Chapter 10 Special Partnership Issues
EFFECTS OF DISTRIBUTION ON THE PARTNERSHIP
A partnership generally recognizes no gain or loss on liquidating distributions made to its partners.16 If a Sec. 751 deemed sale occurs, however, the partnership may recognize gain or loss on assets deemed sold to its partner. Because a partnership interest is generally a capital asset, the sale of a partnership interest results in the partner recognizing a capital gain or loss. However, if a partnership has Sec. 751 assets, the partner is deemed to sell his or her share of the underlying Sec. 751 assets, thereby causing a corresponding ordinary gain or loss to be recognized
EXCHANGE OF A PARTNERSHIP INTEREST
the IRS allows exchanges of interests within a single partnership
Liabilities
Increase a shareholders basis
inventory is considered a Sec. 751 asset only if the inventory is substantially appreciated.
Inventory is substantially appreciated if its FMV exceeds 120% of its adjusted basis to the partnership. For purposes of testing whether the inventory is substantially appreciated (but only for that purpose), inventory also includes unrealized receivables. The inclusion of unrealized receivables in the definition of inventory increases the likelihood that the inventory will be substantially appreciated.
SECTION 751 PROPERTY
The definition of Sec. 751 property is slightly different for sales or exchanges than for distributions because inventory does not have to be substantially appreciated to be included as Sec. 751 property. Thus, all inventory and all unrealized receivables are Sec. 751 assets in a sale or exchange situation. Treasury Regulations under Sec. 751 take a hypothetical asset sale approach to determine the amount of ordinary income or loss the partner recognizes on the sale or exchange of a partnership interest Under the regulations, the partnership is deemed to sell all its assets for their FMV immediately before the partner sells his or her interest in the partnership
EXCHANGE OF SEC. 751 ASSETS AND OTHER PROPERTY
A current distribution receives treatment under Sec. 751 only if the partnership has Sec. 751 assets and an exchange of Sec. 751 property for non-Sec. 751 property occurs. Accordingly, if a partnership does not have both Sec. 751 property and other property, the rules discussed above for simple current distributions control the taxation of the distribution. Similarly, a distribution that is proportionate to all partners or (1) consists of only the partner's share of either Sec. 751 property or non-Sec. 751 property and (2) does not reduce the partner's interest in other property is not affected by the Sec. 751 rules. However, any portion of the distribution that represents an exchange of Sec. 751 property for non-Sec. 751 property must be isolated and is not treated as a distribution at all. Instead, it is treated as a sale between the partnership and the partner, and any gain or loss realized on the sale transaction is fully recognized. The character of the recognized gain or loss depends on the character of the property deemed sold. For the party deemed the seller of the Sec. 751 assets, the gain or loss is ordinary income or loss
TERMINATING AN INTEREST IN A PARTNERSHIP
A partner can terminate or dispose of an interest in a partnership in a number of ways. The two most common are receiving a liquidating distribution and selling the interest. Other possibilities include giving the interest away, exchanging the interest for corporate stock, and transferring the interest at death.
BASIS IN ASSETS RECEIVED
A partner's basis of an asset received in a liquidating distribution is determined using rules similar to those used to determine the basis of an asset received in a current distribution. For both kinds of distributions, the basis in unrealized receivables and inventory is generally the same as the property's basis in the partnership's hands. Under no condition is the basis of these two types of assets increased Remember that a liquidating distribution of money, unrealized receivables, and inventory having a total basis to the partnership less than the partner's basis in his or her partnership interest results in the recognition of a loss. However, the partner recognizes no loss if the distribution includes any property other than money, unrealized receivables, and inventory. Instead, all the remaining basis in the partnership interest must be allo-cated to the other property received regardless of that property's basis to the partnership or its FMV. Application of this rule can create strange results.
EXCHANGE FOR CORPORATE STOCK
A partnership interest may be exchangedfor corporate stock in a transaction that qualifies under the Sec. 351 nonrecognition rules For Sec. 351 purposes, a partnership interest is property. If the other Sec. 351 requirements are met, a single partner's partnership interest can be transferred for stock in a new or an existing corporation in a nontaxable exchange. The partner treats this as if he or she had transferred any other property under the Sec. 351 rules. The basis in the corporate stock is determined by the partner's basis in the partnership interest. The holding period for the stock received in the exchange includes the holding period for the partnership interest. As a result of the exchange, one of the corporation's assets is an interest in a partnership, and the corporation (not the transferor) is now the partner of record. Thus, the corporation must report its distributive share of partnership income along with its other earnings.
SALE OF A PARTNERSHIP INTEREST
Absence any contrary rules, a partner's sale or exchange of a partnership interest would generate a capital gain or loss under Sec. 741 because a partnership interest is usually a capital asset. Section 751, however, modifies this result by requiring the partner to recognize ordinary income or loss (and possibly Sec. 1250 gain) on the sale or exchange of a partnership interest to the extent the consideration received is attributable to the partner's share of unrealized receivables and inventory items.
Loss recognition from liquidating distributions
Although a partner can never recognize a loss from a current distribution, he or she can recognize a loss from a liquidating distribution. A partner recognizes a loss only if (1) the liquidating distribution consists of money (including money deemed distributed), unrealized receivables, and inventory, but no other property and (2) the partner's basis in the partnership interest exceeds the total basis of these distributed properties (including cash).The amount of the loss is the difference between the partner's basis in the partnership interest before the distribution and the sum of money plus the bases of the receivables and inventory (to the partnership immediately before the distribution) that the partner receives.
Reductions in a partner's share of liabilities are treated as cash distributions.
A reduction in liabilities due to new partners or other reasons constitutes a recognized gain for existing partners To calculate gain determine existing basis and percentage of ownership and liabilities e.g. represents current interest of 30% of 250,000. 20,000.00 current basis 75,000 current liability share New partnership results in 20% share of partner interest, existing partner liability drops 75,000.00 20,000.00 current basis ,- 50,000.00 new liability = existing partner gained 25,000. in reduced liability gain is subtracted from basis and the difference is recognized as gain in this scenario 5,000.00
FORMATION OF AN LLC, LLP, OR LLLP.
A second option for obtaining limited liability protection for all owners is for the partnership to become an LLC. Under Rev. Rul. 95-37,30 the conversion is viewed as a partnership-to-partnership transfer. The property transfer does not cause the partners to recognize gain or loss nor does the transfer terminate the tax year for the partnership or any partner. The basis for the partners' interest in the partnership will be changed only if the liability shares for the partners change
OTHER PAYMENTS
Payments made to a retiring partner or to a deceased partner's successor-in-interest that exceed the value of that partner's share of partnership property have a different tax result for both the retiring partner and for the partnership. payments represent payments for property (e.g., payments to a general partner retiring from a service partnership for his or her interest in unrealized receivables and for his or her interest in partnership goodwill) also are taxed under these rules Under these rules, a payment is treated as either a distributive share or a guaranteed payment the excess payment is a function of partnership income the income is considered a distributive share of partnership income If the amount of the excess payment is determined without regard to the partnership income, the payment is treated as a guaranteed payment.25 If the payment is a guaranteed payment, the retiring partner recognizes ordinary income, and the partnership generally has an ordinary deduction Note: . If the payment is taxed as a distributive share, the character of the income is determined by the type of income earned by the partnership. In contrast, the payment is always ordinary income if it is treated as a guaranteed payment.
SECTION 751 ASSETS DEFINED
Section 751 assets include unrealized receivables and inventory. These two categories encompass all property likely to produce ordinary income when sold or collected The application of Sec. 751 in conjunction with partnership distributions or sales of a partnership interest is of concern to individual partners because the rules may trigger ordinary income recognition rather than capital gains.
EFFECTS OF SEC. 751
Section 751 has essentially the same impact on both liquidating and current distributions. To the extent the partner exchanges an interest in Sec. 751 assets for an interest in other assets (or vice versa), that portion of the transaction bypasses the distribution rules. Instead, this portion of the transaction is treated as a sale occurring between the partnership and the partner. One notable difference occurs between liquidating distributions and current distributions having Sec. 751 implications: the postdistribution interest in partnership assets is zero for the liquidating distribution because it terminates the partner's interest in the partnership.
Holding Period in Distributed Assets
The distributee partner's holding period for any assets received in a liquidating distribution includes the partnership's holding period for such property.15 If the partnership received the property as a contribution from a partner, the partnership's holding period also may include the period of time the contributing partner held the property prior to making the contribution (see Chapter C:9). The distributee partner's holding period for his or her partnership interest is irrelevant in determining the holding period of the assets received.
In a liquidating distribution
amount of money received plus the distributee partner's total basis of the nonmoney property received normally equals the partner's predistribution basis in the partnership interest. The only two exceptions to this rule apply when the money received exceeds the partner's basis in his or her partnership interest, causing the partner to recognize a gain, or when money, unrealized receivables, and inventory are the only assets distributed and the partner recognizes a loss. In all other liquidating distributions, the distributee partner recognizes no gain or loss. Instead, that partner's predistribution basis in his or her partnership interest is transferred to the cash and other property received
an LLC with two or more members that does not elect association status is a partnership for tax purposes
and is subject to all the rules applicable to other partnerships. Thus, the formation of the LLC; income, gain, loss, and deductions that flow through to the LLC members; current and liquidating distributions; and sale, gift, or exchange of an interest in the LLC all fall under the partnership rules. An LLC treated as a partnership is subject to the Sec. 704 rules for special allocations and allocations of precontribution gain or loss, to the Sec. 736 rules for retirement distributions, and to the Sec. 751 rules pertaining to unrealized receivables and inventory
If the transferor partner receives payment for his or her interest in the partnership's Sec. 751 assets
he or she must recognize ordinary income no matter how the transaction is structured. The partnership's basis in Sec. 751 assets is increased in the case of a liquidating distribution. When a sale transaction takes place, the partnership's basis in Sec. 751 assets is increased only if the partnership has an optional basis adjustment election in effect
RECOGNITION OF GAIN
A current distribution that does not bring Sec. 751 into play cannot result in the recognition of a loss by either the partnership or the partner who receives the distribution Under Sec. 731, partners who receive distributions recognize a gain if they receive money distributions that exceed their basis in the partnership. For distribution purposes, money includes cash, deemed cash from reductions in a partner's share of liabilities, and the fair market value (FMV) of marketable securities.
PAYMENTS FOR PARTNERSHIP PROPERTY
Payments made for the property interest are taxed under the liquidating distribution rules. Like any liquidating distribution made to a partner, payments made to a retiring partner or a deceased partner's successor-in-interest in exchange for his or her property interest are not deductible by the partnership If the retiring or deceased partner was a general partner and the partnership is a service partnership (i.e., capital is not a material income producing factor), payments made to a general partner for unrealized receivables and goodwill (when the partnership agreement does not provide for a goodwill payment on retirement or death) are not considered payments for property. Instead, any such payments are treated as other payments
Sec. 754 election
Sec. 743 mandates a special basis adjustment equal to the difference between the transferee (purchasing) partner's basis in the partnership interest and the transferee partner's share of basis of partnership assets. This basis adjustment, arising from a transfer, belongs only to the transferee partner (and not to the other partners) if a partnership distributes property to a partner, the partnership makes no adjustment to the basis of its remaining property unless an optional basis adjustment election is in place or unless the mandatory basis adjustment rule discussed later applies
amount realized on the sale of a partnership interest
made up of money plus the FMV of nonmoney property received plus the seller's share of partnership liabilities assumed or acquired by the purchaser.
ELECTING LARGE PARTNERSHIP TAXABLE INCOME.
Much like other partnerships, the calculation of electing large partnership taxable income includes separately stated income and other income. However, the items that must be separately stated are very different for the electing large partnership. Likewise, the items included in other income differ significantly. The main reason that Congress added electing large partnerships to the IRC was to provide a form of flow-through entity that does not require so much separate reporting to each partner of many different income, loss, and deduction items. Simpler reporting from the partnership to the partners was the goal, so fewer items are separately stated and many more items are combined at the partnership level
LIQUIDATING DISTRIBUTION OR SALE TO PARTNERS
An unusual tax planning opportunity exists when one partner withdraws from a partnership and the remaining partners proportionately increase their ownership of the partnership. The partners can structure the ownership change as either a liquidating distribution made by the partnership or as a sale of the partnership interest to the remaining partners. In fact, the substance of the two transactions is the same, only the form is different
EVENTS CAUSING A TERMINATION TO OCCUR
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 or Within a 12-month period a sale or exchange of at least 50% of the total interest in partnership capital and profits occurs.
OPTIONAL ADJUSTMENT
If a new incoming partner purchases his or her partnership interest from an existing partner, the new partner's basis in the partnership interest equals the purchase price plus the new partner's share of partnership liabilities. The new partner's basis in the partnership is likely to be different from his or her share of basis of the underlying assets in the partnership.
RETIREMENT OR DEATH OF A PARTNER
If a partner dies or retires from a partnership, that partner's interest can be sold either to an outsider or to one or more existing partners. Often, however, a partner or a deceased partner's successor-in-interest departs from the partnership in return for payments made by the partnership itself. When the partnership buys out the partner's interest, the analysis of the tax results focuses on two types of payments: payments made in exchange for the partner's interest in partnership property and other payments.
OPTIONAL AND MANDATORY BASIS ADJUSTMENTS
In general, a partnership makes no adjustment to the basis of its property when a partner sells or exchanges his or her interest in the partnership, when a partner's interest transfers upon the partner's death, or when the partnership makes a property distribution to a partner. A partnership, however, may adjust basis of its assets if the partnership makes an optional basis adjustment election under Sec. 754
BASIS EFFECTS OF DISTRIBUTIONS
In general, the partner's basis for property distributed by the partnership carries over from the partnership. The partner's basis in the partnership interest is reduced by the amount of money received and by the partner's basis in the distributed property. These distributions decrease the partners basis Cash Carryover basis in receivables Carryover Basis in land The difference equals the post difference basis for partner
INVENTORY.
Inventory for purposes of Sec. 751 includes three major types of property: Items held for sale in the normal course of partnership business Any other property that, if sold by the partnership, would not be considered a capital asset or Sec. 1231 property Any other property held by the partnership that, if held by the selling or distribute partner, would be property of the two types listed above In short, cash, capital assets, and Sec. 1231 assets are the only properties that are not inventory.
TAX SHELTERS AND LIMITED PARTNERSHIPS
Tax shelters at their best are good investments that reduce and/or defer the amount of an investor's tax bill. Traditionally, shelter benefits arise from leverage, income deferral, deduction acceleration, and tax credits
Transfer of basis instead of loss recognition
The basis allocation procedure delays loss recognition until the previous partner either depreciates or sells the property. The allocation procedure also may change the character of the loss The partnership should avoid distributing low basis property along with cash, unrealized receivables, and inventory so that the partner can obtain an immediate loss deduction
HOLDING PERIOD AND CHARACTER OF DISTRIBUTED PROPERTY
The partner's holding period for property distributed as a current distribution includes the partnership's holding period for such property.5 The length of time the partner owns the partnership interest is irrelevant when determining the holding period for the distributed property. If the partnership distributes property that is an unrealized receivable in its hands, the distributee partner recognizes ordinary income or loss on a subsequent sale of that property. If the partnership distributes property that is inventory in its hands, the distribute partner recognizes ordinary income or loss on a subsequent sale that occurs within five years of the distribution date
Gain or Loss recognition from liquidating contribution
The rule for recognizing gain on a liquidating distribution is exactly the same rule used for a current distribution. A partner recognizes gain only if any money distributed exceeds the partner's predistribution basis in his or her partnership interest. Distributed money includes money deemed distributed to the partner from a liability reduction or the FMV of marketable securities treated as money
UNREALIZED RECEIVABLES.
Unrealized receivables are certain rights to payments to be received by a partnership to the extent they are not already included in income under the partnership's accounting methods. the term unrealized receivables includes most potential ordinary income recapture items A primary example of this type of unrealized receivable is the potential Sec. 1245 or 1250 recapture on the partnership's depreciable property, which is the amount of depreciation that would be recaptured as ordinary income under Sec. 1245 or 1250 if the partnership sold property at its FMV. other recapture provisions creating unrealized receivables are Sec. 617(d) (mining property), Sec. 1252 (farmland), and Sec. 1254 (oil, gas, and geothermal property). Assets covered by Sec. 1278 (market discount bonds) and Sec. 1283 (short-term obligations) generate unrealized receivables to the extent the partnership would recognize ordinary income if it sold the asset Sec. 751(c). Unrealized receivables may have basis if costs or expenses have been incurred but not taken into account under the partnership's method of accounting
INCORPORATION.
When limited liability is important, the entire partnership may choose to incorporate. Normally such an incorporation can be structured to fall within the Sec. 351 provisions and can be partially or totally tax exempt. When a partnership chooses to incorporate, three possible alternatives are available
Precontribution Gain Recognition
a distribution also may trigger recognition of previously unrecognized precontribution gain or loss precontribution gain or loss is the difference between the FMV and adjusted basis of property when contributed to the partnership. Two different distribution events may trigger recognition of precontribution gain or loss First, if a partner contributes property with a precontribution gain or loss, the contributing partner must recognize the precontribution gain or loss when the partnership distributes the property to any other partner within seven years of the contribution Second, under Sec. 737, property distributions to a partner may cause the partner to recognize his or her remaining precontribution gain if the FMV of the distributed property exceeds the partner's basis in his or her partnership interest before the distribution
If the interest being transferred equals or exceeds 50% of the profits and capital interests
a sale to the remaining partners terminates the partnership. A liquidating distribution does not cause a termination to occur
liquidating distribution
a single distribution,or one of a planned series of distributions, that terminates a partner's entire interest in the partnership. If the partner's interest is drastically reduced but not terminated, the distribution is treated as a current distribution. A liquidating distribution can occur when only one member of a partnership terminates his or her interest, several partners terminate their interests but the partnership continues, or the entire partnership terminates and each partner receives a liquidating distribution. Rules for taxation of a liquidating distribution are the same whether one partner terminates his or her interest or the entire partnership liquidates.
If the partnership has an optional basis adjustment election in effect
the allocation of the adjustment to the individual partnership assets can be different depending on whether the transaction is structured as a sale or as a liquidating distribution.
