7.3 Partnership Terminations, Mergers & Divisions

Partnership Terminations, Mergers & Divisions

Unlike corporate entities that generally continue uninterrupted regardless of shareholder turnover, partnerships are historically contractual associations governed by the aggregate principle. Under federal tax law, however, the termination of a partnership is strictly regulated by IRC §708. A partnership does not terminate for tax purposes merely because it dissolves under state law, changes its name, or admits new partners.

For the Special Enrollment Examination Part 2, candidates must understand what causes an actual termination under IRC §708(b)(1), understand the statutory repeal of "technical terminations," manage the special rules for two-person partnerships, and apply the continuation tests and conveyancing forms governing partnership mergers and divisions.

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Actual Partnership Terminations: IRC §708(b)(1)

Under IRC §708(a), an existing partnership is considered as continuing if it is not terminated. Under IRC §708(b)(1), an actual termination occurs in only two operational circumstances:

1. Complete Cessation of Business (§708(b)(1)): No part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
2. Reduction to a Single Partner: The business ceases to be operated in partnership form because only one partner remains (e.g., one partner buys out all other partners), converting the business into a sole proprietorship.

IRC §708(b)(1) Actual Termination Conditions:
  ├── Condition 1: Complete Cessation of All Business Activity
  └── Condition 2: Entity Drops to a Single Owner (Sole Proprietorship)

The Winding-Up Doctrine

A partnership does not terminate the moment the partners decide to stop operating. Under Treas. Reg. §1.708-1(b)(1), the partnership continues for federal tax purposes throughout its winding-up period until all assets are distributed, debts are settled, and operations are fully concluded. Even nominal business activity, such as collecting outstanding accounts receivable or defending a lawsuit, preserves partnership status.

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Permanent Repeal of Technical Terminations

A critical area of historical confusion on the EA exam is the concept of a "technical termination."

• Old Law (Pre-2018): Under former IRC §708(b)(1)(B), a partnership was deemed to undergo a "technical termination" if within a 12-month period there was a sale or exchange of 50% or more of the total interest in partnership capital and profits. This triggered a deemed contribution of assets to a new partnership and a deemed liquidating distribution, closing the tax year and terminating tax elections.
• Current Law (TCJA & OBBBA): The Tax Cuts and Jobs Act permanently repealed IRC §708(b)(1)(B) for taxable years beginning after December 31, 2017. Under permanent federal tax law, the sale or exchange of 50%, 80%, or even 99% of partnership interests within 12 months does NOT terminate the partnership.

Impact of Repeal on the Partnership

Because technical terminations no longer exist:

• The partnership's taxable year does not close for continuing partners;
• Partnership tax elections (including an active IRC §754 election) remain in full force;
• The partnership retains its existing Employer Identification Number (EIN);
• Depreciation schedules do not restart; the partnership continues depreciating its property under existing recovery periods.

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Two-Person Partnerships: Death or Retirement of a Partner

When one partner leaves a two-person partnership, only one partner remains. Under state law, a partnership requires at least two persons. However, federal tax regulations establish a vital exception to protect continuing liquidations:

The Ongoing Liquidation Exception (Treas. Reg. §1.708-1(b)(1)(i))

Under Treas. Reg. §1.708-1(b)(1)(i) and Treas. Reg. §1.736-1(a)(6), if one partner in a two-person partnership dies or retires, and their interest is being liquidated through ongoing Section 736 liquidating distributions from the partnership:

• The partnership is treated as continuing for federal tax purposes until the deceased or retiring partner's interest is completely liquidated.
• The surviving partner and the departing partner (or the estate of a deceased partner) continue to be treated as partners on Form 1065 until the final liquidating distribution is paid.

Direct Partner Buyout (McCauslen Doctrine)

In contrast, if the remaining partner purchases the departing partner's interest directly in a personal transaction (rather than through partnership distributions):

• The partnership terminates immediately on the purchase date because the business ceases to be carried on by two or more partners.
• Under Revenue Ruling 67-65 and McCauslen v. Commissioner, the purchasing partner is treated as:
  1. Continuing their original undivided share of partnership assets (retaining their original holding period and basis); and
  2. Purchasing the remaining undivided share of assets directly from the departing partner (acquiring a new cost basis and a fresh holding period beginning the day after purchase).

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Partnership Mergers and Consolidations: IRC §708(b)(2)(A)

When two or more partnerships merge or consolidate into a single resulting partnership, IRC §708(b)(2)(A) determines which partnership continues and which terminates.

The Greater-Than-50% Continuation Rule

The resulting partnership is considered the continuation of any merging or consolidating partnership whose members own an aggregate interest of more than 50% in the capital and profits of the resulting partnership.

• Single Continuing Partnership: If members of only one merging partnership own > 50% of the resulting partnership, that partnership is the continuing entity. All other merging partnerships terminate.
• Tie-Breaker Rule (Cross-Ownership): If members of more than one merging partnership own > 50% of the resulting entity, the resulting partnership is treated as the continuation of the partnership that contributed the greatest dollar value of assets (net of liabilities). All other merging partnerships terminate.
• No Partnership Exceeds 50%: If members of NO merging partnership own more than 50% of the resulting partnership, all merging partnerships terminate, and the resulting entity is treated as a brand new partnership.

Partnership Merger Continuation Test (> 50% Capital & Profits):
  ├── Exactly One Merging Group > 50%  ==> That Partnership Continues
  ├── Multiple Groups > 50%            ==> Partnership with Greatest Net Asset Value Continues
  └── No Group > 50%                   ==> All Terminate; Brand New Partnership Formed

Tax Consequences of Merger

• Continuing Partnership: Retains its EIN, taxable year, accounting methods, and tax elections (including §754).
• Terminated Partnerships: Their taxable years close on the date of merger. They must file a final short-period Form 1065.

Regulatory Forms of Merger (Treas. Reg. §1.708-1(c)(3))

Federal regulations recognize two primary conveyancing forms for partnership mergers:

1. Assets-Over Form (Default Rule): The terminating partnership is treated as contributing all of its assets and liabilities to the resulting partnership in exchange for interests, followed by a liquidating distribution of those interests to its partners. This default applies unless the parties formally execute the assets-up form.
2. Assets-Up Form: The terminating partnership distributes its assets and liabilities up to its partners in complete liquidation, and the partners immediately contribute those assets and liabilities to the resulting partnership. To qualify, state law documents must legally convey the assets directly to the partners.

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Partnership Divisions: IRC §708(b)(2)(B)

Under IRC §708(b)(2)(B), when a single partnership divides into two or more separate partnerships, continuation is determined by the same greater-than-50% ownership benchmark:

The Continuation Test for Divisions

Any resulting partnership whose members had an aggregate interest of more than 50% in the capital and profits of the prior divided partnership is treated as a continuation of the prior partnership.

• Resulting Partnership > 50%: Treated as a continuation of the prior partnership. It retains the original partnership's tax elections.
• Resulting Partnership ≤ 50%: Treated as a new partnership (requiring a new EIN, new tax elections, and initial Form 1065).
• No Resulting Partnership > 50%: If no resulting partnership has members who owned > 50% of the original entity, the prior partnership is completely terminated, and all resulting entities are brand new partnerships.

The "Divided Partnership" Designation

If multiple resulting partnerships qualify as continuations, Treas. Reg. §1.708-1(d)(2)(i) designates one as the "divided partnership" (which retains the original EIN and files the continuing return):

• If the partnership that transferred assets is treated as continuing, it is the divided partnership.
• Otherwise, the continuing resulting partnership that received the assets with the greatest net fair market value is the divided partnership.

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Comparison Table: Terminations, Mergers & Divisions

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Common Exam Traps & Pitfalls

• Trap 1: The Technical Termination Zombie: Do not select answers stating that a sale of >50% of partnership interests terminates the partnership. The TCJA permanently repealed technical terminations.
• Trap 2: State Law Dissolution Myth: Filing dissolution papers under state law does not terminate the partnership for federal tax purposes. The entity continues until the winding-up period is finished.
• Trap 3: Exactly 50% Does Not Continue: Both merger and division rules require more than 50% (> 50%). Exactly 50% is not sufficient to qualify as a continuation.
• Trap 4: Two-Person Immediate Termination: A two-person partnership does not terminate upon the death or retirement of one partner if the entity makes ongoing liquidating payments under Section 736.