by Many partnership agreements require that a partner who wishes to dispose of his interest in the partnership do so by surrendering it to the partnership in exchange for a liquidating distribution. Many partnership agreements do not allow the unrestricted sale to the public since the remaining partners do not want to be forced to accept anyone who may not be desirable for the business, who may not have the requisite skills, or who may not get along with the other partners. The partnership agreement will also often contain a formula for determining the liquidating distribution that reduces the partner’s basis in the partnership to 0.
Liquidating distributions are based on the fair market value (FMV) of a partner’s capital account, so the partnership property must be revalued and unrecorded intangible assets, such as goodwill, must be included. The value of the liquidating distribution = the amount received by the withdrawing partner + any extinguished apportioned debt.
Liabilities. When a third-party buy a partnership interest, the buyer generally assumes the selling partner’s share of indebtedness of the partnership, and thus, is added on to the sale price.
Hot Assets
A partnership that has unrealized receivables and inventory, i.e., hot assets, that, when sold by the partnership, causes it to recognize ordinary income complicates the taxation of the selling partner’s interest, since some of the gain or loss may be ordinary rather than capital. The selling partner must recognize the income just as if those assets were sold, with the ordinary income being allocated to the partner. This rule prevents the conversion of ordinary income into capital income that is usually taxed at a lower rate through the sale of the partnership interest.
Unrealized receivables consist of accounts receivable of a cash basis partnership and anything that is sold that is subject to depreciation recapture rules.
Abandonment or Worthlessness of Partnership Interest:
Depending upon the circumstances, the abandonment or worthlessness of a partnership interest may give rise to a loss deduction under Code Sec. 165. Whether the loss is capital or ordinary depends on whether or not the loss results from the sale or exchange of a capital asset. If there is an actual or deemed distribution from the partnership, the transaction is treated as a sale or exchange of the partnership interest and any resulting loss is capital, except as provided in Code Sec. 751(b) (relating to inventory and unrealized receivables).
See Code Sec. 731(a), Code Sec. 741, and Rev. Rul. 93-80, 1993-2 C.B. 239. Thus, for example, if the abandonment results in the relief of the partner’s share of the partnership’s liabilities, the loss will be capital even if no other consideration is received. In addition, the receipt of a de minimis amount of consideration will cause the loss to be a capital loss. However, a partner who does not receive any consideration and is not relieved of a liability may take an ordinary loss on the abandonment of a partnership interest. Citron, B. Philip, (1991) 97 TC 200.
Sale of Entire Interest When a partnership interest is sold, it is necessary to allocate partnership profit or loss between the transferor-partner and the transferee-partner. Generally, the taxable year of the partnership as a whole does not close on the sale or exchange of a partner’s interest. Code Sec. 706(c)(1) ; Reg § 1.706-1(c)(1) . This is true even though the transfer often results in the partnership’s technical dissolution under the nontax rules of most jurisdictions.
However, a partnership’s taxable year closes with respect to a partner who sells his entire partnership interest. Code Sec. 706(c)(2)(A); Reg § 1.706-1(c)(2) . Accordingly, the selling partner’s distributive share of the partnership’s tax items for the short period, ending on the disposition date, is included in his tax return for his taxable year that includes the sale date. Reg § 1.706-1(c)(2)(i).
Thus, if the sale occurs in December of Year 2, a selling calendar year partner in a January fiscal year partnership may be required to include as many as 23 months of partnership income on his Year 2 return (his share of the partnership’s income for the partnership year ending January of Year 2 and his share of the partnership’s income from January of Year 2 to December of Year 2). The other partners will not be affected by the sale.
The selling partner’s share of partnership tax items may be determined either by making an “interim closing” of the partnership books and determining the amount of partnership’s items up to the day of the sale. However, if the partners agree, the partnership’s income, gain, loss, deduction, and credit for the entire year may be allocated between the selling partner and the buyer. This can be done by estimating what the partner’s share of the partnership’s items would have been had he remained a partner until the end of the year and prorating these items between the selling partner and the buyer. The proration may be based on the portion of the taxable year that has elapsed before the sale, exchange, or liquidation or may be determined under any other reasonable method. Reg § 1.706-1(c)(2)(ii).
