Missing partnership merger definition raises questions.

• Author: Langdon, Nancy L.

The regulations under Sec. 708 set forth detailed rules governing the federal income tax consequences of a partnership merger. They lack, however, clear guidance on when a transaction resulting in the combination of two partnerships into a single partnership constitutes a merger governed by those regulations. The lack of guidance is especially problematic for determining the federal income tax consequences when a taxpayer collapses two partnerships--one an upper-tier partnership, or UTP, and the other a lower-tier partnership, or LTP--into a single entity.

The lack of a merger definition means that the tax characterization can vary dramatically depending on how the transaction is viewed. To illustrate possible different treatments, consider this scenario.

Example: X, Y, and a UTP own 10%, 10%, and 80% interests, respectively, in an LTP. Neither X nor Y holds an interest in the UTP. The parties agree to consolidate the two entities by having X and Y contribute their LTP interests to the UTP in exchange for interests in the UTP. For state law purposes, both legal entities still exist after the transaction, although for federal income tax purposes only one partnership remains. The remaining partnership is owned 10% by X, 10% by Y, and 80% by the UTP's former partners.

Because of the lack of guidance on partnership mergers, there appear to be at least three potential characterizations of this transaction for federal income tax purposes.

Alternative 1: LTP Merges Into UTP

It is generally thought a merger exists in any case in which (1) at least two tax partnerships exist immediately before a transaction, (2) immediately after the transaction only one tax partnership exists, and (3) the equity holders of each of the preexisting tax partnerships become equity holders in the single remaining tax partnership as part of the transaction. From this perspective, the transaction could be viewed as a merger because two partnerships existed at the beginning of the day and only one partnership remains at the end.

Sec. 708(b)(2)(A) provides:

In the case of a merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of this section, be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership [(the ownership test)]. Here, determining which of the LTP or the UTP should be considered the continuing...