Computing capital gains on sales of partnership and S corp. interests.

• Author: Tillinger, Janet W.

Regs. Sec. 1.1(h)-1, (1) effective Sept. 21, 2000, addressed the application of look-through capital gains to sales of interests in, partnerships, S corporations and trusts. These regulations will have a major effect on how practitioners approach characterizing gain or loss on the sale of partnership or S corporation interests. All examples and conclusions in this article are consistent with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA); the EGTRRA does not change the capital gain tax rates or otherwise affect this article's planning suggestions and analyses.

Historically, practitioners have viewed partnership interests and S stock as capital assets and generally have treated their sale as resulting in long- or short-term capital gain or loss. For partnerships, Sec. 751(a) has long recharacterized some of the long-term capital gain to ordinary income. While practitioners may have been aware of the potential existence of Sec. 751 "hot assets" when an interest was sold or exchanged, as a practical matter, they often were unable to acquire sufficient information to compute the gain that should have been Sec. 751 ordinary income.

The new regulations were written pursuant to Congressional mandate (2); thus, they are legislative regulations with the force of law. Tax professionals who had bypassed the complexities surrounding sales or exchanges of partnership interests. (treating the transactions as resulting in capital gains or losses) now have clear and unavoidable guidance from the regulations and their examples. Moreover, under the regulations, S corporations and their owners will have to cope with the intricacies of the lookthrough recognition provisions for the first time. As an additional incentive to pursue an in-depth understanding of these rules, the increased popularity of limited liability companies (LLCs) as substitutes for incorporated entities has increased the importance of the partnership taxation rules. Unfavorable outcomes under these regulations are potentially the greatest for such entities.

This article analyzes the new regulations, along with associated compliance challenges and planning opportunities. It begins with a brief overview of current capital gain rules before examining the regulations' application to capital gain recognition of sales of partnership and S corporation interests, and offers caveats and planning ideas.

Overview

Prior to the Taxpayer Relief Act of 1997 (TRA '97), net capital gain, defined in Sec. 1222(11) as the excess of net long-term capital gain over net short-term capital loss, was taxed at the individual's marginal rate, up to a maximum 28% (see Exhibit 1 at right). The pre-TRA '97 capital gain rules provide a foundation for understanding the post-TRA '97 rules (and their interpretations) as they apply to sales or exchanges of passthrough ownership interests under the new final regulations.

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After the TRA '97, as amended by the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98), the general netting process outlined in Exhibit 1 is maintained. However, in general under Sec. 1(h), for noncorporate taxpayers (individuals, estates and trusts), a maximum 20% rate applies to adjusted net capital gain. A 10% rate applies to adjusted net capital gain otherwise taxed at a 15% rate. "Adjusted net capital gain" is net capital gain (as defined under pre-TRA '97 law) minus gain attributable to the sale or exchange of (1) collectibles and (2) Sec. 1202 small business stock, to the extent the gain is included in income. A maximum 28% rate applies to gain attributable to collectibles and small business stock. A maximum 25% rate applies to unrecaptured depreciation from Sec. 1250 real estate held for more than one year.

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Beginning in 2001, eight percent and 18% rates, apply to gain from certain property held more than five years. (3) Exhibit 2 on p. 30 illustrates these rules and clarifies that the 20% and ten-percent rates (and, beginning in 2001, the 18% and eight-percent rates) apply only to adjusted net capital gain.

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Twenty-five Percent Gain

Under Sec. 1(h)(1)(D), a 25% rate applies to unrecaptured Sec. 1250 gain on property held more than one year. "Unrecaptured Sec. 1250 gain" is defined by Sec. 1(h)(7)(A) as the amount of gain (beyond that treated as ordinary income) that would be treated as ordinary income if depreciation on Sec. 1250 property were subject to 100% recapture. For purposes of the general capital-gain recognition rules, a ceiling limits unrecaptured Sec. 1250 gain to the sum of the ordinary income recognized and the total depreciation taken. The excess gain over this amount is Sec. 1231 gain, which, subject to the lookback rules, is taxed at a maximum 20% rate. The lookback rules apply before the Sec. 1231 gain can enter into the long-term capital gain netting process. The taxpayer must look back over a five-year period and recharacterize Sec. 1231 gain as ordinary income to the extent of any net Sec. 1231 losses reported during the five-year lookback period.

Twenty-eight Percent Gain

According to Sec. l(h)(5), a 28% rate applies to (1) capital gains and losses from the sale or exchange of collectibles held for more than one year and (2) Sec. 1202 gain (50% includible) on the sale of stock of certain small business corporations. Collectibles are defined in Regs. Sec. 1.1(h)-1(b)(2) by referring to Sec. 408(m) (without the exception provided in Sec. 408(m)(3) for certain gold, silver and platinum coins). The definition includes items typically thought of as collectibles (e.g., art, stamps, coins, wine and antiques).

Treatment of Capital Losses

Any excess of losses over gains from computing 28% gain may first be used to reduce unrecaptured Sec. 1250 gain and then to offset 20% gain. The excess of short-term losses over short-term gains are used first to reduce 28% gain, then 25% gain, and finally, 20% long-term gain. These netting rules generally operate to provide the most taxpayer-favorable outcome. (See Examples 1 and 2 on p. 30.)

Example 1: H sells the following capital assets in 2002: Holding Adjusted Fair market Asset period basis (AB) value (FMV) Collectibles * 3 years 1,000 3,000 Sec. 1250 property (original cost, $80,000) ** 8 years 50,000 100,000 Other property *** 9 months 20,000 40,000 Totals $71,000 $143,000 Capital Asset Gain gain rate Collectibles * 2,000 28% Sec. 1250 property (original cost, 30,000 25% $80,000) ** 20,000 20% Other property *** 20,000 None Totals $72,000 * Collectibles gain of $2,000 is long-term and taxed at a maximum 28% rate. ** The difference between the $50,000 AB and the $80,000 cost of the Sec. 1250 property represents unrecaptured depreciation, taxed at a maximum 25% rate. The property appreciated in value from its $80,000 original cost to $100,000, for a 20% Sec. 1231 gain of $20,000 (subject to the Sec. 1231 lookback rules). *** Other property is short-term and gets no reduced capital gain rate; it will be taxed at H's regular marginal tax rate. Lookthrough Capital Gains

Sales/Exchanges of Long-term Interests

Regs. Sec. 1.1(h)-1 applies to the sale or exchange of partnership interests, S stock and trust interests held for more than one year. The sale or exchange of any portion of an interest deemed to have a short-term holding period is not subject to the lookthrough provisions. However, sales of interests held short-term can still result in income recharacterization. Nonetheless, under these rules, even a partner with no gain or loss on the sale or exchange of a partnership interest may recognize ordinary income and capital or ordinary loss and capital gain on the transfer. (4)

Definition

Generally, capital gain attributable to the sale or exchange of an interest in a passthrough entity held for more than one year is long-term (20%) capital gain. Under Regs. Sec. 1.1(h)-1(a), when a partnership interest is sold or exchanged, the selling partner's recognized gain or loss may consist of four components:

1. Sec. 751(a) ordinary income.

2. Collectibles gain (28%), but not loss.

3. Unrecaptured Sec. 1250 gain (25%).

4. Residual long-term capital gain (20%) or loss.

   On the sale or exchange of an S interest, the selling shareholder may recognize gain or loss characterized as:

1. Ordinary income under Secs. 304, 306, 341 and 1254.

2. Collectibles gain (28%), but not loss.

3. Residual long-term capital gain (20%) or loss. (See Exhibit 3 below.)

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   Regs. Sec. 1.1(h)-1(b) defines a partner's lookthrough capital gain on the sale of a partnership interest as the sum of his collectibles gain and unrecaptured Sec. 1250 gain. Under Regs. Sec. 1.1(h)-1(c), a partner's residual long-term capital gain or loss is the long-term capital gain or loss that he would recognize under Sec. 741 (pre-lookthrough long-term capital gain or loss), minus his lookthrough capital gain.

   An S shareholder's lookthrough capital gain is only his proportionate share of collectibles gain. Pre-lookthrough gain is the long-term capital gain that the shareholder would recognize on the sale of his S stock. The residual long-term gain or loss is the pre-lookthrough gain minus the selling shareholder's lookthrough capital gain. (5)

   Sec. 751 Ordinary-income Recognition

   Ordinarily, the sale or exchange of a passthrough interest results in capital gain or loss; an exception exists for sales or exchanges of partnership interests. Under the Sec. 751(a) hot asset rule, an amount received in exchange for a partnership interest generally will be ordinary income, to the extent attributable to unrealized receivables and inventory. Sec. 1250 property is treated as an unrealized receivable for Sec. 751 purposes to the extent of the amount that would be recaptured as Sec. 1250(a) ordinary income. Hot assets are deemed sold for their FMV; ordinary income realized from a deemed sale is allocated to the selling partner in proportion to the...