Chapter 11: Partnership distributions, sales, etc

1. 406Lec11..PPT Chapter 11: Partnership distributions, sales, etc PARTNERSHIP PARTNERSHIP • Nonliquidating & Liquidating Pro-rata Distributions Assets Assets L i q u i d a t i n g P r o r a t a (proportionate) PARTNERSHIP PARTNERSHIP Assets Assets N o n - L i q u i d a t i n g Non - P r o r a t a (disproportionate) 1

2. Issues regarding partnership ownership changes • Non-Liquidating (current) distributions to partners slide 3 • - Draws of cash, distribution of other assets. • - Partners ownership % changed ↑ or ↓ but not to 0%. • - General rule: nontaxable, carryover basis of asset. • Liquidating distributions to partners slide 13 • - Partners interest reduced to 0%. • - If pro-rata distribution of assets, generally no gain/loss • Sale of partnership interest slide 18 • - Considered a sale of share of assets. • - Gain could be part capital, ordinary • Pre-contribution gain §737 slide 9, hot asset rules §751 slide 11, optional basis rules §754 slide 20 • - Special calculations in certain circumstances

3. 406Lec11..PPT I & II. Nonliquidating & Liquidating Prorata Distributions • General rule for all prorata distributions : No gain or loss if cash or property distributed. Gain Exceptions Partner recognizes gain only if : text p 11-4 i) Cash is distributed in excess of interest basis Cash includes reduction in liabilities.or ii) Contributed property is distributed §704 or §737 (see later) Loss ExceptionsPartner recognizes loss only if: text p 11-8 i) a. Distributions are to liquidate interest and b. Basis in interest > (distribution of cash + basis in A/R + basis in inventory) and c. No other property is received or ii) Contributed property is distributed §704 or §737 (see later) 3

4. Example: Partnership cash distribution • Partnership distributes $10,000 cash to 10% partner Joe. • Partnership liabilities total $50,000. • Joe has basis in interest of $10,000. (includes share of liabilities) • Effects if distribution is non-liquidating or liquidating? • Results: • Non-liquidating: • No effect from liabilities since Joe is still in partnership. • Liquidating: • Modification: What if liquidating and basis = $20,000? 4

5. 1 & II. Nonliquidating & Liquidating Prorata Distributions continued • Partner’s basis in property received = Carryover unless: i) If basis in partner’s interest < property basis to partnership. Then, limit partner’s basis in property. text p 11-5 or ii) If aliquidatingdistribution, partner has more basis in interest than partnership has basis in distributed property. Then, increase partner’s basis in assets (except A/R and inventory. Basis is carryover only).text p 11-8,9 NOTE: There are many basis allocation rules: text p 11-5,6,8 - A/R and Inventory get basis first, - Then other property gets what’s left over. - A few others rules within categories. 5

6. 1 & II. Nonliquidating & Liquidating Prorata Distributions continued • Partner’s holding period in property received includes partnership’s holding period (tacked on). • Character of gain/loss on sale of property received by partner upon sale is same as if partnership sold it. - If inventory, character determined by partner’s ownership after 5 years. (Possible shift to capital or §1231.) 6

7. Example: Partnership cash & property distribution • Partnership distributes cash & land to partner Sue. Sue has $30,000 basis in interest. • Assume non-liquidating. • Cash distributed = $20k. Partnership had $8k basis in the land. FMV land is $10k. • Sue’s interest basis = • Land basis = • Same as above but it is to liquidate partner (0% ownership) • Cash distributed = $20k. Partnership had $8k basis in the land. FMV land is $10k. • Sue’s interest basis = 7

8. Example: Partnership cash & property distribution • Partnership distributes cash & land to partner Sue. Sue has $30,000 basis in interest. • Assume non-liquidating (Partner’s % ownership unchanged.) • Cash distributed = $25k. Partnership had $8k basis in the land. FMV land is $10k. • Sue’s interest basis = 8

9. 1 & II. Nonliquidating & Liquidating Prorata Distributions continued • Distributions of Contributed property§704 or §737 i) §704 Contributing partner recognizes gain or loss if: - Property contributed to partnership within 7 years and - Noncontributing partner receives the property. §704 also covers when property is sold.Ch 10 slide 13, text p 10-26 , 11-11 ii) §737 Contributing partner recognizesgain (not loss) if: - Property contributed to partnership within 7 years and - Contributing partner receives other property Recognize lesser of pre-contribution gain or FMV of distributed property over partners interest basis.text p 11-11 §704 §737 PARTNERSHIP PARTNERSHIP GAIN GAIN 9

10. Example: Recognition of pre-contribution gain • Smithcontributes car with FMV $100k and basis $0 to partnership. • Jonescontributes land with FMV $100k and basis $0 to partnership. • Within 7 years only the car is distributed to Jones. Effects? • Both Smith and Jones have gain under 2 different rules: • Under §704 Smith claims • (contributing partner’s property of car is distributed to another partner) • Under §737 Jones claims • (contributing partner of land receives other property) • Note: Both § 704 & § 737 provide that basis in contributed asset is increased (or decreased) after distribution. Car basis & land basis will each be $100k. 10

11. NonliquidatingNon-Prorata Distributions §751 text p 11-11 • Occurs when partner doesn’t receive their % share (disproportionate) of “§751 hot assets”. Hot assets are: - Unrealized Receivables defined as: Depreciation recapture potential and Cash basis A/R - Substantially Appreciated Inventory defined as: All noncash assets except Sec 1231 and capital assets and Total FMV > 120% Total basis of such assets. • Effect of §751 is to recast distribution as sale between partners. - Gain or loss may be recognized. - Nature could be capital or ordinary income. 11

12. Example: Non-proratadistribution with Hot Assets Partnership owned equally by 3 partners (A ,B and C) has: BasisFMV Cash 3600 3600 Inventory Note: 1200 > 120% x 600 600 1200 Land 1800 2400 Assume that in a non-liquidating distribution, the inventory is distributed to a partner A and $1,200 of cash is distributed to partner B and $1,200 cash is distributed to partner C. Results? Step 1: Pretend a pro-rata distribution of $1,200 is made to each of the partners which consists of: 1/3 of the inventory = 1/3 of the cash = Step 2: Pretend A spends $800 of cash for 2/3 of inventory: $400 of cash to each of B, C. They each recognize A has basis in inventory = If half of land was distributed instead of hot asset, no gain to B, C. and A has carryover basis in land. 12

13. Liquidating payments to retiring partner §736 text p 11-12 • Instead of partner selling partnership interest to an existing or new partner, the partnership makes cash payments as a buyout of partner’s interest (similar to a redemption). • Two types of buyout payments under §736: - §736(b) payments are considered payment for property. - §736(a) “other” payments are for everything else, such as A/R, future consulting, unstated goodwill, etc $$$ cash PARTNERSHIP Buy back interest in property, receivables, goodwill, etc 13

14. Liquidating payments to retiring partner §736 text p 11-12 • §736(b) payments are for partner’s share of “non-hot” partnership property. Rules: i) Payments - partners basis = Gain (usually capital)* ii) Possible basis adjustment for partnership. See later. iii) Goodwill is “property” only if specifically described as such in partnership agreement. * Treatment is just like an asset sale! §736(b) payments do NOT include Unrealized receivables for A/R and payments for goodwill which aren’t stated in partnership agreement. 14

15. Liquidating payments to retiring partner §736 text p 11-12 • §736(a) “other” payments are for unrealized receivables for A/R, unstated goodwill, and guaranteed payments. (but not depreciation recapture as for hot assets on slide 11). Rules: i) Income to retiring partner* ii) Deductible by partnership* If paid over time, partnership agreement can dictate when 736(b) versus 736(a) payments occur. If silent, then proportionate. * Treatment is just like guaranteed payments discussed in chapter 10. 15

16. Example: Liquidating payments to retire a partner §736 • Partnership has this balance sheet: BasisFMV • Cash 100 100 • A/R 0 150 • Land 250 250 • 500 • Unstated Goodwill ??? • Liquidate 10% partner (basis of 20 in interest) by paying cash of $100.Results? • Note excess value is unstated goodwill. That is, if 10% is worth $100, entire company must be worth $1,000. Goodwill = $500. • 736(b) payments = • Capital gain = No affect on partnership. • 736(a) payments = • Ordinary income = . Partnership deducts 65 as a guaranteed payment. 16

17. Example: §736 payments - MODIFICATION • MODIFICATION: Assume partnership agreement modified to classify any payments in excess of balance sheet FMV as for Goodwill. Results? • Partnership now has this balance sheet: BasisFMV • Cash 100 100 • A/R 0 150 • Land 250 250 • Goodwill 0 . • Liquidate 10% partner (basis of 20 in interest) by paying cash of $100. • 736(b) payments = • Capital gain = No affect on partnership unless basis adjustment elected to goodwill (see later) • 736(a) payments = • Ordinary income = . Partnership deducts 15. 17

18. Sale of partnership interest text p 11-17 • Remember sales proceeds includes assumption of partnership liabilities. Treated as if additional cash received. • If hot assets are present, seller must allocate proceeds and recognize some ordinary income. text p 11-18 For sale rules only, inventory doesn’t have to be substantially appreciated to be a hot asset. • For sale, §751 hot asset rules don’t cause more gain recognized. They just reclassify some gain as ordinary . • Basis adjustment with respect to purchasing partner only can be made if §754 election is in effect. (See next topic) 18

19. Example: Sale of partnership interest • Konk LLC has 2 partners, Chuck and Mary and this balance sheet: BasisFMV • A/R 0 50 • Land 20 50 • N/P (6) (6) • Joe buys 50% interest from Chuck for FMV which is $47. 50% x (100 – 6) • Chuck has basis of $10 in portion sold. Results? • Chuck has gain = • Ordinary portion under §751 = 50% x hot assets = • Capital gain = • Joe basis in interest = purchase = • - $50 is Joe’s Outside basis • - Note Joe’s share of partnership basis in assets = 50% x 20 = $10. $10 is Joe’s Inside basis. • Joe’s outside basis ≠ inside basis. 19

20. Optional Basis adjustments §754 text p 11-23 • Election made by partnershipto increase/decrease it’s basis(inside basis) in assets when: i) New partner purchases an interest (adjust only new partner’s share of assets) or ii) Partner dies (adjust only beneficiary’s share of assets) or iii) Partner takes on a lower/higher basis in distributed property than that in the hands of the partnership. or iv) Partner recognizes gain/loss on receipt of distributed property. • Allocate basis adjustments from iii) or iv) to assets of a similar character owned by partnership. • Once elected, requires adjustments (+ and -) for all subsequent years and for all affected partners. 20

21. Example: Optional basis adjustments §754 • Refer to previous Sale of partnership interest example: • Konk LLC with partners Chuck & Mary BasisFMV • A/R 0 50 • Land 20 50 • N/P (6) (6) • Joe buys 50% interest from Chuck for $47. • Joe’s Outside basis = $50 andInside basis = $10. • 1) AssumeKonk immediately sells land for $50 and collects all A/R. Result: • Mary and Joe each have Capital gain = • Mary and Joe each have Ordinary income= • 2) Assume Konk makes an election to adjust inside basis under §754. • Result: • -Joe’s inside basis in assets is now = $50. Allocate based on FMV. • - Basis in A/R = 0 + 25 adj. Gain = (50%)(50) – 25 = 0 • - Basis in land = 10 + 15 adj. Gain = (50%)(50) – 25 = 0 • Note: Partner Mary not affected by election until something happens that affects her outside basis. 21

22. MISCELLANEOUS • Adjustment similar to §754 required (even if no election) on sale of interest when partnership’s Inside Basis of assets > $250,000 of FMV. Called built in loss. Rule stops new partner from getting excess depreciation or loss text p 11-27 • Partnership termination occurs when: text p 11-27 i) Only one owner remains or ii) Sale of 50% of interests within 12 monthsunder §708(b)Year closes on termination date. Called “technical termination”. • On termination, considered as liquidation. Distribute assets and liabilities pro-rata to each partner. • New partnership would then be created in technical terminations. 22