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.