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by Nick Crandall, Rachele Gregory and Eric Myers
This article is the final in our series on the tax implications of the different structures used to buy or sell a business. Check out our other articles related to C-corporations and S-corporations. This article will help you understand the tax implications for both buyer and seller in the purchase or sale of ownership units or assets of a partnership such as a limited liability company (LLC). Partnerships are known for their pass-through taxation structure, and depending on the type of partnership, may provide liability protection. Whether you’re looking to buy or sell, careful analysis and consideration are needed to ensure the correct outcome.
In a transaction to purchase the units of a partnership, the buyer acquires the ownership shares of the company from the seller(s) and become the legal owners of the entity. The entity continues to operate as it has but under new ownership.
In most cases the buyer will receive a step up in basis in a purchase of partnership units and will inherit all the underlying assets and liabilities of the partnership that were in place at the transaction date. When a buyer purchases 100% of a partnership, the transaction is a deemed purchase of the underlying assets of the acquired partnership under Revenue Ruling 99-6. There are two situations discussed in Revenue Ruling 99-6 in which a buyer becomes the sole owner of an LLC.
In situation one, a partnership owned equally by two people has one partner purchase the entire partnership interest of the other partner. In this situation, the acquiring partner is deemed to receive a distribution of 50% of the underlying assets of the partnership while simultaneously purchasing the remaining 50% of the assets from the selling partner. The buyer receives a step up in basis on the portion of the assets they are deemed to have purchased and will have a carryover basis in the assets that they are deemed to contribute to the “new” partnership which will operate post-acquisition. The buyer would now have two holding periods for the underlying assets of the partnership. The first would be a carryover holding period for the assets that they are deemed to have always owned as a partner. The second holding period begins the day after the transaction and is allocated to the portion of the assets that were deemed purchased from the exiting partner.
The seller in situation one will calculate their gain as if they had sold the underlying assets of the partnership. Unlike the sale of stock for a C-corporation or S-corporation, some of the gain in the sale of partnership units may be recharacterized to ordinary income instead of being all capital gain. The ordinary income will be based on items such as depreciation recapture or unrealized gains on ordinary income assets such as inventory or accounts receivable. These assets are commonly referred to as hot assets.
In situation two, two partners sell their entire interest to an unrelated person that has no ownership in the partnership. In this situation, both selling partners are deemed to receive a distribution of the assets of the partnership and then sell those assets to the new owner(s). As in situation one, the sellers will need to calculate their gain on the sale as if they had sold the underlying assets of the partnership with some of their gain being ordinary and some being capital.
The buyer will be deemed to have purchased the underlying assets from the selling partners and will receive a step up in basis in the assets. The seller will need to allocate the purchase price among the assets and determine the appropriate treatment of each asset class.
Cash basis sellers must be cognizant of the impact of the hot asset rules in particular. Whereas the hot asset rules very clearly generate ordinary income on the value of cash basis receivables, the rules do not clearly permit an offsetting ordinary deduction for cash basis payables and accrued expenses, including with respect to transaction expenses. Careful consideration and planning is needed to ensure minimization of the amount of ordinary income to sellers.
Another unique aspect of selling a partnership interest is when a buyer acquires less than 100% of the ownership of a partnership. In the C-corporation and S-corporation articles, we discuss that when stock is purchased there is no adjustment or consideration for how much is paid for the ownership. In a partnership transaction, this is not the case because the Internal Revenue Code treats partnerships differently. In this situation, there is a calculation under Internal Revenue Code Sections 734 and 754 that allows the partnership to calculate an increase in basis of the underlying assets that will allow deductions to be allocated back to the purchasing partner. The nuances and complications of these code sections are outside the scope of this article but are important considerations when purchasing a partnership interest.
An asset transaction involves the transfer of the individual assets or group of assets of one business to another. In some cases, a newly formed entity is created by the buyer and in other cases an existing business will purchase the assets and absorb them into their current operations.
The buyer of the assets will receive a step up in basis in the tangible and intangible assets to fair market value based on the purchase price they paid for the asset which includes any assumed liabilities. The tangible assets, generally, can be deducted as ordinary expense or through depreciation in a very short amount of time. The intangible assets must be amortized over a 15-year period from the date of the transaction.
The seller will have ordinary income and capital gain income passed through to them from the partnership as dictated by the purchase price allocation that is discussed below. The ordinary income items will be taxed at the sellers’ ordinary income tax rate. The capital gain income will be taxed at the lower preferred tax rate that is usually 20%. As mentioned above, the participation of the seller in the business will determine if any of the capital gain income will also be subject to the 3.8% NII tax. If the seller lives in a state with an income tax the pass-through income will be taxed by that state. Some states do allow for certain pass-through gains to be exempt from income.
One of the main points of contention in a partnership equity or assets sale is the allocation of the purchase price. The buyer typically wants more of the purchase price allocated to ordinary income items such as inventory or tangible property (such as equipment and furniture and fixtures). The allocation of purchase price to these items allows the seller to take deductions for them much earlier after the transaction than when the purchase price goes to intangible assets. On the other hand, the seller wants more of the purchase price allocated to intangible assets and goodwill so that more of the gain is taxed at the lower capital gains rates. The allocation of the purchase price should be negotiated and agreed upon by both parties prior to the closing of the transaction. The parties do not have to agree on the exact numbers but should agree on the methodology that is going to be used to determine the value assigned to these assets. We have seen business owners not spend enough time around this part of the transaction or leave the allocation schedules open-ended which could cause them to pay much more in tax than they had planned on. Note that the methodology language should be as specific as possible with respect to the methodology. For example, what is the source of the numbers – seller’s tax basis, seller’s book basis prior to purchase accounting adjustments, buyer’s GAAP basis opening balance sheet, etc.?
One other item that must be considered in both a sale of partnership units and the sale of partnership assets is how any recourse liabilities will impact the gain to the selling partner. Recourse liabilities are liabilities, such as loans, that both the partners and the partnership are liable for. The most common recourse debt is when a partner is required by a bank to provide a personal guarantee on a loan. When these debts are paid off or transferred to another partner or person there is a deemed distribution for the selling partner that may cause additional gain to be recognized on the transaction. It is important that the consequences of recourse debt are considered in any partnership transaction. The complexities of recourse debt are outside the scope of this article.
Often states taxes can be materially different in a sale of partnership equity versus a sale of partnership assets. A sale of partnership assets may permit the partnership to make a pass-through entity tax election with respect to the sale. A sale of partnership assets is more often subject to state taxation based on operations of the business, whereas a sale of partnership equity is more often subject to state taxation based on the resident of the home state. These factors can make a material difference in tax obligations of the partners.
As noted above, an acquiror of partnership assets or partnership equity can generally achieve a step-up in tax basis with respect to its purchase price. This being said, there are limited circumstances where buyer’s ability to amortize the purchase price can be impacted by the acquisition structure – for example with respect to goodwill that may be subject to the anti-churning rules.
At Elliott Davis, our Closely Held Business and Transaction Advisory Services teams have years of experience working with customers to understand and execute the appropriate transaction structure whether they are buying or selling. We can work with you to understand the different options available, the tax implication of each, and help you determine the best path forward for you and your business. Contact us to get started.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
