When to report ordinary income if a partnership with hot assets redeems a partnership interest and the liquidating distributions are made over several tax years.

• Author: Bensimon, Daniel
• Position: Tax Law

When a partner in a business partnership retires with a buyout agreement in place, the buyout agreement typically requires either a sale of the retiring partner's interest to the remaining partners (a cross purchase agreement) or a redemption of the retiring partner's interest by the partnership. If the partnership does not have unrealized receivables or substantially appreciated inventory, the choice to the retiring partner between a cross purchase (a sale by the retiring partner) or a liquidating distribution is generally income tax neutral. If the partnership's assets consist of unrealized receivables, substantially appreciated inventory, or both, the timing for the reporting of the retiring partner's ordinary income can be drastically different in a sale of a partnership interest as opposed to a redemption of a partnership interest. If the partnership or the remaining partners are strapped for cash, an installment sale and the liquidating distribution may be spread over subsequent tax years.

If the partnership's assets consist of unrealized receivables, appreciated inventory items, or both (commonly referred to as "hot assets" (1)), the retiring partner should be aware of the uncertainty under Subchapter K and the regulations of a looming ordinary income tax trap when receiving liquidating distributions spread over multiple tax years.

Deferred Payment Sale of a Partnership Interest (2)

Upon the sale (3) or liquidation of a partnership interest, [section][section] 751(a) and (b) are designed to prevent an assignment of one partner's share of ordinary income to another partner. The mechanism that prevents this assignment of ordinary income creates a fiction under [section] 751(a) for a sale and a fiction under [section] 751(b) for a redemption of a partnership interest. A disproportionate distribution can occur when: 1) the partner receives more than his or her share of hot asset (4) items in a partnership distribution; or 2) the partner receives less than his or her share of hot asset items in a partnership distribution; or 3) the distributee partner's redistribution allocation of hot assets changes.

In an all cash redemption, a portion of the partnership distribution is recharacterized as a taxable sale or exchange between the partner and the partnership. Section 751(b) divides the partnership distribution into two steps: 1) The retiring partner receives a distribution equal to his or her proportionate share of hot assets; and 2) the retiring partner then exchanges the hot assets that were deemed distributed to the retiring partner for an increased portion of cold assets (i.e., cash) that the retiring partner actually received. (5)

The examples in the regulations determine a partner's interest in [section] 751 and other property by reference to the partner's interest in partnership capital. (6) If the partnership has [section] 751 assets, then the partner's interest in those assets is determined to be that fraction of their value equal to the partner's fractional interest in all partnership capital. For example, if the partner's capital account is 40 percent of the sum of all partners' capital accounts, the partner has a 40 percent share of the partnership's [section] 751 assets. (7)

Character of Gain Recognized from Sale of Hot Assets with Lump Sum Payment (8)

At the time a retiring partner relinquishes an interest in [section] 751(b) property, the distributee partner realizes ordinary income (9) measured by the difference between his or her adjusted basis for the hot assets relinquished and the fair market value of other property received in exchange for the hot assets. (10) On the other hand, the character of the gain or loss to the partnership is determined by reference to the character of the assets it exchanges for the relinquished [section] 751(b) property, which is generally capital in character. (11)

Recognition of Income When a Partnership Without Hot Assets Makes a [section] 736(b) Liquidating Distribution in Installments

Treasury Regulation [section] 1.736-1(b)(6) states that except to the extent [section] 751(b) applies (i.e., hot assets), the amount of any gain or loss with respect to payments under [section] 736(b) for a retiring or deceased partner's interest in property for each year of payment shall be determined under [section] 731. Section 736(a)(1) recognizes gain in a liquidating payment only when the money distributed exceeds the adjusted basis of the partner's interest in the partnership immediately before the distribution. Section 731(a)(2) defers a recognized loss to the retired partner until after the last distribution has been made so that any unrecovered outside basis is deducted as a capital loss at that time.

Example--A retires from the ABC partnership and is to receive $12,000 in two annual installments of $6,000 each in liquidation of his interest in [section] 736(b) property, none o f which is [section] 751 property. The partner's basis in his partnership interest is $9,000. Under the general cost-recovery rule, the retired partner would recover his entire basis during the second $6,000...