Dispositions of Partnership Interests and Partnership Distributions
Dispositions of Partnership Interests and Partnership Distributions
Determine the tax consequences to the buyer and seller of the disposition of a partnership interest, including the amount and character of gain or loss recognized.
Sellers are primarily concerned about their realized and recognized gain or loss on the sale of their partnership interest.
Sellers' debt relief is included in the amount realized from the sale.
Buyers' main tax concerns are determining their basis in the partnership interest they acquire and their inside bases of the partnership assets.
A buyer's outside basis after an acquisition is generally his cost plus his share of partnership liabilities. A buyer's inside basis is generally the same as the seller's inside basis at the sale date.
The sale of a partnership interest does not generally affect a partnership's inside basis.
A partnership's tax year closes for the selling partner upon the sale of a partnership interest.
Hot assets include unrealized receivables and inventory items.
Unrealized receivables include the rights to receive payment for goods delivered or to be delivered, or services rendered or to be rendered, as well as items that would generate ordinary income if the partnership sold the asset for its fair market value, such as depreciation recapture.
There are actually two definitions of inventory items. The first under §751(a) applies to sales of partnership interests and includes all classic inventory items and assets that are not capital or §1231 assets. The second definition of inventory [§751(b)] applies primarily to distributions and includes only substantially appreciated inventory.
Sellers classify gains and losses from the sale of partnership interests as ordinary to the extent the gain relates to hot assets.
Hot assets are also important to determine whether a distribution is proportionate or disproportionate.
List the reasons for distributions, and compare operating and liquidating distributions.
Distributions from a flow-through entity are one mechanism to return business profits or capital to the owners of the entity.
Distributions may also be used to liquidate an owner's interest in the business or to completely terminate the business.
Operating distributions include distributions in which the owner retains an interest in the business.
The purpose of liquidating distributions is to terminate an owner's interest in the business.
Determine the tax consequences of proportionate operating distributions.
Partnerships do not generally recognize gain or loss on the distribution of property.
Most operating distributions do not result in gain or loss to the partner receiving the distribution. Gains and losses are deferred through basis adjustments to the distributed assets and basis of the partnership interest.
A partner recognizes a gain from an operating distribution if she receives a distribution of money that exceeds the basis in her partnership interest.
Partners never recognize losses from operating distributions.
Determine the tax consequences of proportionate liquidating distributions.
The tax issues in liquidating distributions are primarily twofold: (1) determining whether the liquidating partner recognizes a gain or loss, and (2) allocating the liquidating partner's basis in her partnership interest to the distributed assets.
A partner recognizes a gain only when the partnership distributes more money than her basis in the partnership interest.
A partner recognizes a loss only when the partnership distributes cash and hot assets and the partner's basis in the partnership interest is greater than the sum of the bases of the distributed assets.
In all other cases, a partner does not recognize gains or losses from a liquidating distribution; rather, she will simply reallocate her basis in the partnership interest to the distributed assets.
The key to the allocation process is to focus on two factors: (1) the type of property distributed, and (2) whether the total basis in distributed assets is larger or smaller than the partner's basis in the partnership interest.
The character of the distributed assets usually stays the same to the partner as in the partnership.
Explain the significance of disproportionate distributions.
Disproportionate distributions occur when the assets distributed in either operating or liquidating distributions do not represent the partner's proportionate share of the partnership's hot and cold assets.
A disproportionate distribution causes a shift in the proportion of ordinary income and capital gain income from the partnership. Therefore, the rules require the partner to treat a disproportionate distribution as a sale or exchange.
If a partner receives more cold assets than her proportionate share in a distribution, she will generally recognize ordinary income in an amount equal to the appreciation of hot assets not distributed to her. If a partner receives more hot assets than her proportionate share, she will recognize capital gain equal to the appreciation of cold assets not distributed to her.
The disproportionate distribution rules ensure that partners cannot convert ordinary income into capital gain through distributions.
Explain the rationale for special basis adjustments, determine when they are necessary, and calculate the special basis adjustment for dispositions and distributions.
Discrepancies between a partner's inside and outside basis may cause a partner to be overtaxed or undertaxed, at least temporarily. Special basis adjustment rules allow the partnership to eliminate discrepancies between inside and outside bases to correct the artificial income or loss at the partnership level.
Basis discrepancies may occur following the acquisition of a partnership interest and following distributions where a partner receives more or less than her share of the inside basis in the partnership property.
When a new investor purchases a partnership interest, she may make a special basis adjustment equal to the difference between her outside basis and her share of inside basis if the partnership has a §754 election in effect.
A special basis adjustment is mandatory even without a §754 election in effect when a partner sells a partnership interest and the partnership has a substantial built-in loss at the time of the sale.
When a partner recognizes a gain from a distribution or takes a basis in distributed property less than the partnership's basis in the property, the partnership will have a positive special basis adjustment to increase the partnership asset bases.
When a partner recognizes a loss from a liquidating distribution or takes a basis in distributed property greater than the partnership's basis in the property, the partnership will have a negative special basis adjustment to decrease the partnership asset bases.