In the plethora of files across my desk over the years, navigating compliance issues for liquidating distributions of a partner’s interest in a partnership have 3 buzzworthy considerations to avoid unwanted scrutiny.
- Calculating the recognized gain or loss from a cash or property distribution in liquidation of the partnership interest
- Substantiating the partner’s basis in property received in liquidation.
- Correctly determining the character and holding period of the property distributed.
When it comes to calculating the recognized gain or loss from a liquidating distribution IRS Revenue Agents are trained to determine whether the distributions were:
- Current in the tax period
- Part of a disguised sale
- A distributive share of partnership income
- A guaranteed payment
- An exchange for partnership property.
Lessons learned –
- If the distribution included hot assets or marketable securities, they are generally treated as cash and affect calculation of gain or loss calculation.
- Astute Revenue Agents will verify BOTH the partnership basis in the property distributed AND the partner’s basis in its partnership interest.
- To verify a partner’s basis in its partnership interest Revenue Agents will:
- review prior year partnership returns.
- request the partner’s outside basis schedule.
- verify –
- prior changes in partners’ capital contributions
- purchase interests in the partnership
- that the partner reported any gain resulting from partnership distributions in excess of basis as income
- request partnership tax capital account details, including:
- workpapers showing contributions & distributions.
- allocations for each partner for the current and prior seven years
- inquire about the tax basis of contributed property.
- obtain –
- a copy of each partner’s tax capital account
- a schedule showing how liabilities were allocated among partners.
- A series of distributions resulting in a liquidation can take place over more than one tax year, so astute Agents look at subsequent year distributions to determine if a liquidating distribution took place.
- Generally if there was a distribution of money or property to a partner within two years of contribution of money or property by the partner, the disguised sale rules will be investigated.
- If there is a loss recognized a partner must completely liquidate his or her entire interest before a loss on the liquidation is allowable.
- Gains from the sale of interests in partnerships, including a partner’s liquidation gains (to the extent the partner was a passive owner) are considered Net Investment Income (NII) reported on IRS Form 8960.
When it comes to substantiating a partner’s basis in property received in liquidation of his or his/her interest astute Revenue Agents determine the partnership’s pre-distribution (aka ‘inside’ basis) in property distributed by verifying:
- The purchase price of assets purchased by the partnership.
- The tax depreciation claimed by the partnership.
- The basis of property contributed by partners.
Lessons learned – Astute Revenue Agents will:
- Investigate whether the partnership made or revoked a Code Sec. 754 – basis adjustment – election by reviewing:
- the partnership agreement for a Code Sec. 754 election
- prior year Forms 1065.
- current year form 1065 – specifically question 12 of Schedule B
- Request the basis adjustment calculations.
- Review the tax depreciation schedule and the asset appraisal report.
- Even with no Code Sec. 754 election, revenue agents will invest resources determining:
- whether a substantial basis reduction or substantial built-in loss adjustment occurred on the transfer of a partnership interest.
- the type of assets distributed to the partner.
- if the partner assumed liabilities associated with distributed assets.
- Be prepared for the Revenue Agent to request:
- a list of assets distributed.
- a liquidation agreement from the partnership
- an interview with all partners if the liquidation agreement is not available.
- The basis of hot assets in the hands of a partner cannot exceed their inside basis in the hands of the partnership.
When it comes to determining the character and holding period of property distributed astute Revenue Agents will cultivate additional facts by determining when and how the partnership obtained distributed property. Be sure to tread lightly with relevant workpapers or correspondence.
Lessons learned – Astute Revenue Agents will:
- Determine if any of the distributed property are hot assets, which give rise to ordinary income (or loss).
- Verify how the partnership acquired the property distributed to the partner, which could affect the partner’s holding period.
Governing Statutes and Regulations
Code Sec. 736(a) – Payments not in exchange for partnership property. Liquidation payments that are not in exchange for partnership property are treated either as:
- Distributive shares of partnership income if the amount is determined with regard to partnership income.
- Guaranteed payments if the amount is determined without regard to partnership income.
Code Sec. 736(b)(1) – In a liquidating distribution, to the extent payments are received by a partner for its interest in partnership property, the payments are taxable under the rules applicable to non-liquidating distributions.
Reg § 1.736-1(b)(1) – In allocating liquidating distribution payments to the partner’s interest in partnership property, generally, the valuation placed by the property in an arm’s length agreement among the partners will be regarded as correct.
Code Sec. 736(b)(3) – Special rules apply if capital is not a material income-producing factor for the partnership, and the partner receiving the liquidating distribution was a general partner in the partnership.
- Under these rules, the partner recognizes gain to the extent money (or deemed money) distributed exceeds the partner’s outside basis in its partnership interest.
- A liquidating distribution of partner’s interest in a partnership that includes a disproportionate amount of hot assets may trigger ordinary income, gain, or loss to both the partnership and its partners.
- Loss is recognized to the extent the partner’s outside basis exceeds money distributed and the basis of any unrealized receivables, or inventory (“hot assets”).
- A partner will not recognize a loss on a liquidating distribution if it receives any property other than money or hot assets.
Code Sec 732 – Basis of distributed assets.
- In a liquidating distribution, the outside basis of the partner must be allocated to all the assets received in the distribution.
- Basis is always allocated first to money.
- The basis allocated to the other property distributed to a partner is generally a carryover basis from the partnership’s inside basis.
- In the event there is insufficient outside basis to give each asset a carryover basis, the shortfall must be allocated.
- That shortfall is first allocated to the assets other than unrealized receivables and inventory.
- If those assets’ bases are reduced to zero, then the shortfall is allocated to the hot assets, reducing their bases.
Code Section 734 – Basis adjustments.
- Following a distribution where a partner recognizes gain or loss or the basis of distributed assets is adjusted from their carryover bases, an inside/outside basis disparity is created.
- If a partnership has a Code Sec. 754 election in effect or if the distribution resulted in a substantial basis reduction – ie. the sum of the loss recognized and basis reduction exceeded $250K – the disparity is resolved by adjusting the basis of the assets remaining in the partnership.
- A partnership has a substantial built-in loss that requires basis adjustment to partnership assets on a transfer of a partnership interest if either:
- The partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value (“FMV”) of the property, or
- The transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their FMVs immediately after the transfer as per Code Sec. 743(d)
Code Sec 735(b) – Holding period. A partner’s holding period for partnership property distributed to it includes the period the partnership held the property.
Code Section 1411 – Net investment income tax.
- A 3.8% net investment income tax (NIIT) is imposed on individuals’ net investment income (NII), which includes interest, dividends, annuities, royalties, rents, and capital gains.
- Business income is generally exempt, but income from passive activities and financial instrument and commodity trading is subject to the tax.
In summary, reports that should be tied out in advance of any Revenue Agent inquisition include:
- the partnership agreement
- distribution agreements
- the partner’s outside basis calculation
- the partnership’s inside basis
- the partnership depreciation schedule
- appraisal of any hot assets distributed.
Have a question? Contact John Dundon, EA.
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