Chapter 11

Q20. What is the partner's basis in the property received?

A20. Code section 732(b) provides the partner with an aggregate basis in the distributed property equal to his pre-distribution outside basis less any cash received in the liquidation.

Q21. What does this exchange basis mechanism accomplish?

A21. This exchanged basis mechanism preserves any gain or loss inherent in the partner's interest for recognition when the partner disposes of the distributed assets.

Q22. What happens if more than 1 asset is distributed? What does code section 732(c) say to do in that situation? Step 1?

A22. Step 1 - If inventory items or unrealized receivables have been distributed, those properties are first tentatively assigned a basis equal to the basis of each such property to the partnership.

Q23. What if the sum of the partnership's bases in the distributed unrealized receivables and inventory items exceeds the basis to be allocated (the partners outside basis less cash received in the transaction)?

A23. Then the partnership's basses on those properties must be reduced by the amount of the excess.

Q24. How is this reduction achieved?

A24. This reduction is achieved by first allocating basis decreases among the properties with unrealized built-in loss (properties with an assigned basis greater than their value) in proportion to the amounts of such los and only to the extent of the built-in loss of each property.

Q25. What happens if that is not enough?

A25. If needed, additional decreases are allocated in proportion to the remaining adjusted bases of the unrealized receivables and inventory items.

Q26. What is step 2 now?

A26. If the basis to be allocated exceeds the partnership's basis in the distributed unrealized receivables and inventory items, then each other distributed property is next assigned a basis equal to the partnership's basis in that property.

Q27. Basis increases or decreases then must be allocated to the other distributed properties if what?

A27. If the partner's remaining basis (the basis remaining after any unrealized receivables or inventory items are assigned basis equal to their bases in the hands of the partnership) is greater or less than the sum of the partnership's bases on those properties.

Q28. What if an overall increase is required?

A28. If an overall increase is required, the increase is accomplished by first allocating basis increases among the properties with unrealized appreciation in proportion to such appreciation and only to the extent of each property's unrealized appreciation.

Q29. What about any additional increases?

A29. Any additional increases are allocated in proportion to the respective FVMs of the properties.

Q3. And all other payments?

A3. All other payments fall into the much narrower second category and are characterized by Section 736(a) as either a distributive share of partnership income, if based on profits of the firm, or as guaranteed payments under Section 707(c), if determined without reference to partnership income.

Q30. What if an overall decrease is required?

A30. The decrease is accomplished by first allocating basis decreases in proportion to the unrealized built-in loss in the properties (again, only to the extent of such loss) and then in proportion to the remaining adjusted bases of the properties.

Q31. Character?

A31. 735(a) preserves the ordinary income character in the hands of the partner indefinitely for any unrealized receivables and 5 years for inventory items

Q31. What happens with holding period on these items?

A31. In keeping with the treatment of operating distributions, the distribute partner may tack the partnership's holding period under section 735(b)

Q32. Consider a different situation where a partner who receives solely cash, unrealized receivable and inventory items in a liquidating distribution. In this event, UNLIKE the case with operating distributions, Section 731(a)(2) provides that the partner recognizes a loss to the extent that what?

A32. Code section 731(a)(2) provides that the partner recognizes a loss to the extent that his outside basis exceeds the sum of the cash distributed plus the partner's Section 732 transferred basis in the receivables and inventory items.

Q33. Character of this loss?

A33. The loss is considered as incurred on the sale or exchange of a partnership interest and thus is a capital loss under section 741

Q34. Where a partner only receives cash, any realized gain or loss must be recognized because?

A34. Because the partner may not defer recognition by way of an exchanged basis

Q35. And if the partner also receives ordinary income assets?

A35. IF the partner also receives ordinary income assets, immediate recognition of loss is required to prevent the partner from converting a capital loss into an ordinary loss on the sale of the distributed assets

Q36. Example - Assume that a retiring partner with an outside basis of $60 receives $20 cash and ordinary income assets with an inside basis of $25 in a liquidating distribution to which section 736(a) and 751(b) do not apply. What would be the first step?

A36. The partner first reduces his outside basis by the $20 cash received

Q37. What would this leave him with?

A37. He would now be left with a $40 exchanged basis to spread among the ordinary income assets, which would result in less ordinary income or more ordinary loss when the partner sells those assets.

Q38. What is the issue you run into here?

A38. Section 732(c)(1)(A) limits the partner's basis in ordinary income assets to the partnership's pre-distribution inside basis - $25 in this example

Q4. What are premium payments?

A4. Payments that exceed the value of the retiring partner's share of partnership property.

Q50. Would the disproportionate distribution rules in section 751(b) override the general rules of section 731, 732 on a partnership's operating distributions?

A50. OH hell yes

Q93. What happens if the payment falls under section 736(a)?

A93. If a payment falls under this section ,the partnership is entitled to current deductions for what will be classified as section 707(c) guaranteed payment to the retiring partner even if the payment represents a capital expenditure. In this manner, the continuing partners obtain an immediate deduction for the purchase of the retiring partner's share of partnership goodwill.

Q94. Is this a significant improvement over what would happen under section 736(b)?

A94. Yes, this is a significant improvement over the 15-year amortization provided by section 197 of the additional inside basis that may arise if the distribution attributable to goodwill is treated as a payment for partnership property under 736(b). Such additional basis would arise only if the retiring partner recognized capital gain on the distribtu8ion and the partnership had a section 754 election in place, and even then only to the extent such basis increase is allocated to goodwill under section 755

Q95. So generally, what happens when the choice is available?

A95. When the choice is available, the parties generally should opt for Section 736(a) treatment of the payments for goodwill because the overall tax treatment to the retiring partner and the continuing partners will yield a net tax benefit. In that case, one would expect the continuing partners to share the tax savings from their deduction by compensating the retiring partner for being taxed on the goodwill payments as ordinary income rates.

Q96. Would certain payments that he parties designate as NOT made in respect of partnership property (whether premium payments or otherwise) present the same planning opportunities relating to the distinction between payments for stated or unstated goodwill described above?

A96. Yes, with one critical distinction, payments falling under section 736(a) because they are not made in respect of partnership property are available to any type of partner in any type of partnership.

Q97. How would these payments usually be treated?

A97. These payments likely will give rise to ordinary income to the retiring partner (and certainly will if the payment is fixed in amount(, while effectively entitling the continuing partners to a current deduction for the amount of payments

Q98. And if the payment instead had been designated as made in return for the retiring partner's share of goodwill?

A98. The payment would give rise to capital gain to the recipient partner and, at most, an inside basis increase for the continuing partners in capital assets (provided a section 754 election is in effect).

Q51. Would it have an identical role with liquidating distributions?

A51. Yes

Q52. This being said, payments received by a retiring general partner for her interest in unrealized receivables or unstated goodwill of a services partnership are governed by section 736(a). Is that correct?

A52. Yes

Q53. Because of this, what happens?

A53. The partner's share of unrealized receivables is disregarded in determining the partner's pre-distribution share of Section 751 assets and the partner's pre-distribution share of unstated goodwill is disregarded in determining her share of Section 741 assets.

Q54. Would any payments received by the partner in exchange for her share of partnership unrealized receivables or unstated goodwill or any "premium" payments received (amounts paid in excess of the FMV of the partner's share of partnership property) be governed by section 736(a)?

A54. Yes

Q55. So thus, what is there treatment in regards to this?

A55. These are similarly disregarded in determining the partner's post distribution share of Section 751 and 741 assets.

Q56. What would section 751(b) still apply to?

A56.Section 751(b) still applies, however with respect to disproportionate distributions between the remaining 751 assets (recapture gain and substantially appreciated inventory) and Section 741 assets

Q57. Example - operation of section 751(b) in this context. Assume the ABC service partnership has 3 equal general partners and the following balance sheet. Cash - $45K, $45K; Accounts Receivable - $0, $15K; Inventory - $0, $15K; Goodwill - $0, $15K; Partner A - $15K, $30K; Partner B - $15K, $30K; Partner C - $15K, $30K.

A57. For following questions

Q58. Assume partner A's interest is liquidated and he receives a $30K cash payment from the partnership with no designation that $5K is paid for goodwill. What is the first thing that happens to A?

A58. A would be taxed on $10K (the payment for A's share of the receivables and unstated goodwill) as ordinary income characterized under section 736(a).

Q59. And then under section 736(b)?

A59. A's share of Section 736(b) assets prior to the distribution is $15K of cash and $5K of inventory. After the distribution, A has $20K of cash (disregarding the $10K payment governed by section 736(a)) and no further interest in the partnership inventory.

Q6. This determination is the initial and most critical dividing line between what?

A6. Between section 736(a) and 736(b) payments

Q60. So now for 751(b) in determining the extent of the application of 751(b) what would be disregarded in this example?

A60. The $10K of 736(a) payments as well as the 736(a) property being compensated - the receivables and goodwill.

Q61. What are A's interests in the 751 assets (other than those under 736(a)) prior to the transaction and afterwards?

A61. Prior to the transaction is $5K and afterwards it is zero

Q62. His interest in 741 assets (other than those under 736(a)) both prior and after the transaction?

A62. Prior to the transaction is $15K (1/3rd of the $45K cash) and afterwards it is $20K

Q63. So what did he receive too much and too little of?

A63. Thus, A receives $5K to few 751 assets and $5K to many 741 assets.

Q64. What is the next step now in 751(b)?

A64. A is deemed to have received a phantom distribution of $5K of inventory with a transferred basis of zero and to have sold the inventory to the partnership for $5K cash, realizing $5K of ordinary income on the constructive sale.

Q65. And the final step? Result?

A65. The final step is to determine the tax consequences of the remaining actual distribution of $15K. Since A's outside basis is $15K, the cash distribution merely reduces his basis to zero and no gain or loss is recognized under section 731

Q66. Now what if the partnership were not a services partnership or A were not a general partner?

A66. Section 736(a) would not apply and A's interest in the Section 751 assets would have bene $10K prior to the distribution and zero afterwards, while his interest in the section 741 assets would have been $20K before and $30K after the distribution. Thus A would have a $10K phantom distribution of Section 751 property with a zero basis, and A would realize $10K of ordinary income on the constructive sale and $5K of LTCG under section 731(a0(1).

Q67. We have seen that section 736(b) embraces payments for a retiring partner's interest in partnership property with limited exceptions. To the extent that 736(b) does not apply what would come in its place?

A67. 736(a) assumes control

Q68. If the amount received by the retiring partner is determined with respect to the income of the partnership, how would the payment be treated?

A68. The payment is treated as part of the partner's distributive share

Q69. Otherwise what?

A69. Otherwise that amount constitutes a guaranteed payment under section 707(c)

Q7. So is the dividing line between a retiring partner's interest in a partnership goodwill (generally falling under 736(b)) and a premium payment made to the exiting partner separate from her interest in partnership property (736(a)) always easy to decipher?

A7. No

Q70. In either case, the payment generally results in what type of income?

A70. Ordinary income to the retiring partner and a current partnership deduction (or the equivalent) that benefits the remaining partners

Q71. The scope of Code section 736(a) payments is very limited and would only apply to?

A71. Payments received by a general partner in a partnership in which capital is not a material income-producing factor for (1). The partner's share of unrealized receivables (not including recapture or similar gain) and (2). Partnership goodwill if the partnership agreement does not expressly provide for such payments.

Q72. When would Capital not be a material income-producing factor?

A72. Where substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services.

Q73. So would medical, dentistry, accounting, architectural, or other service partnerships fall within this classification?

A73. Yes

Q74. Why is the application of Section 736(a) to unrealized receivables even more narrow than it first appears?

A74. Because section 736(a) only embraces payments to compensate a liquidated general partner in a services partnership for his interest in the partnership's receivables that have NOT been included in income. This is made clear by the regulations, which provide that only payments in excess of the partner's basis (including any special personal inside basis) in the unrealized receivables are encompassed by section 736(a). To the extent o the partner's share of the inside basis, receivables are considered as already realized and thus covered by section 736(b).

Q75. So would section 736(a) only apply to PAYMENTS for unrealized receivables? Explain

A75. To the extent that the receivables are distributed in kind, there is no "payment" and the partner's receipt of the receivables is taxed under the section 736(b) regime.

Q76. Does the term "payment" require a cash transfer?

A76. No, and thus a distribution of other assets, such as land or stock, in exchange for a GP's interest in unrealized receivables in a services partnership also is governed by Section 736(a)

Q77. What about payments for recapture gain?

A77. Payments for recapture gain automatically fall under section 736(b)

Q78. Similar to the treatment of unrealized receivables, section 736(b) generally applies to payments for the retiring partners share of?

A78. Goodwill

Q79. So when would code section 736(a) assume jurisdiction over such payments?

A79. If they are made to a retiring general partner in a services partnership to the extent that the payments exceed the partner's inside basis, if any, in the goodwill, and the liquidation agreement does NOT specifically state that the payment is for goodwill.

Q8. So if the distinction between Section 736(a) and 736(b) payments were limited to determining whether or no the payments are made in respect of the retiring partner's interest in partnership property, would the classification for liquidating distributions be fairly straightforward?

A8. Yes

Q80. Would goodwill normally have a zero basis?

A80. Goodwill normally would have a zero basis unless the partnership previously acquired a business and allocated a portion of the purchase price to goodwill or unless the basis of goodwill was increased in a different code section.

Q81. Do the parties in this situation have the flexibility to do with the goodwill?

A81. The parties in this situation have the flexibility to remove goodwill from section 736(a) and send it back to section 736(b) by including a specific provision in the agreement governing the liquidation.

Q82. To fall within Section 736(b) payments allocated to goodwill must be?

A82. Reasonable

Q83. What is the treatment for Premium payments?

A83. The regulations provide that Section 736(a) also applies to classify the tax treatment of any "premium" payments to a retiring partner (in either a services or capital partnership) in excess of payments for that partner's interest in partnership property.

Q84. How do you determine if there is a premium?

A84. To determine whether there is a premium, one must first determine the amount of the partner's share of the partnership's property. Any payments in excess of that amount in the form of cash or other property are governed by Section 736(a), regardless of the legal form (general or limited) of the partnership.

Q19. Code section 731 provides what for both the partner and the partnership?

A19. Section 731 provides nonrecognition treatment to the partner and the partnership on the distribution

Q2. What is the general rule on treatment?

A2. Code section 736(b) provides the general rule. With some exceptions, it treats payments for the partner's interest in partnership property as distributions in liquidation of the retiring partner's interest. The tax consequences of these payments therefore are governed by the familiar distribution provisions (732, 734, 735).

Q1. Code section 736 classifies payments in liquidation of a retiring partner's interest in a continuing partnership by dividing them into what 2 categories?

A1. (1). Payments for the partner's interest in partnership property and (2). All of payments

Q10. If the partnership agreement does not expressly provide for such payments of Goodwill then what would this goodwill be called?

A10. This is "unstated" goodwill

Q11. So for both of these items what would happen? What circumstance?

A11. In either case payments are removed from section 736(b) only if the retiring partner is a general partner of a partnership in which capital is NOT a material income producing factor.

Q12. If income is NOT a material income producing factor then this would be what type of partnership?

A12. Services partnership

Q13. So is the scope of property removed from Section 736(b) quite limited?

A13. Yes

Q14. What is the limitation on unrealized receivables?

A14. The definition of unrealized receivables for this purpose does not include recapture gain

Q15. What is another restrictions put in by the regulations?

A15. The regulations provide that even when the Section 736(b)(2) exclusions apply, they only extend to payments in excess of the retiring partner's inside basis (including any special personal inside basis) in that partner's share of unrealized receivables and unstated goodwill.

Q16. So once the divide between section 736(a) and 736(b) has been navigated, generally how are 736(b) items treated?

A16. These payments are governed, with a few limited exceptions by the same statutory scheme applicable to operating distributions.

Q17. As with operating distributions, a retiring partner recognizes gain on a liquidating distribution only to what extent (general rule)?

A17. Only to the extent that the cash received exceeds the partner's outside basis.

Q18. If both cash and property are distributed, what is usually what happens?

A18. First, the partner reduces his outside basis by the cash received, and then, in effect, he exchanges his remaining partnership interest for the other assets received in the distribution.

Q40. Disregarding for the moment the impact of sections 736(a) and 751(b), would a partnership recognize gain or loss on a liquidating distribution of property?

A40. No, a partnership generally recognizes neither gain nor loss on a liquidating distribution of property.

Q41. What about the basis of partnership property?

A41. This is generally not adjusted as a result of the distribution

Q42. Bus as with operating distributions, a partnership wit ha Section 754 election in effect may?

A42. May adjust the basis of its assets to prevent the distortions that result from a liquidating distribution

Q43. We have seen that on certain liquidating distributions, a partner may recognize gain or loss. If gain is recognized, what can the partnership do?

A43. The partnership may increase the basis of capital assets or Section 1231 property it retains by the amount of the gain.

Q44. What if the retiring partner recognizes a loss while a Section 754 election is in effect?

A44. Section 734(b) conversely requires the partnership to decrease the inside basis of its retained capital assets and Section 1231 property by the amount of the loss

Q45. What happens if the liquidating partner's exchanged basis in distributed capital assets or Section 1231 property exceeds the partnership's inside basis in those assets and a Section 754 election is in effect?

A45. The partnership must decrease its basis in retained assets of a similar class in an amount equal to the increase in the basis of the distributed assets in the hands of the retiring partner

Q46. A partnership also must decrease its basis in retained assets even if a Section 754 election has not been made whenever a liquidating distribution results in a ?

A46. Results in a "substantial basis reduction".

Q47. When does a "substantial basis reduction" occur?

A47. A substantial basis reduction occurs if the downward basis adjustment that would have bene made toe the partnership's assets if a Section 754 election had been made exceeds $250K.

Q48. Example - If a liquidating partner recognizes a loss on the distribution that is greater than $250K, what is the partnership required to do?

A48. The partnership is required to decrease the basis in its retained assets even if it has never made a section 754 election.

Q49. Similarly, a basis reduction in a partnership's retained assets is required if the basis of capital assets or Section 1231 property that are distributed in a liquidating distribution is increased by?

A49. By more than $250K above the partnership's basis in those assets

Q5. What is the first step in sorting out the tax treatment of payments to a retiring partner?

A5. Is to determine whether the payments are being made to the partner in respect of her interest in partnership property.

Q92. So why would the retiring general partner of a services partnership not insist that the agreement state that a payment is being made in respect of goodwill to avoid ordinary income treatment?

A92. The answer rests with the tax treatment of the continuing partners

Q85. If you are a retiring partner, would you care or would you be indifferent to whether cash payments attributable to your share of the partnership's unrealized receivables are classified under section 736(a) or section 736(b)? Explain why?

A85. You would be indifferent because if the payments fall within section 736(b), the distribution implicates section 751(b), triggering a hypothetical distribution of the retiring partner's share of the receivables that would be sold back to the partnership at FMV. After the section 751(b) smoke clears, the retiring partner recognizes ordinary income on the portion of the distribution attributable to his share of unrealized receivables. If the payment to the partner of a fixed amount for his share of the same receivable falls within section 736(a), the retiring partner recognizes ordinary income on this amount as a guaranteed payment under section 707(c).

Q86. Who does this decision matter for?

A86. Continuing partner

Q87. Why is that the case?

A87. In a hypothetical exchange required by section 751(b) in connection with a section 736(b) distribution, the partnership would take a cost basis in the retiring partner's share of the partnership's unrealized receivables. Although the basis increase may be helpful when the receivables re collected or sold, that result can be improved. If the payment to the retiring partner fell under section 736(a) and therefore were treated as a guaranteed payment under section 707(c), the partnership would be entitled to a corresponding current deduction that is not subject to the capitalization requirement

Q88. What are we saying in short here?

A88. In short, treating payments to a retiring partner for unrealized receivables as Section 736(a) payments entitles the continuing partners to a current deduction as opposed to a future reduction in income when the receivables are liquidated.

Q89. Would similar considerations come into play with respect to goodwill? Explain the different options

A89. The determination of whether payments to a retiring partner in a services partnership for goodwill fall under 736(a) (for unstated goodwill) or Section 736(b) (for stated goodwill)

Q9. What makes things more complicated is that the statute excludes from Section 736(b) what two items?

A9. (1). Unrealized receivables and (2). Partnership goodwill, if the partnership agreement does not expressly provide for such payments

Q90. Would each of these yield considerably different tax results?

A90. Yes

Q91. Explain

A91. The disposition of goodwill typically gives rise to capital gain for the seller. If the parties provide for the payment of goodwill in an agreement, the payments are not excluded from section 736(b)(1) and therefore will be treated as distributions. Because goodwill does not constitute Section 751(b) property, such payment would give rise to capital gain to the extent they exceed the retiring partner's outside basis in the partnership interest. But if the amounts paid to the retiring partner for unstated goodwill are not dependent on partnership profits, the retiring partner will recognize ordinary income on these payments under section 707(c)