Tax and accounting aspects of liquidating a partner's interest.

• Author: Orbach, Kenneth N.

EXECUTIVE SUMMARY

* If capital is not a material income-producing factor for a partnership, payments in liquidation of a general partner's interest do not include amounts paid for goodwill (unless the partnership agreement provides for goodwill payments) and unrealized receivables.

* The mixing of the entity and aggregate approaches for tax purposes results in complex rules and records.

* When a distributee partner receives multiple properties in liquidation of his interest, the issue of allocation must be addressed.

The tax analysis of the liquidation of a general partner's interest in a partnership involves use of both the aggregate and entity theories, making for great complexity in record-keeping. Through the use of extensive examples, this article explains the tax and financial accounting treatment of a complete liquidation of such an interest under proposed regulations.

From an accounting viewpoint, a partnership is a separate business entity; an "entity" approach is employed to maintain financial records. From a tax viewpoint, a partnership is treated as an entity for some purposes and as an "aggregate" of its partners for others. The mixing of two approaches for tax purposes gives rise to complex rules and tax records that do not plague traditional financial statements. This article analyzes certain tax complexities that arise when a partnership liquidates a partner's interest. The effect of recent proposed regulations under Secs. 732, 734, 743 and 755 on such liquidating distributions is examined through eight examples, one of which also presents possible financial accounting treatments of the liquidating distribution, both at the partnership and partner levels.

Liquidation of Partner's Interest

Example 1: W, X, Y and Z are equal partners in WXYZ partnership, in which capital is a material income-producing factor.(1) WXYZ's balance sheet is shown below. W has a $20,000 basis in his partnership interest (i.e., a $20,000 outside basis). WXYZ distributes inventory with a $48,000 fair market value (FMV) to W in complete liquidation of his interest. If WXYZ were to sell the machine, it would recognize $16,000 of Sec. 1245 ordinary income. A Sec. 754 election has not been made; there is no unstated goodwill.

WXYZ Partnership balance sheet Basis FMV Cash $16,000 $16,000 Accounts receivable 0 32,000 Inventory 32,000 64,000 Land 16,000 32,000 Machine 16,000 32,000 $80,000 $176,000 Capital-W $20,000 $44,000 Capital-X 20,000 44,000 Capital-Y 20,000 44,000 Capital-Z 20,000 44,000 $80,000 $176,000 Tax Analysis

Because capital is a material income-producing factor for WXYZ, W receives $44,000 FMV of inventory in exchange for his $44,000 interest in partnership property. Thus, W receives a Sec. 736(b) payment of $44,000; the remaining $4,000 of inventory received is a Sec. 736(a) payment.

Sec. 736(a) payment: Because the $4,000 of inventory received by W as a Sec. 736(a) payment is determined without regard to partnership income, the payment is a guaranteed payment under Sec. 736(a)(2). W recognizes $4,000 of ordinary income and takes a $4,000 basis in this part of the inventory. XYZ has a Sec. 162 deduction in the same amount under Regs. Sec. 1.736-1(a)(4). In addition, because XYZ met its $4,000 Sec. 736(a)(2) obligation to W with appreciated property with a $4,000 FMV and a $2,000 adjusted basis, it recognizes $2,000 ($4,000-$2,000) of income on the transfer.

Sec. 73600 payment: The $44,000 inventory distribution is subject to Sec. 751(b) because W has received more than his share of "hot" assets(2) and has relinquished more than his share of "non-hot" assets. The hot assets are the $32,000 accounts receivable, the $16,000 Sec. 1245 recapture potential from the machine(3) and the $64,000 FMV of inventory.(4) The effect of Sec. 751(b) is analyzed below.(5)

Several observations are warranted. First, Sec. 751(b) is concerned with W's interest in the FMV of partnership property. Second, the total inventory W receives (as shown below) is $44,000 ($16,000 + $28,000), not $48,000, because the former amount is the Sec. 736(b) payment. Third, the $28,000 "excess inventory received" is reduced to $16,000 by the "relinquished" recapture potential of $4,000 and the $8,000 "relinquished" accounts receivable; according to Regs. Sec. 1.751-1(b)(1)(i), Sec. 751(b) applies only to the extent of the exchange of hot assets for non-hot assets (and vice versa). The Sec. 751 (b) deemed distribution and exchange are as follows (the Parentheses indicate an item's basis to the partnership and FMV):

Distribution Partnership Sec. 751(b) Cash $4,000 Land ($4,000,$8,000) Inventory ($8,000, $16,000) Machine ($4,000, $4,000) Non-Sec. 751(b) Inventory ($14,000, $28,000) After the Sec. 751(b) deemed distribution, W takes a $4,000 basis in the land and a $4,000 basis in the machine, under Sec. 732(a).(6) W's outside basis is reduced to $8,000 ($20,000-$4,000 cash-$4,000 land-$4,000 machine). W recognizes a $4,000 ($8,000 -- $4,000) capital gain on the deemed exchange of land with XYZ. Because XYZ has purchased for $8,000 land that had a $4,000 basis to WXYZ, the land has a $4,000 basis step-up.(7) XYZ has $8,000 of ordinary income ($16,000 -- $8,000) on its "sale" of inventory to 145 correlatively, W takes a $16,000 basis in that part of the inventory.

In the non-Sec. 751(b) distribution, W receives inventory worth $28,000 with a tax basis to the partnership of $14,000. Because W's outside basis after the Sec. 75 l(b) distribution is $8,000, he takes an $8,000 basis in the inventory distributed in the non-Sec. 75 l(b) distribution, under Sec. 732(b); this is a $6,000 step-down from the partnership's basis in the property.(8)

W's tax consequences: W has inventory with a $48,000 FMV and an adjusted basis of $28,000 ($4,000 Sec. 736(a) guaranteed payment + $16,000 Sec. 751(b) "purchase" + $8,000 non-Sec. 751(b) distribution). W recognizes a $4,000 capital gain on the "sale" of land to XYZ and $4,000 of ordinary income on the Sec. 736(a)(2) guaranteed payment.

XYZ's tax consequences: XYZ recognizes $8,000 of ordinary income on the "sale" of inventory to W. XYZ gets a $4,000 step-up in basis in land on its "purchase" from W. The $4,000 Sec. 736(a)(2) guaranteed payment is deductible by XYZ; the $2,000 gain on the payment of the Sec. 736(a)(2) obligation with appreciated property is includible in XYZ's income. After the transaction, XYZ's balance sheet is as follows:

XYZ Partnership balance sheet Basis FMV Cash $16,000 $16,000 Accounts receivable 0 32,000 Inventory 8,000 16,000 Land 20,000 32,000 Machine 16,000 32,000 $60,000 $128,000 Capital-X $22,000(*) $42,667(**) Capital-Y 22,000 42,667 Capital-Z 22,000 42,666 $66,000 $128,000 (*) $20,000 original amount + (($8,000 ordinary income on sale + $2,000 gain on guaranteed payment - $4,000 guaranteed payment)/3).

(**) $128,000/3. This may also be derived as follows: $44,000 original amount - ($4,000 bonus paid to W by XYZ to liquidate his interest/3).

Financial Accounting Treatment

To examine the financial accounting treatment of the liquidation, WXYZ's original balance sheet is expanded to include financial basis.

WXYZ Partnership balance sheet Tax Financial basis FMV basis Cash $16,000 $16,000 $16,000 Accounts receivable -0- 32,000 32,000 Inventory 32,000 64,000 32,000 Land 16,000 32,000 16,000 Machine 16,000 32,000 24,000 Total $80,000 $176,000 $120,000 Capital-W $20,000 44,000 30,000 Capital-X 20,000 44,000 30,000 Capital-Y 20,000 44,000 30,000 Capital-Z 20,000 44,000 30,000 Total $80,000 $176,000 $120,000 The liquidation of a partner's interest provides an opportunity to bring the financial balance sheet to current FMVs if the FMVs of all the assets and liabilities are known.(9) The WXYZ partnership agreement requires the revaluation of assets for financial statement purposes on the liquidation of a partner's interest. The transaction is recorded on the partnership's books as follows:

Entry to book-up the assets and allocate income to partners: Inventory $32,000 Land 16,000 Machine 8,000 Capital-W $14,000 Capital-X 14,000 Capital-Y 14,000 Capital-Z 14,000 The balance in W's capital account after this entry (but before recording the liquidating distribution) is $44,000. The $4,000 difference between the FMV of the inventory distributed to W and W's capital account could be attributed to unrecorded goodwill; alternatively, the excess could represent a bonus paid to W to entice him to relinquish his partnership interest. Because it is assumed that the FMV of the recorded assets fairly represents total asset FMV, it can be assumed that the remaining partners are paying W a bonus to facilitate the liquidation. The entry to record the liquidation of W's interest in exchange for inventory is as follows:

Capital-W $44,000 Capital-X 1,333 Capital-Y 1,333 Capital-Z 1,334 Inventory $48,000 Several points warrant observation. First, the character of income (e.g., ordinary income, capital gain) is of no consequence for purposes of the financial entries. Second, X's, Y's and Z's...