Study Unit 11: Disposition Of A Partner's Interest PDF

1 STUDY UNIT ELEVEN DISPOSITION OF A PARTNER’S INTEREST 11.1 Sale of a Partnership Interest............................................. 1 11.2 Liquidating Distributions...................................

1 STUDY UNIT ELEVEN DISPOSITION OF A PARTNER’S INTEREST 11.1 Sale of a Partnership Interest............................................. 1 11.2 Liquidating Distributions................................................. 3 The disposition of a partner’s interest in a partnership may be accomplished by either a sale or a liquidation. Because the tax consequences differ between the two methods, it is important to understand the differences between them. 11.1 SALE OF A PARTNERSHIP INTEREST The sale of a partnership interest generally results in a capital gain or loss. The gain or loss is the difference between the amount realized and the adjusted basis of the partnership interest. 1. The amount realized includes the relief of any liabilities that have been assumed by the buyer. EXAMPLE 11-1 Relief from Partnership Liabilities Tami sold her share of a partnership for $29,000. Her basis in the partnership is $24,000, including $10,000 of liabilities. The selling price is considered to be $39,000 ($29,000 cash received plus the $10,000 relief of liabilities). Thus, her gain on the sale of the partnership interest is $15,000 ($39,000 – $24,000). 2. The basis of the partnership interest must be adjusted for the current year’s distributive share and other allocations. 3. The partnership may make an election for an optional adjustment to the basis of partnership assets in the year the interest is transferred. a. The adjustment is the difference between the transferee partner’s basis for the partnership interest and the proportionate share of the basis of all partnership property. 4. The sale may be made to an outside party or another partner. A sale to the partnership is treated as a liquidating distribution. 5. Note that a sale of a partnership interest relates to a partner’s outside, or adjusted, basis. Inside basis relates to the basis the partnership has in its assets and can be affected by some elections by either the partner or partnership. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 11: Disposition of a Partner’s Interest Unrealized Receivables 6. If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. Termination of Partnership 7. A partnership terminates for federal tax purposes only when operations of the partnership cease. The partner’s self-employment income includes the partner’s distributive share of income earned by the partnership through the end of the month in which the partner’s death occurs. a. Sale or exchange termination is treated as a distribution of assets immediately followed by the contribution of those assets to a new partnership. b. The tax year of a partnership closes with respect to a partner whose entire interest in the partnership terminates by death, liquidation, or other means. 1) A deceased partner’s allocable share of partnership items up to the date of death will be taxed to the decedent on his or her final return. 2) Any items allocated after the date of death will be the responsibility of the successor in interest. 3) A return must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. 4) The partnership’s tax year does not end. 8. The conversion from a partnership to an LLC (limited liability company) is not considered a sale, exchange, or liquidation of any partnership interest. a. The partnership’s tax year does not close, and the LLC can continue to use the partnership’s taxpayer identification number. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 11: Disposition of a Partner’s Interest 3 11.2 LIQUIDATING DISTRIBUTIONS Distributions liquidating the entire interest of a partner may be due to partnership termination and/or the retirement or death of the partner. Sale to the partnership of a partner’s entire interest is treated as a liquidating distribution. 1. Payments to a retired partner that are determined by partnership income are treated as a distributive share of partnership income, regardless of the period over which they are paid. The income is characterized at the partnership level. a. Payments to a retiring partner in liquidation of an interest that are treated as distributive shares of partnership income or as guaranteed payments are subject to self-employment tax. 2. Amounts received from the partnership in liquidation of a partnership interest are generally treated the same as other (nonliquidating) distributions. a. Gain is recognized to the extent money distributed exceeds the liquidating partner’s adjusted basis (AB) in the partnership interest immediately before the distribution. 1) Decrease of the partner’s share of partnership liabilities is treated as a distribution of money. 2) The gain is capital gain. However, precontribution gain or disproportionate distribution of substantially appreciated inventory (SAI) or unrealized receivables (URs) could result in ordinary income. a) Inventory is considered substantially appreciated if its FMV exceeds 120% of the partnership’s adjusted basis. b. The liquidating partner is treated as a partner for tax purposes until all payments in complete liquidation have been made. 3. Distributions of inventory made in exchange for all or part of a partner’s interest in other partnership property are governed by the “substantially appreciated” rule. a. Gain from such distributions are taxed as ordinary income if the fair market value exceeds 120% of the partnership’s AB of inventory. Loss 4. A loss is realized when money and the FMV of property distributed are less than the AB of the partnership interest. a. No loss is recognized if any property other than money, unrealized receivables, and inventory is distributed in liquidation of the interest. b. Loss recognized is limited to any excess of the AB in the partnership interest over the sum of money and the AB in the URs and inventory. c. Loss recognized is characterized as if from sale of a capital asset. EXAMPLE 11-2 Loss on Partnership Interest Liquidation Amber has a basis in a partnership of $17,000. In complete liquidation of her interest, she received $11,000 in cash and receivables with a basis of $0. Amber will report a capital loss of $6,000 ($17,000 – $11,000 – $0) from the liquidation. The basis of the receivables will be $0 to her. If she had received a capital asset instead of the receivables, she would not qualify to take a loss, and the capital asset would have a basis to her of $6,000 ($17,000 – $11,000). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 11: Disposition of a Partner’s Interest 5. The partner’s basis in the distributed property is the partnership’s AB in the property immediately before distribution, but is limited to the distributee’s AB in the partnership interest immediately before distribution minus any money received in the distribution. a. If the total partnership basis of assets distributed exceeds the partner’s basis in the partnership interest, allocate the decrease in the same manner as for current distributions (as described in item 1.e. in Study Unit 10, Subunit 2). b. For liquidating distributions only, if the basis in the partnership interest exceeds the total partnership basis of distributed assets, allocate the increase by the following steps: 1) Determine the amount of basis to be allocated. Beginning basis – Money received – Unrealized receivables and inventory = Basis to allocate 2) First, assign the existing basis to each property. 3) Allocate any appreciation to each asset. 4) Allocate any remaining basis (Basis to allocate – Appreciation of distributed assets) to the assets based on FMV prior to the distribution. EXAMPLE 11-3 Adjusted Basis of Partnership Interest -- Liquidating Distributions Immediately before receiving the following distribution in the complete liquidation of Scotch Associates, the adjusted basis of Hop’s partnership interest in Scotch was $180,000. Fair Market Basis Value Scotch Cash $100,000 $100,000 Real estate 96,000 70,000 Hop’s basis in the real estate is $80,000 because, in the liquidating distribution, Hop’s basis in his partnership interest must be reduced by the amount of money received. The remaining basis is then allocated to other property received, in this case, the real estate. EXAMPLE 11-4 Basis of Property Distributed in Liquidation In the complete liquidation of Taper, Inc., Mary received the following property distributions. Mary’s partnership interest before the distribution was $150,000. Equipment $20,000 FMV $20,000 Basis (Taper) Building $80,000 FMV $50,000 Basis (Taper) Because Mary’s basis in the partnership exceeds the partnership’s basis in the distributed assets, 1. The existing basis is first assigned to each asset – $20,000 for the equipment and $50,000 for the building. 2. Next, the unrealized appreciation in each property is allocated. Nothing is allocated to the equipment because there is no unrealized appreciation. The building is allocated basis of $30,000 ($80,000 – $50,000) for unrealized appreciation. 3. Accordingly, $50,000 ($150,000 – $20,000 – $50,000 – $30,000) remains to be allocated. It is allocated based on the FMVs of the properties. The equipment will be allocated $10,000 [$20,000 FMV ÷ ($20,000 FMV equipment + $80,000 FMV building) × $50,000 remaining], and the building will be allocated $40,000 [$80,000 FMV ÷ ($20,000 FMV equipment + $80,000 FMV building) × $50,000 remaining]. 4. The basis in the equipment will be $30,000 ($20,000 + $10,000), and the basis in the building will be $120,000 ($50,000 + $30,000 + $40,000). 6. The distributee’s holding period in the distributed property includes that of the partnership. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 11: Disposition of a Partner’s Interest 5 Disposition of Distributed Assets 7. Gain on the sale of URs distributed by the partnership is OI. a. Gain or loss realized on inventory distributed depends on the nature of the property in the distributee’s hands. Partnership Liquidation Figure 11-1 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling the order of distributions when a partnership is liquidated. The XYZ partnership is liquidating. The liquidation of a partnership starts with a review of the company’s assets, including property and cash, and its debts. The partners then sell the company’s assets, which can result in a gain or a loss. Notice the van driving off with the assets. The money received from selling the assets goes to pay the debts the company owes, even if the company sells the assets at a loss. At the business closeout party, Partners X, Y, and Z divide the pizza, which represents the partnership’s value. The animals’ expressions indicate the order in which partnerships distribute liquidated assets. Limited partners’ shares are paid before general partners, but any loans must be paid first. Notice that the snake, who is a limited partner, expected to eat first but was stopped by the goat, a general partner with a loan to the partnership. The goat’s loan will be paid first, the snake’s share will be paid second, and whatever is left over will be divided between the remaining general partners, the goat and the lion, based on their respective ownership of partnership shares. The lion, therefore, eats last and is visibly upset. The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].