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;
-
The fair market value of other property received; and
-
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
|
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 this module. |
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:
-
The
names, addresses, and ID numbers of the transferees and transferors;
-
The
date of the exchange; and
-
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
|
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, The rules
for Sections 754 and 755 are covered later in sections b, c
and d.
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
|
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
|
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.
|
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;
-
Section
751 hot assets, and
-
other
assets (i.e., capital and Section 1231 assets).
|
Example
|
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
|
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 that 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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