In 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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