Selling vs. liquidating a partnership interest.

• Author: Ellentuck, Albert B.
• Position: Case study

Facts: The Beta Partnership is an accrual-basis partnership with three partners (Jackie, Kevin and Linda). Jackie is considering disposing of her partnership interest. If she were to dispose of her interest currently, she would recognize $5,000 of ordinary income based on the following balance sheet:

Beta Partnership Balance Sheet

Adjusted Basis FMV Cash $12,000 $12,000 Inventory 45,000 60,000 Fixed assets (net of depreciation) 42,000 48,000 Total $99,000 $120,000 Adjusted Basis FMV Capital Jackie $33,000 40,000 Kevin 33,000 40,000 Linda 33,000 40,000 Total $99,000 $120,000 Jackie wants to know if there is a way she can reduce the amount of ordinary income she will recognize on the sale of her interest; Sec. 751 (a) provides that the deemed sale of unrealized receivables and inventory results in ordinary income recognition. Alternatively, she would like to know if there is a way to reduce the ordinary income she would recognize if her interest is liquidated by the partnership; in a liquidation, under Sec. 751 (b)(1), a deemed sale of unrealized receivables and substantially appreciated inventory results in ordinary income recognition. However, the definition of what constitutes "substantially appreciated inventory" does provide some planning opportunities to avoid the recognition of such ordinary income. Issue: Can Jackie reduce the amount of ordinary income recognized from the disposition of her partnership interest?

Analysis

Beta does not own any unrealized receivables. As part of the Tax Reform Act of 1997 (TRA '97), Congress amended Sec. 751 and deleted the previous requirement that inventory had to be substantially appreciated for it to be Sec. 751 property. This change was for sales or exchanges of partnership interests that take place after Aug. 5, 1997 and fall under the provisions of Sec. 751(a). Under this change, property merely has to satisfy the definition of inventory to be treated as Sec. 751 property. However, distributions under Sec. 751(b) still follow the rule that inventory must be substantially appreciated to be considered a "hot asset." Thus, if Jackie is contemplating a sale of her Beta interest, there is no way to avoid ordinary income treatment, as long as the partnership has appreciated inventory of any kind.

If Jackie liquidates her partnership interest (i.e., she receives a liquidating distribution), some planning options exist. Ordinary income will be triggered in a distribution only if there is a...