When a withdrawing partner’s interest is terminated through multiple, or a series of distributions to the partner, each distribution can be considered a liquidating distribution as opposed to a current distribution.  This is so even if the partner is a tax partner until the final distribution is made (see IRC Section 761) and recognizes gain only after total, actual or the constructive money distributions would exceed the outside basis of the partner’s partnership basis.  Therefore, this is not necessarily installment sale treatment, but rather open transaction treatment.  It is also important to note that a withdrawing partner can only recognize a loss once the final liquidating distribution is received.

The partnership’s obligation to make the distribution is not treated as a cash equivalent for a cash method taxpayer nor is it treated as an obligation for an accrual method taxpayer.  Under IRC Section 736, the obligation to make these deferred payments is not a debt obligation.  Thus, the liquidating distributions can be made by the partnership to the partner as a debt obligation that liquidates the interest immediately and thus the withdrawing partner is considered more as a creditor than as a partner of the partnership.

For example, John is withdrawing from J Cubed, LLC and the partnership agreement satisfies the special allocation regulations.  John is entitled to receive $100k upon his withdrawal.  Half is payable upon withdrawal and the other half in the year after the withdrawal.  John’s outside partnership basis is $75,000.  Thus, assuming there is no 751 Exchange, John will not recognize gain on the initial distribution of $50,000 because of the $75,000 in outside basis and gain recognition rules.  All of the $25,000 gain John will recognize will be recognized upon the second distribution.  J Cubed’s obligation to make the second $50,000 distribution is not a debt obligation.  The gain of $25,000 may be capital gain, but one should always considerable the collapsible partnership rule.  Assuming John had an outside basis of $150,000 and received the same $100,000 total in distributions, the loss could not be recognized until the second payment was made.

If you have tax questions relating to the sale of a business or business interest, discuss these questions and issues with a Denver tax attorney at The McGuire Law Firm.  You can schedule a free consultation with a tax attorney in Denver who can assist you with your matters.

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.

The sale of an entire partnership or all of the partnership assets will result in a single tax on the disposition.  This is because a partnership is a pass through entity and thus the tax consequences and implications will pass through to the partners and will also result in adjustments to the partner’s outside basis.

When your partnership is sold, the partnership recognizes gain or loss on the individual assets determined by the character of the asset and the holding period of the partnership’s asset.  This gain or loss is determined without reference to the partner’s outside basis or the partner’s holding period of their partnership interest.  It is important to note that the partnership will not (or does not) terminate until the proceeds are distributed to the partners.  Gain or loss that is recognized by the partnership on the disposition is taxed to the partners and will create an adjustment to the partner’s outside basis in the partnership. Because gain or loss is recognized at the partnership level, a partnership could sell a long term capital asset and a new partner, would realize long term capital gain.

Example: John, Jim and Jeff have equal one-third share of all profits and losses of J Cubed LLC.  J Cubed LLC has no partnership liabilities (remember a liability could be treated as an amount realized) and there are no 704(c) allocation.  The LLC balance sheet states:

Book               Value               Gain (loss)

Capital Assets             $90,000           $60,000           ($30,000)

Unrealized AR            $0                    $60,000           $60,000

Total                $90,000           $120,000         $30,000

John Capital                $30,000           $40,000           $10,000

Jeff Capital                 $30,000           $40,000           $10,000

Jim Capital                  $30,000           $40,000           $10,000

Total                $90,000           $120,000         $30,000

J Cubed LLC sells its assets to SK LLC for $120,000.  John, Jeff and Jim will each be taxed on 1/3 of the capital loss ($30,000) and the ordinary income on the Section 751 property of $60,000.  This will increase each of their capital accounts by $10,000 to $40,000.  J Cubed will distribute the $120,000 to John, Jeff and Jim in accordance with their capital accounts and thus each will receive $40,000.  Because the partner’s outside basis is the same as their capital accounts, they will not realize or recognize any gain (or loss).

The partnership and purchaser must allocate the purchase price among the assets purchased.  This allocation will determine the purchaser’s basis in the assets purchased and the partnership’s pass through capital gain, ordinary income, and/or loss, in addition to whether such loss would be full deductible (or subject to certain capital loss limits or other limits), what portions if any would be eligible for the installment method, and what portions (if any) would be eligible for non-recognition.

The amounts the parties will allocate to the assets are not, and likely will not be identical.  The purchaser can include the amount of money or consideration paid in addition to the costs of the acquisition and the partnership that has sold the assets can reduce the amount realized by the transaction costs and transfer costs etc.  This will result in an increased amount paid for the purchaser and a decrease of the amount realized for the partnership.  The parties are required to file Form 8594 with the Internal Revenue Service, which will state the portion of the purchase price that has been allocated to goodwill or going concern or 197 intangibles.

Based off of the example above, if J Cubed LLC paid fees and transactions costs of $20,000 the net proceeds would be $100,000 and if SK LLC paid legal fees of $15,000, SK LLC’s purchase price would be $135,000.

A tax attorney or business attorney can assist you with the sale or purchase of a partnership or partnership assets and the tax & business related issues and implications of the transaction.  Contact The McGuire Law Firm to speak with a Denver tax attorney or business attorney regarding your partnership, tax and transaction related questions and issues.