Tax implications when partners part ways
Ancient Roman – Wif a partner decides to enter into a sale or exchange of his partner’s interest, tax consequences can often be lurking. One of the most common problems arising from the sale of partner interests is the generation of income from so-called “hot assets” – often in the form of unrealized receivables and inventories – held by the partnership.
Unrealized receivables may include partnership attributes such as depreciation recovery, mining property and cash receivable, along with certain other recoveries. Inventory items can include both assets commonly recognized as inventory along with some other items that cannot be treated as capital goods or sold as Section 1231 property.
The partnership rules generally require a partner to have the same percentage share of the profit or loss from the sale of hot assets as from the sale of assets that are not hot. If the distribution of non-cash property to a partner causes a partner’s share of income and loss from assets that produce capital gains or losses to differ from the partner’s share of income and loss from warm assets, then Section 751(b) of the Code would apply.
While the section’s rules can be complicated, the general effect is to cause a distribution of non-cash assets that changes the percentage share a partner has in a capital gain or loss property compared to hot assets to result in the partnership. and the partner recognizing profits on the distribution. This income recognition by both parties is intended to ensure that the distribution does not distort any amount of capital gains/losses or ordinary income that the partner receiving the distribution must recognize.
Consider the following scenarios to illustrate this: Let’s assume we have a customer, individual “A”, who owns one-third of F Co’s stake. owns, and his base in his interest is $30. Client A holds his partnership interest for longer than one year. Client A wants to sell its stake for the fair market value of $220 to “D”, an unrelated buyer. Now that we know this information, let’s take a look at the different scenarios based on their taxation.
In scenario 1, F is Co. a C Corporation. That means Client A would recognize $190 in profit ($220-$30) based on the sale of his stake. The entire profit would be taxed as a long-term capital gain. In scenario no. 2, F Co. a sub-chapter S company. In this case, client A would recognize $190 in profit from the sale of his interest, which would be taxed as a long-term capital gain. In scenario no. 3, F Co. an LLC taxed as a partnership. Here, client “A” would recognize $130 in ordinary income and $60 in capital gains for the sale of his interest. Instead of all of the profits going into capital gains, as in a corporation, there should be an appropriation toward ordinary income and capital gains when it comes to selling partner interests involving hot assets.
The sale of partner interests is notorious for the potential tax traps for the ignorant. Generating phantom revenue through unexpected hot assets is just one of many potential tax traps that come when a partner enters into a sale or exchange of its partnership interest. Partners may be able to protect themselves from such tax surprises or structure a transaction to avoid them altogether.
Business partners considering selling their partnership interests should consult a tax attorney or accountant to ensure an optimal transaction structure.
Roman Basi is a lawyer and CPA at Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-wrote this article with Ian Perry, staff accountant at Basi & Basi.