Example of Collapsible Partnership Rule by Denver Tax Attorney

The collapsible partnership rule has been discussed in previous articles.  The article below is an example of a transaction whereby the collapsible partnership rule would apply.  The example below should help illustrate when the sale of a partnership interest can generate ordinary income and the allocation of basis to determine the amount of ordinary income that must be realized.

Example:  Jeff is an equal partner in J Cubed LLC and has a $10,000 basis in his partnership interest.  The assets of the partnership are $10,000 in cash, $12,000 in inventory with a $9,000 adjusted basis and investments with an adjusted basis of $11,000 and fair market value of $17,000.  Jeff sells his partnership interest to James for $13,000.  Thus, Jeff realizes a $3,000 gain from the sale of his partnership interest.  $1,000 of the amount realized would be due to the appreciation in the partnership’s inventory.  Thus, Jeff would report $1,000 as ordinary income and the remaining $2,000 of gain would be reported as capital gain.  This can be broken down as follows:

 

Jeff’s Basis: $10,000

 

Jeff’s Basis in Inventory: $3,000 (1/3 of $9,000)

Jeff’s Amount Realized from Inventory: $4,000 (1/3 of $12,000)

Amount Realized of $4,000 less Adjusted Basis of $3,000= $1,000 gain from the inventory and thus ordinary income based upon the collapsible sale rule.

Jeff had a total basis of $10,000 and received $13,000.  $3,000 of his basis was applied to the inventory and thus of the remaining $9,000 that Jeff realized, Jeff’s remaining $7,000 of basis is applied, and $2,000 of capital gain is realized.  Thus, Jeff’s total amount realized is $3,000.

In applying the collapsible sale rule is it possible for the selling partner to report both ordinary income and a capital loss?  Yes, this can occur.  Consider a situation in which the partnership has inventory with a fair market value higher than the adjusted basis and investments with a fair market value lower than the adjusted basis.  To make this easier, we will look at an example with numbers.  Assume Jeff has a $5,000 adjusted basis in his partnership interest and will sell this interest to Locksley for $5,500.  The assets of the partnership are as follows:

 

Asset               Adjusted Basis            Fair Market Value

Cash                $7,500                         $7,500

Inventory        $3,000                         $6,000

Investments     $4,500                         $3,000

From the sale of his interest, Jeff will realize $2,000 from the sale of inventory and with an adjusted basis of $1,000 in the inventory report $1,000 of ordinary income.  Jeff’s remaining adjusted basis is $4,000 but the remaining amount realized is $3,500.  Thus, Jeff would have a loss of $500, which would be a capital loss because the loss was realized through the disposition of Jeff’s remaining partnership assets, which would be considered a capital loss.  Jeff would realize both ordinary income and a capital loss through the sale of his partnership interest.

You can speak with a Denver tax attorney at The McGuire Law Firm if you have any tax or business related questions.  A tax attorney can help you understand the tax implications of certain transactions and prepare & plan for future transactions.  Schedule a free consultation with a Denver tax attorney- 720-833-7705.

 

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