Disposition of a Partnership Interest

Todays Agenda
General rules governing the transfer of a partnership interest Rules regarding Section 751 assets Taxable vs. Nontaxable Transfers Section 743(b) Basis Adjustment Payments to Retiring Partners under Section 736
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Disposition of a Partnership Interest There are numerous ways a partner can dispose of an interest in a partnership Can you name a few?

Disposition of a Partnership Interest Some Examples

Sell to another person or the partnership Gift Retirement Liquidation of the partnership Incorporation of the partnership Charitable contribution
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Disposition of a Partnership Interest

The most common way to dispose of a partnership interest is to sell it to either another partner, the partnership or an unrelated third party. Code Section 741 governs the treatment of a sale of a partnership interest.
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Sale of a partnership interest

Economically, is there any difference between a sale to the partnership and a liquidating distribution from the partnership?
a. Yes

b. No

Sale of a partnership interest

Tax-wise is a sale to the partnership the same as a liquidating distribution from the partnership?

a. Yes
b. No

Answers
Economically, is there any difference between a sale to the partnership and a liquidating distribution from the partnership? Answer: a. No
Tax-wise is a sale to the partnership the same as a liquidating distribution from the partnership? Answer: b. No

Economically, the partner that is disposing of his partnership interest will have the same amount of property whether he sells the interest or receives a distribution from the partnership. However, the Code and the courts distinguish between a sale and a distribution
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General Rules Section 741

In a sale of a partnership interest the partner will recognize a gain or loss on the sale of a capital asset.
Amount of gain or loss = Amount received minus Adjusted basis of partnership interest

Advance or Draw
Assume Peter sold his partnership interest for $100,000 to Tom. Peters adjusted basis in his partnership interest is $36,000. Included in his basis is his share of partnership liabilities of $6,000.

How much gain or loss will Peter recognize on the sale of his partnership interest?
a. b. c. d. $ 64,000 $ 70,000 $100,000 $ 0
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Answer
.

Answer: b. $ 70,000

The amount realized on the sale of a partnership interest must always include the partners share of liabilities. In this case the amount realized is the $100,000 cash received from Tom plus the relief of Peters share of partnership liabilities of $6,000. Therefore, the gain is $106,000 $36,000 = $70,000
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Important Issues
What interest is being sold?
Must check to see if the complete interest or only a partial interest is being sold Must also check what type of interest is being sold if the partner is both a general partner and a limited partner
In this case the partner has a single capital account and basis must be prorated between the two types of interest
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Important Issues
A sale of a partnership interest can cause a Section 708 termination of the partnership if more than 50% of the profits and capital interest is transferred within a 12-month period A sale always terminates the partnerships year for the selling partner

The partner must adjust his basis in the partnership interest by his share of the partnerships income or loss to the date of sale
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Basis Determination
Kate sold her one-fourth interest in JKLM this year on July 31st. The partnership had earned $240,000 as of that date, however, it expects to loose $60,000 over the next five months. Kates adjusted basis at the beginning of the year was $40,000. What is her adjusted basis when she sold her partnership interest?
a. b. c. d. $40,000 $85,000 $100,000 None of the above
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Answer
Kate sold her one-fourth interest in JKLM this year on July 31st. The partnership had earned $240,000 as of that date, however, it expects to loose $60,000 over the next five months. Kates adjusted basis at the beginning of the year was $40,000.

Answer: c. $100,000 According to Section 708, the partnerships books should be closed at the date of the sale to determine the partnerships income. Therefore, Kate should increase her basis by $60,000. However, the practical answer in many cases is to prorate income. If income were prorated Kate would only increase her basis by $26,250.
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Other Issues to Consider Seller

In determining a partners adjusted basis in his or her partnership interest any loss limitations under Code Sections 704(d), 465, and 469 must be considered A sale of a partnership interest does not create basis for Section 704(d), but it does for Section 465. Gain on a sale of a partnership interest that produced passive income is considered passive as well.
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Other Issues to Consider Buyer

The new partners basis in the partnership interest is equal to the amount paid for the interest plus the share of liabilities assumed. If the old partner was subject to Section 704(c), the new partner is the successor to the old partner and will be subject to Section 704(c). The new partner is also the successor to the old partners Section 704(b) capital account
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Determination of Basis and Gain Part I

At the beginning of the year Susan had a basis in her partnership interest of $40,000 (this amount includes her share of partnership liabilities of $8,000). During the year she sold her 1/3 interest to Kim for $50,000. Before the sale the partnership had an operating loss of $12,000 for the year.

How much gain or loss does Susan recognize on the sale? Why?

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Answer
Susan has a gain of $22,000 on the sale of her partnership interest. The amount received on the sale was $58,000 consisting of the $50,000 in cash from Kim and the $8,000 relief of liabilities. Her adjusted basis was $36,000 consisting of her beginning basis of $40,000 less her share of the partnerships loss up to the date of sale of $4,000.
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Determination of Basis and Gain Part II

At the beginning of the year Susan had a basis in her partnership interest of $40,000 (this amount includes her share of partnership liabilities of $8,000). During the year she sold her 1/3 interest to Kim for $50,000. Before the sale the partnership had an operating loss of $12,000 for the year. What is Kims basis in her partnership interest after the purchase?

.
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Answer
Kims basis in her partnership interest would be $58,000 which consists of the $50,000 she paid for the interest plus the $8,000 of liabilities she assumed from Susan.

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Agenda
General rules governing the transfer of a partnership interest Rules regarding Section 751 assets Taxable vs. Nontaxable Transfers Payments to Retiring Partners under Section 736
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Sale of a Partnership Interest with Section 751 assets

Section 751(a) applies to gain attributable to Section 751 assets Section 751(a) prevents a partner from converting his share of ordinary income into capital gains. If Section 751(a) applies, then gain on the sale of a partnership interest can be part ordinary income and part capital gain
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Section 751 Assets

Section 751 assets are referred to as hot assets Hot Assets include unrealized receivables and inventory Included in unrealized receivables are cash basis A/R and depreciation recapture
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Question
Does Section 751(a) Apply?
Libby sells her partnership interest to Susan for $45,000 in cash. The partnership is a service partnership that only has cash and cash basis accounts receivables for assets. Does Section 751(a) apply to this sale? a. Yes b. No

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Answer
Does Section 751(a) apply to the sale? Answer: a. Yes If a partnership has Section 751 assets, Section 751(a) applies to a sale of a partnership interest. In this case the partnership has cash basis accounts receivables which are Section 751 assets
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Sale of a Partnership Interest with Section 751 Assets

To determine the gain or loss on the sale of a partnership interest the partner must first determine the total gain or loss Then the sale must be bifurcated between Section 751 and non-751 assets. Next the partner must determine the gain or loss on the sale of the Section 751 assets Lastly, the partner must determine the gain or loss under Section 741
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Gain on Sale of Section 751 Assets

The amount of Section 751 gain that the partner must report is his share of the gain the partnership would have if it sold all its Section 751 assets for their FMV. The gain on the sale of Section 751 assets is reported as ordinary income.
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Section 741 Gain

The amount of gain or loss under Section 741 is the difference between the total gain or loss and the amount reported under Section 751. The gain or loss under Section 741 is capital. It is possible to have a Section 751 gain and a Section 741 loss or vice versa
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Case Study 1 Disposition of a Partnership Interest

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Case 1 Issues
The amount received on the sale of a partnership interest always includes the relief of liabilities. Section 751(a) applies if the partnership has either unrealized receivables or inventory. The gain or loss on Section 751 assets is calculated first and is the partners share of the difference between the FMV and the partnerships basis of those assets. Section 751 gain or loss is ordinary. Section 741 gain is the difference between the total gain or loss on the sale and the Section 751 gain or loss. Section 741 gain or loss is 31 capital.

Case 1 Scenario A
Section 751(a) does apply to this transaction because the partnership owns inventory which is a Section 751 asset. Susans total gain on the sale is $6,700. Sales Price: Cash $17,200 + Relief of Liabilities $ 7,000 = $24,200 Adjusted Basis: Capital $10,500 + Share of Liabilities $7,000 = $17,500 Total Gain = $24,200 $17,500 = $6,700
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Case 1 Scenario A
Susans Section 751 gain is: FMV of Section 751 Assets Pship basis of Section 751 Assets Total Gain Susan Share of 751 Gain

$9,600 7,500 $2,100 $700

Susans Section 741 Gain = Total Gain Section 751 Gain $6,700 - $700 = $6,000
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Case 1 Scenario B
Section 751(a) would apply to this transaction because the partnership has cash basis accounts receivable Alices amount realized on the sale is Cash of $15,000 + Debt Relief of $1,000 = $16,000 Her adjusted basis is Capital of $9,000 + Share of Debt $1,000 = $10,000 The total gain without Section 751(a) is $6,000.
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Case 1 Scenario B
The total Section 751(a) gain would be FMV of A/R $14,000 Basis of A/R 0 Section 751(a) Gain $14,000 Alices share of the Section 751(a) gain would be $7000. Alice would have a Section 741 loss of $1,000. Total gain of $6,000 less Section 751(a) gain of $7,000.
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Agenda
General rules governing the transfer of a partnership interest Rules regarding Section 751 assets Taxable vs. Nontaxable Transfers Payments to Retiring Partners under Section 736

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Which transfer would generally be a nontaxable exchange of a partnership interest?

a. Transfer to a corporation b. Retirement c. Like-Kind Exchange d. Abandonment
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Answer
Answer: a. Transfer to a corporation

As long as the requirements of Section 351 are met the transfer of a partnership interest to a corporation would be tax-free. All the other transfers would be taxable.

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Transfer of a Partnership Interest to a Corporation

If a partner transfers his partnership interest to a corporation in exchange for stock in the corporation and all the requirements under Section 351 are met, the transfer will be tax-free When there is a contribution of a partnership interest with liabilities in excess of basis of the interest to a corporation, Section 357(c) will result in gain.
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Converting a Partnership Interest

If a general partnership interest is converted into a limited interest or vice versa the conversion is not a disposition.
Likewise the conversion of a general or limited partnership into an LLC or an LLP is not a disposition. However, there may be a gain on the conversion because of the change in 40 the partners share of debt.

Abandonment of an Interest
Mark has a 25% interest in a partnership. His basis in his interest is $20,000 consisting of his $15,000 capital account and his share of partnership liabilities of $5,000.
How much gain or loss will Mark recognize if he abandons his interest? What is the character of the gain or loss?

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Answer
When a partner abandons his partnership interest it is treated as a sale for the amount of debt relief. Therefore Mark is deemed to have sold his interest for $5,000, which results in a loss on the abandonment of $15,000. The loss would be treated as a capital loss. A partner can have a gain on the abandonment of a partnership interest if his or her adjusted basis is less than his or her share of partnership debt.

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Like-Kind Exchange of a Partnership Interest

Per Code Section 1031(a)(2)(D) the nonrecognition provisions of Section 1031 do not apply to any exchange of interests in a partnership. This is true even though the underlying properties may be identical. Code Section 1031 does not apply to conversions of the type of partnership interest because conversions are not deemed exchanges.
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Case Study 2 Taxable vs. Nontaxable Transfers

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Case 2 Issues
Abandonment of a partnership interest can result in a gain or loss. The gain or loss is capital.
A like-kind exchange of a partnership interest is a taxable transaction.

If the requirements of Code Section 351 are met the contribution of a partnership interest to a corporation is nontaxable. An exception applies if liabilities transferred exceed the basis of the partnership interest.
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Case 2 Scenario A
The abandonment of a partnership interest is an exchange of the partnership interest for the deemed cash distribution (relief of liabilities). In this case Debbie would have a $15,000 loss ($25,000 debt relief - $40,000 basis) on the abandonment of her partnership interest. The loss would be a capital loss. In this case the amount of debt relief is more than her basis in the partnership interest. Thus Debbie would have a gain on the abandonment of $15,000 ($25,000 debt relief - $10,000 basis). The gain would be capital.

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Case 2 Scenario B
The requirements under Section 351 would be met because Bill transferred property (the partnership interest) solely in exchange for stock of the corporation and immediately after the exchange he was in control of the corporation. Because Section 351 is met, Bill would not have to recognize a gain or loss on the transfer. In this case Section 357(c) would create a gain equal to the excess of liabilities transferred over basis. Thus, Bill will recognize a gain of 47 $10,000 ($15,000 debt relief - $5,000 basis).

Case 2 Scenario C
Section 1031 does not apply to an exchange of partnership interest based on Section 1031(a)(2)(D). The transfer would be treated as a taxable exchange. Laura would have to recognize a gain of $20,000 on this transfer. The gain is computed by determining the amount realized ($100,000 FMV of property received + $50,000 debt relief - $50,000 assumption of debt =$100,000) less adjusted basis ($30,000 capital + $50,000 share of debt = $80,000).
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Agenda
General rules governing the transfer of a partnership interest Rules regarding Section 751 assets Taxable vs. Nontaxable Transfers Section 754(b) Basis Adjustments Payments to Retiring Partners under Section 736
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When does it apply?

On any distribution or sale that creates a disparity between the partners inside and outside basis
The disparity is caused by the fact that outside basis is at cost and the transaction has no affect on inside basis
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Section 754 Election

Code allows the partnership to make an election under Section 754 to adjust the basis of the assets Applies to both a step up or step down in basis Once the election is made it is effective for all future transactions

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Rules for making the Adjustment

Sale of a partnership interest Section 743(b) Liquidating Distribution Section 734(b)

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Section 743(b)
Partner specific
Adjustment not made on the partnerships books off balance sheet adjustment

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Amount of Adjustment
Difference between the buyers outside basis and share of inside basis
If outside basis is higher positive adjustment If outside basis is lower negative adjustment

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Section 743(b) Regulations

Define a partners inside basis as the sum of their share of previously taxed capital
Previously taxed capital = balance in the partners tax capital account

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Section 743(b) Regulations

Require a hypothetical sale of all assets at FMV immediately The partners share of the gain or loss is the amount of the adjustment

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Example 1
AB, an equal partnership. A sells her interest to X for $300. Immediately after the transaction the balance sheet is: Book Value Inventory 100 200 Land 100 400 Capital 200 600

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Adjustment under Section 743(b)

Purchase price was $300. Under the hypothetical transaction is as if X bought of each asset
Sales Price Cost Gain

Inventory Land

100 200

50 50

50 150

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Allocating the Adjustment

Section 755 governs the allocation
Allocated First between two classes of assets
Capital (including 1231) Noncapital

Does not affect partnership books

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Example
Asset Cash Stock Machinery Building Inventory A/R
Goodwill

Basis 100 100 50 200 80 70

0

FMV 100 300 100 500 140 60

300

Gain
200 50 300 60 (10) 300

Share
100 25 150 30 (5)

150

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Allocation Problem
Partner sold 50% interest for $750.
Gain on sale is $450. Allocation between capital and noncapital assets based on the income and gain allocated to the partner
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Allocation Problem
Ordinary income is from inventory, accounts receivable and depreciation recapture 30-5+25 = 50.
Capital gain is from other assets 100+150+150 = 400

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Allocation
The $50 is allocated between the ordinary income assets The $400 is allocated to the capital assets
If basis of depreciable assets are stepped-up, the partner is allowed an annual depreciation deduction 63

Adjustments from Distributions

Section 734(b) applies
Affect the common partnership property

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Allocation under Section 755

Based specifically on the event which triggered the adjustment. Amount assigned to a particular class of assets
Once assigned to a particular class, it is divided among assets in that class

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Allocation under Section 755

Positive adjustment
First to assets with unrealized appreciation in proportion to their relative appreciation Then based on relative FMV

Negative adjustment
First to assets with unrealized depreciation in proportion to their relative depreciation Then based on adjusted basis

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Agenda
General rules governing the transfer of a partnership interest Rules regarding Section 751 assets Taxable vs. Nontaxable Transfers Section 743(b) Basis Adjustments Payments to Retiring Partners under Section 736
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Payments made to a Retiring Partner

Section 736 governs the payments made to a retiring partner Section 736 divides all payments into two classes Section 736(a) payment not for the partners interest in partnership property; and Section 736(b) payments for the partners interest in partnership property

Section 736 makes a distinction between distributions to general partners of service partnerships and all other distributions

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Payments made to a Retiring Partner

Section 736(a) payments are taxed as a distributive share or a guaranteed payment depending if the amount depends on partnership income.
Section 736(b) payments are taxed as distributions.

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Payments to a Retiring Partner

To induce a partner to retire the partnership will pay him $100,000 at a time when the value of his partnership interest is $25,000.
Does Section 736 apply to this distribution? If so, how much of the payment is a Section 736(a) payment and how much is a Section 736(b) payment?

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Answer
Section 736 does apply to this transaction because the partner is retiring from the partnership.
Section 736(a) says all payments to a retiring partner are Section 736(a) payments unless Section 736(b) applies. Section 736(b) says payments made in exchange for the retiring partners interest in partnership property are not Section 736(a) payments

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Answer
In this case, $75,000 was not for the partners interest in partnership property, so it is a Section 736(a) payment. Since the amount is fixed in amount it is deemed a guaranteed payment. The remainder, $25,000, is a Section 736(b) payment treated as a distribution.
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Payments by Service Partnerships to General Partners

In this context Section 736 views payments as being for any of five different things:
Payment not for the partners interest in property Section 736(a) payment Payment for the partners share of unrealized receivables Section 736(a) payment Payment for the partners share of unstated goodwill Section 736(a) payment Payment for the partners share of stated goodwill Section 736(b) payment and Payment for the partners share of other property Section 736(b) payment

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Payment to a Retiring Partner

A partner withdraws from a partnership, receiving a $35,000 cash payment. He is a general partner in a service partnership. $10,000 of the payment is for his share of unrealized receivables and $5,000 is for unstated goodwill.
How is the distribution to the partner treated under Section 736? What is the tax effect to the retiring partner and to the remaining partners?

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Answer
Under Section 736 because the retiring partner is a general partner in a service partnership, the payments for his share of unrealized receivables and for the unstated goodwill will be Section 736(a) payments. The partner will have $15,000 of ordinary income under Section 736(a) and the remaining partners will get a deduction of $15,000. 75

Answer
The rest of the payment ($20,000) is a Section 736(b) payment which is taxed as a distribution. The partner will have a gain or loss equal to the difference between the amount received and his basis in his partnership interest.

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Case Study 3 Payments to Retiring Partners

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Case 3 Issues
Section 736 applies to payments made to retiring partners Payments to retiring partners are either Section 736(a) payments or Section 736(b) payments These payments are taxed differently Payments made to general partners from a service partnership are treated differently than payments made to a partner in a partnership where capital is a material income-producing 78 factor under Section 736(b)(2)

Case 3 Scenario A
Kevin is deemed to have received a payment of $30,000 consisting of the $25,000 cash payment plus the $5,000 debt relief.

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Case 3 Scenario A
Of this amount $14,000 is a Section 736(a) payment. The $14,000 is made up of the excess over his share of partnership assets of $11,000 ($30,000 amount received - $19,000 share of partnership assets), that amount is a Section 736(a) payment because it is not a payment for property; plus $2,000 payment for his share of A/R which is a Section 736(a) payment because of Section 736(b)(2)(A); plus $1,000 payment for his share of unstated goodwill. 80

Case 3 Scenario A
The payment for his interest in the machines value in excess of basis is not a payment for an unrealized receivable for Section 736 purposes. The remaining payment of $16,000 is a Section 736(b) payment.

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Case 3 Scenario A
The Section 736(a) payment will be a guaranteed payment because it does not depend on the partnerships income. Kevin will have ordinary income of $14,000 under Section 736(a) and the partnership will get a deduction of $14,000. Kevin will have a liquidating distribution of $16,000 under Section 751(a). This distribution will cause him to recognize $8,000 more ordinary income related to the depreciation recapture on the machine and a capital loss of $1,000. 82

Case 3 Scenario B
Because Section 736(b)(2) does not apply in this situation, only $11,000 the payment in excess of the value of Kevins interest in partnership property is a Section 736(a) payment. Section 736(a) gives Kevin $11,000 of ordinary income and the partnership has an $11,000 ordinary deduction. 83

Case 3 Scenario B
Kevins $19,000 Section 736(b) payment is a distribution. Section 751(b) will give Kevin $10,000 more ordinary income related to the depreciation recapture on the machine and the unrealized A/R and the partnership will now have a basis of $2,000 for its unrealized receivables and $12,000 for the machine. Kevin will recognize no capital gain or loss.
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