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!

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.

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.