and therefore, how the transaction is structured determines the tax outcomes.

But before we can talk about the tax consequences of partnership reorganizations, we need to review the basics of partnership taxation. In Part I of this two-part series on partnership reorganizations, we’ll answer the following questions:

• How does tax basis work in partnerships?
• What are built-in gains?
• Are partnership distributions taxable?

How does tax basis work in partnerships?

To form a partnership, the partners and the partnership exchange items of value. Partners typically contribute some sort of asset to the partnership — cash, land, or other property — in exchange for equity interest in the partnership. The basis that each partner had in the assets they contribute will become the basis they hold in their partnership equity. Let’s look at an example:

Josie and Penny form Partnership A. Josie contributed $400,000 of cash. Penny contributed $200,000 of cash, and land that she purchased years ago for $150,000. The fair market value of the land is now $200,000.

Because both Josie and Penny contributed assets valued at $400,000 to Partnership A, they each have a 50/50 interest in the partnership. But their tax bases in their respective equity holdings are different.

• Josie contributed $400,000 of cash, so her “outside tax basis” in her equity holdings is $400,000.
• Penny contributed $200,000 of cash and an asset with a basis of $150,000, so Penny’s “outside tax basis” in her equity holdings is $350,000.
• Partnership A has basis in the assets it receives. Its “inside basis” of the property it receives is the same as the basis the partners had at the time of contribution, so the partnership’s “inside basis” is $750,000: $600,000 of cash, and $150,000 for the land.

What are built-in gains?

Thinking about the example above, both Josie and Penny contributed the same value to the partnership: assets with a $400,000 FMV. But Penny contributed an appreciated asset. At the time she contributed that land, there was an unrecognized gain of $50,000. This is considered a “built-in gain.”

Section 704(c) of the Internal Revenue Code (IRC) addresses the taxation of built-in gains. Under IRC Section 704(c), the partner who contributed property with a built-in gain is going to be responsible for recognizing a gain (or loss) when that property is later sold. Let’s look at an example:

Let’s assume that the partnership sold the land for $260,000 two years later, resulting in a gain of $110,000 ($260,000 sales price less $150,000 inside basis). Penny would be allocated the first $50,000 of that gain, and the remaining would be split evenly between Josie and Penny. This means that Josie would be allocated $30,000 of gain and Penny would be allocated $80,000 of gain.

Are partnership distributions taxable?

In general, distributions a partnership makes to its partners are nontaxable events. This is true even if the distribution is a liquidating distribution. In a full liquidating distribution, the partners take basis in the distributed property equal to the outside basis they held in their partnership interest.

But when there are built-in gains, things get a bit more complex.

Seven-year anti mixing-bowl rule

To prevent taxpayers from avoiding IRC Section 704(c) gains by contributing appreciated assets to a partnership then receiving nontaxable distributions, the IRS implemented a seven-year anti mixing bowl rule. There are two scenarios that would trigger the anti mixing-bowl rules:

• Distributing the appreciated property to other partners:
  If the partnership distributes property with a built-in gain to one of the other partners within seven years of the contribution, the partner that contributed the appreciated asset must recognize a gain.
• Distributing other property to the contributing partner:
  If the partnership distributes other property to the contributing partner within this seven-year period, the contributing partner must recognize a gain.

The gain the contributing partner must recognize is the gain they would have recognized under IRC Section 704(c) as if the contributed property had been sold by the partnership. This gain will also increase the contributing partner’s outside tax basis in their partnership interest.

Let’s continue with our Josie and Penny example:

If within seven years the partnership distributes the land to Josie rather than selling it, Penny will recognize the same gain recognition that she would have recognized under IRC Section 704(c). Let’s assume the partnership distributes the land (which is now valued at $260,000) to Josie, and distributed $260,000 of cash to Penny in a nonliquidating distribution. Penny would recognize $50,000 of built-in gain, and her inside tax basis would increase by $50,000.

But the seven-year anti mixing-bowl rule is the one we want to focus on. In Part II of this series on partnership reorganizations, we will build upon this information to discuss how partnership reorganizations are taxed. 

For more information on partnership reorganization, contact us today.