In a previous article drafted by a tax attorney at The McGuire Law Firm, taxation issues upon the sale of a partnership interest were discussed. The article below has been drafted by a Denver tax attorney to discuss the character of the gain or loss upon the sale of a partnership interest and the Collapsible Partnership Rule.
General income tax principles would hold that the character of any gain or loss from a sale is dictated and determined by referencing the character of the asset sold. A partnership interest is a capital asset under Internal Revenue Code Section 741 and thus a partner would report a capital gain or loss upon the sale of such interest. However, a re-characterization requirement exists that is referred to as the collapsible partnership rule, where a selling partner may have to re-characterize all or a portion of the gain as ordinary income upon the sale of their partnership interest.
The collapsible partnership rule applies only if and when the partnership owns an asset that would produce ordinary income if the asset were sold by the partnership at fair market value. The collapsible partnership rule is not applicable if a partnership only owns assets of which have declined in value (the asset(s) adjusted basis is in excess of the fair market value). In short, this rule will prevent a partner from converting ordinary income into capital gain by selling their partnership interest. It is important to note and keep in mind that the collapsible partnership rule will apply even if a partner sells only a portion of their partnership interest, and even if the sale is made to an existing partner. See Rev. Rule 59-109.
This rule will split the sale of a partnership interest into two separate components: one being a capital asset component; and, two being an ordinary asset component. Gain from the ordinary asset component will be taxed as ordinary income and the remaining portion is treated as capital gain. The rule produces a deemed sale of the partner’s allocable share of the partnership’s ordinary income assets, which would produce ordinary income, and the remainder is treated as the typical capital partnership interest, thus receiving sale or exchange treatment. In terms of what constitutes an ordinary income asset, one could consider unrealized receivables and inventory as ordinary income assets. See IRC 751 and applicable treasury regulations.
In determining whether the rule should apply and the applicable consequence, one would follow these steps:
– Step 1: Determine the selling partner’s amount realized and adjusted basis.
– Step 2: Determine of the partnership owns any unrealized receivables or inventory. If not, all gain is treated as capital.
– Step 3: Bifurcation- Allocate a portion of the amount realized and the adjusted basis between the ordinary asset(s) and the capital asset(s).
– Step 4: Allocation of Amount Realized- Determine what portion of the amount realized can be attributed to the value of the partner’s interest in the partnership’s ordinary income assets. Note: If a selling partner and the purchaser make this allocation, the allocation will usually be respected by the Internal Revenue Service.
– Step 5: Determine the amount of adjusted basis that is attributable to the basis in the ordinary income asset(s). Under the 751 regulations, the amount of the adjusted basis allocated to the ordinary income assets is an amount equal to the basis such assets would have if the partner would have received the assets in a non-liquidating distribution.
– Step 6: The difference between the amount realized and allocated adjusted basis would be characterized as ordinary income. The remainder is treated as a capital gain or capital loss.
If you are considering selling your partnership interest and have questions regarding the tax implications of such transaction talk with a Denver tax attorney and business attorney at The McGuire Law Firm. A free consultation is offered to all potential clients.
