CHAPTER 8
PARTNERSHIPS: DISTRIBUTIONS, TRANSFER
OF INTERESTS, AND TERMINATIONS
LECTURE NOTES
8.1 DISTRIBUTIONS FROM A PARTNERSHIP
1.
Distributions from partnerships to partners are made in cash and/or partnership
property. All distributions fall into two categories: Liquidating or Nonliquidating.
a.
Categorization as a liquidating or nonliquidating distribution depends
solely on whether the partner remains a partner after the distribution.
b.
Liquidating distributions occur when either of the following happens.
c.
d.
(1)
The partnership itself liquidates and distributes all of the
partnership property to its partners.
(2)
An ongoing partnership redeems the interest of one of its partners.
Nonliquidating distributions are any other distributions and of the following
two types.
(1)
Draw. Distributions of a partner’s share of current or accumulated
partner-ship profits that have been taxed to the partner.
(2)
Partial liquidation. Distributions that reduce the partner’s interest
in the partnership capital but do not liquidate the partner’s entire
interest.
These distributions may be either proportionate or disproportionate. The
taxation of disproportionate distributions can be extremely challenging.
Proportionate Nonliquidating Distributions
2.
Generally, partnerships and partners do not recognize gains or losses on
proportionate nonliquidating distributions.
a.
However, gain is recognized by the distributee partner if cash
received exceeds the partner’s outside basis in the partnership immediately
before the distribution. Gain is generally capital in nature.
b.
Cash distributions include decreases in a partner’s share of partnership
liabilities.
c.
3.
Marketable securities distributions are also generally treated as a cash
distribution. The amount treated as a cash distribution is somewhat tricky
to calculate.
In general, distributed property carries over the partnership’s basis to the
distributee partner and the partner’s outside basis is reduced by a like amount.
a.
If the partnership’s basis in the distributed property exceeds the distributee
partner’s outside basis before the distribution, some or all of the property will
have a basis determined by the partner’s outside basis (substituted basis).
Assets are deemed to be distributed in the following order.
1.
2.
3.
First, cash and “deemed” cash (debt relief but not marketable
securities).
Then, unrealized receivables and inventory.
Last, all other assets (including marketable securities).
b.
If more than one asset is distributed in category (2) or (3), and if the
partner would be required to step down the basis of assets in the category,
special rules apply (Text Examples 9 and 10).
c.
Unrealized receivables are amounts that ultimately will be recognized as
ordinary income in the future. Depreciation recapture is an unrealized
receivable.
d.
Inventory includes all partnership assets except cash, capital, and § 1231
assets.
e.
Examples. Partner Bob’s basis in his partnership interest is $50,000. What
gain or loss is recognized, what is Bob’s basis in the property received,
and his basis in his partnership interest, if the partnership makes the
following independent proportionate nonliquidating distributions?
1.
Partnership distributes $40,000 in cash. Bob reduces his basis in
the partnership to $10,000, has $40,000 cash, and recognizes no
gain or loss.
2.
Partnership distributes $60,000 cash. Bob reduces his basis in the
partnership to $0, has $60,000 cash, and recognizes a gain of
$10,000 on the excess distribution.
3.
Partnership distributes $40,000 cash and accrual basis accounts
receivable with a $20,000 basis and value. Bob reduces his basis in
partnership to $0, has $40,000 cash, and a $10,000 substituted basis in
the receivables. He recognizes no gain or loss.
4.
Partnership distributes $8,000 of inventory value with a $5,000
basis. Bob reduces his basis in the partnership to $45,000, has a
$5,000 carryover basis in the inventory, and recognizes no loss as
this is a nonliquidating distribution.
5.
Partnership distributes two parcels of land, each with a value of
$30,000. The partnership’s basis in parcel A is $40,000 and in
parcel B is $20,000. Bob reduces his basis in his partnership
interest to $0, assigns a $50,000 substituted basis to the two
parcels, and recognizes no gain or loss. His $50,000 basis is
allocated between the two parcels as follows.
a)
b)
c)
First, parcels are assigned carryover bases of $40,000 for
parcel A and $20,000 for parcel B ($60,000 total).
Next, the decline in value for parcel A is eliminated, reducing
its basis from $40,000 to $30,000. The basis of parcel B is not
adjusted because it is an appreciated asset.
Last, bases in the two properties now total the $50,000 basis
Bob must allocate to the parcels. Parcel A is allocated a
$30,000 basis and parcel B is allocated a $20,000 basis. Bases
are now closer to the values of the properties.
Proportionate Liquidating Distributions
4.
Proportionate liquidating distributions consist of either a single distribution or a
series of distributions that result in the termination of the partner’s entire interest in
the partnership. The partnership may or may not also liquidate.
5.
Normally, a partnership and its partners do not recognize gains or losses when
property or cash is distributed in proportionate liquidating distributions.
a.
Partners recognize gains when they receive cash distributions or are
relieved of partnership debts (deemed cash distribution) that exceed their
outside basis.
b.
Gain or loss recognized by the distributee partner is usually capital in
nature.
ADDITIONAL LECTURE RESOURCE
Arthur Fixel (Arthur Fixel, 33 TCM 857, T.C. Memo. 1974-197) received unpleasant news
when he dissolved his partnership in 1966. At the time of the dissolution, Mr. Fixel
“assigned and conveyed his share of partnership assets to [his partner] in exchange for the
latter’s agreement to assume [all partnership] liabilities.” Mr. Fixel received no cash or
other assets but was relieved of more than $90,000 in partnership liabilities. He claimed
that his entire net assets on the date of dissolution totaled only $20,000, and argued that the
assumption of his liabilities should be limited to the net asset amount. The Tax Court
disagreed. It also found itself “not satisfied either as to the accuracy of the values of the
listed assets or the completeness of the list” and determined that the $90,518.33 should be
included in Mr. Fixel’s taxable income as a net gain.
6.
Loss is recognized if the following occurs.
•
•
The distributee partner receives only cash, unrealized receivables, and
inventory from the partnership, and
The inside bases of the distributed assets is less than the partner’s outside
basis in the partnership immediately before the distribution.
7.
Mixed distributions of assets are deemed to be distributed in the order presented
in part 3.a. of this outline.
a.
Distributed assets take a carryover basis from the partnership and reduce the
partner’s outside basis dollar for dollar. Eventually, some assets typically take
a substituted basis from the partner’s outside basis. This occurs because the
partner’s outside basis must reach $0 because the partner’s interest
terminates.
b.
If more than one asset is distributed in the same category, a partner may
have to step the bases in assets up or down. However, unrealized
receivables and inventory cannot be stepped up or down. If other assets
are stepped up, special rules determine how the basis is allocated
(Example 13).
c.
Examples. Jill, a partner in a partnership, has a basis in her interest of
$50,000. What gain or loss does Jill recognized and what is her basis in
the property received if the partnership makes the following independent
proportionate liquidating distributions? The partnership also liquidates.
Compare the results of these examples with the previous examples for
Bob.
1.
Partnership distributes $40,000 cash. Jill has $40,000 cash and
recognizes a loss of $10,000, because she received only cash in the
distribution.
2.
Partnership distributes $60,000 cash. Jill has $60,000 cash, and
recognizes a gain of $10,000 on the excess distribution.
3.
Partnership distributes $40,000 cash and accrual basis accounts
receivable with a $20,000 basis and value. Jill has $40,000 cash
and a $10,000 substituted basis in the receivables. She recognizes
no gain or loss.
4.
Partnership distributes $8,000 of inventory value with a $5,000 basis.
Jill takes a $5,000 carryover basis in the inventory, and reports a
$45,000 loss on the liquidation, because she received only cash,
inventory, and/or unrealized receivables in the distribution.
5.
Partnership distributes two parcels of land, each valued at $20,000.
Basis in parcel A is $10,000 and in parcel B is $20,000. The land
parcels are capital assets to both Jill and the partnership. Jill
assigns $50,000 substituted basis of to the two parcels. Jill’s
$50,000 basis is allocated between the two parcels as follows.
a) First, the parcels are assigned carryover bases of $10,000
for parcel A and $20,000 for parcel B ($30,000 total).
b) Next, the appreciation in parcel A is added to the basis of
the parcel. This increases its basis from $10,000 to
$20,000. The basis of parcel B is not adjusted above
$20,000 because it is not an appreciated asset.
c) Bases in the properties now total $40,000, but Jill must
allocate $50,000 to them. The additional $10,000 basis is
allocated according to the relative values of the property.
The properties have equal values ($20,000). Therefore, the
$10,000 is allocated equally ($5,000 to each parcel). Jill’s
basis in each parcel, then, is $25,000.
d) Jill recognizes no gain or loss. Note that Jill can “step-up”
the basis in land (a capital asset), but she cannot “step-up”
her basis in unrealized receivables or inventory.
Property Distributions with Special Tax Treatment
8.
Disguised sales receive the usual sale or exchange treatment (see Chapter 10 for
discussion).
9.
Distributions of marketable securities are generally treated as cash distributions
equal to their fair market value (FMV) reduced by a “gain limitation amount.”
The FMV is determined on the distribution date.
a.
The definition of marketable securities is broad and includes
almost any debt or equity interest that is actively traded. However,
securities contributed by a partner and distributed to the same partner fall
outside this definition.
b.
Gain Limitation Amount. For reducing the cash equivalent, the “gain
limitation amount” equals the excess, if any, of:
•
•
c.
10.
The partner’s share of appreciation in the distributed security
before the distribution, less
The partner’s share (if any) of appreciation for any portion of
securities of the same class and issue retained by the
partnership after the distribution.
(1)
If the distribution terminates the partner’s interest or if the
partnership distributes all of the securities, the second number
above will be $0.
(2)
Allowing this gain limitation effectively defers some or all of the
partner’s gain. This makes sense because the intent of the
provision is to require gain recognition if the partnership purchases
stock with the intent of immediately distributing it to partners.
The partner’s basis in the distributed security is determined under regular
distribution ordering rules, plus any gain recognized under this provision.
Property distributions where precontribution gains exist may result in a taxable
gain to the contributing partner in two situations.
a.
Contributed property is distributed to a different partner within 7 years of
its contribution.
b.
(1)
The amount of gain recognized by the contributing partner is the
remaining net precontribution gain.
(2)
The contributing partner’s basis in the partnership increases by the
amount of the gain recognized.
(3)
The distributee partner’s basis in property received increases by
the amount of the precontribution gain recognized by the
contributing partner.
A partner contributes property with a precontribution gain, and within 7
years of the contribution, this partner receives a distribution of property
other than cash.
(1)
The amount of gain recognized is the lesser of the
remaining net precontribution gain or the excess value of the
distributed property over the partner’s basis in the partnership
interest.
(2)
The contributing partner’s basis in the partnership increases by the
amount of the gain recognized.
(3)
The partnership increases its basis in the precontribution gain
property by the amount of the gain recognized by the distributee
partner.
Disproportionate Distributions
11.
12.
A disproportionate distribution is a distribution in which the distributee partner’s
share of the partnership’s unrealized receivables or substantially appreciated
inventory (hot assets) either increases or decreases as a result of the distribution.
a.
Inventory is substantially appreciated if the value of all inventory items
exceeds 120% of the partnership’s basis in them.
b.
The definition of inventory for this purpose is broad enough to include all
the accrual basis accounts receivable and any cash basis unrealized
receivables.
c.
For sales of a partnership interest, inventory is not required to be
“substantially” appreciated—any appreciation will result in ordinary income
to the selling partner.
Tax consequences of disproportionate distributions can be very complex and are
only discussed in this chapter in limited detail.
a.
If a disproportionate distribution of hot assets is made, the distribution is
recast as:
(1)
Distribution of the partner’s proportionate share of hot assets, and
(2)
Sale of these hot assets back to the partnership at value in
exchange for a portion of the assets actually received in the
distribution.
b.
The partner recognizes ordinary income on the deemed sale of hot assets
and the partnership takes a cost basis for the deemed hot asset purchases
(Example 21).
ETHICS & EQUITY
Partnerships as Tax Shelters Tax shelters are typically designed to offer both tax and
economic benefits to the investor. As a tax advisor, in reviewing an offering document
(“Prospectus”) for such an investment, the trick is to make sure:
•
The tax benefits are based on provisions that were adopted to encourage investment
in a specific area (rather than merely exploiting one or more loopholes overlooked by
Congress in adopting the provision), and
•
The proposed economic benefits are feasible in light of current economic conditions
and constraints documented in the Prospectus.
Before 1981, the real estate tax shelters were typically structured to meet both of these
objectives. Depreciation allowances and interest expense deductions were generally great
enough to produce deductible losses while the properties were leased at rates high enough to
yield cash flows that could be distributed to the partners. What a great deal for the investor:
nontaxable cash flows and ordinary tax deductions in the same year!
In 1981, to help the country recover from an economic downturn, accelerated depreciation
deductions were enacted to encourage investment in real property. Property values
appreciated quickly and artificially: rental rates alone could not support these higher property
values. Some aggressive real estate developers put together real estate shelters where much of
the benefit to the investor related only to tax savings.
This might sound familiar: as the economy improved, Congress scaled back depreciation
deductions. Overheated real estate prices returned to sustainable levels. Then Congress took
note of the losses being claimed by real estate investors and the passive loss rules were
enacted. Investors could no longer deduct losses as anticipated. Real estate ventures based on
realistic market prices and financing terms survived. Real estate ventures based primarily on
tax savings faltered; many of those properties were eventually foreclosed on – with investors
facing tax on the resulting “phantom gains” from liability relief. Many people believe this
chain of events was responsible in part for the collapse of the Savings & Loan industry in the
late 1980s and early 1990s.
It might seem that the state of the economy in the late 2010’s is something novel, but to a
great extent, it follows the pattern of 20 years earlier. And the same cautions apply now:
when considering an investment (or advising your clients) make sure the returns are based on
sound economic benefits that will exist even if tax laws change!
8.2 LIQUIDATING DISTRIBUTIONS TO RETIRING OR DECEASED
PARTNERS
13.
One of the most common methods for disposing of a partnership interest is to
receive one or more distributions of money or property from the partnership in
exchange for the partnership interest. The major reasons for such payments are
the following.
•
•
•
•
14.
Continuing partners are not interested in having an unknown party as a
partner.
Partnership assets other than money are needed to continue the business.
Such payments reward the retiring partner for years of partnership service.
By spreading the liquidating payments over a period of years, the
partnership is able to avoid a possible working capital shortage which
could result from an immediate withdrawal of a retiring partner’s capital.
Partnership payments to a retiring partner are classified as either
a.
A payment for the partner’s share of the partnership property [§ 736(b)],
or
b.
As an income payment [§ 736(a)].
c.
Note: In this chapter, for simplicity, all payments under § 736 are assumed
to be in cash.
Property Payments
15.
Payments for a retiring or withdrawing partner’s interest in partnership assets are
classified as § 736(b) property payments.
16.
Payments for the following items are not § 736(b) payments if the partnership is in
the service industry and the retiring or deceased partner is a general partner. (Most of
the problems and examples in Chapter 11 assume the partnership is primarily a
service-producer, and the retiring partner is a general partner.)
17.
a.
Partnership unrealized receivables.
b.
Unstated goodwill. If the partnership agreement specifies an amount to be
paid as goodwill, it is treated as a § 736(b) property payment.
c.
Certain annuities and lump-sum payments.
The § 736(b) property payments are treated as distributions in liquidation of the
partner’s interest in the partnership.
a.
If the partnership has hot assets and the payment to the partner is in cash, a
disproportionate distribution arises. The partner’s proportionate share of
the hot assets results in ordinary income. The remaining (cash) distribution
is treated as a return of that partner’s outside basis.
b.
Any cash amounts received in excess of that basis create gain to the
partner.
c.
The distributee partner recognizes a capital loss equal to the amount of
basis not recovered through the cash distribution.
d.
Section 736(b) payments are not deductible by the partnership.
Income Payments
18.
Payments not classified as § 736(b) property payments are § 736(a) income
payments. These payments are treated as either of the following.
a.
Guaranteed payments if not determined by reference to partnership
income. These payments are taxed as ordinary income to the distributee
partner and are deductible by the partnership.
b.
Distributive shares if determined by reference to partnership
income. These payments are taxed according to their character as reported
on the distributee partner’s K-1.
ADDITIONAL LECTURE RESOURCE
Dr. Julian E. Jacobs was a partner in a medical clinic in Charlotte, N.C., for 28 years,
until he moved away for health reasons (Julian E. Jacobs, 33 TCM 848, T.C. Memo.
1974-196). Because he was not of retirement age, he was not eligible (under the terms of
the partnership agreement) for any payments from the partnership except for his “equity
interest” and “his share of undistri-buted net profits.” However, the partnership agreed to
pay Dr. Jacobs an additional amount of $35,000. Dr. Jacobs understood this $35,000 to
be payment for goodwill and, therefore, treated it as a capital gain.
The records of the partnership were confusing and the IRS took the position that the
payment qualified either as Dr. Jacobs’ interest in accounts receivable or as a guaranteed
payment, and therefore was subject to taxation as ordinary income. The Tax Court agreed
with Dr. Jacobs, indicating that he had certainly worked at the clinic and in the Charlotte
community long enough to have established goodwill. Also, the $35,000 payment, if it
was intended to be Dr. Jacobs’ share of accounts receivable, fell far short of the $61,622
that he would have been due.
Series of Payments
19.
Partnership buyout payments may be made over several years in specified
installments. These buyout payments may be determined by reference to the
future partnership income.
a.
Partners and the partnership should affirmatively agree to the
allocation between § 736(a) and (b) payments.
b.
In absence of an agreement, Regulations specify classification
rules for payments.
8.3 SALES OF A PARTNERSHIP INTEREST
General Rules
20.
Entity versus Aggregate Concept.
a.
Under the entity concept, a partnership interest is an intangible
asset much like an ownership interest in a corporation. As such, a
partnership interest is treated as a capital asset, the disposition of which
results in capital gain or loss.
(1)
Gain or loss is computed as the difference between
the amount realized and the selling partner’s adjusted basis in the
partnership interest.
(2)
Gain attributable to the selling partner’s share of
unrealized gain on collectibles is taxed at maximum 28% rate and
for unrecaptured § 1250 gain at maximum 25% rate.
(3)
While the selling partner’s share of partnership
liabilities is considered in determining the gain or loss on the
disposition, the gain/loss is not affected because both the amounts
realized and outside basis are increased by equal amounts. Thus,
the liabilities are a “wash” in the gain computation.
Example. The NOP Manufacturing Partnership has always operated
at breakeven (i.e., has never made a profit or suffered a loss). Partner Natalie,
a general partner who originally invested $1,000 in the partnership, sells her
interest for $5,000 in cash and the assumption of her $10,000 share of
partnership debt. If the tax basis balance in her capital account is $1,000 (her
original investment), her gain on the sale is $4,000.
Selling price
Cash
Assumption of debt share
Total
Natalie’s basis in interest
Capital account (tax basis)
Debt share
Gain on sale
$ 5,000
10,000
$15,000
$ 1,000
10,000
(11,000)
$ 4,000
b.
Under the aggregate or conduit concept, a partnership interest is
treated as an ownership interest in each partnership asset. As such, a
partnership interest represents an undivided interest in the ordinary income
assets and capital or § 1231 assets of the partnership.
c.
Partnership income for the taxable year must be allocated between the buying
and the selling partner. The partnership tax year closes with respect to the
selling partner [§ 706(c)(2)(A)] and this closing could result in income
bunching when the partner’s tax year-end differs from the partnership’s.
Effect of Hot Assets
21.
For hot assets (§ 751 assets), the selling partner allocates a portion of the sale
proceeds to these assets and recognize ordinary income (loss). The remaining
sales proceeds are allocable to the selling partner’s capital asset interest and result
in a capital gain or loss.
a.
Unrealized receivables include accounts receivable of a cash basis
partnership, and depreciation recapture.
b.
Inventory (as broadly defined) is a hot asset.
c.
Hot asset treatment is to prevent partners from converting their
respective shares of partnership ordinary income into capital gain, by
selling their interests just before such income is recognized by the
partnership.
Example. Tim’s 1/3 interest in the TUV Partnership is sold to David for $75,000.
On the sale date, the cash basis partnership has unrealized receivables from
services of $210,000. Tim’s basis in his partnership interest is $2,000, thus the
sale results in a $73,000 gain. Without § 751(a), Tim’s $70,000 (1/3 of $210,000)
share of forthcoming partnership ordinary income would be converted into capital
gain. However, under § 751(a), Tim must report $70,000 of ordinary income and
a $3,000 capital gain.
Example. The RST Partnership is selling all of its assets and discontinuing
operations. The partnership’s principal assets are fully depreciated shrimp boats
worth $400,000. Two days before the partnership sells its assets, Ray’s 25%
partnership interest (basis $30,000) is sold for $120,000. Without § 751(a), Ray
could avoid recognizing $100,000 (l/4 of $400,000) of depreciation recapture
when the partnership sells the boats. Under § 751(a), Ray has $100,000 ordinary
income and a $10,000 capital loss. There is no “ceiling” on the § 751(a) ordinary
income.
8.4 OTHER DISPOSITIONS OF PARTNERSHIP INTERESTS
Transfers to a Corporation
22.
If a partner transfers a partnership interest to a controlled corporation, the
transaction is usually nontaxable under § 351.
a.
However, if the partner’s share of partnership debt exceeds the partner’s
outside basis, the excess is treated as gain from the sale of the interest [§
357(c)] and is ordinary income to the extent § 751 applies to the transfer.
b.
To receive the benefits of small business stock (§ 1244 stock),
corporations should issue stock directly to the partners. If issued to the
partnerships, the § 1244 benefits may be forfeited because the partners are
not the original owner.
Like-Kind Exchanges
23.
Nontaxable rules for like-kind exchanges do not apply to partnership interests.
Therefore, the exchanges of partnership interests are fully taxable.
Death of a Partner
24.
Transfer of a partnership interest due to a partner’s death is not treated as a sale or
exchange of the interest.
a.
Transfer of a partnership interest because of a partner’s death closes the
partnership’s tax year with respect to the deceased partner. Thus, income
bunching may occur on the deceased partner’s final tax return.
b.
Basis in the partnership interest for the deceased partner’s successor is
determined under §1014 (i.e., fair market value on date of death or
alternate valuation date if effected). For decedents dying in 2010 who
choose not to have the estate tax apply, a modified carryover basis (under
§1022) must be used.
c.
For basis determined under §1014,
(1)
It is likely that this “outside” basis will be higher than the
“inside” basis (the successor’s share of the partnership’s basis in its
assets).
(2)
With a § 754 election, the transferee partner is entitled to a
special basis adjustment under § 743 to equalize the outside and
inside basis amounts.
Gifts
25.
Gifts of partnership interests create no gains/losses with two possible exceptions.
a.
When the donor’s share of partnership debt exceeds the donor’s basis in
the partnership, the transfer is treated as part-gift and part-sale.
b.
If the partnership is using the cash method of accounting and has
receivables at the time of transfer, the IRS may consider the gift to be a
taxable anticipatory assignment of income.
c.
The partnership’s taxable year does not close with respect to the donor.
8.5 OPTIONAL ADJUSTMENTS TO PROPERTY BASIS
26.
When a partner purchases a partnership interest, the amount paid reflects its value.
This may be substantially different than the inside basis of the assets. A
partnership, not the partner, can make a § 754 election (optional adjustment
election) to adjust the inside basis of the partnership property to reflect the
purchase price (§ 743 adjustment).
a.
Only the purchasing partner receives the benefit of the § 743 adjustment.
b.
Partnerships with a § 754 election in effect are bound to the election in all
subsequent years, unless consent from the IRS is received.
c.
Partnerships with substantial built-in losses are required to make the § 743
adjustment whether or not a § 754 election is in effect. “Substantial” in
this case is at least $250,000.
Adjustment: Sale or Exchange of an Interest
27.
Partnership’s adjustment for the transferee partner’s purchase is computed as
follows:
Adjustment = Transferee’s outside basis
– Transferee’s inside basis in all partnership property
Example. Ken sells his 1/3 interest in the KLM Partnership to Pamela for
$40,000. Ken’s outside basis in the partnership is $24,000. At the time of the sale
the asset portion of the KLM Partnership balance sheet is as follows.
Cash
Accounts receivable
Merchandise inventory
Equipment
Investments in stocks/bonds
Asset Portion of KLM Balance Sheet
Adjusted Basis
Market
Per Books
Value
$ 3,000
$ 3,000
-06,000
42,000
72,000
15,000
24,000
12,000
15,000
$72,000
$120,000
The § 754 election requires a§ 743(b) adjustment of $16,000 [$40,000 purchase
price less $24,000 basis in assets (1/3 X $72,000)]. The $16,000 adjustment
benefits only Pamela.
The $16,000 § 743(b) adjustment is allocated as follows.
Cash
Accounts receivable
Merchandise inventory
Equipment
Investments in stocks and bonds
$
-02,000
10,000
3,000
1,000
When the partnership later collects the $6,000 accounts receivable, Pamela’s
$2,000 share of the partnership income will be offset by the $2,000 basis
adjustment she made to the accounts receivable. Therefore, she will not recognize
any ordinary income from the receivables. Gains on the sale of other partnership
assets will be similarly treated.
Adjustments: Partnership Distributions
28.
Optional adjustments under § 734 are available to the partnership when property
is distributed to a partner. Because the adjustment is made to the partnership’s tax
basis of remaining assets, all partners share in § 734 adjustments.
(1)
Basis is increased by any gain recognized by the partner and the excess of
the partnership’s basis over the partner’s basis in the distributed property.
(2)
Basis is decreased by any loss recognized by the partner and for
liquidating distributions, the excess of the partner’s basis over the
partnership’s basis in the distributed property.
29.
A partnership may not want to make a § 754 election because the cost of keeping
the records under § 754 may be greater than the perceived benefit of the election.
ADDITIONAL LECTURE RESOURCE
In recent years, the IRS and Congress have modified the calculations made under § 743(b),
§ 734(b) and § 755. While the calculations are not significantly changed, some situations in
which § 754 applies will produce different results than was previously the case.
Five significant modifications should be noted. Under the final regulations, it is possible to
allocate positive adjustments to some assets and negative adjustments to other assets. While
this appears to most students to be completely logical, the prior regulations did not permit this
degree of flexibility. Instead, they required positive adjustments to be allocated only to
appreciated assets and negative adjustments only to depreciated assets.
Another modification puts the burden of reporting § 743(b) adjustments on the partnership
rather than on the partner.
A third modification requires the transferee partner to notify the partnership within 30 days
(one year in the case of a deceased partner’s successor in the interest) of acquiring the
interest. In the written notification, the partner must include the partner’s adjusted basis for
the partnership interest.
The fourth modification requires use of the residual method in valuing any § 197 assets. The
application of the residual method is explained in Reg. § 1.755-1.
A final modification requires that the optional basis adjustments must be made if there is a
substantial basis reduction, as defined by the Code. A substantial basis reduction exists if the
adjusted basis of the partnership property exceeds the value of the property by more than
$250,000 at the time the partnership interest is transferred in a sale or exchange or because a
partner dies. A similar required adjustment must be made if a distributee partner recognizes
more than a $250,000 loss on a distribution or if the adjusted basis of distributed property to
the distributee increases by more than $250,000 because of the distribution.
8.6 TERMINATION OF A PARTNERSHIP
30.
31.
Termination events include the following.
a.
Sale or exchange of a partnership interest results in a termination of the
entire partnership when 50% or more of the total interests in partnership
capital and profits are sold or exchanged within any 12-month period.
b.
The partnership also terminates when no part of the partnership operations
are conducted in partnership form.
c.
The partnership’s tax year closes upon termination of the partnership.
In a technical termination of the partnership, the “old” partnership is treated as
transferring its assets and liabilities to the “new” partnership in exchange for the
interests in the new partnership. These interests in the new partnership are
immediately distributed to the partners in the liquidating (old) partnership and the
old partnership goes out of existence.
a.
partnership.
All the assets of the old partnership take a carryover basis to the new
b.
interests.
The continuing partners take a substituted basis for their partnership
Example. The NOP Partnership’s balance sheet on December 31, 2011, is as
follows.
Cash
Inventory
Capital asset
Nate, capital
Oscar, capital
Peter, capital
Adjusted Basis
$30,000
9,000
21,000
$60,000
Market Value
$30,000
9,000
45,000
$84,000
$20,000
20,000
20,000
$60,000
$28,000
28,000
28,000
$84,000
On December 31, Nate sells his interest to Katelyn for $28,000, and Oscar sells
his to Whitney for $30,000. Whitney paid more than Katelyn simply because
Whitney did not bargain as well. The sale of the two interests results in a
“technical” termination of the partnership.
Old NOP Partnership is considered to terminate and transfer its assets to new
KWP Partnership. KWP takes a carryover basis in each asset. The interests in the
KWP Partnership are then distributed to Katelyn, Whitney, and Peter. The
partners take substituted bases in the 1/3 partnership interests they receive in the
KWP Partnership. Katelyn’s substituted basis will be $28,000, Whitney’s will be
$30,000, and Peter’s will be $20,000.
32.
33.
A technical termination may have numerous consequences, including the
following.
a.
Income bunching may occur when the partnership and the partners have
different tax years.
b.
Depreciable assets will be treated as new MACRS assets in the new
partnership.
c.
The old partnership’s favorable tax year will be lost and may not be able
to be reelected by the new partnership.
Partly due to the possible negative results that occur in a termination, many
partnership agreements have a clause which restricts the sale or exchange of
partnership interests.
8.7 OTHER ISSUES
Family Partnerships
34.
If capital is a material income-producing factor and one or more of the family
members render significant services to the partnership, an allocation of
partnership income based solely on capital accounts is not allowed [Carriage
Square, Inc., 69 TC 119 (1977)]. Instead, partnership income is allocated first to
the service partner(s), in an amount representing reasonable compensation for
services. Any remaining partnership income is allocated among the partners based
upon capital account balances.
35.
For children under the age of 19 or full-time students under age 24, the kiddie tax
provisions may apply.
Limited Liability Companies
36.
Limited liability companies (LLCs), limited liability partnerships (LLPs), and
limited liability limited partnerships (LLLPs) offer the benefits of partnership
taxation and limited liability for all the owners. In recent years, the number of
limited entities formed has increased tremendously. All the large multinational
accounting firms operate as LLPs.
ADDITIONAL LECTURE RESOURCE
Writing new regulations for LLCs is not an easy job.
•
In December 1994, the IRS proposed regulations concerning what constitutes selfemployment income from an LLC.
•
In a 1996 speech to the AICPA’s Tax Division, the IRS Chief—Branch 3 (PassThroughs and Special Industries), admitted that the IRS was rethinking the
proposed regulations and might make significant changes in them. He noted that
the proposed regulations are too narrow in focus. He further noted that the
changes in the proposed regulations might be so significant that the IRS would
need to reissue the changed regulations in proposed form, thereby starting the
hearing and comment process all over again.
•
On January 10, 1997, the IRS issued new proposed regulations on the selfemployment issue. This time, the proposed regulations focus on the definition of a
limited partner and when an LLC member will be classified as a limited or a general
partner for self-employment tax purposes. As of this writing, these regulations are
still proposed.
•
As discussed in Chapter 10, in summer 2009, various courts (e.g., the Tax Court and
the Court of Federal Claims) ruled that a member of an LLC should not automatically
be treated as a passive investor for purposes of the §469 passive loss rules. The logic
in these cases could also apply in determining whether an LLC owner is subject to
self-employment tax on his or her share of LLC profits.
Limited Liability Partnerships
37.
LLPs and LLLPs offer greater protection to the partnership than a general or
limited partnership.
a.
In a general partnership, the partners are jointly and severally
liable for all partnership debts. In some states, the partners in LLPs or
LLLPs are jointly and severally liable for contractual liabilities. They are
not, however, personally liable for the malpractice and torts of their
partners (a partner is always personally liable for her/his own malpractice
or other torts.)
b.
LLPs and LLLPs require formal organizational documents and
must register with the state. LLPs can be formed in all states and there are
currently 20 states that recognize LLLPs.
Anti-Abuse Regulations
38.
IRS can disregard the form of a partnership transaction when it is abusive.
a.
A transaction is abusive if it satisfies two tests.
(1)
The principal purpose of the transaction is to
substantially reduce the present value of the partners’ aggregate
Federal tax liability.
(2)
The potential tax reduction must be inconsistent
with the intent of Subchapter K.
b.
If the two tests are met, the IRS will recast the transaction in a
manner that reflects the transaction’s underlying economics.
c.
The IRS will not recast transactions that have a bona fide business
purpose.