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Partnership Taxation
Module: Sales of Partnership Interests

 

Sales of Partnership Interests  - Selected Readings       [ Close This Page ]   
 

Please browse the following statutory provisions

Code Sections
Regulations
741
1-751-1
 
751
 
 
 

. 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, less

  •   The adjusted basis of the partnership interest. Regs. Sec. 1.741-1(a)

The amount realized on the sale of a partnership interest consists of:

  1. The amount of money received;
  2. The fair market value of other property received; and
  3. 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

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.


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

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.

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:

  1. The names, addresses, and ID numbers of the transferees and transferors;
  2. The date of the exchange; and
  3. 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

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.


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.


Study Questions Make your selection by clicking the appropriate response letter.

1.

T sells a 1/3 partnership interest and receives the following in exchange-. $5,000 in cash and land ($15,000 fair market value and $10,000 basis). T was also relieved of his share of a $15,000 debt owed by the partnership. T's amount realized on the sale is.

 
$5,000
 
$20,000
 
$25,000
 
$35,000

2.
Regarding the sale of a partnership interest involving Section 751 assets, what information is required to be filed with respect to that partnership?
 
Form 8308 must be attached to the selling partner's tax return.
 
If a partner recognizes ordinary income, no form or attachment is necessary.
 
A Form 8308 must be filed showing the required information concerning the transferee and attached to Form 1065.
 
Form 8308 must be attached to Form 1065 showing required information about the transferee and transferor.

3.
ABC partnership has land with fair market value of $21,000 and basis of $15,000. If D purchases C's one-third interest for $7,000, the basis of the land to the partnership, assuming no special elections, is:
 
$7,000
 
$15,000
 
$17,000
 
$21,000

4.

In order to avoid an inequity between the inside and outside basis in a sale between a new and old partner, a Section 754 election can be made. Concerning this election, which of the following is true?

 
The election, once made, is permanent.
 
The election is made on a sale-by-sale basis.
 
The election is made on a year-by-year basis.
 
The election is made to primarily benefit the selling partner

. 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

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

$6,000
$15,000
 
Liab & Capital
Basis
FMV
S Capital
$3,000
$7,500
T Capital
3,000
7,500

TOTAL

$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.

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

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.

 

Note

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.


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;

  1. Section 751 hot assets, and
  2. other assets (i.e., capital and Section 1231 assets).
Example 3

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)).


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

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.


Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following statements concerning the sale of a partnership are true?

 
The amount realized must be bifurcated between the capital assets and the ordinary assets.
 
Hot assets are assets that are taxed as ordinary income.
 
The ordinary income recognized will be the amount realized attributed to the sale of hot assets.
 
The sale of a partnership is taxed under the aggregate theory.

2.
The ABC partnership has the following assets:
  Basis FMV
Cash $ 9,000 $ 9,000
Acct rec. 0 30,000
Investments 6,000 21,000
  $15,000 $60,000

If partner C has an adjusted basis of $5,000 and sells the entire one-third interest to D for $20,000, what is the character and amount of any gain recognized by C?

 
$15,000 capital gain.
 
$10,000 ordinary gain, $5,000 capital gain.
 
$15,000 ordinary gain.
 
$5,000 ordinary gain, $10,000 capital gain.

3.

The ABC partnership has the following assets.

  Basis FMV
Cash $12,000 $12,000
Acct rec. 6,000 6,000
Investments 9,000 21,000
Machine 30,000 51,000
  $57,000 $90,000

If partner C has an adjusted basis of $19,000 and sells the entire one-third interest to D for $30,000, what is the character and amount of any gain recognized by C? (Assume $15,000 depreciation has been taken on the machine.)

 
$ 6,000 capital gain, $5,000 ordinary income.
 
$ 4,000 capital gain, $7,000 ordinary income.
 
$11,000 ordinary income.
 
$11,000 capital gain.

4.

The AB partnership has the following assets.

  Basis FMV
Investments $40,000 $30,000
Inventory 10,000 18,000
Acct rec. - 0 - 12,000
  $50,000 $60,000

If partner B with adjusted basis of $25,000 sells the entire 1/2 interest to C for $30,000, what is the character And amount of any gain recognized by B?

 
$ 5,000 ordinary gain.
 
$ 5,000 capital gain.
 
$ 6,000 ordinary gain, $1,000 capital loss.
 
$10,000 ordinary gain, $5,000 capital loss.

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