The Internal Revenue Code and its related regulations stretch over 70,000 pages long – but that does not mean every issue is addressed. In early December, the IRS released proposed regulations on contentious issues related to partnership terminations. The IRS has now concluded that under Section 708, partnerships may not deduct unamortized startup or organizational costs at technical termination. Here is a breakdown of the details and a few examples of how the newly proposed regulations work.
Section 708 considers a partnership terminated if either of the following apply:
- The partners no longer perform any type or portion of the business of the partnership.
- The partnership sells or exchanges 50 percent or more the partnership interests in any 12-month period.
This is what the IRS considers a technical termination. Legally, the partnership still exists but from a tax perspective it does not. Instead, a new partnership is created for tax purposes under Reg. Section 1.708-1(b)(4).
The new partnership is technically born through a two-step process. First, the old partnership is deemed to have contributed all its assets and liabilities under Section 721 in exchange for an interest in the new partnership. Second, under Section 731, the newly created partnership immediately distributes interest in itself to the partners of the technically terminated entity.
Startup and Organizational Costs
Partnerships regularly have necessary expenses such as legal fees to set up and form the business. These are what the IRS refers to as “organizational expenses.” Expenses incurred after this formation period but before the start of active trade or business activities are considered startup costs. Startup costs typically include expenses such as marketing, advertising and training costs.
Generally, organizational and startup costs are not deductible because they have an indefinite useful life. Code sections 709(b) and 195(b), however, allow the deduction of up to $5,000 of organizational cost and an additional $5,000 of startup costs during the first year the partnership is in business. These deductions are limited, dollar for dollar, for every dollar these expenses are over $50,000. Costs that cannot be deducted right away are allowed to be amortized over a 15-year period. Take a look at the following example of these rules.
Excelon (a partnership) incurs $8,000 of organizational costs and $12,000 of startup costs during its first year of operations. Excelon is allowed to deduct $5,000 each of the organizational costs and startup costs. The $3,000 of organizational costs and $7,000 of startup costs cannot be deducted, but can be amortized over a 15-year period.
You might be wondering what happens if the partnership liquidates before it can fully amortize the expenses. In this case, whatever portion remains is deductible in the year of liquidation.
Putting It All Together
Since technical terminations are treated as a liquidation of the partnership, many experts have concluded that the partnership may deduct any remaining unamortized balances at technical termination. Until the newly released proposed regulations, it was unclear as to whether this was the proper treatment of this issue.
The proposed IRS regulations have now clarified the rules. Under the recently released rules, unamortized balances of organizational or startup costs may not be deducted at technical termination. The unamortized balances are treated similarly to all other assets and are considered transferred to newly created partnership, which is allowed to continue amortizing them over their remaining useful life. Let’s look at an example of how this works.
Sample, LLC (a partnership) is technically terminated. At the time of termination there are $4,000 of organizational and $9,000 of startup costs that still need to be amortized over eight more years.
Sample, LLC is not allowed to deduct the leftover $13,000 of unamortized expenses under the proposed regulations, despite the technical termination. The balances are considered transferred to the newly formed partnership under tax law and it continues amortizing them over the outstanding eight years.
We hope this article helps you understand the new proposed regulations surrounding the technical termination of partnerships. Give us a call if you think we can help your partnership with accounting, tax or other financial matters.