Exit StrategiesHoward E. Abrams

Warren Distinguished Professor, USD School of LawNovember 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 one-third 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 YCA 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 TO

CA OB CA OB

100 100 100 100 Formation

45 0 45 0 Book-Up of Blackacre

-190 -100 0 0 Distribution of Blackacre

50 50 50 50 Sale of Whiteacre

5 50 195 150 Totals

Asset Book Value Inside Basis

Cash $ 200 $ 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 SaleA B C

CA OB CA OB CA OB

25 10 25 10 25 10

Assets Book Value Adj. Basis Value

Cash 75 75 75

Note: There is a suspended $45 inside basis adjustment but no gain recognized on the distribution.

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 DisappearX Y Z

CA OB CA OB CA OB

100 100 100 100 Formation

0 490 0 0 Borrowing

400 0 400 0 Book-Up

0 0 -490 -490 Distribution

0 0 --- --- 10 10 Purchase by Z

0 205 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 Y Z

CA OB CA OB CA OB

0 0 0 0 Initial values

0 300 0 200 Borrowing

1200 0 800 0 Book-up

-300 -300 -200 -200 Distribution

200 -300 0 300 300 Purchase by Z

900 0 300 0 300 300 Totals

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 Y Z

CA OB CA OB CA OB

900 0 300 0 300 300 Initial values

0 1200 0 400 0 400 Sale of property

0 0 0 0 0 -400 743(b) adjustment

0 -300 0 -200 0 0 Debt repayment

900 900 300 200 300 300 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 StrategiesHoward E. Abrams

Warren Distinguished Professor, USD School of LawNovember 2015

www.taxnerds.com

Copyright 2015 by Howard E. Abrams