A
partner can dispose of a
partnership interest in the
following ways:
By sale
to one or more of the
other partners.
By sale
to a third party.
By
exchange of the
partnership interest for
other property.
By
transfer back to the
partnership in return
for at least one
liquidating distribution
leading to a complete
liquidation of the
partnership interest.
By
retirement.
By gift
or contribution.
By
death.
By
surrendering the
partnership interest
through abandonment,
forfeiture, or
worthlessness of the
partnership interest.
Each of the
above methods for disposing
of a partnership interest is
covered in this chapter.
This
chapter also addresses:
The
character of the gain or
loss on the disposition
of a partnership
interest.
The
effect of related debt
disposition.
The
recognition of
accumulated suspended
passive losses
associated with a
partnership interest.
ISSUE:
SALE OR EXCHANGE OF A
PARTNERSHIP INTEREST
Under
subchapter K, the rules for
the disposition of a
partnership interest follow
the entity theory of
partnership taxation. All
determining factors of the
disposition (for example,
basis, holding period, and
character of the gain or
loss) are considered with
respect to the partnership
interest without reference
(except for IRC section 751
assets) to the underlying
assets of the partnership.[1]
IRC
section 741. Recognition
and character of gain or
loss on sale or exchange
In the case
of a sale or exchange of a
partnership interest, gain
or loss shall be recognized
by the transferring
partner. Such gain or loss
shall be considered as gain
or loss from the sale or
exchange of a capital asset,
except as otherwise provided
in IRC section 751 (relating
to unrealized receivables
and inventory items which
have appreciated
substantially in value).
However, the substantially
appreciated requirement
under IRC section 751(a),
relating to the sale or
exchange of a partnership
interest, has been repealed
by the TRA ‘97 (Refer to
1997 TRA for effective
dates), therefore, disregard
that requirement.
The gain or
loss from the disposition of
a partnership interest is
the difference between the
amount realized and the
partner’s adjusted basis
(outside basis) in the
interest immediately before
the disposition. Although
the formula for calculating
gain or loss is simply
stated, addressing each
component in detail is
essential.
The amount
realized consists of cash
plus the fair market value
of property received plus
the selling partner’s share
of partnership liabilities
assumed by the buyer (IRC
section 752(b)).
The
adjusted basis of the
partnership interest begins
with the original
partnership basis as
determined under IRC
sections 722 or 742,
relating to the original
acquisition of the
partnership interest. It is
increased by those items
specified in IRC sections
705(a)(1) and 752(a) and
decreased by those specified
in IRC sections 705(a)(2)
and 752(b). At the time of
the sale or exchange, IRC
section 752(d) treats the
selling partner’s share of
partnership liabilities in
the amount realized in much
the same way as IRC section
752(b) treats a deemed
distribution.
Because the
transferring partner’s basis
in the partnership must be
determined as of the date of
disposition, any adjustments
to basis must also include
the transferring partner’s
share of partnership income
or losses from the beginning
of the partnership year to
the date the partner ceases
to be a partner.
Characterization of Gain or Loss
In
conjunction with the
determination of any gain or
loss to be recognized by the
disposing partner, in the
presence of IRC section 751
assets, a separate
calculation will be required
to determine the portion of
the transaction to be
considered capital and the
portion to be treated as
ordinary. When the sale of
the partnership
interest includes both
cold assets
(capital assets) and
hot assets (assets
with built in ordinary
income potential), the sale
is said to be bifurcated
(split) into two components,
capital gains and losses
from the cold assets, and
ordinary gains and losses
from the hot assets.
Further
complications arise when a
single asset has both hot
and cold asset attributes
subject to the recapture
provisions of IRC section
751(c). IRC section 751(c)
treats the amount to be
recaptured as an unrealized
receivable. Upon the sale
of a partnership interest,
recapture will generate
ordinary income even though
depreciable assets are
capital assets (Treas. Reg.
section 1.751-1(c)(4)). The
ordinary income component of
the gain is computed first.
Any remaining amount of the
gain is capital.[2]
The
disposing partner’s ordinary
gain or loss is the
difference between the
amount realized attributable
to IRC section 751 assets
less the partnership’s
adjusted basis associated
with these items.
The sale of
a partnership interest
resulting in a gain can be
reported under the
installment method under IRC
section 453 if at least one
payment is received after
the year of sale. A sale
resulting in a loss cannot
be reported under the
installment method (IRC
section 453(a)).
Additional Filing Requirements
Generally,
IRC section 6050K requires
that a Form 8308, Report of
a Sale or Exchange of
Certain Partnership
Interests, must be filed for
each sale or exchange of a
partnership interest which
contains IRC section 751
property. (The Forms 8308
are to be filed as an
attachment to the
partnership's Form 1065.)
The penalty for the
partnership's failure to
file Form 8308 is governed
by IRC section 6721. There
is generally a $50 penalty
imposed for each infraction
or violation.[3]
IRC section
706(c)(2)(A) provides that
the taxable year of a
partnership shall close with
respect to a partner whose
entire interest in the
partnership terminates.
Additionally, IRC section
708(b)(1)(B) generally
provides for the taxable
year of the partnership to
close if there has been a
sale or exchange of 50
percent or more of the total
interest in partnership
capital and profits within a
12-month period.
Exchanges
of Partnership Interest
There are
many ways to exchange
partnership interests. The
most common ways are to:
Exchange an interest in
one partnership for an
interest in another
partnership.
Exchange a limited
partnership interest for
a general partnership
interest in the same
partnership.
Exchange a partnership
interest for a direct
ownership right to all
or part of a partnership
asset.
Exchange a partnership
interest for a member
interest in a successor
LLC or LLP.
Exchange of a
partnership interest for
corporate stock while
incorporation of the
partnership.
The
exchange of a partnership
interest in one partnership
for an interest in another
partnership will result in
gain or loss recognition,
even if both partnerships
own like-kind property.
IRC section 1031(a)(1)
generally provides for
non-recognition of gain or
loss on exchange of
particular properties of
like kind. Exchanges of
partnership interests,
however, are specifically
excluded from IRC section
1031 by IRC section
1031(a)(2)(D).
The
exchange of a partnership
interest for a different
partnership interest in the
same partnership as part of
a conversion of the
partnership from general
liability to limited
liability or vice-versa, is
generally a non-recognition
event. See Rev. Rul 84-52,
1984-1 C.B. 157. Also, the
conversion of an interest in
a domestic partnership into
an interest in a domestic
LLC classified as a
partnership for federal tax
purposes (and visa-versa) is
treated generally like a
partnership to partnership
conversion pursuant to Rev.
Rul. 84-52. See Rev. Rul.
95-37, 1995-1 C.B. 130.
The
exchange of a partnership
interest for a direct
ownership right to all or
part of a partnership asset
is essentially a
distribution in liquidation
of the partnership
interest. Such an exchange
was at issue in
Chase v. Commissioner,
92 T.C. 874 (1989). The
Tax Court determined that
the substance over form
doctrine applied and the
transaction failed to
qualify for non-recognition
under IRC section 1031. See
IRC section 1031(a)(2)(D).
Chase v.
Commissioner should
be cited in situations where
the form of the transactions
fail to reflect the economic
realities of the
transactions.
The
exchange of a partnership
interest for corporate stock
can result in taxable income
to the transferring partner
if the FMV of the stock
received exceeds the
adjusted basis of the
partnership interest
transferred. If IRC section
351 is applicable, the
exchange may not be taxed.
In a qualified IRC section
351 exchange, however,
liabilities assumed by the
corporation that are in
excess of the partner’s tax
basis in the partnership
interest and other assets
contributed to the
corporation for the stock
will trigger a gain under
IRC section 357(c).[4]
Note:
Unless there is an IRC
section 754 election in
effect, the inside basis of
partnership assets are not
changed as a result of the
sale or exchange of a
partnership interest. If
there is an IRC section 754
election in effect, the
inside basis of partnership
assets is adjusted to
reflect the purchase price
but only for the partner who
acquired the partnership
interest. Application of
the adjustment serves to
eliminate the discrepancy
between the purchasing
partner’s inside and outside
bases.[5]
Examination Techniques
As can be
expected from the myriad of
tax consequences that may
result from the sale or
exchange of a partnership
interest, the selling
partner will be looking to
reduce the tax effects of
any gains and to stretch the
tax benefits of any losses
on the sale.
After
determining that there has
been a sale or exchange, the
character of the gain or
loss must be determined.
This is accomplished through
an analysis of each asset
transferred in the
transaction or series of
transactions.
What did
the seller/transferring
partner receive? What did
the taxpayer relinquish?
What additional benefits
accrue as a result of the
sale or exchange? Review
the facts and circumstances
surrounding the partnership
interest and the taxpayer's
relationship to the
recipient of the partnership
interest and the remaining
partners. Do not let the
elaborately structured
form of the
transaction overshadow its
actual substance.
The initial
indication that a partner
has disposed of a
partnership interest should
be evident from the
partner’s Schedule K-1. A
change in a partner’s
ownership percentages of
profits, capital, or losses
from the beginning of the
tax year to the end of the
tax year as reported on the
Schedule K-1, may indicate
either a disposition of part
or all of the partner's
ownership interest. A
reduction of a partner's
ownership interest to an
amount other than zero may
be indicative of a partial
sale, exchange, or
liquidation. It should be
noted, however, that such a
reduction may also be
related to changes in the
partnership agreement or a
partnership's attempt to
reflect more accurately the
intent of the partnership
agreement.
Exchanges
between partners of their
ownership interest in
profits, losses, and
capital, as reported on
their Schedules K-1, should
be scrutinized as they may
alter the allocation of
distributive items. In
short, these exchanges may
not be supported by bona
fide transactions between
the affected partners.[6]
If there is
any increase in a partner’s
ownership interest in
profits, losses, or capital
or the addition of a new
partner, the Schedule K will
generally identify the
parties involved.
Review item
J of theSchedule K-1,
Analysis of partner’s
capital account, especially
when there is a negative
capital account interest at
the beginning of the year
and a zero capital account
interest at the end of the
year. This review, along
with a scrutiny of
partnership debt appearing
on the balance sheet, and a
review of more than one
year's Schedule K-1, Item F,
Partner’s share of
liabilities, may lead to a
conclusion that there have
been events that qualify as
deemed distributions
pursuant to IRC section
752(b).
If the
partner’s capital account
was reduced to zero, check
for amounts on any of the
distribution lines on the
Schedule K-1. No
distribution may be an
indication that there was a
sale, while a distribution
may be a sign of a
liquidation by way of a
distribution.
Does the
balance sheet show
inventory? If it does,
consider the ordinary income
component (IRC section 751)
of the sale.
If the
partnership is on the cash
method, determine if it has
contracted for services to
be performed in the future
or for goods to be delivered
at a later date. The value
of these contracts may have
been imputed to the selling
price of the partner’s
interest in recognition of
the value of an unrealized
receivable.
The
presence of depreciable
assets on the balance sheet
should raise questions as to
whether there is a potential
for depreciation recapture.
Depreciation recaptured
under IRC section 1245 or
IRC section 1250 is treated
as an unrealized receivable
under IRC section 751(c) and
any gain or loss recognized
by the disposition of the
property is traced as
ordinary income or loss
pursuant to IRC section
724(a).
Was Form
8308, Report of a Sale or
Exchange of Certain
Partnership Interests, filed
with the partnership Form
1065? The presence of hot
assets on the balance sheet,
along with the understanding
that there had been a sale
or exchange of a partnership
interest should raise a red
flag that a Form 8308 should
have been filed.
A
comparison of the beginning
and ending balance sheets
can disclose a step-up in
basis. Alternately, amounts
appearing on the "Other
deductions" line of
Schedules K and K-1 may be
an indication of additional
depreciation calculated on
the step-up. This item
should be distributive to
the purchasing partner
only. This item may also be
separately reported to
partners who acquired their
interest by purchase in
prior years, at which time
they received a step-up.
Transfers
between family members which
are identified as a gift may
trigger sale or exchange
treatment for the donor to
the extent partnership
liabilities are assumed by
the donee.[7]
Under IRC section 704(e)(3),
the purchase of a
partnership interest from a
family member is treated as
if created by a gift.[8]
If there
has been an optional basis
adjustment, look for the IRC
section 754 election.
The selling
partner’s tax return should
be reviewed. If necessary,
it should be examined to
determine if the sale or
exchange was reported
correctly.
Prior and subsequent
years' partnership
tax returns
Calculation of the
selling partner’s
basis.
Agreement of sale
between the selling
partner and
purchaser, including
any provisions for
debt assumption.
Calculation of
built-in
depreciation
recapture potential.
Contracts for future
services and/or
delivery of goods to
be performed by the
partnership at the
time of the
disposition.
Calculation of
optional basis
adjustment, if any.
Disposing partner’s
tax return for the
year of the
disposition.
Interview Questions
Interview
questions are contingent on
the extent to which the
documents requested present
a clear picture as to how
the disposition and its tax
consequences were reported;
specifically:
Were all types of
IRC section 751 hot
assets taken into
account?
How
were hot assets
valued with respect
to the selling
partner’s interest?
To
what extent was the
transferring
partner’s share of
partnership
non-recourse
liabilities assumed
by the transferee?
Was
the disposing
partner liable for
recourse debt? Did
the partner remain
liable for the debt
after disposing of
the partnership
interest? If the
transferee takes the
partnership interest
subject to recourse
debt, are there any
agreements between
the transferee and
transferor which
give the appearance
that the transferor
may nevertheless pay
off the debt in the
future? Consider
that the obligation
to the transferor
may be too
contingent. If that
is the case, the
debt becomes part of
the amount realized
from the sale.
If
there has been an
optional basis
adjustment and there
is no indication of
an IRC section 754
election on the
partnership return
currently under
exam, on what year’s
return, if ever, was
the election first
made? Is the
election still in
effect?
Any
discrepancies
between the
determination made
by the examining
agent and the
results of the
disposition reported
by the disposing
partner would
require an
examination of the
disposing partner’s
tax return.[9]
Questions should be
designed to
reconcile to the
correct amount.
Did
the transferor and
transferee treat the
sales price
consistently with
respect to hot and
cold assets?
Revenue Ruling 84-52, 1984-1
C.B. 157
The conversion of a general
partner interest into a
limited partner interest,
and vise versa, within the
same partnership, generally
will result in no gain or
loss recognition by the
partner under section 741 or
1001 of the Code. If, as a
result of the conversion,
there is no change in the
partner’s share of
liabilities section
1.752-1(e) of the Treasury
Regulations, there is no
change to the partner's
partnership interest's
adjusted basis. If there is
a change in the partner's
share of partnership
liabilities under Treas.
Reg. section 1.752-1(e), and
such change causes a deemed
contribution of money under
IRC section 752(a) then IRC
section 722 will increase
the partner’s adjusted basis
in the partnership. If the
conversion causes a deemed
distribution of money under
IRC section 752(b) then the
partner's partnership basis
shall be reduced by IRC
section 733, but not below
zero. The amount by which
the deemed distribution
exceeds the partner's
adjusted basis in the
partnership, will generate a
gain to be recognized by the
partner, as provided for in
IRC section 731.
IRC section
1223(1) holds that the
holding period of the
acquired partnership
interest becomes that of the
interest converted.
Revenue Ruling 84-53, 1984-1
C.B. 159 This Revenue Ruling
illustrates, by way of four
examples, various basis
allocations and adjustments
that may occur when a
partner owns multiple
interest in a partnership
and disposes of only a
portion of such interests.
When
considering sales and
exchanges by a partner with
multiple interests, the
partner is deemed to have a
single basis in the
partnership. If the partner
disposes of less than the
entire partnership interest
owned, then the basis
allocated to the interest
disposed of is determined
with reference to fair
market values of the
interests retained and
disposed. See Treas. Reg.
section 1.61-1(a).
Revenue Ruling 95-37, 1995-1
C.B. 130
This ruling treats the
conversion of a partnership
interest into an LLC
interest in much the same
manner as conversions
described in Revenue Ruling
84-52.
Crenshaw v. Commissioner,
450 F.2d 472; 1971 U.S. App.
(5th Cir.) The Court of
Appeals for the Fifth
Circuit, in reviewing the
facts surrounding a complex,
multi-tiered transaction,
found, in a case of
substance versus form, that
the series of transactions
amounted to nothing more
than a sale of a partnership
interest subject to IRC
section 741. The taxpayer
had argued for tax-free
liquidation treatment under
IRC section 736(b) followed
by a tax-free exchange of
like-kind property under IRC
section 1031.
Pollack v.
Commissioner, 69 T.C. 142
(1977) The Tax Court ruled
that the loss resulting from
the disposition of a
partner’s interest in a
partnership should be
characterized as a capital
loss pursuant to IRC section
741 rather than an ordinary
business loss, as the
taxpayer had claimed.
Characterization of a
partnership interest as a
capital asset neither
depends on the taxpayer’s
motive when acquiring the
interest nor the fact that
treatment would be different
if the taxpayer had
established the enterprise
as a business other than a
partnership.
Collapsible Partnerships A collapsible
partnership is the sale or
exchange of an interest in a
partnership by a partner
prior to receipt by the
partnership of unrealized
receivables or inventory
items which have appreciated
substantially in value. See
S. Rept. No. 1616, 86th
Cong., 2d Sess., p. 77 1960;
S. Rept. No. 1622, 83rd
Cong., 2d Sess., p. 98
(1954). Any consideration
attributable to such
unrealized receivables or
inventory items considered
to be property received from
the sale or exchange of
property other than a
capital asset. See IRC
section 751(a).
It should
be noted that the following
cases, involved tax years
that predate the 1954 Code,
but the findings are
consistent with the intent
behind enactment of IRC
sections 741 and 751.
Trousdale v. Commissioner,
219, F.2d 563 (9th Cir.
1955) In this case, the
partners wanted to terminate
their partnership.
Essentially all of the
services to be performed by
the partnership had already
been performed. The only
assets remaining in the
partnership were accounts
receivable. The partnership
then disguised its
dissolution as a sale. The
Tax Court held and the Court
of Appeals for the Ninth
Circuit affirmed that the
payments received were in
fact for services rendered
by the partnership and not
for a sale of the
partnership. As a result,
the income was held to be
ordinary income.
Haggard v. Wood, 298 F.2d 24
(9th Cir. 1961) The sole business
of the partnership was the
cultivation of a cotton
crop. At the time of the
sale, the crop was ready for
harvest and market. The
partners and purchaser, who
were all related, took
particular care, through
correspondence and the
agreement of sale, to depict
the transaction as the sale
of partnership interests and
not the sale of partnership
assets. The partners were
paid for their partnership
interests out of the
proceeds the purchaser
received from the sale of
the cotton crop.
The Court
of Appeals for the Ninth
Circuit affirmed the
district court’s
determination that the
partners should recognize
ordinary income from the
sale of the partnership's
only asset rather than
capital gain from the sale
of a partnership interest.
In reaching its decision,
the court discussed
Trousdale v. Commissioner.
Resources
RIA U.S.
Tax Reporter – Income Taxes
CCH
Standard Federal Tax
Reporter
Thomas
Crichton, IV et al., 712 Tax
Mgmt., Partnerships -
Taxable Income; Allocation
of Distributive Shares;
Capital Accounts.
Kevin N.
Kemp et al., 718 Tax Mgmt.,
Dispositions of Partnership
Interests - Termination of a
Partnership.
2 William
S. McKee, William F. Nelson
& Robert L. Whitmire,
Federal Taxation of
Partnerships and Partners
sec. 15.07 (3d ed. 1997).
2 William
S. McKee, William F. Nelson
& Robert L. Whitmire,
Federal Taxation of
Partnerships and Partners,
ch. 17 (3d ed. 1997).
Steven C.
Thompson,
Partnership Taxation
– Fundamentals, Englewood,
CO; MicroMash, Chapter 6,
Sale of Partnership
Interests.
Geoffrey F.
Grossman, Choosing
the Most Advantageous Method
for Disposing of a
Partnership Interest,
3 J. P'ship Tax'n 219 (Fall
1986).
Doug W.
Banks & David E. Karr,
Sale of Partnership
Interest Can Produce
Unexpected Tax Results
Without Proper Planning,
38 Tax'n for Accts. 92 (Feb.
1987)
ISSUE:
LIQUIDATION OF A PARTNER’S
INTEREST IN THE PARTNERSHIP
There is
little, if any, economic
difference between a pro
rata sale of a partnership
interest to the remaining
partners and a liquidation
of the interest by way of
liquidating distributions
from partnership assets.
Ultimately, the departing
partner’s interest is
terminated in favor of the
remaining partners. The tax
effects are, however, quite
different, depending on the
path taken.
The
following points highlight
how the liquidation of a
partner’s interest in a
partnership differs from the
sale of such an interest.
In a
liquidation, the “buyer”
is the partnership
rather than any of the
existing partners or a
third party (who
replaces the partner).
In a
liquidation, the
partnership makes a
distribution, or series
of distributions, in the
form of cash and/or
partnership assets to
the liquidating
partner. IRC section
761(d).
In a
liquidation, a series of
distributions may take
place over a period of
one or more year.
In a
liquidation, the
partner’s interest will
not be considered
liquidated until the
final distribution has
been made. IRC section
736(b).
A
partner owning more than
one interest must
terminate all of its
interests in the
partnership in order to
qualify any
distributions received
as liquidating
distributions. IRC
section 761(d).
A
distribution not in
liquidation of a
partner’s entire
interest, is a current
distribution. Current
distributions include
distributions in partial
liquidation of a
partner’s interest as
well as distributions of
the partner’s
distributive share of
current partnership
income.
Liquidation of a
partnership interest
does not trigger a
technical termination of
the partnership under
IRC section 708(b)(1)(B)
even when the liquidated
interest represents 50
percent or more of the
total interest in
partnership capital and
profits. Treas. Reg.
section 1.708-1(b)(2).
For
taxable years beginning
after December 31, 1997,
IRC section 706(c)(2)(A)
provides that the
taxable year of a
partnership will close
with respect to a
partner whose entire
interest is terminated
as a result of death,
liquidation, or
otherwise. For taxable
years beginning before
January 1, 1998, IRC
section 706(c)(2(A)
provided that the
partnership's taxable
year closed with respect
to a partner whose
entire interest was
terminated as a result
of sales, exchanges, or
liquidation, except that
the taxable year of a
partnership with respect
to a partner whose
interest terminated as a
result of death did not
close prior to the end
of the partnership's
taxable year.
The
following points relate to
distributions in complete
liquidation of an interest
in a partnership (although
some may also apply to
non-liquidating/current
distributions):
Where
money (including
marketable securities as
per IRC section 731(c))
is distributed by a
partnership to a
partner, no gain shall
be recognized to the
partner, except, to the
extent that the amount
of money distributed
exceeds the adjusted
basis of the partner’s
interest in the
partnership immediately
before the
distribution. See
Treas. Reg. section
1.731-1(a)(i).
A
deemed distribution
under IRC section 752(b)
is considered a
distribution of money.
IRC section 752(b).
Generally, no gain shall
be recognized to a
distributee partner with
respect to a
distribution of property
(other than money) until
the partner sells or
otherwise disposes of
the property. Treas.
Reg. section
1.731-1(a)(1)(i).
Exceptions to this rule
are provided in IRC
sections 736 and 751.
A loss
is recognized by a
partner only upon
liquidation of the
partner's entire
interest in the
partnership, and only if
the property distributed
to the partner consists
solely of money,
unrealized receivables
(as defined in IRC
section 751(c)), and
inventory items (as
defined in IRC section
751(d)(2)).[11]
Upon a
liquidating
distribution, loss is
recognized by the
distributee partner to
the extent of the excess
of the adjusted basis of
the partner’s interest
in the partnership at
the time of the
distribution over the
sum of any money
distributed to the
partner and the basis of
any IRC section 751
assets distributed.
Treas. Reg. section
1.731-1(a)(2).
Note,
the treatment of IRC
section 751 assets under
Treas. Reg. section
1.731-1(a)(2) serves to
prevent the partner from
converting capital loss
to ordinary loss when
disposing of IRC section
751 assets. Similar
treatment does not apply
if the result of the
liquidation, after the
distribution of money,
is a gain.
Any
gain realized or loss
sustained by a partner
on a sale or exchange of
inventory items (as
defined in IRC section
751(d)) received in a
distribution from a
partnership shall, if
sold or exchanged within
5 years from the date of
the distribution, be
considered ordinary gain
or ordinary loss. IRC
section 735(a)(2);
Treas. Reg. section
1.735-1(a)(2).
Any
gain realized or loss
sustained on the
disposition by the
distributee partner of
unrealized receivables
(as defined in IRC
section 751(c))
distributed by a
partnership, shall be
considered as ordinary
income or ordinary
loss. IRC section
735(a)(1).
The
holding period of the
distributed property to
the distributee includes
the holding period of
the partnership, except
in the case of inventory
items. IRC section
735(b).
Any
gain realized or loss
sustained by a
distributee partner in
complete liquidation of
a partnership interest
is treated as a gain or
loss from the sale or
exchange of a capital
asset. IRC sections
731(a) and 741.
Under
IRC section 731(b), no
gain or loss is
recognized by the
partnership on a
distribution to a
partner of property,
including money.
However, the partnership
may recognize gain or
loss from certain
distributions which,
under IRC section
751(b), are treated as a
sale or exchange of
property between the
distributee partner and
the partnership.
Generally,
in most instances of
distributions of property
the partner takes a
carryover basis in the
property distributed.
However, in a liquidating
distribution, the basis of
distributed property in the
hands of the distributee is
limited to his or her
outside basis after it has
been reduced by money
received.
Example 7-1
A
partner with an outside
basis of $1000 before
distribution receives,
in liquidation of his or
her partnership
interest, a cash
distribution of $300
and partnership
equipment with a basis
to the partnership of
$800. Since the partner
has a reduced outside
basis of $700 ($1000
less the cash received
of $300), the equipment
will have a basis of
$700 to the
distributee.
Conversely, if the
equipment had a basis to
the partnership of only
$200 it would still
receive a basis of $700
in the hands of the
distributee. No
gain or loss is reported
until the distributee
disposes of the
equipment.
If the
distribution includes both
hot and cold assets any
unrealized loss would be
allocated to the cold
asset(s), increasing the
basis of such property in
the hands of the former
partner. IRC section 732(c)
covers the allocation of
basis on distributed
property. The requirement
of allocating unrealized
loss to cold assets only
serves to prevent ordinary
income from being converted
to capital gain upon
disposition of the hot
assets by the distributee.[12]
If the
partnership makes an IRC
section 754 election,
optional basis adjustments
can be made to the
undistributed partnership
property under IRC section
734(b), in accordance with
the rules of IRC section
755. Such adjustments can
serve to correct for
differences that have arisen
as a result of property
distributions. These
differences are triggered by
the distributee taking a
basis in the distributed
property that is different
from the basis of the
property in the hands of the
partnership or when the
distributee recognizes gain
or loss on the
distribution. For further
discussion of optional basis
adjustments see Chapter 3
and the underlying
Regulations as well as texts
cited as Resources, all of
which provide several good
examples.
In the
matter of liquidating
distributions the examiner
should be wary of instances
where the partner whose
interest has been liquidated
may be attempting to:
Claim
losses from his or her
liquidated interest at a
time when the interest
had not yet been fully
liquidated.
Claim a
loss from a fully
liquidated interest in
the partnership while
holding yet another
interest in the
partnership.
Claim
losses from a liquidated
interest while ignoring
deemed distributions
under IRC section
752(b). Or, in general,
exclude deemed
distributions under IRC
section 752(b) from the
computation of the
amount realized as
distributed.
Claim
losses from distributed
cold assets prior to
disposing of those
assets.
Allocate basis to
distributed IRC section
751 hot assets in a
manner designed to
reduce the impact of
ordinary income
recognition or convert
ordinary income into
capital gain.
While no
gain or loss is recognized
by the partnership on a
distribution to a partner,
with the exception of
distributions under IRC
section 751(b), the examiner
should be alert to the
following possibilities:
The
partnership may make a
disproportionate
distribution to avoid
the full impact of IRC
section 751(b).
The
partnership may attempt
to expense certain items
of the distribution.
Optional basis
adjustments to
undistributed assets
under IRC section 734(b)
may be allocated in a
manner designed to
benefit the remaining
partners in a way not
intended by the statute.
If the
partnership has an IRC
section 754 election in
place, it may have
failed to make optional
basis adjustments under
IRC section 734(b) which
serve to reduce the
basis of property
remaining in the
partnership.
If
there has been a deemed
distribution under IRC
section 752(b), the
partnership may have
allocated the debt in
favor of a particular
partner rather than
proportionately.
The first
hint that a partner’s
interest had been
liquidated, or is in the
process of being liquidated,
can be seen on the
partnership return. Does
the partner’s Schedule K-1
contain a distribution? If
it does, then it should also
break down the distribution
as to cash and property.
This information is also
available on Schedule M-2.
Does the
partner’s Schedule K-1 end
with zero capital and no
remaining share of
partnership liabilities? If
the Schedule K-1 shows that
the partner is no longer
treated as a partner at the
end of the partnership year,
then there may have been a
complete liquidation of the
partner's interest. If it
is found that the partner
has another interest in the
partnership, as evidenced by
an active Schedule K-1, then
the partner's interest has
not been completely
liquidated.
The
examiner should review the
balance sheet, Schedule M-2
and other partners' Schedule
K-1. If the balance sheet
shows that a partner has
loaned money to the
partnership, or if the
Schedule M-2 shows
contributions to capital
(Treas. Reg. section
1.731-1(c)(3)), and/or the
remaining partners' Schedule
K-1 show a disproportionate
reallocation of the
liquidating partner’s profit
and loss interests and
capital interest, then the
transaction may have been a
sale rather than a
liquidation.
One of the
critical differences between
a sale of a partnership
interest and distributions
in liquidation of the
partnership interest is the
ability to defer gain on the
distribution in liquidation.
Example 7-2
If a
partner with an adjusted
basis in the partnership
of $100,000 and a
partnership interest
with a FMV of $150,000
sells half of his
interest for $75,000,
the partner will be
required to report a
capital gain of $25,000
($75,000 - $50,000),
pursuant to IRC section
741. However, if
$75,000 was distributed
to the partner in
partial liquidation of
his partnership
interest, then no
current income is
recognized since the
total received ($75,000)
is less than the
adjusted basis of the
partner’s interest in
the partnership
($100,000), immediately
before the
distribution. See IRC
section 731(a)(1).
It is,
therefore, essential that
the examiner determine the
source of the funds
distributed by the
partnership. In an issue of
substance versus form, the
examiner should question the
validity of any amendments
to the partnership
agreement, or any side
agreements, which cast the
transaction as a
distribution in liquidation.
Issue
identification regarding
deemed distributions under
IRC section 752(b), optional
basis adjustments under IRC
section 734(b),
consideration of IRC section
751 assets and recapture
provisions are similar to
those used for sales and
exchanges.
The
partner’s return should be
reviewed for possible issues
regarding the distributee’s
treatment of gains or losses
reported and basis applied
to distributed property
resulting from the
distribution in partial or
complete liquidation.
Documents to Request
Generally,
the documents requested for
an examination of the issue
of distribution in partial
liquidation or a
distribution in complete
liquidation should mirror
that of a sale or exchange,
with the exception of the
documents which spell out
the plans for liquidation of
the partner’s interest.
Documents requested are in
many ways similar to those
requested for the retirement
of a partner. The reader is
referred to the “Sale and
Exchange of a Partnership
Interest” section of this
chapter, as well as the
section on “Retirement or
Death of a Partner.”
Interview Questions
Is the
distribution a
distribution in
liquidation of a
partner’s interest (IRC
section 731(a)(2)) or
payments to a retiring
partner or deceased
partner’s successor in
interest under IRC
section 736? There are
significant differences,
as you will see, in the
section of this chapter,
which covers retirement
of a partner.
Generally, any questions
directed at resolving
issues of basis, capital
gain and loss versus
ordinary gain or loss,
optional basis
adjustments (with the
understanding that there
are differences between
IRC sections 734(b) and
743(b)), etc., should be
similar to questions
raised for sales and
exchanges of partnership
interests.
Any
discrepancies between
the determination made
by the examining agent
and the results of the
liquidating
distributions or
distributions in
complete liquidation
reported by the
distributee partner
require an examination
of the seller’s tax
return.
Sections 731 through 737
Section 751
Section 752
Section 754
Section 755
Section 761
Supporting regulation
and specific regulations
cited above.
Treatment of Payments for
Goodwill Service
partnerships often make
payments for goodwill to
liquidating partners. IRC
section 736 provides that
the liquidating partner and
partnership may execute an
agreement regarding how such
payments are to be treated.
IRC section 736(a) allows
the partner to treat the
payment for goodwill as
ordinary income and the
partnership to treat it as
deductible. IRC section
736(b) allows for the
partner to treat such
payment as capital gain and
the partnership is left
without a deduction.
If the
partnership is sold,
however, IRC section 741
governs. IRC section 741
declares that the selling
partner's interest in the
partnership's goodwill is a
capital gain to the partner
and nondeductible by the
partnership, regardless of
any agreements between the
parties.
Cases to
review in this area include:
Smith v.
Commissioner,
37 T.C. 1033,
aff’d 313 F.2d
16 (10th Cir. 1962)
(providing for the
agreement between the
liquidating partner and
the partnership to be
controlling with respect
to whether a payment is
for goodwill).
Cooney v.
Commissioner,
65 T.C. 101 (1975)
(stating that since the
agreement provided that
no part of a payment in
liquidation was to be
attributed to goodwill,
the court found that it
had "no latitude" and no
part of such payment
could be treated as
goodwill).
Resources
RIA U.S.
Tax Reporter – Income Taxes
CCH
Standard Federal Tax
Reporter
2 William
S. McKee, William F. Nelson
& Robert L. Whitmire,
Federal Taxation of
Partnerships and Partners;
part VI: Distributions and
Part VII: Death or
Retirement of a Partner (3d
ed. 1997).
Steven C.
Thompson,
Partnership Taxation –
Fundamentals,
Englewood, CO; MicroMash,
Chapter 7B, Liquidating
Distributions
Laura E.
Cunningham & Noel B.
Cunningham, The Logic of
Subchapter K: A Conceptual
Guide to the Taxation of
Partnerships, Chapters 11
through 13.
James A.
Doering, Disposition
of Less than an Entire
Partnership Interest: What
are the Tax Effects?
15 J. P'ship Tax'n 141
(Summer 1998)
Janet B.
Wright, Liquidating
the Partnership: An Analysis
of the Issues and
Opportunities, 14
J. P'ship Tax'n 229 (1998).
Any of the
methods for disposition of a
partnership interest
presented in the chapter on
sales and exchanges is
available to a retiring
partner. The two methods
most commonly employed are:
By sale
to one or more of the
existing partners or to
a third party.
By sale
direct to the
partnership.
The second
method of disposition,
liquidation, is discussed
above. Payments in complete
liquidation of a retiring
partner’s interest in the
partnership, or a deceased
partner’s successor in
interest, are governed by
IRC section 736. Were it
not for IRC section 736,
retirement of a partnership
interest would be
indistinguishable from
liquidation.
Since IRC section 736
applies to payments to both
retiring partners and a
deceased partner’s successor
in interest, any discussion
in this section is
applicable to both, even
when only one or the other
is indicated.
Payments to
a retiring partner or
deceased partner’s successor
in interest consist of:
Payments for the
partner’s interest in
the partnership (IRC
section 736(b)).
Payments that are
considered distributive
shares of partnership
income if the amount is
determined with regard
to the income of the
partnership (IRC section
736(a)(1)).
Payments that are
considered guaranteed
payments described in
IRC section 707(c) if
the amount is determined
without regard to the
income of the
partnership (IRC section
736(a)(2)).
It is
important to recognize that
the purpose of IRC section
736 is to categorize
payments to the
partners identified in its
title, and only those
partners (see Treas. Reg.
section 1.736-1(a)(1)(ii)).
After the categorization is
made, the rules of the
various other subchapter K
sections serve their
function.
Certain
provisions of IRC section
736 were amended by the
Revenue Reconciliation Act
of 1993 (RRA ’93). The
changes were effective for
payments to partners
retiring or dying on or
after January 5, 1993.
There is a transition rule
stating that the new rules
will not apply to partners
who retire or die after
January 5, 1993, if there
was a binding contract in
effect on January 4, 1993.
In these instances, the
deduction of IRC section
736(a) payments made to such
qualified partners will
continue to be allowed to
the partnership, while RRA
’93 places a limitation on
deductibility.
For years
before the enactment of RRA
’93 the tax rate gap between
capital gains and ordinary
income was minimal.
Generally, retiring partners
were indifferent as to the
treatment of payments they
received under IRC section
736 in those years. So, for
example, payments to the
departing partner for his or
her share of goodwill were
treated as IRC section
736(a) payments even though
goodwill is a capital
asset. This allowed the
partnership to take a
deduction for the payment
rather than treat it as a
nondeductible capital
expenditure. The
distributive income of the
remaining partners was
reduced, while the departing
partner did not experience
any significant economic
adversity from reporting
this payment as ordinary
income due to the
insignificant tax difference
between ordinary income and
capital gain.
RRA ’93
altered the treatment of
payments under IRC section
736 by limiting the types of
payments that could be
classified as made under IRC
section 736(a) and
classifying all other
payments made under IRC
section 736(b), payments for
the interest of the retiring
partner in partnership
property. RRA ’93 requires
that the partnership and the
retiring partner agree to
the inclusion of a
reasonable amount of the
goodwill as an IRC section
736(b) payment, thereby
reducing deductions to the
partnership for its payments
for a capital asset. On the
other hand, RRA ’93
eliminates unrealized
receivables (IRC section
751(c)) from IRC section
736(b) payments, thus
preventing the conversion of
ordinary income to capital
gain. This section will
concentrate on the post RRA
’93 application of IRC
section 736.
Payments
under IRC section 736(a) are
liquidating payments. These
payments are unrelated to a
retiring partner’s interest
in partnership property.
Rather than being considered
distributions, payments are
for part of the retiring
partner’s distributive share
of partnership income or
guaranteed payments to the
partner, as determined by
IRC section 736(a)(1) and
736(a)(2).
The
characteristics of payments
under IRC section 736(a) for
the departing partner, the
partnership and its
remaining partners are:
Payments under IRC
section 736(a)(1) are
generally ordinary
income to the retiring
partner or deceased
partner’s successor in
interest;
Payments under IRC
section 736(a)(2) are
always ordinary income
to the retiring partner
or deceased partner's
successor in interest;
Payments under these two
subsections serve to
reduce the distributive
shares of the remaining
partners;
Payments under IRC
section 736(a)(1) are
included in the income
of the recipient for his
taxable year with or
within which ends the
partnership taxable year
for which the payment is
a distributive share;
Payments under IRC
section 736(a)(2) are
included in the income
of the recipient for his
taxable year in which
the partnership is
entitled to deduct the
guaranteed payment
(Treas. Reg. section
1.736-1(a)(5)).
Payments made under IRC
section 736(a)(2) are
deductible by the
partnership (Treas. Reg.
section 1.736-1(a)(4));
and,
A
payment under IRC
section 736(a)(1)
retains its character
for purposes of
determining the taxation
of the recipient (IRC
section 702(b)).
The
characteristics of IRC
section 736(b) payments are:
Payments made in
exchange for the
partner’s interest in
partnership property are
distributions;
All
payments to a retiring
limited partner in a
partnership in which
capital is not a
material
income-producing factor
and all payments to all
partners in a
partnership where
capital is a material
income-producing factor
are IRC section 736(b)
payments. Exception:
payments for the
partner’s interest in
unrealized receivables
(IRC section 751(c) –
depreciation recapture)
which are in excess of
the partnership's basis
in such receivables are
IRC section 736(a)
payments (Treas. Reg.
section 1.736-1(b)(2)).
IRC
section 736(b) payments
do not include any
amount paid for the
partner's share of
goodwill in excess of
the partner's basis in
the partnership
interest; unless
specifically provided
for in the partnership
agreement. (Treas. Reg.
section 1.736-1(b)(3)).
IRC
section 736(b) payments
are reported in the
taxable year in which
received, regardless of
the departing partner’s
or the partnership’s
method of accounting
(Treas. Reg. section
1.736-1(a)(5)).
If an
IRC section 754 election
is in place, the
partnership can receive
a step-up in basis under
IRC section 734(b) for
the excess amounts paid
for the retiring
partner’s interest in
the partnership
property.
The rules
for the allocation of
payments between IRC section
736(a) and IRC section
736(b) are contained in
section 1.736-1(b)(5) of the
Treasury Regulations.
If the
payments are fixed in amount
and made over a number of
years, section 1.736-1(b)(6)
of the Treasury Regulations
allows the partner to elect
to attribute an amount of
gain to each installment
payment instead of first
recovering basis. Examples
are provided in section
1.736-1(b)(7) of the
Treasury Regulations.
The
following points are made
regarding the death
of a partner:
Death
of the partner does not
ordinarily result in the
termination of the
partnership under IRC
section 708(b).
Termination of a
partnership interest by
reason of death does not
result in the closing of
the partnership taxable
year (IRC section
706(c)(1)).
The
taxable year of the
partnership closes with
respect to a partner
whose interest in the
partnership terminates
by reason of death (IRC
section 706(c)(2)(A)).
This rule represents a
change included in the
Taxpayer Relief Act of
1997 (TRA ’97) and is
effective for
partnership taxable
years beginning after
December 31, 1997.
The
amount includible in the
gross income of a
successor in interest of
a deceased partner under
IRC section 736(a) is
considered income in
respect of a decedent
under IRC section 691
(IRC section 753).
Pre-TRA
‘97
The
decedent’s individual
return closed as of the
date of death (Treas.
Reg. section
1.443-1(a)(2)). This
does not mean that an
individual files his
Form 1040 for a period
other than his normal
calendar year. (See next
item).
The
final return of a
deceased partner does
not include any
partnership distributive
items (income, loss,
deductions and
credits). IRC section
706(a) governed here
because the death of the
partner caused the
partner's year to end
earlier than that of the
partnership.
The
deceased partner’s share
of partnership
distributive items was
included in the return
of the successor, even
if income was
distributed during that
part of the year which
pre-dated the partner’s
death (IRC section
731(a)(1) and Treas.
Reg. section
1.731-1(a)(1)(i)).
TRA
’97, IRC section
1246(a), amended IRC
section 706(c)(2)
requiring that the
partnership year close
with respect to the
deceased partner as of
the date of death. As a
result, the partner’s
share of income, losses,
deductions and credits
are included in the
partner’s final income
tax return, as
determined from the
beginning of the
partnership year to the
date of the partner’s
death.
The
person named in the
partnership agreement as
successor partner in the
event of death is
recognized as the
successor for federal
income tax purposes
(Treas. Reg. section
1.706-1(c)(3)(ii)).
A sale
of the entire deceased
partner’s partnership
interest as of the date
of death will not cause
a partnership
termination (IRC section
706(c)(2)(A)(i)). The
decedent and the new
partner must each
include their
proportionate share of
partnership income,
loss, deductions and
credits.
Transfer, upon death, of
the partner’s interest
in the partnership does
not result in
disposition gain. That
is, no gain is
attributed to the
decedent even if the
interest entails a share
of partnership debt or
unrealized receivables.
No gain
is recognized on the
transfer to the
decedent’s estate, or to
a successor by bequest
(IRC section 752(d),
Treas. Reg. section
1.752-1 and
Crane v. Commissioner,
331 U.S 1 (1947)).
Any
suspended passive
activity losses will be
allowed on the
decedent’s final
return. However, the
suspended loss is
reduced by the amount by
which the basis of the
partnership interest to
the successor
(stepped-up basis)
exceeds the adjusted
basis of the partnership
interest to the decedent
immediately before
death (IRC section
469(g)(2)). If,
as a result of this
provision, any part of
the suspended passive
activity loss is not
allowed on the
decedent’s final return,
it will not be allowed
to anyone, ever (IRC
section 469(g)(2)(B)).
The
basis of the partnership
interest to the
successor is the FMV as
of the date of death or
alternate valuation date
(IRC section 1014(a)),
reduced by income in
respect of a decedent
and, increased by the
successor’s share of
liabilities as of the
date of death or
alternate valuation date
(Treas. Reg. section
1.742-1)). Refer to IRC
section 691 for rules
relating to income in
respect of a decedent
(IRD).
The
successor partner’s
basis in the partnership
interest will be its FMV
per IRC sections 742 and
1014. This may result
in the successor having
an outside basis in
excess of the
partnership’s inside
basis. If an IRC
section 754 election is
in place, the
partnership can step-up
the basis of assets
under IRC section 743(b)
solely for the benefit
of the successor.
If the
IRC section 754 election
is in place and the
successor’s outside
basis is less than the
partnership’s inside
basis, a step-down in
basis will be required.
A
successor may continue
as a partner.
A
successor may sell the
partnership interest to
the existing partners or
a third party. See the
“Sales and Exchanges”
section of this chapter.
A
successor may have his
partnership interest
liquidated. See the
discussion of IRC
section 736, above.
Examination Techniques
Examination
techniques and issue
identification focus on post
RRA ’93, for transactions
involving partners who
retire or die on or after
January 5, 1993.
Aside from
the allocation of payments
under IRC sections 736(a)
and 736(b), payments made in
retirement of a partner’s
interest or deceased
partner’s successor in
interest bear numerous
similarities to payments in
complete liquidation of a
partner’s interest under IRC
section 731.
IRC section
736 is designed to prevent
tax avoidance by requiring
the departing partner and
the partnership to treat the
payments consistently. This
was reinforced by RRA ’93
which requires that payments
must be treated as made in
exchange for the partner’s
interest in partnership
property under IRC section
736(b) and not as a
distributive share or
guaranteed pa
