Allocations with Respect to Contributed Property

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Exit Strategies
Howard E. Abrams
Warren Distinguished Professor, USD School of Law
November 2015
www.taxnerds.com
Copyright 2015 by Howard E. Abrams
Exit Issues
 Computation of Gain or Loss
 Determination of the Ordinary Income Component
 Basis Implications of the Transaction
 Impact on the Other Partners
Sale of Partnership Interest:
Overview
 Gain or loss computed under section 1001 (share of
liabilities increases amount realized)
 Ordinary income component determined under
section 751(a)
 Capital gain rate determined by partnership assets
 Possible basis adjustment under section 743(b)
 Possible technical termination
Sale of Partnership Interest:
Computation of Ordinary Income
 OI component equals distributive share of ordinary
income as if all assets were sold for fair market
value.
 Note: this amount is independent of purchase price
paid for the partnership interest.
Sale of Partnership Interest:
Capital Component
 Total gain or loss equals comparison of amount
realized (including debt share) with selling partner’s
outside basis.
 Capital gain (loss) component equals total gain
minus OI component.
 Note: if sale price is greater (less) than liquidation
value, excess (reduction in) gain is capital: OI
component is fixed and independent of sale price.
 Capital gain rates(s) turn on assets held by the
partnership.
Sale of Partnership Interest:
Example 1
 The P partnership owns cash of $100,000, a capital
asset with adjusted basis of $20,000 and value of
$60,000, and inventory with adjusted basis of
$50,000 and value of $80,000. X has a one-tenth
interest in the venture with outside basis of
$17,000. X sells its partnership interest for $24,000.
 OI component equals $3,000.
 Total gain equals $24,000 - $17,000, so capital gain
equals $7,000 - $3,000, or $4,000.
Sale of Partnership Interest:
Example 2
 The P partnership owns cash of $100,000, a capital
asset with adjusted basis of $70,000 and value of
$60,000, and inventory with adjusted basis of
$50,000 and value of $80,000. X has a one-tenth
interest in the venture with outside basis of
$22,000. X sells its partnership interest for $24,000.
 OI component equals a gain of $3,000.
 Total gain equals $24,000 - $22,000, or $2,000, so
capital gain equals $2,000 – ($3,000), or a loss of
$1,000.
Sale of Partnership Interest:
Purchasing Partner
 Outside Basis: The purchasing partner takes a cost
outside basis increased by debt share.
 Capital Account: The purchasing partner takes the
selling partner’s capital account without change.
Sale of a partnership interest is NOT an event that
authorizes a revaluation of partnership assets and a
restatement of capital accounts.
 If an election is in effect or is made by the
partnership, an adjustment under section 743(b)
can be made.
Sale of a Partnership Interest: The
Section 743(b) Adjustment
 An adjustment is made to each ordinary income
that gives the purchasing partner a cost basis in
each asset.
 If the purchasing partner pays the liquidation
amount, an adjustment is made to each capital
asset that gives the purchasing partner a cost basis.
If more or less is paid, there will be a greater or
lesser adjustment to the capital assets.
Sale of a Partnership Interest: The
Mandatory 743(b) Adjustment
 Even if no election under section 754 is in effect for
the year of sale, an adjustment must be made if
there is a net loss in the partnership’s assets in
excess of $250,000. Note that this rule can result in
mandatory negative adjustments much less than
$250,000. It can even result in a mandatory postive
adjustment.
Sale of a Partnership Interest:
Other Issues
 Can the sale of a partnership issue be reported on
the installment method?
Sale of a Partnership Interest:
Other Issues
 Can the sale of a partnership issue be reported on the
installment method?
 The statute provides that installment sale treatment is
not available to the extent of the selling partner’s share
of ordinary income recapture under section 1245 and
1250. See I.R.C. §453(i)(2).
 In Mingo v. Commissioner, T.C. Memo. 2013-149, aff’d,
5th Cir. (Dec. 9, 2014), the court seems to have held
that the installment method cannot be used with
respect to share of any ordinary income asset.
Liquidating Distribution of Cash:
Overview
 Gain or loss is computed by comparing amount of
cash distributed to the exiting partner’s outside
basis (share of liabilities treated as additional cash)
 Ordinary income share is determined under section
751(b)
 Possible inside basis adjustment under section
734(b); automatic basis adjustment under section
751(b)
Liquidating Distribution of Cash:
Ordinary Income Component
 Section 751(b) captures the exiting partner’s share
of “unrealized receivables” (broadly defined) as
well as the exiting partner’s share of “substantially
appreciated inventory.”
 Proposed regulations will be finalized in
substantially unchanged form. The exiting partner
picks up OI as if all the 751(b) assets were sold for
fair market value, and there is both an inside basis
and an outside basis step-up for the gain
recognized.
Liquidating Distribution of Cash:
Capital Gain or Loss
 The excess of the amount of cash distributed
(including debt share) over the outside basis as
adjusted under section 751(b) is the capital gain
component. If outside basis exceeds amount
realized, there is a capital loss.
 The capital gain is taxed at 20%: no look-thru to the
partnership’s depreciated real estate or collectibles.
 If the partnership has loss inventory, there is
negative character conversion.
Liquidating Distribution of Cash:
Example
 The P partnership owns cash of $100,000, a capital
asset with adjusted basis of $20,000 and value of
$60,000, and inventory with adjusted basis of
$50,000 and value of $80,000. X has a one-tenth
interest in the venture with outside basis of
$17,000. X receives a liquidating distribution of
$24,000 in cash.
Liquidating Distribution of Cash:
Example
 The P partnership owns cash of $100,000, a capital
asset with adjusted basis of $20,000 and value of
$60,000, and inventory with adjusted basis of
$50,000 and value of $80,000. X has a one-tenth
interest in the venture with outside basis of
$17,000. X receives a liquidating distribution of
$24,000 in cash.
 X recognizes ordinary income of $3,000, increases
outside basis to $20,000, so X recognizes a capital
gain of $24,000 – $20,000, or $4,000.
Liquidating Distribution of Cash:
Basis Implications
 The ordinary income component generates its own
inside basis adjustment automatically.
 Any capital gain generates an inside basis
adjustment to the partnership’s common basis in
its capital assets if an election under section 754 is
in effect or is made for the year of exit. Such an
adjustment is made under section 734(b).
 Recognition of a capital loss may trigger a
mandatory downward inside basis adjustment.
Liquidating Distribution of Cash:
Example
 The P partnership owns cash of $100,000, a capital
asset with adjusted basis of $20,000 and value of
$60,000, and inventory with adjusted basis of
$50,000 and fair market value of $80,000. X has a
one-tenth interest in the venture with outside basis
of $17,000. X receives a liquidating distribution of
$24,000 in cash.
 X recognizes ordinary income of $3,000, increasing
the inside basis of the inventory to $53,000. X also
recognizes a capital gain of $4,000, increasing the
inside basis of the capital asset to $24,000 if an
election under section 754 is in effect.
Liquidating Distribution of Cash:
Mandatory Downward Adjustment
 Even if the partnership does not have an election in
effect for the year of exit, a negative adjustment
must be made if such an adjustment would exceed
$250,000. In general, that means the amount of
the exiting partner’s outside basis exceeds the
amount of the distributed cash (including debt
share) by more than $250,000. (I.e., loss in excess
of gain exceeds $250,000.)
Liquidating Distribution of Cash:
Impact on Other Partners
 Inside basis adjustment (if made) eliminates exiting
partner’s share of capital gain and loss.
 Liquidation of an interest in the venture is NOT
treated as a sale or exchange of the liquidated
interest, so no effect on potential technical
termination.
Liquidating Distribution of Cash:
Other Issues
 If the exiting partner receives payments over time,
the default rule is basis recovery first, then gain.
But presumably section 751(b) mandates OI before
basis recovery or capital gain.
 Exiting partner can elect to recognize capital gain
using equivalent of installment method rather than
basis recovery first. High-bracket taxpayers rarely
should make such an election.
Liquidating Distribution of a Note
 Suppose a partnership distributes its own note to a
partner in liquidation of the partner’s interest in
the venture. What are the tax consequences of
such a distribution?
Liquidating Distribution of a Note
 Suppose a partnership distributes its own note to a
partner in liquidation of the partner’s interest in
the venture. What are the tax consequences of
such a distribution?
 Assuming the note is not publicly traded, the
distribution of the note is a nonevent under
subchapter K. Payments on the note will be the
taxable events, as discussed above.
Sale of a Partnership Issue:
Holding Period
 A partner has a single outside basis no matter how
many partnership interests owned under state law.
 A partner has a single capital account no matter
how many partnership interests owned under state
law.
 But a partner can have multiple holding periods for
a single partnership interest.
Holding Period of a Partnership
Interest
 Gain or loss from the sale or exchange of a
partnership interest or triggered by a distribution of
cash from the partnership will be long-term or
short-term depending on the partner’s holding
period in the partnership interest.
 A partner can have a bifurcated holding period in
his partnership interest. That is, gain or loss can be
both long-term and short-term.
Holding Period: Contribution of
Multiple Properties
 When property is contributed to a partnership,
holding period carries over from the contributed
property into the partnership interest.
 If multiple assets are contributed, a proportion of
the partnership interest will receive a holding
period from each contributed asset in proportion to
the relative fair market value of each contributed
property.
Multiple Properties: Example
 X contributes cash of $1,000, capital asset #1 with
value of $2,000 and a sixth-month holding period,
and capital asset #2 with value of $3,000 and a
holding period in excess of one year.
 X will have a new holding period as to one-sixth of
the partnership interest, a six-month holding
period as to one-third of the partnership interest,
and a long-term holding period as to one-half of
the partnership interest.
Holding Period: Subsequent
Contributions
 If a partner contributes cash or property to the
partnership, a portion of the holding period will be
redetermined in proportion to the value of the
contribution as compared with the value of the
partnership interest.
Holding Period: Subsequent
Contributions
 If a partner contributes cash or property to the
partnership, a portion of the holding period will be
redetermined in proportion to the value of the
contribution as compared with the value of the
partnership interest.
 Example: X owns a partnership interest with value
of $500 and a long-term holding period. X
contributes cash of $250. As a result of the
contribution, X has a new holding period in onethird of the partnership interest.
Holding Period: Subsequent
Distributions
 In general, the distribution of cash or property does
not affect the holding period of the distributee
partner in the partnership interest.
 However, cash (but not property) distributed from
the partnership up to 12 months prior to
recognition of gain from sale (or deemed sale) of
the partnership interest is netted against any
contributed cash (but not property) to reduce the
amount of gain treated as short-term.
Holding Period of Partnership
Assets
 While contributing cash or property will convert a
portion of the partnership interest into short-term
property, such contributions have no affect on the
partnership’s holding period with respect to assets
it already owns.
 Accordingly, the sale of assets by the partnership
will be unaffected by the bifurcation rule applicable
to partnership interests.
Discrete Exit Problems and
Solutions
Exiting: Prefer Property to Cash
 To avoid gain to the distributee partner, distribute
property rather than cash. Note: marketable
securities are treated much like cash.
 Can the distributee partner go shopping with the
partnership’s money? In ILM 200650014, the
Service determined that, when no other partner
would at any time have an economic interest in the
property, the answer is no.
Example: Single Capital Asset
 P receives Blackacre in a liquidating distribution
 Outside Basis = $10,000
 Inside Basis of Blackacre = $8,000
 Value of Blackacre = $13,000
Example: Single Capital Asset
 P receives Blackacre in a liquidating distribution
 No gain because no cash
 Asset basis = $10,000
 Note: inside step-down if section 754 election in effect
Example: All Cash
 P receives a liquidating distribution of cash
 Outside Basis = $10,000
 Cash = $13,000
Example: All Cash
 P receives a liquidating distribution of cash
 Gain of $3,000 (not subject to 25% recapture rate)
 Note: inside step-up if section 754 election in effect
Exiting: Loss Inventory
 If a partner exits via cash distribution a partnership
owning loss inventory, the partner’s share of the
loss will be recognized as a capital loss because
§751(b) speaks only to inventory that is
“substantially appreciated.” But if the partner exits
via a sale of the interest, the loss will be ordinary
under §751(a).
Exiting: Loss Inventory Example
 A condominium development ends badly, with the
final unsold units distributed to the partners. One
of the partners holds the unit for two years and
then sells it. Any gain or loss on the sale is ordinary
because the unit was inventory in the hands of the
partnership.
 To convert the gain into potential capital gain, the
partnership must change its holding of the property
prior to distribution.
Exiting: Loss Capital Assets
 If a partner exits a partnership owning loss capital
assets, the exiting loss will be capital if the partner
exits by sale, exchange, or liquidating distribution.
 Abandonment of the interest will convert the loss
into an ordinary loss so long as the exiting partner
has no share of partnership liabilities.
Loss Assets With a 754 Election
 Exiting from a partnership owning loss assets will
trigger a mandatory downward inside basis
adjustment if certain minimum thresholds are met.
While the dollar value of the thresholds are the
same for dispositions and distributions, they
operate very differently.
 A distribution triggers an inside basis adjustment if the
amount of the negative adjustment exceeds $250,000.
 A disposition triggers an inside basis adjustment if the
partnership owns assets have a net loss in excess of
$250,000.
Basis Reduction Example
 X has a 10% interest in the profits, losses and
capital of P. P’s assets have aggregate value of
$500,000 and inside basis of $800,000. X has an
outside basis of $80,000 though the interest is
worth only $50,000.
 A cash distribution of $50,000 does not trigger a
mandatory inside basis adjustment but a sale for
$50,000 does.
Appreciated Property, Incoming
Partner Will Own Limited Interest
 No partner can deduct a share of partnership
deductions in excess of outside basis. §704(d).
 A limited partner cannot be allocated a share of
partnership deductions in excess of the partner’s
capital account balance plus the maximum amount
the partner can be required to contribute to the
venture.
 If Z purchases Y’s interest in a partnership, Z’s
capital account is carried over from Y. Gain
recognized by Y does not increase the account.
Exiting: Depreciated Real Estate
 A partner who sells an interest in a partnership
owning depreciated real estate is subject to the
25% capital gain rate applicable to “unrecaptured
§1250 gain.”
 But an exit in exchange for a liquidating distribution
is not subject that this higher rate. And an election
under §754 will eliminate the exiting partner’s
share of the higher-rate gain permanently.
Simple Distributions
 X and Y each contribute $100 to form the XY
partnership as equal 50% partners. The partnership
purchases Blackacre and Whiteacre for $100 each.
Blackacre increases in value to $190 and Whiteacre
increases in value to $200. If the partnership sells
its assets, the books become:
X
CA
Y
OB
CA
OB
100
100
100
100 Formation
45
45
45
45 Sale of Blackacre
50
50
50
50 Sale of Whiteacre
195
195
195
195 Totals
Simple Distributions
 Now consider what happens if the partnerships
distributes Blackacre rather than selling it.
EO
CA
TO
OB
CA
OB
100
100
100
45
0
45
-190
-100
0
50
50
50
5
50
195
Asset
Cash
100 Formation
0 Book-Up of Blackacre
0 Distribution of Blackacre
50 Sale of Whiteacre
150 Totals
Book Value
$ 200
Inside Basis
$ 200
Reverse Disguised Sales
 The ABCD partnership has four equal partners,
each having an outside basis of $10 and a capital
account of $10. The partnership owns a
nondepreciable capital asset with inside basis of
$40, book value of $40, and current fair market
value of $100. Each partner’s share of the
unrealized appreciation is $15.
Reverse Disguised Sale
 Suppose the partnership borrows $75, guaranteed
only by D. The property, encumbered by the debt,
is then distributed to D in a liquidating distribution.
What are the books of the venture immediately
after D’s exit?
Reverse Disguised Sale
A
B
CA
OB
25
CA
10
Assets
Cash
C
OB
25
Book Value
75
CA
10
Adj. Basis
OB
25
10
Value
75
Note: There is a suspended $45 inside basis
adjustment but no gain recognized on the
distribution.
75
Making Gain Disappear
 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 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.)
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 benefit.
Making Gain Disappear
X
CA
Y
OB
CA
Z
OB
CA
OB
100
100
100
100
Formation
0
490
0
0
Borrowing
400
0
400
0
Book-Up
0
0
-490
-490
0
0
---
---
0
Distribution
10
10 Purchase by Z
205
0
205 Sale of Property
0
0
0
-205 743(b) Adjustment
0
-490
0
0 Debt Repayment
500
305
10
10 Totals
Gain on sale of property equals only $410 because distribution to Y triggered a
positive inside basis adjustment of $390 under section 734(b).
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 Y; Y’s share is offset by Y’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.
Partial Distribution
 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.
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.
Exit Strategies
Howard E. Abrams
Warren Distinguished Professor, USD School of Law
November 2015
www.taxnerds.com
Copyright 2015 by Howard E. Abrams
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