In previous articles, the collapsible partnership rule has been discussed. The article below has been prepared by a tax attorney to further our discussion of this rule and provide an example of the rule when partner’s allocation of profits and losses are different. Many partnership agreements call for special allocations whereby one partner (or multiple partners) may receive a different allocation of profits and/or losses and thus it is beneficial to apply such a situation to the rule.
In this example, we will assume that John, Jimmy & Jeff are the members of a cash basis partnership, J Cubed LLC and that each John, Jimmy & Jeff have a 1/3 interest in the capital of the partnership and partnership losses. John, however has a ½ (50%) interest in the partnership profits because both Jimmy & Jeff realized and acknowledged that John is the true brains behind the business and overall business operations. In regards to the remaining 50% interest, Jimmy and Jeff each have a ¼ interest in partnership profits.
J Cubed LLC has $12,000 in cash, $10,000 in accounts receivable ($0 basis) and $21,000 in investments with a $15,000 adjusted basis. John, Jimmy & Jeff each have an adjusted basis of $9,000 in their partnership interest. John has a value of $17,000 in his partnership interest and Jimmy & Jeff each have a value of $13,000 in their partnership interest. John’s value is $17,000 because he would be allocated 50% of the profits when the receivables are collected ($5,000) and 50% of the profits when the investments are collected ($3,000).
John eventually gets tired of Jimmy & Jeff’s incompetence and wishes to sell his partnership interest, and start a new business. John sells his interest to Terry (who has little to no idea about Jimmy and Jeff) for $17,000. John’s total gain would be $8,000 ($17,000 less $9,000). Of the $8,000 gain $5,000 would be treated as ordinary income because $5,000 would have come from accounts receivable and $3,000 would be treated as capital gain from the investments. John will use this $8,000 gain to start a competing business and eventually, J Cubed LLC (which Jimmy & Jeff decided to dba J Squared after John’s departure) will dissolve.
Because the collapsible partnership rule only applies if a partnership owns ordinary assets, we should take a minute and define ordinary assets or ordinary income assets. An ordinary income asset would be an asset owned by the partnership that would give rise to ordinary income if sold by the partnership at its fair market value. Two categories of ordinary income assets exists under the collapsible partnership rule, those being unrealized receivables under IRC Section 751(c) inventory under IRC Section 751(d). Of course, these categories are fairly broad and thus could trigger application of the rule whenever a partnership owns an asset with ordinary income potential.
Contact The McGuire Law Firm to speak with a tax attorney in Denver if you are considering selling your partnership interest. In addition to tax implications, there are other considerations to make and discuss between the partners, and of course, the proper documents need to be drafted.
Schedule a free consultation with a Denver tax attorney at The McGuire Law Firm!