Chapter 7
SALE OF AN INTEREST IN A PARTNERSHIP OR LLC
LEARNING OBJECTIVES
After completing this chapter, you should be able to do the following:
• Determine the tax consequences associated with the sale of a partner's or member's interest in a partnership or LLC.
• Determine the amount of a partner's gain from sale of a partnership interest which must be recharacterized as ordinary income under Section 751(a).
• Recognize how using the installment method to account for the sale of a partnership interest will affect how the partner will report his or her gain on the sale.
• Recognize when the sale of an interest in a partnership will trigger a technical termination of the partnership.
• Determine the tax basis and holding period of assets owned by the partnership following a technical termination.
• Determine the tax consequences associated with subsequent dispositions of built-in gain or loss assets following a technical termination.
General Tax Consequences Associated With Sale
The general tax consequences of the sale of an interest in a partnership or an LLC are relatively straightforward. The general rule under Section 741 holds that the interest itself is a capital asset, much like stock in a corporation. Accordingly, under the general rule, the partner or LLC member will recognize a capital gain or loss in an amount equal to the difference between the amount realized on the sale and the basis in the interest. Determination of whether this gain is long- or short-term is based on the partner's holding period in the partnership interest, and not on the partnership or LLC's holding period for its assets.
Example 7-1
J is a one-third partner in JDR Partners, a general partnership engaged in the real estate development business. She has been a partner for eight years. Her tax basis in her partnership interest is $100,000. In October, she sold this interest to D for $175,000. Ignoring the potential application of Section 751(a), J will recognize a $75,000 long-term capital gain on the sale, taxable at a maximum rate of 15 percent or 20 percent (depending upon J's income, and possibly subject to an additional 3.8 percent tax).
EFFECT OF LIABILITIES
When the entity has liabilities, those liabilities are allocated among the partners or members and are included in their tax basis. The purchaser's assumption of the selling partner's share of partnership or LLC liabilities must also be included in the amount realized from sale or disposition of the interest. In effect, responsibility for this portion of the entity's liabilities has been shifted to the buyer, albeit indirectly, and increases the economic benefits received by the seller from the exchange. Because a partner's share of partnership liabilities is added to both basis and the amount realized, the net effect of liabilities on gain or loss from a sale will generally be zero.
Example 7-2
A is a one-fourth partner in Alpha Partners.
His basis in his partnership interest is $125,000, consisting of his $50,000 net contribution to capital and his $75,000 share of partnership liabilities.
A plans to sell his interest in the partnership to an unrelated buyer for $200,000 cash.
The total amount realized from the sale will be $275,000 – the $200,000 cash proceeds plus the $75,000 share of partnership debt assumed by the buyer.
Thus, he will recognize a $150,000 gain on the transaction ($275,000 amount realized less his $125,000 basis). Under Section 741, if the partnership has no “hot” assets, his gain will be classified as a capital gain.
RECEIPT OF PROPERTY OTHER THAN CASH
The like-kind exchange rules of Section 1031 do not apply to the exchange of interests in partnerships or LLCs. Thus, any property other than money received by the selling partner in exchange for his or her interest in the partnership interest is included at fair market value in the amount realized from sale.
Example 7-3
L, a 20 percent partner in Windmill Partners, sold his interest in the partnership to C.
His basis in his partnership interest was $350,000, consisting of his $150,000 capital balance and his $200,000 share of partnership liabilities.
L received a cash payment of $125,000, and a tract of real estate with a tax basis of $175,000 and a fair market value of $275,000.
The real estate was not encumbered by debt of any kind.
C also assumed responsibility for L's share of partnership liabilities.
The total amount realized by L on the sale to C is $600,000, consisting of the $125,000 cash payment, the $275,000 fair market value of the real estate, and the $200,000 relief of indebtedness.
As noted, L's tax basis in the partnership interest is $350,000, so he will recognize a capital gain of $250,000 on the exchange with C.
Note that where the seller receives a promissory note from the buyer, the installment method may be used to report the gain under Section 453. Where the partnership owns depreciable property that would be subject to depreciation recapture under Sections 1245 or 1250, application of the installment method is somewhat complicated.
KNOWLEDGE CHECK
1. J is a one-third partner in JDR Partners, a general partnership engaged in the real estate development business. She has been a partner for eight years. Her tax basis in her partnership interest is $100,000, consisting of her $30,000 capital account and her $70,000 share of partnership liabilities. In October, she sold this interest to D for $115,000 cash. D assumed responsibility for J's share of partnership debt. Assume that the partnership has no “hot” assets. How much gain will J recognize as a result of the sale?
a. $0.
b. $15,000.
c. $85,000.
d. $70,000.
HOLDING PERIOD OF PARTNERSHIP INTEREST
Practitioners should be aware of Regulations Section 1.1223-3, governing the determination of the holding period of partnership interests. The regulations provide that in cases where a partner acquired his or her interest in the partnership in more than one transaction, the holding period for the partnership interest must be divided to reflect the different acquisition dates.1 Moreover, the regulations imply that each contribution of cash or property made to the partnership is to be treated as a separate transaction.
Example 7-4
R contributed $25,000 cash and a tract of real property with a tax basis of $40,000 and a fair market value of $75,000 to the QLR Partnership in exchange for a one-third interest.
R purchased the real property three years ago and has made no improvements to it since that time.
Under Section 722, R's tax basis in his partnership interest is $65,000. For purposes of determining his holding period, however, the partnership interest is treated as having been acquired at two different times. The portion of the interest obtained in exchange for the cash contribution is treated as having been acquired on the date of the contribution to the partnership, while the portion obtained in exchange for the contribution of real property will have a holding period dating back to his acquisition of the realty (three years).
For purposes of determining the portion of the partnership interest attributable to the cash contribution, the focus is on the fair value of the cash and property contributed to the partnership.
The property was valued at $75,000 at the date of the contribution. Combined with the $25,000 cash contribution, the value of the partnership interest at the date R joined the partnership was $100,000.
One-fourth (25/100) of this interest is deemed to have been acquired for cash as of the date of the contribution. Three-fourths (75/100) is deemed to have been acquired in exchange for property; the holding period of this portion includes the holding period of the property used to acquire it.
Thus, R's holding period for 3/4 of the partnership interest is three years. If R sells the partnership interest for its $100,000 fair market value within 12 months, he will recognize a $35,000 capital gain, of which one-fourth, or $8,750, will be short-term capital gain, and the remainder, $26,250, will be long-term capital gain.2
Warning: Note the inequity in example 7-4. Although the entire gain from sale of the partnership interest is attributable to the real estate contributed by the partner, one-fourth of this gain is classified as short-term capital gain (and thus is not eligible for the preferential 15 percent or 20 percent maximum tax rate). This is a significant trap for the unwary.
KNOWLEDGE CHECK
2. Six months ago, Eddie contributed $50,000 cash and a tract of real estate valued at $200,000 to Munster Productions, Ltd., a limited liability company that has elected to be treated as a partnership for federal tax purposes, in exchange for a 25 percent interest in profits and capital. Eddie's tax basis in the real estate, purchased five years ago, was $135,000. This month, Eddie sold his interest in the partnership for $300,000. How much long-term capital gain will Eddie recognize as a result of the sale?
a. $0.
b. $50,000.
c. $92,000.
d. $115,000.
Similar dangers await partners or LLC members who sell their interests within twelve months of making a capital contribution to the partnership or LLC. The regulations treat each capital contribution by a partner as a separate transaction requiring division of the partnership (or LLC) interest.
Example 7-5
K is a 20 percent partner in MoonStruck, Limited, an LLC which has elected to be taxed as a partnership.
He joined the company four years ago making an initial capital contribution of $50,000.
This year, when the company decided to begin construction of a large new apartment complex, each of the investors was required to contribute another $100,000 in capital.
Just prior to the capital contribution, the balance in K's capital account was $150,000.
Six months after making the additional capital contribution, K sold his interest in the entity to another investor, recognizing a $300,000 gain on the sale.
The $100,000 capital contribution made earlier in the year represented 40 percent of K's interest in the entity. Thus, 40 percent of his gain, or $120,000, will be classified as a short-term capital gain. The remaining 60 percent will be treated as a long-term capital gain (assuming that Section 751(a) does not apply).3
Warning: Again, example 7-5 illustrates how the provisions of the regulations under Section 1223 can result in harsh and illogical consequences for unsuspecting partners or LLC members. It is extremely important that tax advisers review all changes in partner or member capital balances over the past 12 months when advising clients about the tax consequences of planned sales.
“Hot” Assets and Section 751(a)
“HOT” ASSETS UNDER SECTION 751(A)
The tax consequences are slightly more complicated if the partnership has “hot” assets, as defined in Section 751. For purposes of Section 751(a), “hot” assets are defined as “unrealized receivables of the partnership”4 or “inventory items of the partnership.”5 Thus, these assets are essentially those that would generate ordinary income to the partnership or LLC if sold at their fair market values. Where the partnership or LLC has unrealized receivables or inventory, sale of an interest in the entity will result in some or all of the selling partner's gain being classified as ordinary income, rather than capital gain. In some rather extreme cases, the result may be ordinary income in an amount larger than the total gain realized on the sale, accompanied by a capital loss. Tax advisers need to be particularly careful to explain this potential outcome to clients who may be adversely affected by it.
Unrealized Receivables
Unrealized receivables include the right to payment for goods delivered (or to be delivered) or for services rendered (or to be rendered) to the extent that such payments would trigger ordinary income to the partnership or LLC when collected.6 Thus, accounts receivable of a cash method partnership is an example of unrealized receivables. However, the term unrealized receivables includes much more than a cash method partnership's accounts receivable. Under Section 751 (c), the following items are also treated as unrealized receivables:
• Mining property as defined in Section 617(f)(2)
• DISC stock [Section 992(a)]
• Section 1245 property to the extent that a sale at FMV would generate recapture income
• Stock in certain foreign corporations described in Section 1248
• Section 1250 property to the extent that a sale at FMV would generate recapture income
• Certain farm land described in Section 1252(a)
• Certain franchises, trademarks, or trade names referred to in Section 1253(a)
• Certain oil, gas, or geothermal property which would be subject to recapture under Sections 617(d)(1), 995(c), 1254(a) or one of the other provisions described previously, if sold by the partnership at FMV
• The ordinary income portion of market discount bonds as defined by Section 1278
• The ordinary income portion of other short-term obligations as defined in Section 1283
The most commonly encountered item of unrealized receivables is the recapture element of Section 1245 property.
Inventory Items
For purposes of Section 751(a), inventory items include the following:
• Stock in trade or other property of a kind normally included in inventory, or property held primarily for sale to customers in the ordinary course of business
• Any other property which, on sale, would be classified as property other than a capital asset or Section 1231 property
• Any other property which, if held by the selling partner directly, would be property described in any of the previous three categories.7
RULES OF APPLICATION
Mechanically, the application of Section 751 (a) is uncomplicated. To the extent that the amount realized from the sale of the partnership or LLC interest is attributable to the selling partner's share of partnership or LLC unrealized receivables or substantially appreciated inventory, it is treated as realized from the sale of ordinary income assets. Accordingly, the selling partner or member will recognize ordinary income in the same amount as would be allocated to such partner under Sections 704(b) and (c) had the partnership or LLC sold all its “hot” assets for fair market value immediately prior to sale of the partnership interest by the selling partner or member. The difference between the total gain recognized by the partner or member on sale of the interest and the ordinary income (or loss) recognized under Section 751(a) is classified as a capital gain or loss.
KNOWLEDGE CHECK
3. Cloudcroft Partners has the following assets as of the end of September:
| Basis | FMV | |
| Cash | $15,000 |
$15,000 |
| Stock portfolio | 50,000 |
100,000 |
| Inventory | 60,000 |
190,000 |
| Real estate (Section 1231 property) | 125,000 |
195,000 |
$250,000 |
$500,000 |
What is the total value of the partnership's “hot” assets for purposes of Section 751 (a)?
a. $0.
b. $190,000.
c. $290,000.
d. $500,000.
Example 7-6
Alto, Ltd., a limited liability company classified as a partnership for federal income tax purposes, had the following balance sheets as of the end of September:
| Basis | FMV | |
| Cash | $15,000 |
$15,000 |
| Inventory | 39,000 |
90,000 |
| Capital asset 1 | 56,000 |
125,000 |
| Capital asset 2 | 100,000 |
160,000 |
$210,000 |
$390,000 |
|
| Capital, D | $70,000 |
$130,000 |
| Capital, E | 70,000 |
130,000 |
| Capital, F | 70,000 |
130,000 |
$210,000 |
$390,000 |
On October 1, D sold her one-third interest in Alto to G for its $130,000 fair market value. Her tax basis in her Alto investment is $70,000. Thus, she must recognize a net gain on the sale of $60,000.
However, because Alto has appreciated inventory, a portion of this gain will be classified as ordinary income, rather than capital gain. Had the company sold its inventory for its full $90,000 fair market value, D would have been allocated $17,000 ordinary income (one-third of the total).
Thus, $17,000 of D's gain on the sale will be treated as ordinary income for tax purposes. The remainder of D's gain, $43,000 ($60,000 total gain less $17,000 ordinary income) will be classified as capital gain.
In some cases, the ordinary income triggered by sale of a partnership interest may exceed the total gain recognized on the sale. In such cases, the excess will be offset with a capital loss to the seller.
Example 7-7
Blue Hound Partners had the following balance sheets as of the end of September:
| Basis | FMV | |
| Cash | $15,000 |
$15,000 |
| Accounts Receivable | 0 |
45,000 |
| Equipment (original cost 150,000) | 45,000 |
105,000 |
| Capital assets | 180,000 |
120,000 |
$240,000 |
$285,000 |
|
| Capital, O | $80,000 |
$95,000 |
| Capital, P | 80,000 |
95,000 |
| Capital, B | 80,000 |
95,000 |
$240,000 |
$285,000 |
On October 1, O sold his one-third interest in the partnership to an unrelated buyer for its $95,000 fair market value. O's tax basis in his partnership interest was $80,000.
Thus, he realized a net gain on the sale of $15,000. Under Section 751(a), however, he must recognize as ordinary income his share of the income that would be recognized by the partnership if it sold (collected) the accounts receivable and Section 1245 property (equipment) just prior to sale of his partnership interest.
The total gain inherent in these assets is $105,000; O's share of this would be $35,000. Thus, he will recognize $35,000 in ordinary income from sale of his interest. Because his total gain was only $15,000, he will also recognize a $(20,000) capital loss.
KNOWLEDGE CHECK
4. Oakwood Partners had the following balance sheets as of the end of September:
| Basis | FMV | |
| Cash | $15,000 |
$15,000 |
| Accounts Receivable | 0 |
60,000 |
| Equipment (original cost 150,000) | 45,000 |
90,000 |
| Capital assets | 150,000 |
120,000 |
$210,000 |
$285,000 |
The partnership has no debt. JD is a one-third partner with an equal one-third interest in each of the partnership's assets. If she sells her interest in the partnership for its $95,000 fair market value, how much ordinary income will she recognize under Section 751(a)?
a. $20,000.
b. $25,000.
c. $35,000.
d. $50,000.
STATEMENT MUST BE ATTACHED TO RETURN
For any year in which a partner or LLC member sells his or her interest in a partnership or LLC that owns Section 751 property as of the date of the sale, the partner or member must attach a statement to his or her tax return setting forth separately the following information:8
• The date of the sale or exchange
• The amount of ordinary income recognized under Section 751 (a)
• The amount of capital gain or loss recognized on the sale
Collectibles and Unrecaptured Section 1250 Gain
Like partnership “hot” assets, the existence of collectibles and properties with unrecaptured Section 1250 gain within the partnership can convert what would otherwise be long term capital gain on the sale of a partnership interest into collectibles gain (subject to a maximum tax rate of 28 percent) or unrecaptured Section 1250 gain (subject to a maximum tax rate of 25 percent). Both of these types of income are subject to the 3.8 percent surtax on the net investment income of higher-income taxpayers.
COLLECTIBLES GAIN
When an interest in a partnership held for more than one year is sold or exchanged, the transferor must recognize collectibles gain in the amount of net gain (but not net loss) that would be allocated to that partner if the partnership sold all of its collectibles for cash at their fair market value immediately before the transfer of the interest in the partnership. In general, the term “collectibles” includes works of art, rugs or antiques, precious metals or gems, stamps or coins, and alcoholic beverages. Net collectibles gains are subject to the same tax rates as ordinary income, except that the tax rate on these gains can be no more than 28 percent. Note that the treatment as collectibles gain in this case depends only on the partner's holding period in the partnership interest, and not the partnership's holding period in the collectibles. If only a part of the partner's interest has a long-term holding period, or only part of the exchange of the partnership interest is taxable, only a ratable portion of the partner's share of the collectibles gain will be recognized by the partner. The collectibles gain will reduce the long term capital gain recognized by the partner on the sale of the interest, and might in fact create or increase a residual long term capital loss on the sale.
Example 7-8
The Artique partnership holds paintings worth $300,000, with a basis of $200,000.
Andy, a 25 percent partner in Artique, sells his partnership interest for $400,000. Its basis to him was $250,000, and his overall gain on the sale is $150,000.
Assuming that none of the gain from the hypothetical sale of the paintings would be specially allocated, and Andy's holding period in his partnership interest is entirely long term, he will recognize a collectibles gain of $25,000 (25 percent of $100,000).
The other $125,000 of gain he recognizes would be long-term capital gain. If his holding period in his partnership interest had been only 50 percent long term, he would recognize a short-term capital gain of $75,000, a collectibles gain of $12,500 (50 percent of $25,000), and a long-term capital gain of $62,500 ($75,000 – $12,500).
If his entire holding period was long term, but his basis was $390,000, his overall gain would be $10,000, his collectibles gain would again be $25,000, and his residual long-term capital loss would be $(15,000).
UNRECAPTURED SECTION 1250 GAIN
Generally speaking, unrecaptured Section 1250 gain is the depreciation that has been taken on real property, less the depreciation that would be recaptured as ordinary income if the asset were sold. However, unrecaptured Section 1250 gain cannot exceed the gain recognized on the sale of the asset, less the depreciation recaptured as ordinary income. Unrecaptured Section 1250 gains are subject to the same tax rates as ordinary income, except that the tax rate on these gains can be no more than 25 percent. As with collectibles gains, unrecaptured Section 1250 gains only come into play when a partner sells a partnership interest for which her holding period was long-term. When an interest in a partnership held for more than one year is sold or exchanged, the transferor is required to recognize the unrecaptured Section 1250 gain that would be allocated to that partner if the partnership sold all of its Section 1250 property at their fair market values immediately before the transfer of the interest in the partnership. If a portion of the holding period of the partnership interest is not long-term, or if the exchange of the interest was not fully taxable, only a pro rata portion of the partner's share of the unrecaptured 1250 gain will have to be recognized. As with collectibles gains, unrecaptured Section 1250 gains will reduce the long-term capital gain recognized by the partner on the sale of the interest, and this reduction can create or increase a residual long-term capital loss on the sale.
Installment Sales
The installment sale rules of Section 453 are applicable to the sale of an interest in a partnership or LLC unless the selling partner or member elects to recognize the entire gain in the year of sale. Under Section 453(a), as long as one payment (or more) is received in a tax year after the year of sale, the installment method can be used by the seller to report his or her gain. (The installment sale method does not apply when the seller realizes a loss on the transaction.)
Under Sections 453(b)(2) and 453(i)(2), however, the installment method may not be used to report gain from the sale
• Of personal property “of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year,” nor
• To the extent of the amount which would be treated as ordinary income under Section 1245 or 1250 (or so much of Section 751 as relates to Section 1245 or 1250).
Thus, the issue facing a partner or an LLC member who sells his or her interest in the entity for cash and an installment note is how to classify the sale. The IRS's position, explained in Revenue Ruling 89-108,9 is as follows:
“Under Section 453 of the Code, the income from the sale of a partnership interest may not be reported under the installment method to the extent it represents income attributable to the partnership's … inventory … which would not be eligible for the installment sale treatment if sold directly.”
In addition, there is authority to the effect that a sale of a partnership interest is not eligible for installment sale treatment to the extent of the selling partner's share of unrealized receivables from services rendered.10 As indicated previously, sale of a partnership interest would not be eligible for installment sale treatment to the extent of the selling partner's share of Section 1245 and Section 1250 recapture.11
Example 7-9
Johnson is a 20 percent partner in Wildcat Drillers, LP. The partnership has total assets with a tax basis of $600,000 and a fair market value of $1,000,000.
Included in this total is depreciable equipment with a tax basis of $250,000 and a fair market value of $300,000. The difference between the basis and value of this equipment is entirely attributable to excess depreciation deductions claimed in prior years. The partnership has no other inventory or unrealized receivables and has no debt.
Assume that Johnson sells his 20 percent interest in the partnership for its $200,000 value, receiving a cash payment of $50,000 plus a five-year $150,000 note receivable.
Further, assume that Johnson's tax basis in the interest is $120,000 (equal to his share of the partnership's inside basis in its assets).
He will recognize a total gain of $80,000, of which $10,000 (his share of the partnership's Section 1245 recapture on the equipment) will be characterized as ordinary income and will be recognized in the year of sale.
The $70,000 remainder will be characterized as long-term capital gain. Under the installment method, he will recognize 25 percent ($50,000/$200,000) of the remaining $70,000 of long-term capital gain in the year of sale. The remaining 75 percent of his taxable gain will be reported over the next five years as he receives payments on the note receivable.
Thus, in the year of sale, he will recognize $10,000 ordinary income and $17,500 ($70,000/$200,000 = 35 percent Gross Profit percent × $50,000 cash received) capital gain. The remainder of his capital gain can be reported on the installment method.
KNOWLEDGE CHECK
5. White Star, Ltd. is a limited liability company that has elected to be treated as a partnership for federal income tax purposes. Edward has a 20 percent interest in White Star profits, losses, and capital. The company had the following assets (and no liabilities) as of the end of December:
| Basis | FMV | |
| Cash | $25,000 |
$25,000 |
| Accounts Receivable | 0 |
60,000 |
| Equipment (original cost 150,000) | 45,000 |
95,000 |
| Capital assets | 200,000 |
300,000 |
$270,000 |
$480,000 |
Edward sold his entire 20 percent interest in the company to an unrelated buyer for $16,000 cash, and a five-year, 10 percent note in the amount of $80,000. Edward recognized a $60,000 taxable gain on the sale, which he plans to report under the installment method. What portion of Edward's gain is not eligible to be reported using the installment method and, therefore, must be recognized in the year of sale?
a. $10,000.
b. $12,000.
c. $22,000.
d. $60,000.
Net Investment Income Tax
Code Section 1411 imposes a net investment income tax equal to 3.8 percent of a taxpayer's net investment income. Determining whether this tax applies to the net gain recognized by a partner or LLC member upon the sale of an interest in a partnership or LLC depends on both the nature of the partner's or member's investment in the partnership or LLC and upon the type of activity(ies) conducted by the partnership or LLC. In general, the net investment income tax applies to net gain from the sale of an interest in a passive activity, regardless of the character of the gain ordinary or capital). In contrast, the net gain (or loss) recognized on the sale of an interest in a partnership or LLC in which the partner or member materially participated, or which was otherwise not classified as a passive activity under Section 469, will generally not be subject to the net investment income tax, even if all or part of the gain is classified as capital.12 Of course, to the extent that the gain is attributable to the appreciation of financial instruments or commodities held by the partnership or LLC, then such portion of the gain will be subject to the net investment income tax.13
Sale of an Active (Non-passive) Interest in a Partnership or LLC
Under Code Section 1411, the net investment income tax applies to portfolio income, other gross income from a trade or business which constitutes a passive activity to the taxpayer, and net gain from the sale of assets used in a passive activity or in the activity of selling financial instruments and/or commodities. If a taxpayer sells an interest in a partnership or LLC which is not classified as a passive activity with respect to the taxpayer, only that portion of the net gain from the sale that is attributable to Section 1411 property held by the partnership will be subject to the net investment income tax.
Section 1411 property is property held by the partnership or LLC that, if sold by the entity, would result in net gain or loss subject to the net investment income tax.14 Such property includes the following:
• Portfolio assets, including investments in commodities, held by the partnership
• Collectibles held by the partnership
• Assets owned by the partnership that are used in a trade or business that is passive with respect to the taxpayer
Example 7-10
A, a 50 percent general partner in ABC Partnership, sold her partnership interest to D, an unrelated buyer, for $460,000 cash. A's tax basis in her partnership interest was $215,000. The partnership owned the following assets at the date of the sale:
| Basis | FMV | |
| Cash | $30,000 |
$30,000 |
| Accounts receivable | 0 |
90,000 |
| Investment in collectibles | 80,000 |
120,000 |
| Section 1245 property (original cost $300,000) | 120,000 |
180,000 |
| Section 1231 property | 200,000 |
500,000 |
| Total Assets | $430,000 |
$920,000 |
ABC partnership is engaged in a trade or business activity, and A's investment in the partnership is not a passive investment under Section 469. A will recognize $245,000 gain on the sale of her interest in the partnership. Assume that A is subject to a marginal income tax rate of 35 percent. The gain on sale of her partnership interest will be taxed as follows:
| Ordinary Income | Collectibles Gain | Capital Gain | |
| Recognized gain | $45,000 |
$20,000 |
$180,000 |
| Tax rate | 35% |
28% |
20% |
| Section 1411 tax | 0 |
3.8% |
0 |
| Combined tax rate | 35% |
31.8% |
20% |
| Tax | $15,750 |
$6,360 |
$36,000 |
Because the partnership interest is not a passive activity with respect to A, only that portion of A's gain that is attributable to the partnership's Section 1411 property is subject to the net investment income tax. The investment in collectibles is the only Section 1411 property owned by the partnership. Thus, although the majority of A's gain is capital in nature, only $20,000 of the gain will be subject to the Section 1411 tax. A will owe an additional $58,110 in income taxes as a result of the sale (assuming no offsetting losses from other transactions).
Sale of a Passive Interest in a Partnership or LLC
Where the partner's interest in a partnership is classified as a passive activity under Code Section 469, the net gain recognized by such a partner from the sale of the partnership interest will be subject to the net investment income tax. This is true regardless of the character of the partner's gain on sale of the interest. Under Code Section. 1411(c) (1) (A) (iii), net investment income includes gain from the sale of property not held or used in an active (not passive) trade or business.
Example 7-11
Assume the same facts as in example 7-10, except that A was a 50 percent limited partner in ABC Partnership. Because A is a limited partner, the partnership investment is a passive activity with respect to A, and her entire gain will be subject to the net investment income tax. Assuming that A is subject to a marginal income tax rate of 35 percent, her gain from sale of her partnership interest will be taxed as follows:
| Ordinary Income | Collectibles Gain | Capital Gain | |
| Recognized gain | $45,000 |
$20,000 |
$180,000 |
| Tax rate | 35% |
28% |
20% |
| Section 1411 tax | 3.8% |
3.8% |
3.8% |
| Combined tax rate | 38.8% |
31.8% |
23.8% |
| Tax | $17,460 |
$6,360 |
$42,840 |
Because the partnership interest is a passive activity with respect to A, the entire net gain recognized on sale of the interest will be subject to the investment income tax, even that portion of the gain that is classified as ordinary income under Section 751(a). A will owe an additional $66,660 in income taxes as a result of the sale (assuming no offsetting losses from other transactions).
Potential for Termination of the Partnership
TECHNICAL TERMINATIONS UNDER SECTION 708
Section 708(b)(1)(B) of the Internal Revenue Code triggers a deemed termination of a partnership or an LLC if “within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.” The regulations under Section 708 make it clear that a so-called “technical termination” does not require that the prohibited transfer of 50 percent or more of the interests in the partnership occur in a single sale or exchange transaction. A series of unrelated sales or exchanges which, together, result in the transfer of at least a 50 percent interest in the partnership or LLC within a 12-month period will trigger a technical termination (strictly for tax purposes).
CONSEQUENCES
Treasury Regulations Section 1.708-1 provides that upon a technical termination of the partnership,
• The old partnership is deemed to have contributed all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and
• The old partnership is then deemed to have liquidated, distributing its interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their interests in the old partnership.
The regulations further provide that the taxable year of the old partnership closes on the date of the sale or exchange which triggered the technical termination.
Administrative Costs
What this means for the partnership and its remaining partners depends on the characteristics of the old partnership prior to the technical termination. In general, the primary costs are administrative, resulting in the following potential costs:
• The partnership must file two tax returns for the year of the termination – a final short-year return for the old partnership, and an “initial” short-year return for the new partnership. (The partnership's federal identification number does not change.)
• The old partnership's taxable year, method of accounting, and other elections do not carry over to the new partnership, which must make new elections of its own.
• Excess deduction carryovers under Section 704(d) may expire because the remaining partners will not be able to generate tax basis in their interests in the old partnership, from which such deductions or losses were generated.15
Although losses previously disallowed under Section 704(d) may not survive the technical termination, carryforwards under Sections 465 and 469 (at-risk and passive activity loss carryforwards) will survive, as they are specific to the underlying activity conducted by the partnership rather than to the partnership itself.
Tax Basis and Holding Period of Assets
Other characteristics of the old partnership carry over to the new partnership. For example, as noted previously, the new partnership retains the employer identification number of the old partnership. Moreover, under Section 721, the new partnership's tax basis in all property deemed contributed to it by the old partnership retains the same tax basis as such property had in the hands of the old partnership. Under Section 722, the holding period of all assets also remains the same as in the hands of the old partnership.
It is important to note that if the old partnership had a Section 754 election in effect (or chooses to make one), this election will remain in effect for the purpose of allowing the purchasing partner in the termination transaction to claim a basis adjustment under Section 743(b). However, the old partnership's Section 754 election will not apply to subsequent taxable years of the new partnership (other than the initial taxable year of such partnership, and only with respect to the purchasing partner who entered the partnership in the transaction that resulted in the technical termination).
Example 7-12
On September 1, A, a 50 percent partner in ABC Partnership, sold her partnership interest to D, an unrelated buyer.
The sale terminated ABC Partnership under Section 708(b)(1)(B). ABC, a calendar-year partnership, had a Section 754 election in effect at the date of the sale. ABC will file its final tax return reporting its income for the period January 1 – September 1.
New partnership BCD will take ABC's tax basis in its assets, stepped-up (or down) to reflect the Section 743(b) adjustment for D's benefit.
Assume that BCD does not make a Section 754 election on either its initial short-year return for the period beginning September1 or on a subsequent return. In the year following D's purchase of A's interest in the old ABC partnership, C decides to sell her 25 percent interest in BCD to partner B. Unless BCD makes an election under Section 754 in the year of C's sale, B will not be entitled to a basis adjustment under Section 743(b) because ABC's old Section 754 election does not carry over to new partnership BCD.
In many cases, partners may choose to have the old partnership make a Section 754 election on its final return, rather than having the new partnership make the election with its initial return. This way, the incoming partner receives the benefits of basis adjustments under Section 743(b) without restricting the flexibility of the new partnership in subsequent transactions.
Built-in Gains and Losses
Regulations Section 1.704-4(a)(4)(ii) provide that Section 704(c) built-in gains and losses of the old partnership carry over to the new partnership. Built-in gains will not be increased as a result of the termination of the old partnership and formation of the new one, even if the property of the old partnership has increased in value. That is, the contribution of property by the old partnership to the new one does not create built-in gain or loss under the provisions of Sections 704(c) or 737. Only Section 704(c) gains or losses inherent in the old partnership's balance sheet as of the date of the termination carry over to the new partnership. The incoming partner, however, does step into the shoes of the selling partner with respect to Section 704(c). Thus, in many cases, it may be especially important that the incoming partner be protected by having either the old or new partnership make an election under Section 754.
Example 7-13
Wilson Properties, a calendar-year general partnership, has the following balance sheets at August 30:
| Tax Basis | Book Value | |
| Cash | $15,000 |
$15,000 |
| Property 1 | 75,000 |
225,000 |
| Property 2 | 100,000 |
100,000 |
$190,000 |
340,000 |
|
| Capital, J | $20,000 |
$170,000 |
| Capital, D | 85,000 |
85,000 |
| Capital, R | 85,000 |
85,000 |
$190,000 |
$340,000 |
Property 1 was contributed by partner J and the $150,000 built-in gain inherent in that property will be allocable to partner J under Section 704(c) when realized. On August 30, property 1 was valued at $300,000, and property 2 was valued at $200,000. J, a 50 percent partner, sold her interest in the partnership to Q for $257,500 cash.
The sale of J's interest to Q will trigger a technical termination of Wilson Properties. Old Wilson Properties will be deemed to have transferred all its assets to new Wilson Properties in exchange for a partnership interest therein. Old Wilson Properties then terminates, distributing the interests in new Wilson Properties to partners Q, D and R. The aggregate tax basis of new Wilson Properties' assets remains $190,000, the same as before the technical termination. Although property 1 has appreciated by another $75,000 over its Section 704(b) book value, the Section 704(c) gain inherent in this property remains $150,000 and will be allocated to new partner Q when realized by the partnership (whether through sale, depreciation, and so forth). Property 2 has also appreciated in value relative to its Section 704(b) book value; however, none of this appreciation is subject to Section 704(c). The deemed contribution of this property by old Wilson Properties to new Wilson Properties is not treated as a contribution of appreciated property to a partnership for purposes of Section 704(c).
KNOWLEDGE CHECK
6. Mountain West is a partnership in the real estate development business. The company, which uses the calendar-year, had the following assets (and no liabilities) as of the end of June when Linda sold her 30 percent interest in partnership capital and profits.
| Basis | FMV | |
| Cash | $25,000 |
$25,000 |
| Unimproved Realty | 150,000 |
250,000 |
| Improved Realty (cost 450,000) | 300,000 |
600,000 |
| Other Assets | 125,000 |
325,000 |
$600,000 |
$1,200,000 |
On October 31, another partner, Carol, sold her 25 percent interest in capital and profits. Carol was not the partner who purchased Linda's interest. Which of the following statements is true?
a. The partnership will be deemed to terminate upon sale of Carol's interest, and the $600,000 built-in gain inherent in its balance sheet will be recognized on the old partnership's last tax return as if all its assets had been sold for fair market value.
b. The partnership will be deemed to terminate upon sale of Carol's interest, and the old partnership will be required to file a partnership return for the period of January 1 – October 31.
c. The partnership will be deemed to terminate as of October 31, and any “hot” assets held by the partnership will be deemed to have been sold as of that date.
d. The partnership will recognize built-in gain to the extent of the sale of Linda's 30 percent interest at the time her interest was sold.
7. Which of the following characteristics does not transfer from the old partnership to the new one following a technical termination under Section 708(b)(1)(B)?
a. The old partnership's federal identification number.
b. Tax elections made by the old partnership.
c. Built-in gains inherent in partnership assets subject to Section 704(c).
d. The book and tax capital accounts of the continuing partners.
WHAT CONSTITUTES A SALE UNDER SECTION 708?
It is important to note that a technical termination is triggered whenever at least 50 percent of the aggregate interests in profits and capital are transferred within any 12-month period. The sales or exchanges do not have to occur within a single taxable year to trigger these provisions. They do, however, have to represent different interests in the partnership. For example, the regulations provide that if a partner A sells a 30 percent interest in capital and profits to new partner F, and new partner F subsequently sells that same 30 percent interest to partner M, the two sales taken together constitute the sale of a 30 percent interest in partnership capital and profits (rather than 60 percent).
KNOWLEDGE CHECK
8. Mabel sold a 30 percent interest in the capital and profits of a partnership to Burl on November 1, 2006. On February 1, 2007, Burl sold this interest to Mario. Assume no other transfers of an interest in this partnership. Which of the following statements is true?
a. Burl's sale of the interest will trigger a technical termination of the partnership under Section 708(b)(1)(B).
b. If Burl had sold the interest to Mario before year-end, it would have triggered a technical termination of the partnership, but because the two transactions occurred in separate taxable years, the provisions of Section 708(b)(1)(B) are not triggered.
c. Burl's sale of the interest to Mario will trigger a technical termination unless Mario is related to either Burl or Mabel.
d. The sale of the same interest twice only counts as one transfer and does not trigger a technical termination.
Regulations Section 1.708-1(b)(2) clarifies that a sale or exchange does not have to occur outside the existing group of partners to trigger a termination – sale to another partner is treated as a sale or exchange. In contrast, liquidation of a partner's interest in exchange for a distribution of cash or property is not treated as a sale or exchange, nor is admission of a new partner to the partnership in exchange for a contribution of property under Section 721.
Sale of an interest in an upper-tier partnership (a partnership owning an interest in another partnership) is not treated as a disposition of an interest in the profits and capital of a lower-tier partnership (a partnership an interest in which is owned by the upper-tier partnership) unless such sale terminates the upper-tier partnership. If the upper tier partnership is terminated as a result of the sale or exchange of an interest therein, the upper-tier partnership is treated as having sold or exchanged its entire interest in the capital and profits of the lower-tier partnership. Thus, for example, sale of a 50 percent interest in a partnership that holds a 30 percent interest in another partnership will result in the deemed sale or exchange of a 30 percent interest in the lower-tier partnership (as the upper-tier partnership transfers its interest in the lower-tier partnership to a new upper-tier partnership).
Although the regulations explicitly provide that the transfer of a partnership interest by gift, bequest, or inheritance is not treated as a sale or exchange of that interest, this result may be partially overridden if the partnership holds debt. Assumption by the donee of the donor's share of partnership debt in connection with a gift may be recharacterized as a partial sale of the donated interest.16 Other transactions that may constitute a sale include
• Taxable and tax-free exchanges of a partnership interest,
• Contribution of a partnership interest to a corporation17 or to another partnership,18 and
• Distribution of a partnership interest from a corporation or from another partnership.19
KNOWLEDGE CHECK
9. Pete exchanged his 50 percent interest (capital and profits) in Roth Partners for a 30 percent interest in Edelburgh Partnership. Which of the following statements is true?
a. If the two partnerships are engaged in the same type of business, the exchange may be treated as a nontaxable Section 1031 exchange.
b. The exchange will terminate Roth Partners under Section 708(b)(1)(B).
c. The exchange will terminate Edelburgh Partnership under Section 708(b)(1)(B).
d. Roth Partners will not terminate because a termination of 50 percent or less of a partnership's interest will not cause a technical termination of the partnership.
Partnership Agreement: Restrictions on Sale of Interest
Because of the administrative costs and other potential consequences to the partners, it is not uncommon for a partnership or LLC agreement to include restrictions on the sale or transfer of interests by a partner or member. An example of such a provision is as follows:
"Notwithstanding any other provision of this Agreement, no Limited Partner may assign or otherwise transfer all or any part of its interest in the Partnership, and no attempted or purported assignment or transfer of such interest shall be effective, unless after giving effect thereto, the aggregate of all the assignments or transfers by the Partners of interests in the Partnership within the 12 month period ending on the proposed date of such assignment or transfer would not equal or exceed 50 percent of the total interests of the Partners in the capital or profits of the Partnership, and such assignment or transfer would not otherwise terminate the Partnership for the purposes of Section 708 of the Code."
Note that a sale that violates such an anti-assignment provision in the partnership agreementmay still be counted as a sale for purposes of Section 708(b)(1)(B) unless the partnership can demonstrate that the sale was nullified as a result of the contractual prohibition imposed by the partnership agreement.
Consequences to the Purchaser
Under Section 742, the buyer will take a tax basis in the purchased interest equal to the amount paid for it. However, because the partnership or LLC is not directly involved in the transaction, in the absence of a Section 754 election, the buyer's capital balance on the partnership's books and records will not reflect the amount he or she paid for the interest. Instead, the capital balance of the seller will transfer over to the buyer. This creates the potential that the seller's share of the appreciation or depreciation inherent in partnership or LLC assets prior to the sale will be taxed to the buyer in a subsequent year, even though the buyer presumably paid fair market value for his or her share of these assets.
Example 7-14
Q is a one-third owner of RQJ Ltd., a limited liability company taxed as a partnership for federal income tax purposes.
Her capital balance in RQJ is $165,000, and her share of the LLC's liabilities is $135,000. Her tax basis in her LLC interest is $300,000, and that is also her share of the basis of the partnership assets.
In October, she sold this interest to D for $250,000 cash. D assumed responsibility for her share of the LLC's debts. Thus, the total selling price for the LLC interest is $385,000.
Assuming the LLC has no “hot” assets, Q will recognize an $85,000 capital gain on the sale. D will take a tax basis of $385,000 in the newly acquired interest. Her capital account in the LLC's books and records, however, will remain $165,000.
Likewise, unless the LLC has a Section 754 election in effect (or chooses to make one), D's share of RQJ's inside basis will be $300,000, carried over from Q.
KNOWLEDGE CHECK
10. Jenkins Partnership had the following assets just prior to a technical termination triggered by sale of a 75 percent interest in partnership capital and profits:
| Basis | FMV | |
| Cash | $25,000 |
$25,000 |
| Unimproved Realty | 150,000 |
250,000 |
| Improved Realty (cost $450,000) | 300,000 |
600,000 |
| Other Assets | 125,000 |
325,000 |
$600,000 |
$1,200,000 |
What will be the new Jenkins Partnership's tax basis in its assets?
a. $600,000.
b. $900,000.
c. $1,200,000.
d. $150,000.
As discussed in chapter 6, the Code allows a partnership or LLC to alleviate the potential tax burden subsequently borne by the buyer in such situations. If the partnership has a Section 754 election in effect, or chooses to make one, the incoming partner will be entitled to adjust his or her share of the basis of partnership assets to reflect the price paid for them.
KNOWLEDGE CHECK
11. Assume the same facts as the previous question. Further assume that Jenkins Partnership had no Section 704(c) assets prior to the termination. Which of the following statements is true?
a. The technical termination will cause appreciated assets to be treated as Section 704(c) assets following their transfer to the new Jenkins Partnership.
b. The technical termination will not cause appreciated assets to be treated as Section 704(c) assets following their transfer to the new Jenkins Partnership unless those assets were already subject to the provisions of Section 704(c).
c. If any of the assets of the old Jenkins partnership constituted Section 704(c) property, they will be revalued for purposes of applying Section 704(c) to the new Jenkins Partnership.
d. None of the previous statements is true.