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Sales and Exchanges of Partnership Interests

Sales and Exchanges of Partnership Interests. Sale of partnership interest Exchange of a partnership interest.

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Sales and Exchanges of Partnership Interests

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  1. Sales and Exchanges of Partnership Interests • Sale of partnership interest • Exchange of a partnership interest Chapter 6 Sales & Exchanges of Interests

  2. SALES OF A PARTNERSHIP INTEREST1. Under the entity concept, a partnership interest is an intangible asset much like an ownership interest in a corporation. As such, a partnership interest is treated as a capital asset, the disposal of which results in capital gain or loss. 2. Under the aggregate or conduit concept, a partnership interest is treated as an ownership interest in each partnership asset. As such, a partnership interest represents an undivided interest ina. ordinary income assets andb. capital or § 1231 assets of the partnership. Chapter 6 Sales & Exchanges of Interests

  3. SALES OF A PARTNERSHIP INTERESTIf the partnership has § 751 assets at the time a partnership interest is sold, the selling partner must allocate a portion of the sale proceeds to these assets and recognize ordinary income. The remaining sale proceeds results in a capital gain or loss. Chapter 6 Sales & Exchanges of Interests

  4. SALES OF A PARTNERSHIP INTERESTPurpose of § 751 (a)The purpose of § 751(a) is to prevent partners from converting what would otherwise be their respective shares of partnership ordinary income into capital gain, by selling their interests just before such income is recognized by the partnership. Chapter 6 Sales & Exchanges of Interests

  5. SALES OF A PARTNERSHIP INTEREST (examples)Example #8-1. Tim's one-third interest in the equal TUV Partnership is sold to John for $75,000. On the sale date, the partnership's cash basis balance sheet reflects unrealized receivables of $210,000. The receivables resulted from services rendered in the prior month and are expected to be collected at the end of the current month. Assuming that Tim's basis in his partnership interest is $2,000, the sale results in a $73,000 gain. Without § 751(a), Tim's $70,000 (1/3 of $210,000) share of forthcoming partnership ordinary income would be converted into capital gain. However, under § 751(a), Tim must report $70,000 of ordinary income and $3,000 capital gain. Chapter 6 Sales & Exchanges of Interests

  6. SALES OF A PARTNERSHIP INTEREST(examples)Example 8-2. The RST Partnership plans to sell all of its assets and discontinue operations. The partnership's principal assets are shrimp boats which have been fully depreciated but are worth $400,000. Two days before the partnership sells its assets, Roy's 25% partnership interest (basis $30,000) is sold for $120,000. Without § 751(a), Roy would avoid recognizing $100,000 (l/4 of $400,000) of depreciation recapture which results when the partnership sells the boats. Under § 751(a), Roy has $100,000 ordinary income and a $10,000 capital loss. There is no “ceiling” on the § 751(a) ordinary income. Chapter 6 Sales & Exchanges of Interests

  7. SALES OF A PARTNERSHIP INTERESTWhen determining a partner's gain on disposal of his or her partnership interest, the inclusion of the selling partner's share of partnership debt in the amount realized generally does not affect the amount of gain because both the amount realized and outside basis include equal debt amounts. Thus, the debt “washes” in the gain computation.However, an important exception arises if the partner, due to losses, has an outside basis (in the debt) lower than the face amount of the debt. Chapter 6 Sales & Exchanges of Interests

  8. SALES OF A PARTNERSHIP INTEREST(Example 3)Example 8-3 The NOP Manufacturing Partnership has always operated at breakeven (i.e., has never made a profit or suffered a loss). Partner Norma, a general partner who originally invested $1,000 in the partnership, sells her interest for $5,000 in cash and the assumption of her $10,000 share of partnership debt. If the balance in tax basis equity is $1,000 (her original investment), her gain on the sale is $4,000. Selling price Cash $ 5,000  Assumption of debt share  10,000  Total $15,000  Norma's outside basis (by source) Equity $ 1,000 Debt share 10,000 (11,000) Gain on sale $  4,000  Chapter 6 Sales & Exchanges of Interests

  9. SALES OF A PARTNERSHIP INTEREST(Example 4)Example 8-4. Same as example 6-3 except Norma’s share of losses since the inception of the partnership are $11,000. Therefore her outside basis was reduced from $11,000 to zero by virtue of the losses. When she sells her interest for $5,000 in cash and the assumption of her $10,000 share of partnership debt, her gain on the sale is $15,000. Selling price: Cash $ 5,000  Assumption of debt share  10,000  Total $15,000  Norma's Outside basis <0> Gain on sale $ 15,000  Chapter 6 Sales & Exchanges of Interests

  10. Example 8-5 Donald sells his interest in the partnership to Betty for $47,000 cash and the assumption of Donald’s $3,000 share of partnership debt. Donald’s outside basis is $20,000. Chapter 6 Sales & Exchanges of Interests Continued on next slide

  11. Example 8-5 Continued Problem Solution Chapter 6 Sales & Exchanges of Interests

  12. Example 8-6 Donald sells his interest in the partnership to Betty for $47,000 cash and the assumption of Donald’s $3,000 share of partnership debt. Donald’s outside basis is $45,000. Chapter 6 Sales & Exchanges of Interests Continued on next slide

  13. Example 8-6 cont’d Problem Solution Chapter 6 Sales & Exchanges of Interests

  14. Other Look-through Gain Rules. • Long-term capital gains from selling pass-through entity ownership interests can potentially fall into three different rate groups: • The 25% rate group for look-through unrecaptured Section 1250 gains from real estate. • The 28% rate group for look-through gains from collectibles. • The 15% rate group (or 5% for gains that would otherwise be included in the 10% or 15% rate brackets. Chapter 6 Sales & Exchanges of Interests

  15. Look-through Rule for Collectibles Gains • Under final regulations issued in 2000, gains from selling interests in partnerships, trusts and S Corporations held for more than one year are treated as collectibles gains (28% rate group gain) to the extent the gains are attributable to net unrealized appreciation in the value of collectibles owned by the entity. Chapter 6 Sales & Exchanges of Interests

  16. Look-through Rule for Collectibles Gains • The look-through collectibles gain amount is calculated by pretending that all the entity’s collectibles are sold (immediately before the actual sale) for their respective FMVs and then allocating the appropriate amount of the resulting net gain to the seller of the pass-through entity interest. ( See Reg. 1.1(h)-1(b)(2)(ii).) Note, no similar rule applies to net losses. • The look-through rule for collectibles gains does not apply to redemptions of pass-through entities. Chapter 6 Sales & Exchanges of Interests

  17. Look-through Rule for Unrecaptured Section 1250 Gains • Gains from selling interests in partnerships held over one year are treated as unrecaptured Section 1250 gains (meaning 25% rate group gain) to the extent of such unrealized gains inherent in the depreciable real estate assets owned by the entity. • Same method of allocation as collectible gain. See Reg. 1.1(h)-1(b)(3)(ii). • This look-through rule for unrecaptured Section 1250 gains does not affect sellers of S corporation stock or sellers of trust interests. Nor does it affect redemptions of partnership interests. Chapter 6 Sales & Exchanges of Interests

  18. Look-through Rule for Unrecaptured Section 1250 Gains • Unlike most taxpayers with unrecaptured Sec. 1250 gain, the amount of unrecaptured Section 1250 gain recognized under the look-through rule is not considered to be Section 1231 gain [Reg. 1.1(h)-1(b)(3)(iii)]. Therefore, the look-through gain amount cannot be offset by 1231 losses from other sources. However, it can be offset by capital losses from other sources. Chapter 6 Sales & Exchanges of Interests

  19. Residual Long-term Capital Gain or Loss • The residual long-term capital gain or loss (capital gain taxed at 15% or 5%) equals: • Overall gain or loss from selling the interest held for over one year, minus any amount treated as ordinary income under IRC Sec. 751(a), minus any amount of look-through collectibles gain, minus any amount of look-through unrecaptured Section 1250 gain. • See Reg. 1.1(h)-1(f), Example 1 Chapter 6 Sales & Exchanges of Interests

  20. Example 8-7 --Look Thru Rules • Assume no Sec. 751 assets. In July of 2004, Bill’s outside basis in his partnership interest is $65,000 and he sells his interest for $100,000. If Bill’s share of collectible gain is $10,000 and his share of unrecaptured Sec. 1250 gain is $20,000, then Bill’s gain of $35,000 is taxed as follows: • $10,000 @ 28% • $20,000 @ 25% • $5,000 @ 15% Chapter 6 Sales & Exchanges of Interests

  21. Example 8-8 Residual Capital Loss • Same as Example 8-7 except Bill’s outside basis in his partnership interest is $95,000. Recall, he sells his interest for $100,000 (net gain of $5,000). If Bill’s share of collectible gain is $10,000 and his share of unrecaptured Sec. 1250 gain is $20,000, then Bill is taxed taxed as follows: • $10,000 @ 28% • $20,000 @ 25% • <$25,000> Residual Capital Loss Chapter 6 Sales & Exchanges of Interests

  22. Problem 1a on Page 265 $20,000 ordinary income under Sec. 751 and $40,000 LTCG under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  23. Problem 1b $20,000 ordinary income under Sec. 751 and <$35,000> LTCL under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  24. Problem 1c A’s OB is $75,000. Same result as (a) $20,000 ordinary income under Sec. 751 and $40,000 LTCG under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  25. Problem 1d same result as (a) $20,000 ordinary income under Sec. 751 and $40,000 LTCG under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  26. Problem 2 a-c same result $5,000 ordinary income under Sec. 751 and $40,000 LTCG under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  27. Problem 2 d The contract is an unrealized receivable $15,000 ordinary income under Sec. 751 and $40,000 LTCG under Sec. 741 Chapter 6 Sales & Exchanges of Interests

  28. Problem on Page 267; Assume that B’s outside basis is $10,000 • Realized gain $6,000 ($16,000 - $10,000) • $7,000 of ordinary income under Sec. 751 • $1,000 of collectible gain taxed at 28% • <$2,000> LTCL • Realized gain of $7,000 ($17,000 – 10,000) • $7,000 ordinary income under Sec. 751 • $2,000 collectible gain taxed @ 28% • <$2,000> LTCL • Realized gain $6,000 ($16,000 - $10,000) • $7,000 of ordinary income under Sec. 751 • <$1,000> LTCL Chapter 6 Sales & Exchanges of Interests

  29. Chapter 6 page 272/273 Problem • Realized gain $112,000 ($150,000 - $38,000) • $22,000 of ordinary income Sec. 751 in year of sale • $30,000 of LTCG each year for three years (total 90,000 LTCG) Chapter 6 Sales & Exchanges of Interests

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