With an Internal Revenue Code and related Regulations that stretch to 70,000 pages, you might assume that when it comes to tax law, there’s nothing new under the sun. That every possible scenario has been addressed and resolved, providing the guidance taxpayers need to appropriately report their taxable income. But you’d be wrong.
There remain issues — some seemingly routine – that are unaddressed by the present authority. But that doesn’t mean the IRS isn’t trying to fill in the blanks; when it notices an issue that taxpayers are treating inconsistently, it does its best to issue firm guidance to clear up the confusion.
To wit: last Friday the IRS released proposed regulations that will settle an unsettled area of the law that has been responsible for many a dispute between tax advisors. In regulations issued under Section 708, the IRS concluded that upon a technical termination of a partnership, the partnership may not deduct any unamortized balance of its organizational or start-up costs.
If that sentence only added more confusion to your life, allow me to explain.
Partnership Technical Terminations, In General
Under Section 708, a partnership is considered to terminate any time either:No part of any business of the partnership continues to be carried on by any of its partners, orWithin a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.
This type of termination is referred to as a “technical termination,” because the partnership isn’t actually terminated for legal purposes; instead, the termination is simply a tax concept, as it ends the tax life of one partnership, but gives rise to the new life of a second partnership.
This new partnership is born through the application of Reg. Section 1.708-1(b)(4), which provides that if a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur:The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership in a Section 721 transaction;Immediately thereafter, the terminated partnership distributes interests in the new partnership to the partners of the old partnership in a Section 731 transaction.
Organizational and Start Up Costs
A partnership routinely incurs “organizational expenses” necessary to get it up and running, such as legal fees to design the partnership agreement and register with the state.
After formation, a partnership will typically incur “start-up” costs before they begin an active trade or business, such as marketing costs or costs to train employees.
Under Sections 709 and 195, respectively, these organizational and start-up costs are generally not deductible as they create an asset – the partnership – with an indefinite useful life.
Sections 709(b) and 195(b), however, permit a partnership to deduct up to $5,000 of organizational cost and an additional $5,000 of start-up costs in the year the partnership begins business. The deduction is reduced for every dollar the total organizational or start-up costs exceed $50,000. Any costs that aren’t immediately deducted are amortized over 15 years.
Example: Partnership X incurs $9,000 of organizational costs and $15,000 of start-up costs. Under Sections 709 and 195, respectively, X may deduct $5,000 of organizational costs and $5,000 of start-up costs in the year it begins business. The remaining $4,000 of organizational costs and $10,000 of start-up costs may be amortized over 15 years.
If a partnership is liquidated before the end of the amortization period, any remaining organizational or start-up costs can be deducted at that time.
Example: If partnership X terminates when the unamortized balance of the organizational and start-up costs is $2,500 and $9,000, respectively, X may deduct the $2,500 and $9,000 balances on its final tax return.
Organizational and Start Up Costs and Technical Terminations
Because a technical termination under S708 is treated as a liquidation of the pre-termination partnership, many practitioners – and a few prestigious tax treatises – have concluded that upon a technical termination, the partnership may deduct any remaining unamortized balances of organizational and start-up costs. This position isn’t wrong, mind you, because the authority on the topic was extremely unclear. Until now.