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When Does a Partnership Terminate?


In its simplest form, the dictionary defines the word terminate as, “to bring to an end.” Although this definition seems straightforward, the definition is more complex when referencing the Internal Revenue Code (“IRC”).

The general rule, for identifying a partnership’s termination date, can be defined in the IRC by the occurrence of one of two events:

  1. The discontinuance of partnership business activities, or
  2. The sale or exchange of 50% or more of partnership interests in capital and profits within a twelve month period (aka a Technical Termination).
As it relates to item #2, the twelve month period can include parts of two tax years (i.e. December 1, 2012 through November 30, 2013,) and not just a calendar year.

Discontinuance of Partnership Business Activities

Discontinuance of partnership business activities generally occurs the day when all of the entity’s remaining assets are distributed to its partners. A deemed discontinuance of partnership activity would also occur if the entity were to continue in a different legal form (i.e. a corporation or sole proprietorship). The following is an example of how termination occurs after the partnership has wound up its affairs.

Example #1:

Peter and Paul each own a 20% capital and profits interest in Pete’s Pizza Partnership, Patricia owns the remaining 60%. On 7/1/2012 the three partners agree to dissolve the partnership, sell the partnership assets, pay off the partnership’s liabilities, and distribute the remaining cash to the partners. By 2/15/13, the partnership disposes of its assets, pays off its debts, and distributes the remaining cash.

Based on this example, the partnership does not terminate until 2/15/2013. From 7/1/2012 through the date of termination, the company is deemed to be winding down its affairs, thus continuing business activities.

A variation to Example # 1 could be if the partnership received a note receivable upon sale of its assets and on 2/15/2013, distributed all of the cash to its partners but still held on to the note. Each month, the entity will receive payments of interest and principal until the note is paid off completely. Under these facts, the entity would not be terminated until the note was fully paid off and all cash was distributed to the partners.

If a partnership in the winding down stage, retains cash and had the ability to make distributions could be deemed terminated in that year. Should the entity defer distributions until the next year, partnership deductions could be disallowed because of the deemed termination in the prior period.

Change in Entity Form

A deemed discontinuance of partnership activity also occurs if the entity continues in a different legal form (i.e. a corporation or sole proprietorship). The following changes in entity form could terminate the partnership:

  • Partnership conversion to an LLP
  • Partnership conversion to a multimember LLC
  • Partnership conversion to a single member LLC
  • Partnership conversion to a corporation

In addition to terminating the partnership, other tax issues may rise from one of the listed conversions above. Such issues should be considered by the taxpayer and their tax advisor before final actions are taken.

Other Considerations

When a partnership liquidates by distribution of all partnership assets to its partners, certain tax implications will apply and, as mentioned above, should be discussed with a tax advisor before final actions are taken. As referenced earlier in the Change in Entity Form section, tax consequences arise upon a change in legal form. A change in legal form is also treated as a liquidation and federal income tax rules for partnership liquidating distributions must be considered.

Tax Return and Filing Issues

A final tax return should be filed on Form 1065 (U.S. Return of Partnership Income) with the tax period ending on the liquidation date which is the day when all of the entity’s remaining assets are distributed to its partners. With regard to Example # 1 above, the final tax return would have a tax year ending 2/15/2013. In the instance where the technical termination results from a change in entity form, the final tax return would be filed with a year ending the day the entity’s form changed.




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