All about business July 2018 Tax News

Technical termination (IRS changed, but California did not)

California’s tax system is based (in part) on conformity to provisions of federal tax law, as of a “specified date.” The last time California conformed to the Internal Revenue Code (IRC) was when the Conformity Act of 2015 was enacted. The Conformity Act of 2015 changed California’s specified conformity date to the Internal Revenue Code as of January 1, 2015.

On December 22, 2017, the federal Tax Cuts and Jobs Act of 2017 (Act)[1] was enacted and made many changes to federal law. Specifically, to IRC Section 708. The Act repealed the IRC Section 708(b)(1)(B) rule providing for technical terminations of partnerships (for federal purposes).

What does this mean for California taxpayers?

Because the last time California conformed to the IRC was when the Conformity Act of 2015 was enacted with a specified conformity date of January 1, 2015, this means that California does not conform to the federal provision that repealed the IRC Section 708(b)(1)(B) rule related to technical terminations of partnerships.

Under California law, a partnership is considered as terminated under specified circumstances.[2] Special rules apply in the case of the merger, consolidation, or division of a partnership.[3]

A partnership is treated as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.[4]

A partnership for California purposes will still be treated as terminated if within any 12-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.[5]  This is sometimes referred to as a technical termination.

The effect of a technical termination is not necessarily the end of the partnership’s existence, but rather the termination of some tax attributes. Upon a technical termination, the partnership’s taxable year closes, potentially resulting in short taxable years.[6]  If there is a technical termination mid-year, the partnership will have to file 2 short-year tax returns for California, but will not have short taxable years for federal tax purposes.

Partnership returns are due by the 15th day of the 3rd month following the close of the taxable year (generally March 15). When a partnership has a technical termination and needs to file 2 short-year tax returns for California, the partnership will have 2 due dates, depending on when the technical termination occurred.

An LLC treated as a partnership must follow the federal partnership rules in Subchapter K (IRC Sections 701 through 777) including the ownership change rule. The ownership change rule requires the partnership to be treated as terminated when there is a change of 50 percent or more of the total interests in a partnership within a 12-month period. If there is a technical termination mid-year, the LLC will have to file 2 short-year tax returns and pay for 2 entities (annual tax and fee) because we treat each short-period return as a separate taxable year, and the due date for the filing and payment of taxes will be based on both the beginning and ending of each separate taxable year.

For example, if a multiple-member LLC is taxed as a partnership with 2 members, each owning 50 percent, and 1 member sells his interest to another individual on June 30, the LLC terminates as a partnership effective June 30. The multiple-member LLC must file for the period from January 1 to June 30, and pay the annual tax and fee. The new partnership LLC must file for the period from July 1 to December 31, and must also pay the LLC annual tax and fee.

Remember: An LLC’s annual tax is due on the 15th day of the 4th month after the beginning of the LLC’s year to avoid penalties. Both LLCs must estimate and pay the LLC fee by the 15th day of the 6th month after the beginning of the tax year. An estimated fee penalty may be assessed if it is underpaid. The tax return must be filed by the 15th day of the 3rd month after the end of the taxable year.

As with the IRS (see IRC Sections 6698), we impose penalties on taxpayers when they fail to comply with their tax obligations. California law (Revenue and Taxation Code (R&TC) Section 19172) imposes a partnership/member late filing penalty for the late filing of a pass-through business entity’s tax returns (Forms 565 and 568) or if you file the tax returns without required information.[7] We impose these penalties even if all taxes have been paid or (as is the case with a general partnership) no taxes are imposed.

For tax returns filed on or after January 1, 2011, the partnership or LLC taxed as a partnership late filing penalty is $18 for each month or part of a month (for a maximum of 12 months) multiplied by the total number of partners or members in the entity during any part of the taxable year for which the tax return is filed after its due date. This penalty is in addition to the existing late filing penalty under R&TC Section 19131.

[1]Public Law 115-97.

[2]IRC Section 708(b)(1).

[3] IRC Section 708(b)(2). Mergers, consolidations, and divisions of partnerships take either an assets-over form or an assets-up form pursuant to Treasury Regulation Section 1.708-1(c). 

[4] IRC Section 708(b)(1)(A).

[5] IRC Section 708(b)(1)(B).

[6] IRC Section 706(c)(1); Treasury Regulation Section 1.708-1(b)(3).

[7] Failure to File a Timely Return or Provide InformationUnless failure is due to reasonable cause, a penalty will be assessed against the partnership if it is required to file a partnership return and one of the following occur:

  • It fails to file the return on time, including extensions.
  • It files a return, including Schedules K-1 (565), that fails to show all the information required.

Interest will be charged on the penalty from the date the notice of tax due is sent by us to the date the return is filed.
For “small partnerships,” as defined in IRC Section 6231, the federal exception to the imposition of penalties for failure to file partnership returns, does not apply for California purposes. For more information see R&TC Section 19172.