Divide and Conquer—A Primer on Partnership Divisions

Partnership divisions under IRC Section 708(b)(2)(B) can be useful in several contexts. Partnership divisions are also quirky, with distinctive requirements and results. This blog post examines those requirements and results, and the practical applications of partnership divisions. Although the topic is “partnership divisions,” everything can be applied equally to LLCs which are taxed as partnerships.[1]

IRC Section 708(b)(2)(B) provides that “in the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) shall, for purposes of this section, be considered a continuation of the prior partnership.”

The most distinctive feature of the above paragraph is that, if a partnership divides into two or more partnerships under Section 708(b)(2)(B), any new partnership resulting from the division (including the original partnership) will be treated as a continuation of the original partnership ONLY IF the partners of that resulting partnership had a greater than 50% ownership interest in the original partnership.

Example 1:  A, B, C, D, and E are members of Original LLC, a tax partnership, each with a 20% membership interest. Original LLC divides, with A, B, and C staying on as members of Original LLC, and D and E becoming the new members of New LLC. D and E each have a 50% interest in New LLC. Since D and E had a combined interest of only 40% in Original LLC before the division, New LLC will not be treated as a continuation of Original LLC.

Example 2:  Same facts as Example 1, but C agrees to go along with D and E, and own a nominal interest in New LLC, while also staying with A and B in Original LLC. New LLC will be owned 2% by C, and 49% each by D and E. Now the three members of New LLC are C, D, and E, and those three had a combined 60% interest in Original LLC before the division. Therefore, New LLC will be treated as a continuation of Original LLC. That means that New LLC will inherit the tax attributes and elections of Original LLC. For example, if the two LLCs go forward with a transaction such a sale of real property, the tax treatment will be as though a single partnership was engaging in the sale.

So how is a partnership division effected? Treasury Regulations Section 1.708-1(d)(3)(i) provides that the default form will be the “assets-over form,” which can be described as follows:  Using the Examples above, Original LLC is deemed to contribute property to New LLC in exchange for the sole interest in New LLC. Immediately thereafter, Original LLC distributes the interest in New LLC to D and E (Example 1) or C, D, and E (Example 2) in liquidation (or partial liquidation in the case of C in Example 2) of their membership interests in Original LLC.

Section 1.708-1(d)(3)(ii) provides an alternate form, the “assets up” form, where, instead of property being transferred from Original LLC to New LLC, property is distributed by Original LLC directly to its members in liquidation of their membership interests in Original LLC (or partial liquidation in the case of C in Example 2). The members then contribute the distributed property to New LLC in exchange for their membership interests.

If the partnership division results in continuing partnerships, the original partnership (called the “divided partnership”) will retain its taxpayer ID number (EIN), and the other continuing partnerships will get new EINs. The original partnership will file a tax return in which it must provide the names and contact information of the other continuing partnerships. The continuing partnerships will file their own returns in which they must provide the name and contact information of the original partnership.

Partnership divisions can be useful in situations where partners in a partnership or LLC want to split up, but to retain the tax characteristics of the original partnership. For example, in a private letter ruling by the IRS,[2] a partnership with two equal partners owned land that had been condemned by a government entity. The partnership elected to avoid gain recognition under IRC Section 1033 by using the proceeds from the involuntarily converted property to purchase replacement property. The partners, however, couldn’t agree on appropriate replacement property. So the partnership divided into two partnerships, with the condemnation proceeds split between the two partnerships, and each purchased separate replacement property. Each partnership was controlled by one of the partners, with the other partner owning a nominal interest, as in Example 2, above. The two partnerships resulting from the division, therefore, were continuing partnerships, and each was able to take advantage of the Section 1033 election made by the original partnership.

The facts of the above-described private letter ruling demonstrate how a partnership division involving continuing partnerships can enable partners to split up the partnership where there is a disagreement among the partners on some basic business transaction. The division resolved a disagreement by enabling both partners to operate separately, and still take advantage of a tax-free exchange under Section 1033. Section 1031, governing like-kind exchanges, is a close cousin of Section 1033. In some instances, a partnership division can achieve similar results in the Section 1031 context. For example, if different partners seek different results from the sale of relinquished property, the partners can divide the original partnership into two or more continuing partnerships. The continuing partnerships will retain the tax characteristics of the original partnership (e.g., the acquisition date of the relinquished property), and the tax treatment will be as though a single partnership is engaging in the sale.

[1] An LLC taxed as a partnership (i.e., most multi-member LLCs) is a “partnership” under tax law, and its members are “partners.”

[2] Private Letter Ruling 200921009, May 22, 2009.