Disposition of a Partnership Interest

1
Disposition of a Partnership Interest
2
Todays Agenda

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

3
Disposition of a Partnership Interest
There are numerous ways a partner can dispose of
an interest in a partnership Can you name a few?
4
Disposition of a Partnership Interest Some
Examples

• Sell to another person or the partnership
• Gift
• Retirement
• Liquidation of the partnership
• Incorporation of the partnership
• Charitable contribution

5
Disposition of a Partnership Interest

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

6
Sale of a partnership interest
Economically, is there any difference between a
sale to the partnership and a liquidating
distribution from the partnership?

• Yes
• No

7
Sale of a partnership interest
Tax-wise is a sale to the partnership the same as
a liquidating distribution from the partnership?

• Yes
• No

8
Answers
Economically, is there any difference between a
sale to the partnership and a liquidating
distribution from the partnership? Answer a. No
Tax-wise is a sale to the partnership the same as
a liquidating distribution from the partnership?
Answer b. No

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

9
General Rules Section 741

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

10
Advance or Draw
Assume Peter sold his partnership interest for
100,000 to Tom. Peters adjusted basis in his
partnership interest is 36,000. Included in his
basis is his share of partnership liabilities of
6,000. How much gain or loss will Peter
recognize on the sale of his partnership interest?

• 64,000
• 70,000
• 100,000
• 0

11
Answer
. Answer b. 70,000

• The amount realized on the sale of a partnership
  interest must always include the partners share
  of liabilities. In this case the amount realized
  is the 100,000 cash received from Tom plus the
  relief of Peters share of partnership
  liabilities of 6,000.
• Therefore, the gain is 106,000 36,000
  70,000

12
Important Issues

• What interest is being sold?
• Must check to see if the complete interest or
  only a partial interest is being sold
• Must also check what type of interest is being
  sold if the partner is both a general partner and
  a limited partner
• In this case the partner has a single capital
  account and basis must be prorated between the
  two types of interest

13
Important Issues

• A sale of a partnership interest can cause a
  Section 708 termination of the partnership if
  more than 50 of the profits and capital interest
  is transferred within a 12-month period
• A sale always terminates the partnerships year
  for the selling partner
• The partner must adjust his basis in the
  partnership interest by his share of the
  partnerships income or loss to the date of sale

14
Basis Determination
Kate sold her one-fourth interest in JKLM this
year on July 31st. The partnership had earned
240,000 as of that date, however, it expects to
loose 60,000 over the next five months. Kates
adjusted basis at the beginning of the year was
40,000. What is her adjusted basis when she
sold her partnership interest?

• 40,000
• 85,000
• 100,000
• None of the above

15
Answer
Kate sold her one-fourth interest in JKLM this
year on July 31st. The partnership had earned
240,000 as of that date, however, it expects to
loose 60,000 over the next five months. Kates
adjusted basis at the beginning of the year was
40,000. Answer c. 100,000

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

16
Other Issues to Consider - Seller

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

17
Other Issues to Consider - Buyer

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

18
Determination of Basis and Gain Part I
At the beginning of the year Susan had a basis in
her partnership interest of 40,000 (this amount
includes her share of partnership liabilities of
8,000). During the year she sold her 1/3
interest to Kim for 50,000. Before the sale the
partnership had an operating loss of 12,000 for
the year.
How much gain or loss does Susan recognize on the
sale? Why?
19
Answer

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

20
Determination of Basis and Gain Part II
At the beginning of the year Susan had a basis in
her partnership interest of 40,000 (this amount
includes her share of partnership liabilities of
8,000). During the year she sold her 1/3
interest to Kim for 50,000. Before the sale the
partnership had an operating loss of 12,000 for
the year.
What is Kims basis in her partnership interest
after the purchase?
.
21
Answer

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

22
Agenda

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

23
Sale of a Partnership Interest with Section 751
assets

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

24
Section 751 Assets

• Section 751 assets are referred to as hot
  assets
• Hot Assets include unrealized receivables and
  inventory
• Included in unrealized receivables are cash basis
  A/R and depreciation recapture

25
Question

• Does Section 751(a) Apply?
• Libby sells her partnership interest to Susan
  for 45,000 in cash. The partnership is a
  service partnership that only has cash and cash
  basis accounts receivables for assets. Does
  Section 751(a) apply to this sale?
• a. Yes
• b. No

26
Answer

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

27
Sale of a Partnership Interest with Section 751
Assets

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

28
Gain on Sale of Section 751 Assets

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

29
Section 741 Gain

• The amount of gain or loss under Section 741 is
  the difference between the total gain or loss and
  the amount reported under Section 751.
• The gain or loss under Section 741 is capital.
• It is possible to have a Section 751 gain and a
  Section 741 loss or vice versa

30
Case Study 1 Dispositionof a Partnership
Interest
31
Case 1 Issues

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

32
Case 1 Scenario A

• Section 751(a) does apply to this transaction
  because the partnership owns inventory which is a
  Section 751 asset.
• Susans total gain on the sale is 6,700.
• Sales Price Cash 17,200 Relief of
  Liabilities 7,000 24,200
• Adjusted Basis Capital 10,500 Share of
  Liabilities 7,000 17,500
• Total Gain 24,200 17,500 6,700

33
Case 1 Scenario A

• Susans Section 751 gain is
• FMV of Section 751 Assets 9,600
• Pship basis of Section 751 Assets 7,500
• Total Gain 2,100
• Susan Share of 751 Gain 700
• Susans Section 741 Gain Total Gain Section
  751 Gain
• 6,700 - 700 6,000

34
Case 1 Scenario B

• Section 751(a) would apply to this transaction
  because the partnership has cash basis accounts
  receivable
• Alices amount realized on the sale is Cash of
  15,000 Debt Relief of 1,000 16,000
• Her adjusted basis is Capital of 9,000 Share
  of Debt 1,000 10,000
• The total gain without Section 751(a) is 6,000.

35
Case 1 Scenario B

• The total Section 751(a) gain would be
• FMV of A/R 14,000
• Basis of A/R 0
• Section 751(a) Gain 14,000
• Alices share of the Section 751(a) gain would be
  7000.
• Alice would have a Section 741 loss of 1,000.
  Total gain of 6,000 less Section 751(a) gain of
  7,000.

36
Agenda

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

37
Which transfer would generally be a nontaxable
exchange of a partnership interest?

• Transfer to a corporation
• Retirement
• Like-Kind Exchange
• Abandonment

38
Answer
Answer a. Transfer to a corporation

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

39
Transfer of a Partnership Interest to a
Corporation

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

40
Converting a Partnership Interest

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

41
Abandonment of an Interest
Mark has a 25 interest in a partnership. His
basis in his interest is 20,000 consisting of
his 15,000 capital account and his share of
partnership liabilities of 5,000. How much gain
or loss will Mark recognize if he abandons his
interest? What is the character of the gain or
loss?
42
Answer

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

43
Like-Kind Exchange of a Partnership Interest

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

44
Case Study 2 Taxable vs. Nontaxable Transfers
45
Case 2 Issues

• Abandonment of a partnership interest can result
  in a gain or loss. The gain or loss is capital.
• A like-kind exchange of a partnership interest is
  a taxable transaction.
• If the requirements of Code Section 351 are met
  the contribution of a partnership interest to a
  corporation is nontaxable. An exception applies
  if liabilities transferred exceed the basis of
  the partnership interest.

46
Case 2 Scenario A

• The abandonment of a partnership interest is an
  exchange of the partnership interest for the
  deemed cash distribution (relief of liabilities).
  In this case Debbie would have a 15,000 loss
  (25,000 debt relief - 40,000 basis) on the
  abandonment of her partnership interest. The
  loss would be a capital loss.
• In this case the amount of debt relief is more
  than her basis in the partnership interest. Thus
  Debbie would have a gain on the abandonment of
  15,000 (25,000 debt relief - 10,000 basis).
  The gain would be capital.

47
Case 2 Scenario B

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

48
Case 2 Scenario C

• Section 1031 does not apply to an exchange of
  partnership interest based on Section
  1031(a)(2)(D). The transfer would be treated as
  a taxable exchange.
• Laura would have to recognize a gain of 20,000
  on this transfer. The gain is computed by
  determining the amount realized (100,000 FMV of
  property received 50,000 debt relief - 50,000
  assumption of debt 100,000) less adjusted basis
  (30,000 capital 50,000 share of debt
  80,000).

49
Agenda

• General rules governing the transfer of a
  partnership interest
• Rules regarding Section 751 assets
• Taxable vs. Nontaxable Transfers
• Section 754(b) Basis Adjustments
• Payments to Retiring Partners under Section 736

50
When does it apply?

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

51
Section 754 Election

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

52
Rules for making the Adjustment

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

53
Section 743(b)

• Partner specific
• Adjustment not made on the partnerships books
  off balance sheet adjustment

54
Amount of Adjustment

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

55
Section 743(b) Regulations

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

56
Section 743(b) Regulations

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

57
Example 1

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

58
Adjustment under Section 743(b)

• Purchase price was 300. Under the hypothetical
  transaction is as if X bought ½ of each asset
• Sales Price Cost Gain
• Inventory 100 50 50
• Land 200 50 150

59
Allocating the Adjustment

• Section 755 governs the allocation
• Allocated First between two classes of assets
• Capital (including 1231)
• Noncapital
• Does not affect partnership books

60
Example

• Asset Basis FMV Gain Share
• Cash 100 100
• Stock 100 300 200 100
• Machinery 50 100 50 25
• Building 200 500 300 150
• Inventory 80 140 60 30
• A/R 70 60 (10) (5)
• Goodwill 0 300 300 150

61
Allocation Problem

• Partner sold 50 interest for 750.
• Gain on sale is 450.
• Allocation between capital and non-capital assets
  based on the income and gain allocated to the
  partner

62
Allocation Problem

• Ordinary income is from inventory, accounts
  receivable and depreciation recapture 30-525
  50.
• Capital gain is from other assets 100150150
  400

63
Allocation

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

64
Adjustments from Distributions

• Section 734(b) applies
• Affect the common partnership property

65
Allocation under Section 755

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

66
Allocation under Section 755

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

67
Agenda

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

68
Payments made to a Retiring Partner

• Section 736 governs the payments made to a
  retiring partner
• Section 736 divides all payments into two classes
• Section 736(a) payment not for the partners
  interest in partnership property and
• Section 736(b) payments for the partners
  interest in partnership property
• Section 736 makes a distinction between
  distributions to general partners of service
  partnerships and all other distributions

69
Payments made to a Retiring Partner

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

70
Payments to a Retiring Partner
To induce a partner to retire the partnership
will pay him 100,000 at a time when the value of
his partnership interest is 25,000. Does
Section 736 apply to this distribution? If so,
how much of the payment is a Section 736(a)
payment and how much is a Section 736(b)
payment?
71
Answer

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

72
Answer

• In this case, 75,000 was not for the partners
  interest in partnership property, so it is a
  Section 736(a) payment. Since the amount is
  fixed in amount it is deemed a guaranteed
  payment.
• The remainder, 25,000, is a Section 736(b)
  payment treated as a distribution.

73
Payments by Service Partnerships to General
Partners

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

74
Payment to a Retiring Partner
A partner withdraws from a partnership, receiving
a 35,000 cash payment. He is a general partner
in a service partnership. 10,000 of the payment
is for his share of unrealized receivables and
5,000 is for unstated goodwill. How is the
distribution to the partner treated under Section
736? What is the tax effect to the retiring
partner and to the remaining partners?
75
Answer

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

76
Answer

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

77
Case Study 3 Payments to Retiring Partners
78
Case 3 Issues

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

79
Case 3 Scenario A

• Kevin is deemed to have received a payment of
  30,000 consisting of the 25,000 cash payment
  plus the 5,000 debt relief.

80
Case 3 Scenario A

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

81
Case 3 Scenario A

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

82
Case 3 Scenario A

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

83
Case 3 Scenario B

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

84
Case 3 Scenario B

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