Allocations after an ownership change.

• Author: Keene, David
• Position: Taxation

The rules governing allocations of income, gain, loss, deduction and credit for a partnership experiencing ownership changes involving a closing of a tax year are quite clear. But ownership changes not involving a closing of the tax year trigger unclear and ambiguous interpretations of the allocation rules, resulting in a patchwork of inconsistent answers. This article explains the types of events that trigger closing of the tax year, the types of events that do not and the available allocation methods.

The Code provides a framework of rules governing allocations for changes in partnership ownership interests. Secs. 706(c)(2)(A) and 708(b) describe the change-of-ownership situations that require a closing of the partnership's tax year. In such cases, income, gains, losses, deductions and credits are allocated between the remaining and outgoing or incoming partners. The "closing" statutes have remained fairly constant since 1954; the associated allocation methods have not changed since 1956. For ownership changes not covered by these Code sections (i.e., ownership changes not triggering a closing of the partnership tax year), existing commentary offers inconsistent treatment of allocation issues, often based on regulations, rulings and cases that preceded the enactment of Sec. 706(d) by Section 72(a) of the Tax Reform Act of 1984 (TRA '84). However, because Sec. 706(d) provides clear guidance, it should prevail.

This article discusses the statutory framework governing allocations on changes in partnership ownership interests, and how the allocation rules work. It also briefly discusses some of the pre-TRA '84 rules that applied to ownership changes not resulting in a closing of the partnership's tax year, and explains when these rules should no longer apply.

What Is a Partnership?

To be subject to the partnership taxation rules (including the allocation issues discussed in this article), an entity must fall within the Code's definition of "partnership." With the increased popularity of limited liability companies (LLCs) and other types of state-law-defined entities, the classification issue has become more problematic, but has been ameliorated by the "check-the-box" regulations.(1)

The overall effect of the check-the-box regulation is that a business entity not a trust or a corporation per se is an "eligible entity." An eligible entity with two or more members may elect to be classified and taxed either as a partnership or a corporation. Most entities that are partnerships under state law (e.g., general partnerships, limited partnerships and limited liability partnership), as well as LLCs, will be classified by the Regs. Sec. 301.7701-3(b)(1)(i) default rule as partnerships for Federal income tax purposes.

Closing Events

The Code defines the events that came a closing of the partnership tax year. If a closing event occurs, an allocation of income between partners holding an interest during the tax year is required. (Other ownership changes do not lead to closure yet require allocation, as discussed below.)

When Is Closing Required?

Sec. 706(c)(1) provides a general rule that, except in the case of partnership termination (as defined in Sec. 708(b)) and except as provided in Sec. 706(c)(2)(A), a partnership's tax year does not close as the result of a partner's death, entry of a new partner or the liquidation, sale or exchange of a partner's interest. Sec. 706(c)(2)(A) states that a partnership tax year closes as to a partner whose entire partnership interest terminates (whether by reason of death,(2) liquidation or sale or exchange of interest or otherwise). Sec. 706(c)(2)(B) provides that a partnership's tax year does not close as to a partner who sells or exchanges less than his entire interest or whose interest is otherwise reduced. While a Sec. 706(c)(2)(A) closing affects only the partner(s) involved, Sec. 708(b) applies to the entire partnership.

Additionally, Sec. 708(b)(1) provides that a partnership terminates if (1) business is no longer carried on by any of the partners or (2) there is a 50% or more sale or exchange of the total partnership capital and profits interest within a 12-month period.

If a partnership does not terminate, but a change occurs in any partner's interest during the partnership's tax year, all partners' distributive shares are determined under Sec. 706(d)(1), by taking into account their varying interests in the partnership during the year (varying interests rule).

Effects of Closing

The consequences of closing a partnership tax year are twofold: allocation occurs and the partnership tax year-ends for the affected partner(s). Sec. 706(a) and Kegs. Sec. 1.706-1(c) (2)(ii) require the partner to include in income partnership items for his tax year within or with which his membership in the partnership ends. This rule applies if the partnership tax year closes at its normal year-end or under Sec. 708(b) or 706(c)(2)(A). Thus, if a partnership tax year ended Dec. 31, 1998, its 1998 income will be included on the tax return of any partner whose year ended on the same date or no later than Nov. 30, 1999.

Example 1: DKO partnership has three equal partners and a December 31 year-end. D's tax year ends January 31, K's tax year ends June 30 and O's tax year ends November 30. DKO's income for the year ended Dec. 31,1999 is $99,000. Each partner reports $33,000 for his respective year-end in 2000; D reports his share on his return for the year ending Jan. 31, 2000; K, on his return for the year ending June 30, 2000; and O, on his return for the year ending Nov. 30...