As we’ve seen in preceding chapters, owners of various business entities receive returns on their investments, either when the business makes distributions or upon the sale of their business interest. Corporate shareholders may sell their stock to other investors or back to the corporation. Likewise, partners may dispose of their interest in several ways: sell to a third party, sell to another partner, or transfer the interest back to the partnership. The pay- ments in a disposition (sale) can come from either another owner of the partnership or a new investor; in either case, the sale proceeds come from outside the partnership.
Selling a partnership interest raises unique issues because of the flow-through na- ture of the entity. For example, is the interest a separate asset, or does the disposition represent the sale of the partner’s share of each of the partnership’s assets? (See the Form- ing and Operating Partnerships chapter for a discussion of the entity and aggregate ap- proaches to taxation of flow-through entities.) To the extent the tax rules follow an entity approach, the interest is considered a separate asset and a sale of the partnership interest is very similar to the sale of corporate stock. That is, the partner simply recognizes capital gain or loss on the sale, based on the difference between the sales price and the partner’s tax basis in the partnership interest.
Alternately, to the extent the tax rules use the aggregate approach, the disposition represents a sale of the partner’s share of each of the partnership’s assets. This approach adds some complexity because of the differing character and holding periods of the part- nership assets—ordinary, capital, and §1231. The selling partner also has the additional task of allocating the sales proceeds among the underlying assets in order to determine the gain or loss on each.
Rather than strictly following one approach, the tax rules end up being a mixture of the two approaches. When feasible, the entity approach controls; however, if the result distorts the amount or character of income, then the aggregate approach dominates. We discuss the tax consequences of sales of partnership interests by first taking the perspective of the seller (partner), followed by a discussion from the perspective of the buyer (new investor).
LO 21-1
Seller Issues
The seller’s primary tax concern in a partnership interest sale is calculating the amount and character of gain or loss on the sale. The selling partner calculates the gain or loss as the difference between the amount realized and her outside basis in the partnership.1 Because the selling partner is no longer responsible for her share of the partnership liabil- ities, any debt relief increases the amount the partner realizes from the sale under general tax principles.
Example 21-1
Last year, Chanzz Inc. sold its 30 percent interest in CCS on June 30 to Greg Randall, a wealthy local businessman, to limit its exposure to any further losses. Greg anticipated that CCS would be- come profitable in the near future and paid Chanzz Inc. $100,000 for its interest in CCS. Chanzz’s share of CCS liabilities as of June 30 was $24,000. Chanzz Inc.’s basis in its CCS interest at the sale date was $105,000 (including its share of CCS’s liabilities). What amount of gain did Chanzz recognize on the sale?
Answer: $19,000 gain, computed as follows:
Description Amount Explanation
(1) Cash and fair market value of property received $100,000
(2) Debt relief 24,000
(3) Amount realized $124,000 (1) + (2)
(4) Basis in CCS interest 105,000
Recognized gain $ 19,000 (3) − (4)
THE KEY FACTS Sale of Partnership
Interest
• Seller issues:
• Gain or loss calculation Amount realized:
Cash and fair market value of property received plus Debt relief Less: Basis in partner- ship interest Equals: Realized gain or loss
• Tax year closes with respect to selling partner.
• Buyer issues:
• Outside basis—cost of the partnership interest plus share of partner- ship’s liabilities.
• Inside basis—selling partner’s inside basis at sale date.
• No changes to partner- ship asset bases (unless
§754 election is in effect).
The character of the gain or loss from a sale of a partnership interest is generally capital, because partnership interests are capital assets.2 However, a portion of the gain or loss will be ordinary if a seller realizes any gain or loss attributable to unrealized receiv- ables or inventory items.3 Practitioners often refer to these assets that give rise to ordi- nary gains and losses as hot assets.4 Let’s discuss that term further, because these assets are central to determining the tax treatment of many transactions in this chapter.
Hot Assets As you might expect, unrealized receivables include the right to receive payment for (1) “goods delivered, or to be delivered”5 or (2) “services rendered, or to be rendered.”6 For cash-method taxpayers, unrealized receivables include amounts earned but not yet received (accounts receivable). Accrual-method taxpayers, however, do not
1Partners determine their outside basis as discussed in the previous chapter. Importantly, the outside basis includes the selling partner’s share of distributive income for the year to the date of the sale.
2§731 and §741.
3§751(a). Partnerships are required to provide Form 8308 to all the parties to the sale as well as to the IRS. Sell- ing partners include with their tax returns this form as well as a statement detailing the calculation of any ordi- nary gain from the sale of their interest.
4There are actually two definitions of inventory items in §751. Section 751(a) inventory items are defined in
§751(d) to include all inventory items. However, under §751(b), the definition includes only substantially appreciated inventory. For purposes of determining the character of gain or loss from the sale of partnership in- terests, the term inventory items includes all inventory as in §751(a). However, these two definitions have cre- ated some confusion when using the term hot assets. In this chapter, we use the term hot assets to refer to unrealized receivables and all inventory items as in §751(a). The definition under §751(b) becomes more rel- evant when determining the tax treatment in a disproportionate distribution (discussed only briefly later in the chapter).
5§751(c)(1).
6§751(c)(2).
consider accounts receivable as unrealized receivables because they have already realized and recognized these items as ordinary income. Unrealized receivables also include items the partnership would treat as ordinary income if it sold the asset for its fair market value, such as depreciation recapture under §1245.7
Inventory items include classic inventory, defined as property held for sale to cus- tomers in the ordinary course of business, but also, more broadly, any assets that are not capital assets or §1231 assets.8 Under this definition, assets such as equipment or real estate used in the business but not held for more than a year and all accounts receivable are considered inventory. This broad definition means cash, capital assets, and §1231 as- sets are the only properties not considered inventory.9
7§751(c).
8§751(d)(1).
9This broad definition of inventory includes all unrealized receivables except for recapture. Recapture items are excluded from the definition of inventory items simply because recapture is not technically an asset; rather, it is merely a portion of gain that results from the sale of property. Recapture is, however, considered an unrealized receivable (i.e., hot asset) under §751(a). This idea is important in determining whether inventory is substantially appreciated for purposes of determining the §751 assets for distributions, as we discuss later in the chapter.
CCS’s balance sheet as of the date of Chanzz’s sale of its CCS interest to Greg follows:
Example 21-2
Color Comfort Sheets LLC June 30, 2018
Tax Basis FMV
Assets
Cash $ 27,000 $ 27,000
Accounts receivable 0 13,000
Investments 15,000 12,000
Inventory 1,000 1,000
Equipment (acc. depr. = $20,000) 80,000 86,000
Building 97,000 97,000
Land 20,000 150,000
Totals $240,000 $386,000
Liabilities and capital
Long-term debt $100,000*
Capital—Nicole (49,000)
—Sarah 108,000
—Chanzz 81,000
Totals $240,000
*Of the $100,000 of long-term debt, $20,000 is allocated solely to Nicole. The remaining $80,000 is allocated to all three owners according to their profit-sharing ratios.
Which of CCS’s assets are considered hot assets under §751(a)?
Answer: The hot assets are accounts receivable of $13,000 and $6,000 depreciation recapture (§1245) potential ($86,000 − $80,000) in the equipment. The accounts receivable is an unrealized receivable because CCS has not included it in income for tax purposes under CCS’s cash accounting method. The depreciation recapture is also considered an unrealized receivable under §751(a). Inven- tory would be considered a hot asset; however, because the tax basis and fair market value are equal, it will not affect the character of any gain recognized on the sale.
Review CCS’s balance sheet as of the end of 2019.
Example 21-3
Color Comfort Sheets LLC December 31, 2019
Tax Basis FMV
Assets
Cash $390,000 $ 390,000
Accounts receivable 0 40,000
Inventory 90,000 200,000
Investments 60,000 105,000
Equipment (acc. depr. = $50,000) 150,000 200,000
Building (acc. depr. = $10,000) 90,000 100,000
Land—original 20,000 160,000
Land—investment 140,000 270,000
Totals $940,000 $1,465,000
Liabilities and capital
Accounts payable $ 80,000
Long-term debt
Mortgage on original land 40,000
Mortgage on investment land 120,000 Capital—Nicole 119,000
—Sarah 332,000
—Greg 249,000
Totals $940,000
What amount of CCS’s assets are considered to be hot assets as of December 31, 2019?
Answer: The hot assets include inventory with a fair market value of $200,000, and unrealized receiv- ables consisting of $50,000 of depreciation recapture potential on the equipment, and $40,000 of accounts receivable.
When a partner sells her interest in a partnership that holds hot assets, she modifies her calculation of the gain or loss to ensure the portion that relates to hot assets is prop- erly characterized as ordinary income. The process for determining the gain or loss follows:
Step 1: Calculate the total gain or loss recognized by subtracting outside basis from the amount realized.
Step 2: Calculate the partner’s share of gain or loss from hot assets as if the partner- ship sold these assets at their fair market value. This represents the ordinary portion of the gain or loss.
Step 3: Finally, subtract the ordinary portion of the gain or loss obtained in Step 2 from the total gain or loss from Step 1. This remaining amount is the capital gain or loss from the sale.10,11
10The partner must also determine if any portion of the capital gain or loss relates to collectibles (28 percent capital gain property) or to unrecaptured §1250 gains. This is typically referred to as the look-through rule.
11Any capital gain from the sale of a partnership interest is potentially subject to the 3.8 percent net investment income tax unless the gain is allocable to trade or business assets held by the partnership that generate trade or business income not subject to the tax. See Prop. Reg. §1.1411-7 for a detailed discussion of this concept.
In Example 21-1, we are reminded that Chanzz Inc. sold its interest in CCS to Greg Randall for
$100,000 cash on June 30, 2018. As a result, Chanzz recognized a gain of $19,000 on the sale. What was the character of Chanzz’s gain?
Answer: $5,700 of ordinary income and $13,300 of capital gain, determined as follows:
Step 1: Determine the total gain or loss: $19,000 gain (from Example 21-1).
Step 2: Determine the ordinary gain or loss recognized from hot assets:
(3)
(1) (2) Gain/Loss Chanzz’s Share
Asset Basis FMV (2) − (1) 30% × (3)
Accounts receivable $ 0 $13,000 $13,000 $ 3,900
Equipment 80,000 86,000 6,000 1,800
Total ordinary income $5,700
Step 3: Determine the capital gain or loss:
Description Amount Explanation
(1) Total gain $ 19,000 From Step 1
(2) Ordinary income from §751(a) 5,700 From Step 2
Capital gain $13,300 (1) − (2)
Example 21-4
What if: Assume the same facts as in Example 21-1, except Greg only paid Chanzz $82,800 cash for its interest in CCS. What would be the amount and character of Chanzz’s gain or loss?
Answer: $5,700 of ordinary income and capital loss of $3,900, determined as follows:
Step 1: Determine the total gain or loss recognized:
Description Amount Explanation
(1) Cash and fair market value of $ 82,800 property received
(2) Debt relief 24,000 Chanzz’s share of CCS’s
allocable debt (30% × $80,000)
(3) Amount realized $106,800 (1) + (2)
(4) Basis in CCS interest 105,000
Gain recognized $ 1,800 (3) − (4)
Step 2: Determine the ordinary gain or loss from hot assets:
(3)
(1) (2) Gain/Loss Chanzz’s Share
Asset Basis FMV (2) − (1) 30% × (3)
Accounts receivable $ 0 $13,000 $13,000 $ 3,900
Equipment 80,000 86,000 6,000 1,800
Total ordinary income $5,700
Example 21-5
Buyer and Partnership Issues
A new investor in a partnership is of course concerned with determining how much to pay for the partnership interest. However, his primary tax concerns are about his outside basis and his share of the inside basis of the partnerships assets. In general, for a sale transac- tion, the new investor’s outside basis will be equal to his cost of the partnership interest.12 To the extent that the new investor shares in the partnership liabilities, his share of part- nership liabilities increases his outside basis.
Step 3: Determine the capital gain or loss:
Description Amount Explanation
(1) Total gain $ 1,800 From Step 1
(2) Ordinary income from §751(a) 5,700 From Step 2
Capital loss $(3,900) (1) − (2)
ETHICS
Sarah recently sold her partnership interest for significantly more than her outside basis in the interest. Two separate appraisals were commis- sioned at the time of the sale to estimate the value of the partnership’s hot assets and other assets. The first appraisal estimates the value of the hot assets at approximately $750,000, while the second appraisal estimates the value of
these assets at approximately $500,000. Given that the partnership’s inside basis for its hot as- sets is $455,000, Sarah intends to use the sec- ond appraisal to determine the character of the gain from the sale of her partnership interest. Is it appropriate for Sarah to ignore the first appraisal when determining her tax liability from the sale of her partnership interest?
12§1012. The outside basis will depend, in part, on how the new investor obtains the interest. For example, a gift generally results in a carryover basis whereas an inherited interest typically results in a basis equal to the fair market value as of the date of the decedent’s death.
13Later in the chapter, we discuss situations in which the new investor’s share of the partnership’s asset bases is adjusted after a sale of a partnership interest under §754. Throughout this section, we assume that the part- nership does not have a §754 election in effect.
14§743.
Example 21-6
When Greg Randall acquired Chanzz’s 30 percent interest in CCS for $100,000 on June 30, 2018 (see Example 21-1), he guaranteed his share of CCS’s debts just as Chanzz had done. As a result, Greg will be allocated his share of CCS’s allocable debt in accordance with his 30 percent profit- sharing ratio. What is the outside basis of Greg’s acquired interest?
Answer: $124,000, determined as follows:
Description Amount Explanation
(1) Initial tax basis $ 100,000 Cash paid to Chanzz Inc.
(2) Share of CCS’s liabilities 24,000 30% × CCS’s allocable debt of $80,000
Outside basis $124,000 (1) + (2)
The partnership experiences very few tax consequences when a partner sells her in- terest.13 The sale does not generally affect a partnership’s inside basis in its assets.14 The new investor typically “steps into the shoes” of the selling partner to determine her share of the partnership’s inside basis of the partnership assets. Consequently, the new investor’s
share of inside basis is equal to the selling partner’s share of inside basis at the sale date.
Recall from the preceding chapter that each partner has a tax capital account that reflects the tax basis of property and cash contributed by the partner, the partner’s share of profits and losses, and distributions to the partner. In a sale of a partnership interest, the selling partner’s tax capital account carries over to the new investor.15
Refer to Example 21-2 for CCS’s balance sheet as of June 30, 2018. What is Greg’s share of CCS’s inside basis in its assets immediately after purchasing Chanzz’s 30 percent interest in CCS?
Answer: Greg’s share is $105,000: the sum of Chanzz’s tax capital account of $81,000 and its share of CCS’s liabilities of $24,000. Greg simply steps into Chanzz’s place after the acquisition. In Example 21-6, we determined Greg’s outside basis to be $124,000. A sale of a partnership interest often results in a dif- ference between the new investor’s inside and outside bases because the outside basis is the price paid based on fair market value and the inside basis is the seller’s share of tax basis in the partnership assets.
Example 21-7
CCS had a $60,000 overall operating loss for the 2018 calendar year. The issue of how to allocate the 2018 loss between Chanzz Inc. and Greg was easily resolved because CCS’s operating agreement specifies the proration method to allocate income or loss when members’ interests in CCS change during the year. How much of CCS’s 2018 loss will Chanzz be allocated under the proration method?
Answer: Chanzz is allocated a loss of $9,000, which includes its share of CCS’s loss but for only one- half the year ($60,000 × 30% share × 6/12 months).20 On the sale date, Chanzz decreases its outside basis in CCS by the $9,000 loss to determine its adjusted basis to use in calculating its gain or loss on the sale of its interest.
Example 21-8
Varying Interest Rule If a partner’s interest in a partnership increases or decreases during the partnership’s tax year, the partnership income or loss allocated to the partner for the year must be adjusted to reflect her varying interest in the partnership.16 Partners’
interests increase when they contribute property or cash to a partnership17 or purchase a partnership interest. Conversely, partners’ interests decrease when they receive partner- ship distributions18 or sell all or a portion of their partnership interests. Upon the sale of a partnership interest, the partnership tax year closes for the selling partner only. Regula- tions allow partners to choose between two possible methods for allocating income or loss to partners when their interests change during the year.19 The first method allows the partnership to prorate income or loss to partners with varying interests, while the second method sanctions an interim closing of the partnership’s books.
15An exception occurs when the selling partner contributes property with a built-in loss to the partnership. Only the contributing partner is entitled to that loss [see the Forming and Operating Partnerships chapter and §704(c) (1)(C)]. Therefore, when a new investor buys a partnership interest from a partner that contributed built-in loss property, the new investor reduces his inside basis by the amount of the built-in loss at the contribution date.
16§706(d)(1).
17If all partners simultaneously contribute property or cash with a value proportionate to their interests, their relative interests will not change.
18If all partners receive distributions with a value proportionate to their interests, their relative interests will not change.
19Reg. §1.706-1(c).
20Reg. §1.706-4(c)(3) requires the calendar-day convention when using the proration method. For the sake of mathematical simplicity, we use number of months here and elsewhere in the chapter when applying the proration method.