1
WHEN PARTNERS GO
THEIR SEPARATE WAYS: A
CASE STUDY
Howard E. Abrams
Professor, Emory Law School
Visiting Professor, University of San Diego
School of Law
2
Exit Issues
• Recognition of Income and Loss
• Character of Recognized Gain or Loss
• Inventory that is Not “Substantially Appreciated”
• Unrecaptured Section 1250 Gain
• Tax Consequences to Remaining Partners
• Tax Consequences to the Buyer
3
Allocation of Partnership Tax Items
• A partner’s share of the partnership’s tax items is called
the partner’s “distributive share.”
• When book and tax items occur simultaneously, they must
be allocated together in accordance with the “substantial
economic effect” test of § 704(b).
• When the book items occurs first, it must be allocated in
accordance with the “substantial economic effect” test and
then the tax item must follow when recognized by the
partnership. § 704(c).
• Allocation of tax credits and nonrecourse deductions can
never have “substantial economic effect.”
4
Allocations Under Section 704(b)
• Properly maintained capital accounts.
• Liquidation proceeds distributed according to positive
capital account balances.
• Either an unlimited capital account deficit restoration
obligation or a limited DRO and
• Capital account look-ahead;
• No allocation of deduction can drive the capital account more
negative than the limited DRO; and
• Qualified Income Offset provision in the partnership agreement.
5
Allocations Under Section 704(c)
• Addresses book/tax disparity caused by contribution of
appreciated or loss property (a “forward” layer) or by a
book-up of existing property (a “reverse” layer).
• Special rules substitute loss of depreciation deductions for
recognition of tax gain.
• Ceiling limitation can be addressed by the traditional
method, by the traditional method with curative
allocations, or by the remedial allocation method.
6
Capital Account Maintenance
• Contributed property must be booked into the partnership
•
•
•
•
at current fair market value.
Distributed property must be booked to fair market value
immediately prior to the distribution.
Non-pro rata distributions and contributions permit but do
not require a revaluation of assets and a restatement of
capital accounts.
Distributions reduce capital accounts.
Tax credits do not affect capital accounts.
7
Book-Up example
X and Y each contribute $100 to the XY LLC in exchange for a 50% interest in
profits and losses. The partnership agreement complies with the alternate test
for economic effect, and neither member has an obligation to contribute
additional funds to the venture. XY purchases nondepreciable asset #1 for $80
and nondepreciable asset #2 for $120. When asset #1 has increased in value
to $300 and asset #2 has increased in value to $400, XY distributes asset #1 to
X in a nonliquidating distribution. The partnership does not elect to book asset
#2 to fair market value. Under the partnership agreement, the books of the
venture would become:
______X______ _____Y______
CA OB
CA
OB
$ 100 $ 100
$ 100 $ 100
Initial values
110
0
110
0
Mandatory book-up of asset #1
( 300) ( 80)
0
0
Mandatory book-out of asset #1
($ 90) $ 20
$ 210 $ 100
Final values
8
Book-Up example continued
To comply with the alternate test for economic effect, the books must
become:
______X______
CA
OB
$ 100
$ 100
200
0
( 300)
( 80)
$ 0
$ 20
_____Y______
CA OB
$ 100 $ 100
20
0
0
0
$ 120 $ 100
Initial values
Mandatory book-up of asset #1
Mandatory book-out of asset #1
Final values
9
Book-Up example continued
If asset # 2 is sold by the partnership in a subsequent year and if the gain
is divided equally, the books will become:
______X______ _____Y______
CA
OB
CA
OB
$ 100
$ 100
$ 100 $ 100
Initial values
200
0
20
0
Mandatory book-up of asset #1
( 300)
( 80)
0
0
Mandatory book-out of asset #1
140
140
140
140
Sale of asset #2
$ 140
$ 160
$ 260 $ 240
Final values
10
Book-Up example continued
If the partnership had elected to book asset #2 to fair market value
immediately prior to the distribution of asset #1, the final books would read:
______X______ _____Y______
CA
OB
CA OB
$ 100 $ 100
$ 100 $ 100
Initial values
140
0
140
0
Optional book-up of asset # 2
110
0
110
0
Mandatory book-up of asset #1
(300) ( 80)
0
0
Mandatory book-out of asset #1
0
140
0 140
Sale of asset #2
$ 50 $ 160
$ 350 $ 240
Final values
11
Contributions
• Property: Tax-free to all parties, with basis carried into
partnership interest and inside basis. Capital account
credited with net equity contributed.
• Services: Taxable if contributed in exchange for a capital
interest; tax-free if contributed in exchange for a share of
future profits only (assets must be revalued immediately
prior to contribution).
• The Carried Interest Controversy: The President’s tax
proposal includes changes to the taxation of a profits
interest received in exchange for a contribution of
services.
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Outside Basis
• Outside basis includes the adjusted basis of contributed
property less adjusted basis of distributed property plus
distributive share of income less distributive share of loss.
• Partnership Debt:
• An increase in share of debt is treated as contribution of cash for
outside basis (but not for capital account).
• A decrease in share of debt is treated as distribution of cash for
outside basis (but not for capital account).
• Note: the regulations do not provide a direct way of computing a
change in debt share but only actual debt shares at any point in
time.
13
Nonliquiding Distributions
• Gain is not recognized except to the extent that
distributed cash (including marketable securities) exceeds
outside basis.
• Loss cannot be recognized on nonliquidating distribution.
• Asset basis carried over so long as outside basis can
absorb the reduction.
14
Dispositions
• Gain or loss general capital under § 741.
• Full ordinary income look-thru under § 751(a).
• Full capital gain rate look-thru under § 1(h).
• Can trigger a technical termination.
15
Disposition example
• T has a $275,000 adjusted basis in a one-quarter interest
in the P partnership when P owns the following:
• Land with adjusted basis of $300,000 and value of $400,000.
• Building with adjusted basis of $0, value of $2,000,000, and
unrecaptured § 1250 gain of $1,200,000.
• Inventory with adjusted basis of $800,000 and value of $640,000.
• If T sells the interest for $760,000, there is total gain of
$485,000 of which $225,000 is 15% capital gain,
$300,000 is 25% capital gain, and $40,000 is an ordinary
loss.
• If T sells the interest for only $750,000, then the 15%
capital gain is reduced to $215,000. See Reg. §1.1(h)1(b)(3)(ii).
16
Liquidating Distributions
• Gain equals the excess, if any, of distributed cash over
•
•
•
•
outside basis.
Loss cannot be recognized if the distribution includes a
capital asset or an asset described in § 1231.
In general, outside basis is pushed into asset basis.
Ordinary income look-thru under § 751(b) to the extent of
unrealized receives and other ordinary-income assets if
“substantially appreciated” as a group.
Note: the redemption of a partnership interest is not a sale
or exchange and so cannot trigger a technical termination.
17
Distribution example
• T has a $275,000 adjusted basis in a one-quarter interest
in the P partnership when P owns the following:
• Land with adjusted basis of $300,000 and value of $400,000.
• Building with adjusted basis of $0, value of $2,000,000, and
unrecaptured § 1250 gain of $1,200,000.
• Inventory with adjusted basis of $800,000 and value of $640,000.
• If T receives a liquidating distribution of $760,000, there is
total gain of $485,000, all of which is 15% capital gain.
18
Base Case: Liquidating Distribution of
Cash
• Triggers an actual termination of the venture once the
•
•
•
•
exiting partner is fully paid.
The distribution amount should be equal to the exiting
partner’s capital account (adjusted for unrealized book
appreciation and loss) but the regulations contemplate the
possibility of other amounts.
Ordinary income equal to the extent of share of unrealized
receivables and substantially-appreciated inventory and
inside basis increase of the same amount.
Capital gain is taxed at 15%.
Inside basis increase for capital gain if election under §
754 in effect or is made on final return.
19
Base Case: Will Form Be Respected?
• Assets received as a distribution take a tacked holding
period.
• In Rev. Rul. 99-6, the Service ruled that the purchase of
one interest by the other partner would be treated as an
asset purchase to the purchaser to limit tacking to half the
assets.
• There is no law recharacterizing cash to one partner and
assets to the other, but the possibility of recharacterization
based on Rev. Rul. 99-6 is a possibility.
• Can this risk be minimized by distributing a note to the
exiting partner, paid off over time? Probably.
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Alternative 1: Distribution of Property
• No gain or loss on distribution unless cash plus liabilities
•
•
•
•
exceeds outside basis.
Possible application of § 751(b) if distribution works a
swap of ordinary unrealized receivables or substantiallyappreciated inventory.
Outside basis pushed into assets.
Full ordinary income and loss on sale under § 735 if sale
within five years. – Consider converting inventory to
capital asset prior to distribution if possible.
Direct application of multiple capital gain rates.
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Alternative 2A: Sale of Interest to Other
Partner
• Amount realized includes share of debt.
• Installment sale allowed subject to limitations.
• Rev. Rul 89-108 on inventory (see § 453(b)(2)).
• Section 453(i)(1) on recapture.
• Full ordinary income pick-up under § 751(a).
• Capital gain rate look-thru.
• Asymmetric recharacterization under Rev. Rul. 99-6. Cost
basis in assets deemed purchased.
22
Alternative 2B: Sale of Interest to Third
Party
• Sale taxed the same to exiting partner regardless of the
purchaser.
• Inventory captured as ordinary income.
• Sale can trigger technical termination. (Note that technical
termination does not affect amortization of intangibles
under § 197.)
• Positive outside basis for purchaser only if § 754 election
in effect or mode on partnership return.
23
Exit By Both Partners: Sale of Assets
• Gain or loss recognized:
• Full ordinary income recognition under § 751(a).
• Multiple capital gain rates under direct application of § 1(h).
• Consider application of § 724 on sale of contributed property:
• Inventory by contributing partner;
• Built-in capital loss at time of contribution.
• Bifurcated holding period of partnership interest irrelevant.
• Distribution of cash generally will not trigger gain or loss.
24
Exit By Both Partners: Distribution of
Assets
• Distribution generally tax-free.
• Ordinary income on sale captured by § 735 for 5 years.
• Distribution of contributed property can be taxable to
contributing partner.
• Distribution to partner who contributed appreciated
property within 7 years may trigger taxation of built-in
gain.
• Joint sale of assets may be recharacterized as sale by the
partnership.
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Exit by Both Partners: Joint Sale of
Interests
• For sellers:
• Gain or loss recognized.
• Full ordinary income pick-up under § 751(a).
• For buyer: recharacterization as purchase of assets.
• Cost basis in all assets.
• Complete depreciation restart including intangibles.
Dispositions After Distributions
• Facts: X owns 60% and Y owns 40% of the XY-LLC. XY
owns a single, nondepreciable asset with adjusted basis
and book value of $0 and value of $2,000. Each partner
has a $0 outside basis and capital account, and no
partner has a deficit restoration obligation.
Full Sale with Debt Shift to Z
X
CA
Y
OB
CA
Z
OB
CA
0
0
0
0
0
300
0
200
1200
0
800
0
-300
-300
-200
-200
900
0
0
0
OB
Initial values
Borrowing
Book-up
Distribution
600
800 Purchase by Z
600
800 Totals
XY borrows $500 against its asset and distributes the proceeds to X and
Y. Y then sells her partnership interest to Z, and Y’s share of the liability
shifts to Z. Y’s gain equals $800. Z has an outside basis of $600 + $200
and Y’s capital account of $600. Z enjoys an inside basis adjustment of
positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on
nothing.
Full Sale Without Debt Shift to Z
X
CA
Y
OB
CA
Z
OB
CA
0
0
0
0
0
300
0
200
1200
0
800
0
-300
-300
-200
-200
200
900
200
0
0
OB
Initial values
Borrowing
Book-up
Distribution
600
600 Purchase by Z
600
600 Totals
XY borrows $500 against its asset and distributes the proceeds to X and
Y. Y then sells her partnership interest to Z, and Y’s share of the liability
shifts to X. Y’s gain equals $800. Z has an outside basis of $600 and Y’s
capital account of $600. Z still enjoys an inside basis adjustment of
positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on
nothing.
Partial Sale Without Debt Shift
X
CA
Y
OB
CA
Z
OB
CA
OB
0
0
0
0
0
300
0
200
1200
0
800
0
-300
-300
-200
-200
200
-300
0
300
300 Purchase by Z
0
300
0
300
300 Totals
900
Initial values
Borrowing
Book-up
Distribution
Y sells half of her interest for its value of $300. No debt shifts from the
sale. Y’s gain on the sale equals $300. Immediately before the sale, Y’s
built-in gain equaled $800. How much of that gain moves to Z? Note that Y
recognized a gain of $300 on the sale to Z. Note also that Z’s inside basis
adjustment under section 743(b) will equal Z’s share of the built-in gain in
all events.
Shifting Half the Built-In Gain?
X
CA
Y
OB
CA
Z
OB
CA
OB
900
0
300
0
300
300 Initial values
0
1200
0
400
0
0
0
0
0
0
-400 743(b) adjustment
0
-300
0
-200
0
0 Debt repayment
900
900
300
200
300
400 Sale of property
300 Totals
If half of Y’s built-in gain is shifted to Z, then when the property is sold,
the $2,000 of tax gain will be allocated $1,200 to X, $400 to Y, and $400 to
Z, with Z’s share offset by the 743(b) adjustment. Since Y reported only a
$300 gain on the sale to Z, this means $100 of appreciation in the asset
has gone untaxed (note the book/tax disparity for Y). Only $300 of the
built-in gain should have shifted on the partial sale from Y to Z, leaving
$500 of gain for Y on asset sale.
Shifting Only the Right Gain
X
CA
Y
OB
CA
Z
OB
CA
OB
900
0
300
0
300
300 Initial values
0
1200
0
500
0
0
0
0
0
0
-300 743(b) adjustment
0
-300
0
-200
0
0 Debt repayment
900
900
300
300
300
300 Sale of property
300 Totals
If only $300 of Y’s built-in gain is shifted to Z, then when the property is
sold, the $2,000 of tax gain will be allocated $1,200 to X, $500 to Y, and
$300 to Z, with Z’s share offset by the 743(b) adjustment. Now, Y does not
escape any gain. Note that Z’s capital account, outside basis, and net
income recognition are unaffected.
Sell, Distribute or Both
• Facts: X and Y each contribute $100 to the XY
partnership. XY purchases a nondepreciable asset for
$200, and when it increases in value to $1,000, Y is ready
to exit the venture.
• Y can sell to Z for $500, receive a liquidating distribution
of $500, or some combination of each. Does it matter?
(Ignore the collapse of XY if Y receives a liquidating
distribution.)
Sale by Y to Z
• On the sale, Y recognizes a gain of $400. Z takes a cost
outside basis of $500 and a capital account of $100. Z
enjoys a $400 inside basis adjustment under section
743(b). There is no effect on X, so if the property is then
sold by the partnership, X will recognize a gain of $400. Z
is protected by the 743(b) adjustment.
Distribution to Y
• On the distribution, Y recognizes a gain of $400. There is
a $400 common inside basis adjustment under section
734(b), so that when the asset is sold, the gain to X will
equal $400 (amount realized of $1,000 less adjusted
basis of $600).
• Same basic result as the sale.
Distribution Followed by Sale
• Suppose the partnership borrows $490, guaranteed only
by X. The loan proceeds are distributed to Y, reducing Y’s
interest in the venture from $500 to $10. Y then sells her
remaining interest to Z for $10.
• On the distribution, Y recognizes a gain of $390; on the
sale, Y recognizes an additional gain of $10. Thus, for Y
this offers no improvement.
Benefit to X
• As a result of the leveraged distribution, the partnership is
entitled to an inside basis adjustment of $390 under
section 734(b).
• On the sale of Y’s stub interest to Z, Z takes a cost basis
of $10 and enjoys an inside basis adjustment of $205
under section 743(b).
• When the asset is sold, there is a taxable gain of $410
(amount realized of $1,000 less cost of $200 plus 734(b)
adjustment of $390).
Benefit to X: Continued
• Of the taxable gain of $410, $205 is allocable to X and
$205 to Z; Z’s share is offset by Z’s 743(b) adjustment.
• If the debt is then repaid out of the sale proceeds, XY will
own cash of $510. X’s capital account will equal $500 and
Z’s capital account will equal $10. But X has been taxed
on only $205 rather than on $400 (X’s outside basis is
only $305).
What Happened?
• When cash is distributed to a partner, any gain recognized
by the distributee yields a common inside basis
adjustment under 734(b) benefitting all the partners. This
is a shifting of basis from the distributee to the other
partners, for no net benefit: positive deferral for the other
partners and negative deferral for the distributee. But then
the distributee exits, ending the negative deferral.
Distribution to Y
X
CA
Y
OB
CA
OB
100
100
100
100 Formation
0
490
0
0 Borrowing
400
0
400
0
0
-490
500
590
10
Asset
Property
Book
1,000
Basis
590
0 Book Up
-100 Distribution -> Gain of
390
0 Totals
Debt
(490)