If your law firm is run as a partnership (or as an LLC that is treated as a partnership for federal tax purposes) beware of an arcane and generally unfavorable provision. It’s called the “technical termination” rule and it can potentially come into play for federal tax purposes whenever partnership ownership interests change hands. (Source: Section 708(b)(1)(B) of the Internal Revenue Code)

In a nutshell, here’s how the technical termination rule works and why your firm should be on the lookout for it.

When Does Termination Automatically Occur?

For federal income tax purposes, a partnership is considered to automatically terminate whenever 50 percent or more of the total interests in partnership capital and profits are sold within a 12-month period. Don’t be fooled. This tax rule applies regardless of whether or not your law firm partnership’s (or LLC’s) actual legal existence is terminated under applicable state law by the ownership changes in question. In other words, a so-called technical termination can occur under this rule for federal income tax purposes even though no actual termination has occurred for state-law purposes.

It’s also important to understand that the 12-month testing period that you are required to use in applying the technical termination rule is completely unrelated to the partnership’s tax year and the calendar year.

Example: Let’s say your firm uses a calendar tax year. Assume that a 25 percent interest in capital and profits changed hands in the second half of last year and a different 25 percent interest changes hands during the first half of this year. For federal income tax purposes, your partnership has technically terminated because 50 percent of the total interests in partnership capital and profits changed hands within a 12-month period. However, if the transaction this year only involved a 24 percent interest in capital and profits, the technical termination rule would be avoided — assuming no other interests change hands during the 12-month period that began with the 25 percent ownership change in the second half of last year.

Bottom Line: Basically, you must check to see if a technical termination has occurred each time a partnership interest changes hands by looking back at other ownership changes during the preceding 12 months.

Why Does It Matter?

Good question. In and of itself, a technical termination usually does not result in the partners or the partnership having to recognize any taxable gain or loss. However, there are three important reasons why it does matter:

1. A termination generally requires the affected partnership to start over with depreciation periods, which can mean significantly reduced tax write-offs.

2. The “new” partnership generally must make new choices regarding federal income tax accounting methods and tax elections.

3. Last but not least, a technical termination ends the partnership’s federal income tax year and requires the preparation and filing of a short-period partnership return (on Form 1065 and related Schedules K-1) for the curtailed tax year ending on the termination date. If your law firm partnership uses a fiscal year, this can result in your partners being required to report more than 12 months’ worth of taxable income for the calendar year during which the technical termination occurs.

None of this is good news. As you can see, a partnership technical termination is generally not something you want to happen to your firm. If it does happen, however, you want to get the tax results right. Keep in mind that proper advance planning can often prevent an unwanted technical termination from occurring in the first place.