Today, I’m going to finish looking at a basic view of US partnership taxation by giving a general overview of selling the partnership interest.
As with all sales transactions, we start with section 1001(a) which states:
The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
This is a straightforward proposition and concept for anyone who’s ever been involved with any transaction.
Next, we turn to the partnership subchapter; specifically referencing sections 741 and 751. We start with section 741, which states:
In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).
This means the sale of the partnership interest is subject to capital gains tax rates. However, this does not apply to the selling partners proportionate share of partnership inventory and accounts receivable, which must receive ordinary income treatment under 751:
The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to—
(1) unrealized receivables of the partnership, or
(2) inventory items of the partnership,
shall be considered as an amount realized from the sale or exchange of property other than a capital asset.
Finally, if the partner is relieved of his proportionate share of partnership liabilities, this amount must be considered as money received by the partner in exchange for his interest under 752(d):
In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.
That ends this look at US Partnership tax. If you have any questions about this very complex section of the tax code, please call us at 832.330.4101.
Basis is one of the most important concepts in tax, as it is used to determine gain or loss from the sale of an asset (see generally sections 1001-1016). The partnership tax rules are no different. When a partner contributes property to a partnership, the basis of the contributed property becomes the partner’s basis in his partnership interest:
The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721 (b) to the contributing partner at such time.
Like other business formation sections of the code, the creation of the new business entity leads to deferred recognition of gain from the contributed property, largely to encourage the formation of new businesses. So, assume a partner has a basis of $100 in contributed property. That basis could carry over to his partnership interest.
Lets’ add another wrinkle to the discussion and discuss the effect of liabilities on the partner’s basis. The partnership tax code distinguishes between recourse and non-recourse liabilities. “A liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section 1.752-2. (Treas. Reg. 1.752-1(a)(1)). Section 752 of the Treasury Regulations uses a method called a “constructive liquidation” to determine a partner’s responsibility for a liability. In this calculation the following events happen:
(i) All of the partnership's liabilities become payable in full;
(ii) With the exception of property contributed to secure a partnership liability (see § 1.752-2(h)(2)), all of the partnership's assets, including cash, have a value of zero;
(iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors's right to repayment is limited solely to one or more assets of the partnership);
(iv) All items of income, gain, loss, or deduction are allocated among the partners; and
(v) The partnership liquidates
Basically, the calculations assume the worst possible economic situation happens: namely, that the partnership suddenly has absolutely no assets and the partners are on the hook for the entire amount of the liabilities. To fast forward to the end, “In this context, “economic risk of loss” is a proxy for loss allocations. (Taxation of Partnerships and Partners, Mckee, Nelson and Whitmire, ©2008 RIA, 8.03(1)).
In contrast to recourse liabilities are non-recourse liabilities which are liabilities that are “nonrecourse to the extent that no partner or related person bears the economic risk of loss for that liability under 1.752-2. (Treas. Reg. 1.752-1(a)(2)). Before explaining these rules, a bit of history is in order. In the 1970s, tax shelters marketed to high net worth individuals commonly used limited partnership that were loaded up with non-recourse liabilities (and a minimal initial contribution of cash), which were in turn, usually structured in such a way that the partnership never really paid on them. For example, a partnership would require a cash contribution of $10,000 from a limited partner while taking out a $1 million dollar non-recourse loan that was essentially structured with a massive balloon payment that would occur far after the useful life of the partnership was over. The reason for this was to inflate the partner’s basis, thereby allowing him to take a large amount of deductions for minimal capital input. Therefore, the non-recourse allocations were changed “so as to reflect the manner in which partners share partnership profits. (Taxation of Partnerships and Partners, as above)”
Again, please remember this is a general introduction to partnership tax; there are numerous nuances to this section of the tax code that are far beyond the points listed above. Should you have any questions, please call us at 832.330.4101. And, as always, this is not any specific legal advice for anyone reading this.
One of the greatest benefits of a partnership tax structure is the ability to have disproportionate allocations. For example, suppose A and B form an equal partnership -- that is, they each receive 50% of the partnership's profits and losses. However, the partnership uses a disproportionate allocation method. Partner A could really use the actual income while partner B doesn't need it. Under this situation it's possible to allocate 90% of the income to partner A and 10% to partner B. However, these allocations must also be "substantial" -- a term of art used in partnership tax which is fleshed out in the accompanying Treasury Regulations.
A word of caution: substantial partnership allocations are perhaps one of the most complex areas of tax law. What follows is a brief explanation of this concept. In reality, this section of the code requires many pages to explain its nuances (my "learned treatise" collection of this concept extends to literally hundreds of pages). With that being said, here is the central concept of "substantiality."
Except as otherwise provided in this paragraph (b)(2)(iii), the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement.
Let's translate the above statement into English. Conceptually, think of each potential allocation being a see-saw. When a partner receives more of something, the other partners must receive less. So, in our examples above, when partner A receives 90% of the partnership's income, Partner B receives 10%. This allocation substantially effects the two partners' allocations. In addition, the allocation passes the second test as Partner A has receives more benefits while Partner B's situation is substantially diminished (he's receiving less income).
Again, it's important to remember there are many nuances to this concept that are far beyond a blog post. However, the see-saw analogy helps to convey the basic concept. If you have any additional questions, please call us at 832.330.4101.
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