Sale of partnership interests with open-service or construction contracts.

• Author: O'Connell, Frank J., Jr.

Under Sec. 741, generally, the gain or loss resulting from the sale or exchange of a partnership interest is capital. The one exception to this general rule is Sec. 751(a), which states that the amount of consideration received by a partner in exchange for his partnership interest--attributable to unrealized receivables or inventory items--is considered as an amount received from the sale or exchange of property other than a capital asset. For this reason, the sale of partnership interests versus the sale of partnership assets can result in similar (if not identical) tax consequences. The Sec. 751 rules have been part of the Code for almost 50 years, and over the last few years have seen relatively few changes. However, under Regs. Sec. 1.751-1 (c) (3), transactions occurring after Dec. 14, 1999 may result in substantially different tax treatment between the sale of a partnership interest and the sale of the partnership's assets.

Service and Construction Contracts as Unrealized Receivables under Sec. 751(c)

Unrealized receivables are defined by Sec. 751(c) and Regs. Sec. 1.751-1 (c) (1) (ii), in pertinent part, as any rights (contractual or otherwise) to payment for:

1. Goods delivered, or to be delivered (to the extent that such payment would be treated as received for property other than a capital asset) or

2. Services rendered, or to be rendered, to the extent that income arising from such rights to payment was not previously includible in income under the partnership's accounting method.

Such rights must have arisen under contracts or agreements in existence at the time of the sale or exchange of a partnership interest, although the partnership may not be able to enforce payment until a later time. For example, the term includes rights to payment for work or goods begun but incomplete at the time of the sale or distribution. Based on this definition, any fees or revenues to be collected subsequent to the sale or exchange of service or construction contracts (entered into before the sale or exchange) are considered unrealized receivables.

Effects of Sec. 751(c)

In an applicable asset sale as defined in Sec. 1060, the allocation of the sales price agreed to by the buyer and seller is generally binding on them (although not the IRS) under Regs. Sec. 1.1060-1 (c)(4). Therefore, if the assets of a partnership were sold, the seller might avoid additional ordinary income recognition by agreeing with the buyer to allocate to open-service and...