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Liquidating Distributions Part 1

Liquidating Distributions Part 1. LIQUIDATION OF A PARTNER'S INTEREST §761(d).

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Liquidating Distributions Part 1

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  1. Liquidating DistributionsPart 1

  2. LIQUIDATION OF A PARTNER'S INTEREST §761(d) • “For purposes of [subchapter K], the term "liquidation of a partner's interest" means the termination of a partner's entire interest in a partnership by means of a distribution, or a series of distributions, to the partner by the partnership.”

  3. Impact on Partnership/Partner Tax Year§708(b)(1) • The tax year of a continuingpartnership does not close “as the result of the death of a partner, the entry of a new partner, the liquidation of a partner’s interest in the partnership, or a sale or exchange of a partner’s interest in the partnership.” (§ 706(c)(1)). • However, termination of a partner’s interest “(whether by reason of death, liquidation, or otherwise)” closes the partnership year with respect to the terminated partner (§ 706(c)(2)(A)).

  4. Sale v. LiquidationCooney v. Comm. 65 T.C. at 109 • As stated in Cooney: The critical distinction between a sale of a partnership interest under section 741 and a liquidation of such an interest under section 736 is that a sale is a transaction between a third party or the continuing partners individually and the withdrawing partner, whereas a liquidation is a transaction between the partnership as such and the withdrawing partner. ***

  5. Introduction toCode Sec 736

  6. Scope of Code Sec. 736(a)Reg. Sec. 1.736-1(a)(1)(i) • “Section 736 and [Sec. 736(a)] apply only to payments made to a retiring partner or to a deceased partner's successor in interest in liquidation of such partner's entire interest in the partnership. See section 761(d).” • “Section 736 and [Sec. 736(a)] do not apply if the estate or other successor in interest of a deceased partner continues as a partner in its own right under local law.”

  7. A “Retiring Partner”Reg. § 1.736-1(a)(1)(ii)). • “A retiring partner” is one who “ceases to be a partner under local law” • However, for the purposes of subchapter K, “a retired partner or a deceased partner’s successor will be treated as a partner until his interest in the partnership is completely liquidated.”

  8. Code Sec 736 • Code Sec. 736 divides payments into the following classifications: • Code Sec. 736(a) for a • distributive share or • guaranteed payment. • Code Sec. 736(b) for an interest in partnership property.

  9. Code Sec 736 • Code Sec. 736 merely characterizes the payments. • Once characterized, the payments are taxed under rules in other Code Sections—707, 731, 732, 751, etc.

  10. Proportionate Liquidating DistributionsSolely for Partnership Property – Sec 736(b) (no Sec 736(a) payments)

  11. Proportionate Liquidating Distribution • Same impact on distributee as a current distribution with the following two exceptions: • Loss can be recognized if only cash, unrealized receivables, or inventory items are distributed and additional outside basis remains (see Code Sec. 731(a)(2)) • Distributed assets can get a stepped-UP basis if other assets (other than cash, UR, and Inventory) are distributed and the partner’s remaining outside basis exceeds the partnership’s inside basis in those other assets. (see Code Sec. 732(b) & (c)).

  12. Loss on Proportionate Liquidating Distribution -- Example 6-1 • Ginger’s pre-distribution OB $ 100,000 She receives a Sec 736(b) liquidating distrib. of: Cash $30,000 Inventory (FMV $70K) inside basis $60,000 • Solution: No gain to Ginger. Ginger’s basis in the inventory is $60,000. She recognizes a loss of $10,000 (100,000 – 30,000 – 60,000), her remaining outside basis. Code Sec. 732(c)(1)(A) forbids a basis step up for unrealized receivables or inventory items and Code Sec. 731(a)(2) authorizes the loss.

  13. Basis Increase With Liquidating Distribution -- Example 6-2 • Ginger’s pre-distribution OB: $ 100,000 She receives a Sec 736(b) liquidating distrib. of: Cash $30,000 Inventory (FMV $70K) inside basis $10,000 Invest Land (FMV $10K) inside basis $5,000 • Solution: No gain to Ginger. Her basis in the inventory is $10,000; her basis in the land becomes $60,000 (100,000 – 30,000 – 10,000)—her remaining outside basis. Code Sec. 732(b) authorizes Ginger’s $55,000 increase in her basis in the land.

  14. Distribution of Multiple “Other Assets”

  15. Basis Increase • An increase in the basis of distributed property to the distributee (liquidated partner) can only occur with a liquidating distribution (when outside basis exceeds inside basis), not with a current distribution and can only result in a basis increase for non-751 assets (not for hot assets).

  16. Basis Increase with Multiple “Other Assets” Code Sec 732(c)(3) • Step One: Each distributed asset within the class initially takes a carryover basis. • Step Two: Any increase for “other assets” (where outside basis exceeds inside basis) is allocated first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase (but only to the extent of each property's unrealized appreciation)

  17. Basis Increase with Multiple “Other Assets” Code Sec 732(c)(3) • Step 3: Any remaining increase in basis is allocated among all the distributed assets in the class in proportion to their respective FMV.

  18. Example 6-3 • Bob’s pre-distribution outside basis is $80,000. • The partnership distributes two parcels of land in liquidation (Sec 736(b)) of Bob’s interest: Inside BasisFMV • Parcel A: $40,000 $30,000 • Parcel B: $20,000 $30,000 • Bob’s outside basis exceeds the combined inside basis of both parcels by $20,000 (80,000 – 60,000). • In general, Bob’s basis in the two parcels will be increased from $60,000 to $80,000. How much basis increase is attributed to each parcel?

  19. Example 6-3 • Bob’s basis in the two parcels is determined as follows: • Step One: the parcels are assigned carryover bases of $40,000 and $20,000, respectively ($60,000 total). • Step Two: the unrealized appreciation in parcel B is eliminated, increasing its basis from $20,000 to $30,000. • The basis of parcel A is not adjusted in step two since it is not an appreciated asset.

  20. Example 6-3 • Step three: The remaining increase of $10,000 is allocated among all the distributed assets in the class in proportion to their respective FMV. • Bob’s basis in the two parcels after step two: Bob’s BasisFMV • Parcel A: $40,000 $30,000 • Parcel B: $30,000 $30,000

  21. Example 6-3 : Step Three • Step Three: • $5,000 adjustment to Parcel A (30,000 ÷ 60,000 X 10,000 = $5,000) • $5,000 adjustment to Parcel B (same calculation)

  22. Example 6-3 : Step Three • Bob’s basis in the two parcels after third step: BasisFMV • Parcel A: $45,000 $30,000 (40,000 + 5,000) • Parcel B: $35,000 $30,000 (30,000 + 5,000) Total $80,000 $60,000

  23. Basis DecreaseLiquidating Distributionsand Current Distributions

  24. Basis Decrease • As with a current distribution, a decrease in the basis of distributed property to the distributee partner can occur with a liquidating distribution when inside basis exceeds outside basis. • In that event, the rules for liquidating distributions match those for current distributions.

  25. Example of Basis Decrease in LiquidationSec 732(a)(2) • Ginger’s pre-distribution outside basis $70,000 She receives a liquidating distribution of: Cash $30,000 Investment land (FMV 80K) inside basis $55,000 • Solution: No gain to Ginger. Ginger’s basis in the land is $40,000 (70,000 – 30,000)

  26. Money Distributed in Excess of Outside Basis Liquidating Distributionsand Current Distributions

  27. Gain to Partner on Distribution of MoneyCode Sec 731(a)(1) Code Sec 731(a)(1): “In the case of a distribution by a partnership to a partner • gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution,…”

  28. Example of Code Sec 731(a) • Facts: Ginger’s pre-distribution outside basis is $15,000. She receives a proportionate liquidating distribution of $20,000 cash. • Solution: Ginger recognizes a capital gain of $5,000 (15,000 – 20,000).

  29. § 754 Electionsand § 734 Adjustments

  30. Current v. Liquidating DistributionRegarding Section 754 Election. • The two types of distributions that trigger an inside basis increase (gain recognition and excess inside basis over outside basis; Code Secs. 734(b)(1)(A) and (b)(1)(B)) function the same for liquidating as current distributions. • The two types of distributions that trigger an inside basis decrease are unique to liquidating distributions: • Downward adjustment for partner loss recognition on liquidation. • Downward adjustment for partner who increases basis of distributed asset to match outside basis (where outside basis exceeds inside basis)

  31. Section 734 Adjustment -- Increases • Increase. The partnership increases inside basis by the amount of Section 731(a) (1) gain recognized by distributee partner (Sec. 734(b)(1)(A)). This can occur in a current or liquidating distribution. • Increase. The partnership increases inside basis when the basis of distributed property is limited under Sec. 732(a)(2) or (b) to the distributee partner’s outside basis. (Sec. 734(b)(1)(B)). This can occur in a current or liquidating distribution.

  32. Section 734 Adjustments -- Decreases • Decrease. Decrease partnership inside basis by loss recognized by partner on distribution under Sec. 731(a)(2). (Sec. 734(b)(2)(A)). This can only occur with a liquidating distribution. • Decrease.Decrease partnership inside basis when the basis of distributed property to the distributee is increased in a distribution to match outside basis under Sec. 732(b). (Sec. 734(b)(2)(B)). This can only occur with a liquidating distribution.

  33. Partner Loss and Sec. 754 and 734Example 6-4A • Ginger’s pre-distribution OB $ 100,000 She receives a liquidating distribution of: Cash $30,000 Inventory (FMV $70K) inside basis $60,000 • Solution: No gain to Ginger. Ginger’s basis in the inventory is $60,000. She recognizes a loss of $10,000 (100,000 – 30,000 – 60,000), her remaining outside basis. Code Sec. 732(c)(1)(A) forbids a basis step up for unrealized receivables or inventory items and Code Sec. 731(a)(2) authorizes the loss.

  34. Example 6-4A If the partnership makes a timely Sec. 754 election, the partnership’s basis in its capital assets will be adjusted downward by $10,000. (Sec. 734(b)(2)(A))

  35. Basis Increase and Sec. 754Example 6-4B • Ginger’s pre-distribution OB: $ 100,000 She receives a liquidating distrib. of: Cash $30,000 Inventory (FMV $70K) inside basis $10,000 Invest Land (FMV $10K) inside basis $ 5,000 • Solution: No gain to Ginger. Her basis in the inventory is $10,000; her basis in the land becomes $60,000 (100,000 – 30,000 – 10,000)—her remaining outside basis. Code Sec. 732(b) authorizes the $55K step-up in basis.

  36. Example 6-4B • If the partnership makes a timely Sec. 754 election, the partnership’s basis in its capital assets will be adjusted downward by $55,000. (Sec. 734(b)(2)(B))

  37. 2004 Jobs Act Changeto Code Sec 734

  38. Sec. 734 Adjustment Following Distribution Of Property Code Sec. 734(a) and (d)) • 2004 Jobs Act Change A partnership is required to make a downward basis adjustment to the basis of partnership assets under Code Sec. 734 in the case of a distribution with respect to which there is a substantial basis reduction (Code Sec. 734(b) and (d)). • See IRS Notice 2005-32 for interim guidance (issued in April 2005)

  39. Code Sec. 734(a) and (d)). • A substantial basis reduction means a downward adjustment of more than $250,000 that would be made to the basis of partnership assets if a Code Sec. 754 election were in effect. • Effective: Distributions after October 22, 2004.

  40. Code Sec. 734(a) and (d)).

  41. Partner Loss and Sec. 754 and 734Example 6-5A • Ginger’s pre-distribution outside basis $500,000 She receives a liquidating distribution of: Cash $240,000 • Solution: Ginger recognizes a Sec 731(a)(2) loss of $260,000 (500,000 – 240,000).

  42. Example 6-5A • Even without a Section 754 election, the partnership MUST make a downward adjustment in its capital assets (per Code Sec. 734) because the basis reduction is “substantial.” • The adjustment is “substantial” because the Section 734(b)(2)(A) downward adjustment (arising from Ginger’s loss recognition) exceeds $250,000. • This will not occur with a current distribution because Section 731 does not permit such losses with a current distribution.

  43. Basis Increase and Sec. 754Example 6-5B • Ginger’s pre-distribution OB: $ 500,000 She receives a liquidating distrib. of: Cash $30,000 Inventory (FMV $70K) inside basis $10,000 Invest Land (FMV $300K) inside basis $200,000 • Solution: No gain to Ginger. Her basis in the inventory is $10,000. Her basis in the land becomes $460,000 (500,000 – 30,000 – 10,000), her remaining outside basis. • Code Sec. 732(b) authorizes the $260,000increase in Ginger’s land basis.

  44. Example 6-5B • Even without a Section 754 election, the partnership MUST make a downward adjustment in its capital assets (per Code Sec. 734) because the basis reduction is “substantial.” • The adjustment is “substantial” because the Section 734(b)(2)(B) downward adjustment (arising from Ginger’s land basis increase) exceeds $250,000. • This will not occur with a current distribution because a distributee partner never makes an Section 732(b) upward adjust to the basis of distributed property following a current distribution.

  45. Example of Mandatory Section 734 Adjustment with Accounting Entries

  46. Example Facts • The balance sheet of MLSJ Partnership is on the next slide. • Josey’s pre-distribution outside basis is $600,000 and she receives a liquidating distribution—FMV $700,000--consisting of: • Land #1 -- $500,000 (FMV) (inside basis $100,000) • Money -- $200,000

  47. Pre-Distribution Balance Sheet

  48. Tax Impact on Josey • Josey’s Sec 732(b) Basis in the Land: • Beginning OB: $600,000 • Money <200,000> • Basis in Land = $400,000 (Inside Basis $100K) ($300,000 increase over inside basis) • Under amended Code Sec. 734(b) , there is a “substantial basis reduction” because the Code Sec. 734(b)(2)(B) adjustment (increase in inside basis in the land) exceeds $250,000. Code Sec. 734(d)(1).

  49. Partnership Tax Basis Accounting Entries Debit:Credit: Josey’s Equity $600,000 Cash $200,000 Land #1 $100,000 Land #2 (Sec. 734(b) Adj.) $300,000

  50. Example – After Liquidation of Joseyand Mandatory 734(b) Adjustment * * The partnership’s original basis in Land #2 was $500,000

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