IRS Clarifies Tax Rules for Start-Up Costs of Terminated Partnerships

Ken Berry, Correspondent for AccountingWeb writes: It's a given that a partnership is generally entitled to a limited current deduction for qualified start-up and organizational costs and can amortize the remainder over time. But what are the tax consequences if a partnership technically terminates due to the sale or exchange of its interests? This issue, which was has long been debated by tax commentators, is finally settled under new proposed regulations released by the IRS.

Before we move forward, let's step back to review some of the key components of the existing law. Under Section 708 of the tax code, a partnership is considered to be legally terminated if either of the following occurs:

1. No part of any business of the partnership continues to be carried on by any of its partners.
2. There is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits within a twelve-month period.

The latter is referred to as a "technical termination" because the partnership actually survives. It is terminated for federal tax purposes, while giving rise to a new partnership. The prevailing regulations say this occurs when the old partnership contributes all of its assets and liabilities to the new partnership in exchange for interests in the new partnership, and then immediately distributes those interests to the partners of the old partnership.

Typically, a partnership will incur start-up costs before it gets the business up and running. These expenses normally must be amortized over a period of 180 months (i.e., fifteen years). However, Section 195 allows a current deduction of up to $5,000 of qualified start-up costs, including organizational expenses, investigatory expenses, pre-production expenses, consulting fees and other professional services, and travel costs. 

The maximum $5,000 deduction is phased out on a dollar-for-dollar basis for start-up expenses over $50,000. Any remainder is amortized over the usual fifteen-year period. If a partnership is liquidated before the end of the amortization period, any remaining start-up costs may be deducted at that time.

Because a technical termination under Section 708 is treated as a liquidation of a partnership, some tax experts have argued that the partnership can deduct any remaining unamortized balance of its start-up costs. But now the new proposed regulations nip that theory in the bud. According to the new regs, the remaining unamortized assets are treated as being transferred to the new partnership, which is then required to amortize the costs over their remaining useful life.

Here's an example of how it works: At the time ABC Partnership technically terminates, it has an unamortized balance of $10,000 in qualified start-up costs. The costs have been amortized over seven years of their original fifteen-year period. Under the proposed regulations, ABC Partnership can't deduct the $10,000 of unamortized expenses, even though ABC Partnership is treated as having been terminated under Section 708. Instead, the balance is transferred to the XYZ Partnership, the newly formed partnership, which then can deduct the remaining $10,000 over the last eight years of the original fifteen-year useful life.

The new proposed regulations bring the tax treatment of start-up costs in line with the tax rules for amortizing intangible assets under Section 197. The regulations in this area don't allow accelerated deductions upon a technical termination. View the new regs in their entirety at https://www.federalregister.gov/articles/2013/12/09/2013-29177/partnerships-start-up-expenditures-organization-and-syndication-fees.