In a previous article a tax attorney at The McGuire Law Firm drafted an article regarding inside and outside basis in a partnership to later further a discussion on IRC Section 754. The article below will continue to discuss inside and outside basis and the problems or issues that can occur as we move forward with matters related to a 754 election. The article below will assume the same facts from our July 15th article.
For now we will assume that after X has purchased A’s partnership interest JJJL LLC sells the land for $1.2 Million. Under IRC 1001, the partnership will recognize gain in the amount of $400,000. Because each partner has a 25% ownership interest in the partnership, each will be allocated 25% of the gain, which will be $100,000 to each partner. This gain will increase each partner’s capital account and tax account by $100,000 and thus increase their capital account and tax basis under IRC Section 704. Thus after the sale, the partnership has cash of $1.2 M and $200,000 in other assets totaling $1.4 M, and the partner’s all have a $350,000 basis in their capital accounts with a fair market value of $350,000. However, Woody’s disparity between his capital account at $350,000 and outside basis of $450,000 will remain.
A problem has occurred! When Terry sold his interest he recognized gain of $100,000 through the appreciation of the land and would have paid tax on such gain. When the partnership sold the land, all $400,000 of appreciation in the land would trigger gain to be recognized and Woody will be taxed on $100,000 as well. Why does this problem occur? The problem is due to Woody’s interest being treated as an extension of Terry’s interest in the partnership. In a vacuum, the same $100,000 is being taxed twice- once to Terry and once to Woody. Is this not a violation of tax law and tax principles? Yes, and no, because the issue will eventually be worked out.
As an example, we will assume that a couple of years later the partnership sells the remaining assets with a value of $200,000 and then the partnership will liquidate and distribute the $1.4 Million in cash. Under IRC Section 704, when a partnership liquidates, it generally is required to make liquidating distributions in accordance with each partner’s positive capital account balance and thus each partner would receive $350,000. Under IRC Section 731, when the partnership liquidates, each partner should recognize gain or loss for the difference between the amount received and their basis in the partnership. However, the basis in the partnership is not the capital account or share of inside basis, but the outside basis of the partnership. Thus, for John, Jimmy and Jeff these amounts are the same, but Woody has that difference in his outside and inside basis. No gain or loss will be recognized by John, Jimmy or Jeff, but Woody will recognize a loss of $100,000 because his outside tax basis was $450,000. Too bad for Woody that his capital gain and capital loss were recognized in separate tax years! If Woody has not other capital gains to use the $100,000 capital loss offset, he may have to use $3,000 of the capital loss per year due to the capital loss limitation….. That could take Woody over 33 years to use such loss!
In a later article a Denver tax attorney from The McGuire Law Firm will discuss how the above issue may be able to be fixed and Section 754. If you have tax questions or issues, speak with a Denver tax attorney by calling The McGuire Law Firm. A free consultation is offered to all potential clients!