In the choice of entity debate, the ability to divide the corporation’s business assets and activities into two or more separate corporations, owned by different shareholders, without incurring taxable gain, is often said to be one of the more significant advantages enjoyed by the corporate form of business.  However, though the partnership provisions of the Code do not have comparable rules that speak specifically to the tax-free separation of a partnership’s business, the income tax rules generally applicable to partnerships may, nonetheless, enable a partnership to achieve the same objectives.  This is especially helpful to know where, in the context of a family business, differences of opinion develop among family members that may ultimately impact the continued well-being of the business.

For example, Partnership may have been formed by Parent with Son and Daughter to operate one or more lines of business.  Over time, each of Son and Daughter may have gravitated toward one line or the other, or they may have focused on different aspects of a single business.  Their differing interests may eventually lead to dissension within Partnership, with a liquidation or division of the Partnership being the best option to keep the peace and allow each child to go his or her separate way.  The income tax consequence of such a division will depend upon the manner in which the division is effected.

Types of Partnership Separations

Generally speaking, there are three types of partnership separations.  The first is a liquidation of the partnership or of the partner’s interest in the partnership.  For example, if Partnership (above) distributed the assets of one line of business to the Son alone, with Parent and Daughter remaining in Partnership, Son’s interest in Partnership has been liquidated.  The other two types are partnership divisions.

According to IRS Regulations, in order for there to have been a division of a partnership, there must be two or more resulting partnerships, and at least two members of the prior partnership must be members of each resulting partnership.  In the example above, if Father, Son and Daughter separated, such that Father and Son became members of one partnership, and Father and Daughter became members of another, then it may be said that there has been a division of Partnership.

Assets-Up Division

A division is treated as an “assets-up” form of division where the prior partnership distributes certain assets to some or all of its partners in partial or complete liquidation of their interests in the prior partnership and, immediately thereafter, such partners contribute the distributed assets to a new, resulting partnership in exchange for interests in such resulting partnership.

Assets-Over Division

A division is treated as an “assets-over” form of division where the prior partnership (“Prior Partnership”) contributes certain assets and liabilities to a new, resulting partnership (“Resulting Partnership”) in exchange for interests therein and, immediately thereafter, Prior Partnership distributes the interests in Resulting Partnership to some or all of its partners (those who are designated to receive such interests) in partial or complete liquidation of the partners’ interests in the Prior Partnership.

In the example above, if Partnership (the Prior Partnership) contributed the assets and liabilities associated with one line of business to a new Resulting Partnership in exchange for the equity therein, then immediately distributed that equity to Son and Parent, with Daughter and Parent still owning Prior Partnership, an assets-over form of division will have occurred.

The assets-over form of division appears to provide more favorable tax treatment than an assets-up division.  Of course, when dealing with the taxation of partnerships, even the “more favorable” tax treatment is fraught with risks, some of which are highlighted below.

The transitory ownership by Prior Partnership of 100% of Resulting Partnership would be ignored.  The in-kind distribution by Prior Partnership to Son in complete liquidation of his interest in Prior Partnership, and the distribution to Parent in partial liquidation of his interest in Prior Partnership, would be tax-free, at least at first blush.  The Resulting Partnership would take the assets from Prior Partnership with the same basis and holding period as they had in Prior Partnership.  The partners would take their interests in Resulting Partnership with the same basis they had in Prior Partnership, though they may have split holding periods, depending on the assets contributed.

However, the “split-off” of a line of business by a Prior Partnership may cause a decrease in a partner’s share of the Prior Partnership liabilities.  Such a decrease is treated as a distribution of money by Prior Partnership; if the amount of the deemed distribution exceeds the partner’s adjusted basis in the partnership, the partner will recognize taxable gain.

If a partner receives a distribution of Prior Partnership property (including money) other than unrealized receivables (or substantially appreciated inventory; together “hot assets”) in exchange for his interest in such hot assets, the transaction may be considered a taxable sale or exchange of such property between the distributee partner and Prior Partnership.

If a partner in Prior Partnership had contributed appreciated property (“built-in gain” property) to the partnership, and Prior Partnership is divided in an assets-over transaction, the interest in Resulting Partnership will itself be treated as built-in gain property to the extent the interest is received by Prior Partnership in exchange for the contributed built-in gain property.  In that case, the distribution by Prior Partnership of the interest in Resulting Partnership to one other than the partner who contributed the built-in gain Property to Prior Partnership, generally will trigger gain to such contributor-partner if the division occurs within seven years of the contribution.  That gain may also be triggered where the contributing partner receives an interest in Resulting Partnership that is not attributable to such built-in gain property.


As the foregoing discussion demonstrates, the interplay of the partnership tax rules in the context of a division can be very complex, and there are a number of potential pitfalls.  That is not to say that it is impossible for partners to separate from one another on a tax-efficient basis.  In order to achieve a tax-free division of a partnership, however, these rules need to be navigated carefully and with plenty of planning in advance.