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Outline For:
Partnership
Taxation
Module:
Sales of Partnership
Interests |
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Please
browse the following statutory provisions
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Code
Sections |
Regulations |
741 |
1-751-1 |
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751 |
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A Sale of the Partnership Interest
When
a partnership interest is sold or exchanged,
gain or loss is generally recognized. Because
a partnership interest is treated as a capital
asset, capital gain or loss is recognized to
the transferor partner when the partnership
interest is sold. An exchange of a partnership
interest does not qualify for nonrecognition
treatment under Code Section 1031. IRC
Sec. 741
The
amount of capital gain or loss recognized
on the sale of the partnership interest is
the difference between:
The
amount realized on the sale of a partnership
interest consists of:
-
The
amount of money received;
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The fair market value of other property
received; and
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Any
liabilities of the sale that the buyer assumes.
With
respect to liabilities, the rule is the same
even if the liabilities are nonrecourse and
are secured by property which is worth less
than the liability. The selling partner is
still considered to realize the full amount
of the loan.
Example
1 
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T
sells her partnership interest for $30,000
cash and the buyer assumes T's share of
partnership liabilities in the amount of
$7,000. T's amount realized on the sale
is $37,000.
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Exceptions
to the General Rule If
the partnership has unrealized receivables or substantially
appreciated inventory (referred to as hot assets
), part of the gain or loss on the sale of the partnership
interest will be ordinary gain or loss. Thus, the
sale of the partnership is treated under the aggregate
theory rather than the entity theory.
Note
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The
selling partner experiences the same consequences
as if the underlying assets had been sold,
instead of the partnership interest. Thus,
certain assets (known as Hot Assets) trigger
ordinary income. Hot assets are defined
later in the next section.
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The selling
partner's ordinary gain or loss is the difference
between the amount realized attributable to the
hot assets less the adjusted basis attributable
to those items. The adjusted basis in this case
is generally the partnership's inside basis of the
assets unless a special election has been made.
In effect,
when a sale of a partnership interest contains hot
assets, the sale is split (bifurcated) into two
components - one portion representing capital gains
and losses and the other portion representing ordinary
gains and losses
Required
Attachments When
a partner sells or exchanges a partnership interest
which contains hot assets, an information return
must be filed. IRC Sec. 6050K) The return, Form
8308, must be filed as an attachment to the partnership's
Form 1065 for the taxable year in which the sale
or exchange occurred. Form 8308 must include:
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The
names, addresses, and ID numbers of the transferees
and transferors;
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The
date of the exchange; and
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Other information required by the Form 8308.
If
a partnership is in doubt as to whether hot assets
exist, it should file Form 8308 to avoid the penalty
under Code Section 6722.
The
Partnership's Inside Basis After a Sale
Ordinarily
the inside basis of a partnership asset is not changed
merely because a partnership interest has been sold.
However, the result of such an exchange is not always
equitable.
Example
2
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The
only asset in the XYZ partnership is land
with an adjusted basis of $12,000 and fair
market value of $60,000. W wishes to purchase
X's one-third interest for its FMV of $20,000
(ignoring goodwill). If W makes the purchase,
the inside basis remains the same even though
W has paid X for the appreciation in the
land. If the WYZ partnership were to sell
the land, it would recognize a gain of $48,000
and W would be taxed on one-third of this
amount. In effect, W is being taxed on appreciation
which has already been accrued and paid
to X.
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Inside
Basis To
eliminate the possible inequity of double taxation,
the Code provides that the inside basis can be adjusted
upon a sale of a partnership interest if the partnership
makes an election under Code Section 754. If the
election is made, the inside basis will be adjusted
to reflect the purchase price, but purely for the
benefit of the partner who acquired the interest.
Once
the election is made (at the partnership level)
it becomes permanent. Future adjustments are automatically
required on later sales or exchanges and can involve
disadvantageous downward adjustments to the basis
of partnership property when a partner buys an interest
for a value less than its basis.
Section
755 governs the methodology for making the basis
adjustments, These rules, plus more, are covered
in an entire module on Optional Adjustments to basis.
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Sales Containing Hot Assets
Section 741 provides that the gain or loss recognized
from the sale or exchange of a partnershipinterest
is captial gain except to the extent that §751
applies. Consequently the starting point for characterizing
a sale or exchange of a partnership interest begins
in §751.
Section 751(a) provides that the consideration
received by a selling partner in exchange for
all or part of his or her interest in the unrealized
receivables or inventory items (a.k.a. "Hot
Assets") of the partnership shall be treated
as a sale of an ordinary income producing asset.
The balance of the sale will be treated as a sale
of a capital asset. Thus, understanding the definition
of Hot Assets is imperative to properly classifying
the sale of a partnership interest.
Unrealized
Receivables One
of the hot assets that triggers ordinary income is the
unrealized receivable which is defined as the right
to payment for past or future sales of goods or services
not previously includable in income. This classification
is necessary to insure that ordinary income will not
be avoided when a partnership is sold with cash basis
receivables. With certain exceptions, only partnerships
on a cash basis generate income from unrealized receivables
upon sale of the partnership interest. IRC
Sec. 751(c)(1) and (2).
Example
1
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T
sells his entire interest in the ST partnership
to R for $7,500. T's basis in the partnership
is $3,000 and the partnership has the following
balance sheet:
| Assets |
Basis |
FMV |
| Acct.
Receivable |
$0 |
$8,000 |
| Investment Land |
6,000 |
7,000 |
TOTAL
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$6,000 |
$15,000 |
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| Liab
& Capital |
Basis |
FMV |
| S Capital |
$3,000 |
$7,500 |
| T Capital |
3,000 |
7,500 |
TOTAL
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$6,000 |
$15,000 |
T's total gain is $4,500 ($7,500 - 3,000) of
which $4,000 is ordinary income (1/2 * $8,000
accounts receivable) and the remaining $500
is capital gain.
Note
that the ST partnership is on a cash basis because
the accounts receivable have a zero basis.
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The definition
of unrealized receivables is not, however, limited to
situations involving rights to future payments. The
statutory definition includes a host of partnership
assets which, if sold, would give rise to ordinary income.
IRC Sec. 751(c) Flush Language
Depreciation
recapture as an unrealized receivable
One of the
most overlooked, yet common, unrealized receivables
is depreciable property subject to depreciation recapture
under Section 1245 and 1250. If the partnership owns
assets which are subject to recapture of depreciation,
only the amount of the recapture potential and not the
entire gain is considered to be an unrealized receivable
on the sale of the partnership interest.
The term
Section 1245 property includes all depreciable property
other than buildings or their structural components.
The term Section 1250 means any real property other
than property described in Section 1245. The basis of
Section 1245 and 1250 recapture is zero. Regs.
Sec. 1.751-1(c)(5)
Example
2
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The
BC Partnership has the following Balance Sheet:
| Assets |
Basis |
FMV |
| Accounts Receivable |
15,000 |
15,000 |
| Machine ($8,000
recapture) |
33,000 |
45,000 |
| Total |
$48,000 |
$60,000 |
| A Capital |
24,000 |
30,000 |
| B Capital |
24,000 |
30,000 |
| Total |
$48,000 |
$60,000 |
If C sells his entire interest for $30,000,
he will have a realized gain of $6,000 ($30,000
- $24,000). Of this amount $4,000 will be taxed
as ordinary income (1/2 of the $8,000 recapture).
The remaining $2,000 is attributable to the
Section 1231 gain remaining in the machine and
will be taxed to C as a capital gain.
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Note
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Sections
1245 and 1250 recapture must be computed separately
for each property. Thus, a selling partner may
have to recognize ordinary income even though
the aggregate fair market value of all the Section
1245 and 1250 properties produce an overall
loss.
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Inventory
and Substantially Appreciated Inventory
The second
category of hot assets that triggers ordinary income
attention is the substantially appreciated inventory
item. In order for inventory to be a Hot Asset, the
1997 Act eliminated the requirement that inventory
be substantially appreciated in order to give rise
to ordinary income for sales and exchanges
under Sec. 751 (a). Thus, all inventories become Hot
Assets.
Note, however,
there has been no change with respect to distributions
under Sec. 752(b). Thus, the requirement that inventory
be substantially appreciated continues to apply to
those types of distributions. Substantial appreciation
will not be discussed in this module.
Section
751 Bifurcations
In making
the necessary computations under Section 751, the
basis used for unrealized receivables and for all
inventory after August 5, 1997 is the same as the
inside basis. Of course, the inside basis for an unrealized
receivable for rendering services would generally
be zero. The value allocated to the assets in the
contract of sale of the partnership will generally
be regarded by the IRS as correct, provided those
values represent fair market values. Otherwise, competent
appraisals may be necessary to ascertain value.
After
the values and bases of all assets have been determined,
the assets must be divided into two components;
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Section
751 hot assets, and
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other
assets (i.e., capital and Section 1231 assets).
Example
3
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XYZ
has the following Balance Sheet:
| Assets |
Basis |
FMV |
| Cash |
$10,000 |
$10,000 |
| Accounts Receivable |
0 |
13,000 |
| Inventory |
12,000 |
20,000 |
| Equipment* |
20,000 |
28,000 |
| Land |
50,000 |
45,000 |
| Investments |
7,000 |
13,000 |
| Total |
$99,000 |
$129,000 |
*Includes
$6,000 recapture of depreciation
Partner X with a basis of $33,000 sells a one-third
interest in XYZ for $43,000. Although it appears
X has realized a $10,000 gain, the assets must
be divided in order to determine their character.
Assuming
all the Section 751 inventory items are hot
assets , the assets of the partnership would
be split as follows:
| Hot
(751) Assets |
Basis |
FMV |
| Accounts Receivable |
0 |
13,000 |
| Inventory |
12,000 |
20,000 |
| Equipmentn Deprec |
-
0 - |
6,000 |
| Total |
$12,000 |
$39,000 |
| Other
(741) Assets |
Basis |
FMV |
| Cash |
$10,000 |
$10,000 |
| Equipment |
20,000 |
22,000 |
| Land |
50,000 |
45,000 |
| Investments |
7,000 |
13,000 |
| Total |
$87,000 |
$90,000 |
As
a result of the sale, Partner X must recognize
$9,000 as ordinary income (1/3 * ($39,000 -
$12,000)) and $1,000 as capital gain (1/3 *
($90,000 - $87,000)).
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Section
751 does not impose a ceiling
Realized
gain or loss is ordinarily measured by the difference
between the amount realized by a partner and that partners
outside basis. However, the existence of hot assets
can create a situation where more ordinary income is
recognized than the amount of the realized gain (i.e.,
the ceiling is surpassed). When this happens, the counter-balancing
effect is recognition of a capital loss on the sale
of the partnership interest.
Example
4
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The
AB partnership is on the cash basis and has
unrealized accounts receivable of $15,000 with
a basis of zero. A's proportionate interest
in the hot assets is $7,500. A's outside basis
is $20,000 and the entire partnership interest
is sold for $23,000 resulting in a realized
gain of $3,000. A must first allocate $7,500
of the sales price to the unrealized receivables,
the basis of which is zero. Thus, $7,500 of
ordinary income must be recognized. The remaining
$15,500 of the sale price is allocated to the
balance of the partnership interest that has
a remaining basis of $20,000. Accordingly, A
has a $4,500 capital loss on the balance of
the partnership interest ($15,500 -$20,000),
Note
The amount realized ceiling of $3,000 less the
ordinary income of $7,500 provides a counter-balancing
capital loss of $4,500.
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