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Conversion of a partnership was a continuation, IRS rules

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Tax Hot Topics: Conversion of partnershipIn a recently issued private letter ruling (PLR 201605004), the IRS ruled on the tax consequences of a limited partnership’s conversion to another limited partnership entity formed under the same state law. The PLR concludes that one entity was the continuation of the other, which was classified as a partnership for U.S. federal income tax purposes, and that the partnership did not terminate under Section 708.

The transaction described in the PLR involved PRS 1, a state limited partnership, which, for U.S. federal income tax purposes, was an entity disregarded from PRS 2, which wholly owned PRS 1 indirectly through disregarded entities. PRS 1 owned an interest in PRS 3, a state limited partnership. On a subsequent date, PRS 4 acquired an interest in PRS 3, and PRS 3 became a partnership for U.S. federal income tax purposes. Also on the same date, presumably following PRS 4’s acquisition of an interest in PRS 3, PRS 4 exchanged its interest in PRS 3 for an interest in PRS 1. The exchange resulted in PRS 1’s becoming a partnership and PRS 3’s becoming a disregarded entity of PRS 1 for U.S. federal income tax purposes.

In its analysis, the IRS Office of Chief Counsel cited Rev. Ruls. 84-52 and 95-37. Rev. Rul. 84-52 involved the conversion of a general partnership into a limited partnership. The IRS explained that Rev. Rul. 84-52 treats the conversion as an exchange under Section 721, which does not constitute a sale or exchange for purposes of Section 708.

Rev. Rul. 95-37 discusses the consequences of the conversion of a domestic partnership into a domestic limited liability company (LLC). The IRS explained that the conversion of an interest in a domestic partnership into an interest in a domestic LLC that is classified as a partnership for federal tax purposes is a partnership-to-partnership conversion that is subject to the principles of Rev. Rul. 84-52. The agency held in Rev. Rul. 95-37 that the conversion of a domestic partnership into a domestic LLC does not cause a termination under Section 708. Rev. Rul. 95-37 further explains that the partnership’s tax year did not close under Section 706, and the resulting domestic LLC did not have to obtain a new taxpayer identification number.

Under Section 708(a), a partnership continues unless it terminates. Section 708(b)(1) explains that a partnership terminates if no part of the partnership’s business is carried on by any of its partners, or if within a 12-month period, 50% or more of the interests in the partnership’s profits and capital are sold or exchanged. Treas. Reg. Sec. 1.708-1(b)(2) indicates that the contribution of property to a partnership does not constitute a sale or exchange for purposes of Section 708. Section 721 generally provides for nonrecognition treatment to the partnership and its partners for the contribution of property to the partnership in exchange for an interest.

The IRS concluded in the PLR that PRS 1 would be considered a continuation of the partnership, PRS 3, and that there was no termination under Section 708. Furthermore, the IRS held that the conversion of PRS 3 into PRS 1 did not cause the partners of PRS 3 or PRS 1 to recognize gain or loss under Sections 741 or 1001 (except as provided under the liability allocation rules of Section 752), the partnership’s tax year did not close, and PRS 1did not need to obtain a new taxpayer identification number.

Additionally, the IRS stated that the conversion of PRS 3 into PRS 1 did not result in the assets of the partnership being contributed or distributed to the partners of the partnership, suggesting that the conversion was a nonevent. By taking this view, the IRS seems to be suggesting that this transaction would not be analyzed under other authorities that would involve transfers of property. For example, the facts of the PLR appear similar to those of Situation 2 of Rev. Rul. 99-6, which involved the CD partnership, with partners C and D, and the sale of all of the partnership interests to E. There, the IRS concluded that “for purposes of classifying the acquisition by E, the CD partnership is deemed to make a liquidating distribution of its assets to C and D. Immediately following this distribution, E is deemed to acquire, by purchase, all of the former partnership’s assets.” E is treated as purchasing all of the former partnership’s assets from C and D, obtaining a new holding period for all assets beginning on the day immediately following the date of the sale.

Based on Situation 2 of Rev. Rul. 99-6, the transaction in the PLR could have been treated as though PRS 1 acquired all of the assets of PRS 3. PRS 2 and PRS 4 would be treated as transferring their interests in PRS 3 for partnership interests in PRS 1.  

Another authority that may appear factually similar is Situation 2 of Rev. Rul. 99-5, in which B, an unrelated third party, contributed cash to an LLC whose sole owner was A, in exchange for a 50% interest in the LLC. There, the IRS concluded that the LLC was converted from a disregarded entity to a partnership when B contributed cash to it, and B’s contribution was treated as a contribution to a partnership in exchange for an ownership interest in the partnership, with A being treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest.  

If the analysis of Rev. Rul. 99-5 was applied to the transaction in the PLR, PRS 2 could be viewed as contributing all the assets of PRS 1 (including its interest in PRS 3) to the new partnership, and PRS 4 could be treated as contributing its interest in PRS 3 to the new partnership. However, in the PLR, the IRS apparently did not choose to apply Rev. Rul. 99-6 or Rev. Rul. 99-5. The PLR highlights that the tax characterization of movements of interests in business entities is not always clear and the steps in each transaction need to be analyzed carefully.
           
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