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Partnership - Audit Technique Guide - Chapter 7 - Dispositions of Partnership Interest (Rev. 3/2008)

LMSB-04-0208-007
Rev. 3/2008

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Note:  The names used in the examples are hypothetical.  The names for the partnerships were chosen at random from a list of names of American colleges and universities as shown in Webster’s Dictionary.

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to return to either the previous chapter or the Table of Contents or to proceed to the next chapter.

Chapter 6 | Table of Contents | Chapter 8

Chapter 7    

INTRODUCTION

A partner can dispose of a partnership interest in the following ways:

  • By sale to one or more of the other partners.
  • By sale to a third party.
  • By exchange of the partnership interest for other property.
  • By transfer back to the partnership in return for at least one liquidating distribution leading to a complete liquidation of the partnership interest.
  • By retirement.
  • By gift or contribution.
  • By death.
  • By surrendering the partnership interest through abandonment, forfeiture, or worthlessness of the partnership interest.

The above methods for disposing of a partnership interest are covered in this chapter. This chapter also addresses:

  • The character of the gain or loss on the disposition of a partnership interest.
  • The effect of related debt disposition or relief.
  • The recognition of accumulated suspended passive losses associated with a partnership interest.

SALE OR EXCHANGE OF A PARTNERSHIP INTEREST

The rules for disposing of a partnership interest, in general, treat the partnership as an entity separate and apart from its partners.  This is sometimes referred to as the “entity theory” of partnership taxation.  All aspects of the disposition (for example, basis, holding period, and character of the gain or loss) are determined without reference (except for IRC section 751 assets) to the underlying assets of the partnership.

Recognition and Character of Gain or Loss on Sale or Exchange - IRC section 741

A partner who sells or exchanges a partnership interest must recognize gain or loss.  Because a partnership interest is considered a capital asset, such gain or loss is considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in IRC section 751 (relating generally to the presence of assets within the partnership that would generate ordinary income if sold). 

Calculation of Gain or Loss

The gain or loss from the disposition of a partnership interest is the difference between the amount realized and the partner’s adjusted basis (outside basis) in the interest immediately before the disposition.  Although the formula for calculating gain or loss is simply stated, the actual calculation can be difficult at times. 

The amount realized upon the sale of a partnership interest consists of cash plus the fair market value of property received plus the selling partner’s share of partnership liabilities assumed by the buyer or otherwise relieved in the transaction (IRC section 752(b)).  

The calculation of the partner’s adjusted basis in the partnership interest begins with the initial partnership basis as determined under IRC sections 722 or 742.  This initial basis,   which refers to the partner’s original basis upon acquisition of his/her interest, is then increased by those items specified in IRC sections 705(a)(1) and 752(a) and decreased by those specified in IRC sections 705(a)(2) and 752(b).  At the time of the sale or exchange, IRC section 752(d) includes the selling partner’s share of partnership liabilities in the amount realized.

Because the transferring partner’s basis in the partnership must be determined as of the date of disposition, any adjustments to basis must also include the transferring partner’s share of partnership income or losses from the beginning of the partnership year to the date the partner ceases to be a partner.

As noted, a partnership interest is a capital asset under IRC section 741.  Therefore, the sale of a partnership interest generally gives rise to capital gain or loss.  However, under IRC section 751, capital gain or loss treatment is not available to the extent of the partner's share of “hot assets” (generally ordinary income generating assets) that would generate ordinary income if sold or collected by the partnership.   In essence, this treats the partner’s sale of his/her interest in the partnership entity as a sale of an interest in underlying assets.   To the extent the partner is treated as disposing of his/her interest in hot assets, he/she recognizes ordinary income.

When the sale of the partnership interest includes both cold assets (capital assets) and hot assets (assets with built in ordinary income potential), the sale is divided into two components:   1) capital gains and losses from the cold assets, and 2) ordinary gains and losses from the hot assets.

Complications arise when a single asset has both hot and cold asset attributes subject to the recapture provisions of IRC section 751(c).  IRC section 751(c) treats the amount to be recaptured as an unrealized receivable.  Upon the sale of a partnership interest, recapture will generate ordinary income even though depreciable assets are capital assets (Treas. Reg. section 1.751-1(c)(4)).  The ordinary income component of the gain is computed first.  Any remaining amount of the gain is capital.

The amount of the disposing partner’s ordinary gain or loss is the difference between the amount realized attributable to the hot assets less the partnership’s adjusted basis associated with these assets.   IRC section 751 is discussed more fully in Chapter 4.

The sale of a partnership interest resulting in a gain can be reported under the installment method under IRC section 453 if at least one payment is received after the year of sale.   However, the gain resulting from unrealized receivables and inventory items cannot be reported under the installment method.   See IRC section 453(i).   Moreover, a sale resulting in a loss cannot be reported under the installment method.  See IRC section 453(a).

Requirement to File Form 8308

Generally, IRC section 6050K requires Form 8308, “Report of a Sale or Exchange of Certain Partnership Interests,”   to be filed for each sale or exchange of a partnership interest where the partnership has IRC section 751 property.  Form 8308 is attached to Form 1065 for the tax year of the partnership that includes the last day of the calendar year in which the IRC section 751(a) exchange took place.   Form 8308 is due at the time for filing the partnership return, including extensions.

The penalty for the partnership's failure to file Form 8308 is governed by IRC section 6721.  There is generally a $50 penalty imposed for each infraction or violation.  Higher penalties may apply under IRC 6721(e) where the failure to file Form 8308 was due to intentional disregard.

Closing of the Tax Year of the Partnership

IRC section 706(c)(2)(A) provides that the taxable year of a partnership shall close with respect to a partner whose entire interest in the partnership terminates.  Additionally, IRC section 708(b)(1)(B) provides that if there has been a sale or exchange of 50 percent or more of the total interest in partnership capital and profits within a 12-month period, the taxable year of the partnership closes.  This is usually referred to as a “technical” termination because the partnership's business is not discontinued and the legal entity of the partnership is unchanged.  For tax purposes only, the partnership is deemed to terminate and then begin operating again with the same Employer Identification Number (EIN) number.  Treas. Reg. section 301.6109-1(d)(2)(iii). 

Exchange of a Partnership Interest

There are many ways to exchange partnership interests.

The most common ways are to:

  • Exchange a limited partnership interest for a general partnership interest in the same partnership.
  • Exchange a partnership interest for a direct ownership right to all or part of a partnership asset.
  • Exchange a partnership interest for a member interest in a successor Limited Liability Company (LLC) or Limited Liability Partnership (LLP).
  • Exchange of a partnership interest for corporate stock when incorporating the partnership.

The exchange of a partnership interest in one partnership for an interest in another partnership will result in gain or loss recognition, even if both partnerships own like-kind property.  IRC section 1031(a)(1) generally provides for non-recognition of gain or loss on exchange of particular properties of like kind.  Exchanges of partnership interests, however, are specifically excluded from IRC section 1031 by IRC section 1031(a)(2)(D).

The exchange of a partnership interest for a different partnership interest in the same partnership as part of a conversion of the partnership from general liability to limited liability or vice versa, is generally a non-recognition event.  See Rev. Rul 84-52, 1984-1 C.B. 157.   Also, the conversion of an interest in a domestic partnership into an interest in a domestic LLC classified as a partnership for federal tax purposes (and vice versa) is treated generally like a partnership to partnership conversion pursuant to Rev. Rul. 84-52.  See Rev. Rul. 95-37, 1995-1 C.B.130.

The exchange of a partnership interest for an undivided interest in partnership property followed by a like kind exchange of the distributed property may, in certain circumstances, essentially amount to a taxable exchange of a partnership interest.  Such an exchange was at issue in Chase v. Commissioner, 92 T.C. 874 (1989).   The Tax Court determined that the substance over form doctrine applied and the transaction failed to qualify for non-recognition under IRC section 1031.  See IRC section 1031(a)(2)(D).

The contribution of a partnership interest to a corporation under IRC section 351 is considered an exchange of a partnership interest for corporate stock.  This is generally a tax free transaction if the requirements of IRC section 351 are met.  However, such an exchange can result in taxable income to the transferring partner if the fair market value of the stock received exceeds the adjusted basis of the partnership interest transferred. 

The Effect of Liabilities

In a qualified IRC section 351 exchange, liabilities assumed or taken subject to by the corporation that are in excess of the partner’s tax basis in the partnership interest and other assets contributed to the corporation for the stock will trigger a gain under IRC section 357(c).  IRC section 351 will not be discussed in this Audit Techniques Guide (ATG) but should be researched in other sources. 

Effect of a Sale or Exchange on the Inside Basis of the Partnership’s Assets

Unless there is an IRC section 754 election in effect, the inside basis of partnership assets are not changed as a result of the sale or exchange of a partnership interest, except when the partnership has a substantial built-in loss (more than $250,000) immediately after the transfer.[1]  If there is an IRC section 754 election in effect, the inside basis of partnership assets is adjusted to reflect the purchase price, but only for the partner who acquired the partnership interest.  Application of the adjustment serves to eliminate the discrepancy between the purchasing partner’s inside and outside bases. 

Examination Techniques

Because of the potential complexities involved in the sale or exchange of a partnership interest, errors are common.   In addition, the selling partner generally has an incentive to minimize the tax impact of any gains associated with a taxable sale or exchange and conversely maximize the benefits of any losses.

If the facts indicate there has been a sale or exchange, the character of the gain or loss must be determined.  This requires an analysis of each asset transferred and received and a thorough review of the facts and circumstances surrounding the transfer of the partnership interest and the transferor’s relationship to the recipient and the remaining partners.  In some cases, an elaborate structure is undertaken to mask the true substance of the transaction.  A determination must be made regarding the nature and value of consideration received by the transferor, and whether any other consideration or additional benefits accrued to the transferor as a result of the sale or exchange.

Review Schedule K-1

The initial indication that a partner has disposed of a partnership interest should be evident from the partner’s Schedule K-1.  If there is an increase or decrease in a partner’s ownership interest in profits, losses, or capital or the addition of a new partner, the Schedule K-1 will generally identify the parties involved.

A change in a partner’s share of partnership capital, profits, or losses from the beginning of the tax year to the end of the tax year may indicate a complete or partial disposition the partner's ownership interest.  A reduction of a partner's ownership interest to an amount greater than zero may indicate a partial sale or exchange, or a partial liquidation.

Sometimes a reduction a partner’s share of partnership profits, losses, and/or capital are related to changes in the partnership agreement or to the partnership's attempt to better reflect the partners’ economic sharing arrangement as reflected in the partnership agreement. Such changes may alter the allocation of the partners’ distributive shares of items and may have tax implications. These transactions should be scrutinized to make certain they have substantial economic effect and are otherwise permissible.  See Chapter 6, “Income Allocation,” for a discussion of substantial economic effect.

Negative Capital Accounts

If a partner’s capital account is negative at the beginning of the year and has a balance of zero at the end of the year, the partner may have left the partnership without satisfying his/her share of partnership liabilities.  If so, the departing partner may have received a deemed cash distribution under IRC section 752(b) or there may have been a disguised sale of a partnership interest.  If this is suspected, the following techniques may help in the development of the issue and lead to additional lines of inquiry:

  1. Scrutinize changes in the amount of debt appearing on the balance sheet (Schedule L).
  2. Review item J of Schedule K-1, “Analysis of partner’s capital account”.
  3. Compare Schedules K-1 for several years focusing particularly on Item F, “Partner’s share of liabilities.”
  4. If the partner’s capital account was reduced to zero, check for amounts on any of the distribution lines on the Schedule K-1.No distribution may be an indication that there was a sale, while a distribution may be a sign of a liquidating distribution.

If there has been a sale, exchange, or distribution, consider the ordinary income component(s) (IRC section 751).   If the partnership is on the cash method, determine if it has contracted for services to be performed in the future or for goods to be delivered at a later date.  The value of these contracts may have been imputed to the selling price of the partner’s interest in recognition of the value of an unrealized receivable.

The presence of cost recovery assets on the balance sheet should raise questions as to whether there is a potential for ordinary income recapture.  Depreciation recaptured under IRC section 1245 or IRC section 1250 is probably the most common example of recapture treated as an unrealized receivable under IRC section 751(c).  Other items of ordinary income recapture should be considered in evaluating the presence of unrealized receivables.   Some examples include:

  • Amortization recapture on a disposition of an intangible asset. IRC section 197(f)(7).
  • Recapture resulting from a reduction in basis elected by a partner under the qualified real property indebtedness rules.  IRC section 108(c).
  • Soil and water conservation expenditures recapture.   IRC section 1252.
  • Ordinary gain recognized on the transfer of a franchise, trademark, or trade name.    IRC section 1253.
  • Recapture of depletion, intangible drilling and development costs, and mining exploration costs.  IRC sections 617 and 1254.
  • Accumulated earnings and profits recapture of certain controlled foreign corporations. IRC section 1248.
  • Ordinary income realized on a sale of market discount bonds or short-term obligations. IRC sections 1278 and 1283.
  • Recapture of rental income accrued but deferred.  IRC section 467.

The general rule is that any ordinary gain or loss that would be recognized by the partnership upon disposition of its property should be considered when determining the ordinary income component inherent in a sale of the partnership interest.  

Form 8308, Report of a Sale or Exchange of Certain Partnership Interests

The presence of hot assets on the balance sheet, along with the understanding that there had been a sale or exchange of a partnership interest should raise a red flag that a Form 8308 should have been filed.

A comparison of the beginning and ending balance sheets may show a step-up in the basis of the partnership’s assets.   In addition, amounts appearing on the "Other deductions" lines of Schedules K and K-1 may indicate cost recovery deduction being taken on a transferee partner’s step-up up in basis pursuant to an IRC section 754 election.

Transfers among family members identified as gifts may trigger sale or exchange treatment for the donor to the extent a decrease in the donor’s share of partnership liabilities is treated as a deemed cash distribution.  This may arise because the donee either assumed the liabilities or received the partnership interest subject to the transferor’s share of liabilities.

Documents to Request:

  • Partnership agreement;
  • Prior and subsequent years' partnership tax returns;
  • Calculation of the selling partner’s basis;
  • Sales agreement between the selling and purchasing partner, including any provisions for debt assumption;
  • Calculation of built-in recapture potential;
  • Contracts for future services and/or delivery of goods to be performed by the partnership at the time of the disposition;
  • Calculation of optional basis adjustment, if any
  • Selling partner’s tax return for the year of the disposition

Interview Questions

Interview questions should be developed based on an analysis of the documents received.   For example, inquiries may be necessary regarding:

  • The treatment of IRC section 751 assets;
  • The method for valuing IRC section 751 associated with the selling partner’s interest;
  • The extent to which the transferor partner’s share of partnership nonrecourse liabilities were assumed by or otherwise allocated to the transferee;
  • Whether the transferor partner was liable for recourse debt, and whether he/she remained liable for the debt after the transfer of the partnership interest.
  • If the transferee took the partnership interest subject to recourse debt, whether there were any agreements between the transferee and transferor which give the appearance that the transferor would pay off the debt in the future.If the facts indicate that the transferor’s obligation was eliminated without payment, the transfer or allocation of the debt becomes part of the transferor’s amount realized from the sale.

Supporting Law

Revenue Ruling 84-52, 1984-1 C.B. 157

The conversion of a general partner interest into a limited partner interest, and vice versa, within the same partnership, generally will result in no gain or loss recognition by the partner under section 741 or 1001 of the Code. 

Revenue Ruling 84-53, 1984-1 C.B. 159

Rev. Rul. 84-53 illustrates basis allocations and adjustments that may occur when a partner owns multiple interests in a partnership and disposes of only a portion of such interests.

Revenue Ruling 95-37, 1995-1 C.B. 130

This ruling treats the conversion of a partnership interest into an LLC interest in much the same manner as conversions described in Rev. Rul. 84-52.

Crenshaw v. United States , 450 F.2d 472 (5th Cir. 1971)

The court found, in a case of substance versus form, that a series of transactions in which the taxpayer claimed tax-free liquidation treatment under IRC section 736(b) followed by a tax-free exchange of like-kind property under IRC section 1031 amounted to a sale of a partnership interest.

Pollack v. Commissioner, 69 T.C. 142 (1977)

The Tax Court ruled that the loss resulting from the disposition of a partner’s interest in a partnership should be characterized as a capital loss pursuant to IRC section 741 rather than an ordinary business loss, as the taxpayer had claimed.  Characterization of a partnership interest as a capital asset neither depends on the taxpayer’s motive when acquiring the interest nor the fact that treatment would be different if the taxpayer had established the enterprise as a business other than a partnership.

RETIREMENT OR DEATH OF A PARTNER

Overview

As stated in Chapter 4 (Distributions), a partner generally does not recognize gain or loss upon receiving distributions from a partnership except when the distribution exceeds the partner’s outside basis.  In conjunction with the rules concerning contributions, this reflects a policy of deferring recognition of gain or loss by partners and partnerships in order to eliminate tax impediments to moving property into and out of partnership for legitimate business reasons.

IRC section 736 addresses payments to a retiring partner or a deceased partner’s successor in interest.[2]  It is helpful to think of IRC section 736 as categorizing partnerships into two types: capital intensive partnerships and service partnerships.  Most professional partnerships (for example, law firms and accounting firms, medical or dental practices) in which revenue is generated by fees or commissions would be considered to be service partnerships.  IRC section 736 provides a regime that is favorable to the remaining partners making payments to retire a general partner from a service partnership.  Payments made to retire partners from capital intensive partnerships will follow the regular distribution rules under IRC sections 731, 732(b), and, where applicable IRC section 751(b) (described in Chapter 4).

The fact that a partner may be “retiring” does not necessarily refer to a departure from the partnership due to age or disability. [3]  A "retirement" occurs when the partnership, as an entity, acquires or redeems the partner’s interest, as opposed to a purchase of a partnership interest when a person or entity other than the partnership acquires the partner’s interest.   IRC section 736 does not apply to payments made to continuing partners.  It also does not apply when the partnership is liquidated.  (Treas. Reg. section 1.736-1(a)(1)(i)).

IRC Section 736(b) Payments

While IRC section 736(a) appears first in IRC section 736, IRC section 736(b) actually contains the general rule.  IRC section 736(b) payments are considered payments made by the partnership to the retiring partner for his/her share of partnership property.  Because these payments are considered distributions in liquidation of the partner's interest, as stated above, their tax treatment is generally governed by the liquidating distribution rules of IRC sections 731, 732(b) and 751(b).

IRC section 736(b) payments are taken into account by the recipient partner in the taxable year in which the payments are made, regardless of the departing partner’s or the partnership’s method of accounting (Treas. Reg. section 1.736-1(a)(5)).   If there are any “hot assets” under IRC section 751, ordinary income or loss to the partnership and the retiring partner under IRC section 751 must be computed as each payment is made.

Payments made to a retiring partner by the partnership are economically equivalent to an installment sale of the retiring partner’s interest to the remaining partners.  Depending on what type of assets the partnership owns, IRC section 736 can provide more favorable treatment for a number of reasons.  For example, basis recovery is generally pro rata under the installment method.  Under the partnership distribution rules, basis is generally recovered first.

Example 7-1

Harry, Ralph, and Jill are partners in Everett Partnership.  The partnership’s assets consist of stock and land held for investment.  Additionally, the partnership has a liability that is secured by the land.  The partnership agrees to retire Harry’s interest by means of equal cash payments over a period of five years.  Harry will remain liable for his share of the partnership’s liability until the he receives his last payment.  Since this is a capital intensive partnership, the partnership will treat the payments under the general distribution rules.  Harry will take these IRC section 736(b) payments into account in his taxable year in which the payments are made.  Under IRC section 731(a)(1), he will report any gain only after he has recovered his basis.

IRC section 736(b) payments can be the equivalent of liquidating distributions under IRC section 751(b).

Example 7-2

Harry, Ralph, and Jill are partners in Adelphi Plumbing Supply Partnership, which is a capital intensive partnership.  The assets of the partnership consist entirely of cash, unrealized receivables, and non-appreciated inventory.  The partnership agrees to retire Harry’s interest in partnership property by means of equal cash payments over a period of ten years.  Harry will take these IRC section 736(b) payments into account in his taxable year in which the payments are made.  Because the unrealized receivables are “hot assets” for purposes of IRC section 751, Harry and the partnership will first treat payments for such assets as distributions under IRC section 751(b)[4].  Harry will treat the remainder of the payments under the regular distribution rules of IRC section 731(a)(1) and, thus, will report any gain only after he has recovered his basis.

IRC Section 736(a) Payments

IRC section 736(a) can provide favorable treatment for situations in which a general partner retires from a service partnership[5].  Payments made to a general partner retiring from a service partnership for his/her share of unrealized receivables[6] or unstated goodwill[7] will fall into either of two categories:   1) the retiring partner’s distributive share of income, gain, deduction or loss of the partnership or 2) guaranteed payments - an IRC section 736(a) payment is a "guaranteed payment" if it is determined without regard to the partnership’s income.  See IRC section 707(c). 

These “IRC section 736(a) payments” are desirable from the point of view of the continuing partners because such payments actually or effectively provide the continuing partners with deductions.  Distributive share payments (those determined with regard to the income of the partnership) shift income away from the remaining partners to the retiring partner.  Guaranteed payments, unless required to be capitalized, are deductible by the partnership and reduce the amount of income (or increase the loss) passed through to the remaining partners.   However, IRC section 736(a) payments usually result in ordinary income to the retiring partner and are includible in income by the recipient for the partnership’s taxable year that ends within or with the partner’s taxable year.

Example 7-3

Bill is a member of the Aurora partnership, which is an accounting firm (a service partnership).  The partnership agrees to retire Bill by paying him one-third of the partnership’s income for three years.  Bill stops working in the partnership, but for purposes of IRC section 736, he is still considered to be a partner until his interest is completely liquidated.  The partnership’s assets consist solely of unrealized receivables and goodwill.  The partnership agreement does not state that any of the payments are for the goodwill.  Because the payments are determined with regard to partnership income, they will be treated under IRC section 736(a)(1) as Bill’s distributive share.  In effect, this provides a deduction for the remaining partners.  Bill will include the income in his taxable year with or within which ends the partnership taxable year for which the payment is a distributive share. 

Treatment of Cash Liquidating Payments Made over Several Years

If a retiring partner receives a series of payments over more than one tax year, a determination must be as to whether and to what extent each payment has both IRC section 736(a) and IRC section 736(b) characteristics.  The partners can provide for a reasonable manner of apportioning IRC section 736(a) and IRC section 736(b) payments in the partnership agreement.  If they do not so provide, the IRC section 736(b) portion is calculated based upon a ratio set forth in the regulations.  See Treas. Reg. section 1.736-1(b)(5)(i).

Under Treas. Reg. section 1.736-1(a)(5), the IRC section 736(a) portion of each payment is immediately taxable.  However, under Treas. Reg. section 1.736-1(b)(6) no gain is recognized on the IRC section 736(b) portion until the retiring partner receives distributions of cash which exceed his/her outside basis, except when IRC section 751(b) applies.  The partner may elect to attribute an amount of gain to each installment payment instead of first recovering basis.  See Treas. Reg. section 1.736-1(b)(7) for examples.

If the amounts are not fixed, all payments received are treated as IRC section 736(b) payments to the extent of the fair market value of the retiring partner's interest in partnership property.  The remainder is treated as IRC section 736(a) payments.  See Treas. Reg. section 1.736-1(b)(5)(ii).

If an IRC section 754 election is in place, the partnership will step-up the basis of its remaining assets under IRC section 734(b) to the extent IRC section 736(b) payments to the retiring partner exceed his/her outside basis or decrease basis to the extent the partner’s outside basis exceeds the IRC section 736(b) payments or a “substantial basis reduction” is required irrespective of any IRC section 754 election or non-election.

Death of a Partner

Death of the partner does not ordinarily result in the termination of the partnership under IRC section 708(b), because a disposition by gift, bequest or inheritance is not considered a sale or exchange.  Treas. Reg. section 1.708-1(b)(2).  Accordingly, if a partner’s interest in the partnership terminates by reason of his/her death, the taxable year of the partnership closes, but only with respect the deceased partner’s interest.  IRC section 706(c)(2)(A).  The partner’s share of income, losses, deductions and credits from the beginning of the partnership year to the date of the partner’s death are included in the partner’s final income tax return.

The person named in the partnership agreement as successor partner in the event of death is recognized as the successor for federal income tax purposes.  Treas. Reg. section 1.706-1(c)(3)(ii).  The amount includible in the gross income of a successor in interest of a deceased partner under IRC section 736(a) is considered income in respect of a decedent under IRC section 691.  IRC section 753.

Often partnership agreements will contain pre-existing “buy-sell” agreements which specify that the partnership interest will be sold upon the death of a partner.  These buy-sell agreement set forth the manner of conducting such a sale.  Ordinarily, the sale of a partnership interest by a partner owning 50 percent or more of the capital and profits of the partnership within a 12 month period will cause the partnership to terminate.  IRC section 708(b).  The partnership will close with respect to the deceased partner, and the decedent and the new partner must each include their proportionate shares of partnership income, loss, deductions and credits in income.  See Treas. Reg. section 1.706-1(c)(3)(iv) & (vi) Example (2).

Passive Activity Losses

Suspended passive activity losses are deductible on the decedent’s final return.  However, the amount of the deductible suspended loss is reduced by the amount by which the basis of the partnership interest to the successor (stepped-up basis) exceeds the adjusted basis of the partnership interest to the decedent immediately before death.  IRC section 469(g)(2).  If, as a result of this provision, any part of the suspended passive activity loss is not allowed on the decedent’s final return, it is extinguished and will not be allowed to anyone.  IRC section 469(g)(2)(B).

The basis of the partnership interest to the successor is the fair market value as of the date of death or alternate valuation date.  IRC section 1014(a).  This amount is reduced by income in respect of a decedent and, increased by the successor’s share of liabilities as of the date of death or alternate valuation date.  Treas. Reg. section 1.742-1.  IRC section 691 provides rules relating to income in respect of a decedent (IRD).

The successor partner’s basis in the partnership interest is the fair market value per IRC sections 742 and 1014.  This may result in the successor having an outside basis in excess of the partnership’s inside basis.  If an IRC section 754 election is in place, the partnership can step-up the basis of assets under IRC section 743(b) solely for the benefit of the successor.  Conversely, if an IRC section 754 election is in place and the successor’s outside basis is less than the partnership’s inside basis, a step-down in basis will be required.[8]

Examination Techniques

  • Determine whether any capital is a material income-producing factor in the partnership (in other words, is the partnership a service partnership or a capital intensive partnership).
  • Determine whether allocations between IRC section 736(a) and IRC section 736(b) payments were reasonable and consistently treated by the retiring and continuing partners.
  • Determine whether partnership items were properly allocated between the decedent and the successor in interest (or successor partner in the case of a sale of the partnership interest). 
  • Determine if adjustments made under IRC section 734(b) or IRC section 743(b) were properly calculated.
  • Make certain that the retiring partner’s share of liabilities was properly accounted for.
  • To the extent that IRC sections 469(g)(2) and 469(g)(2)(B) are applicable, make sure that neither the decedent nor the successor have claimed a deduction for suspended passive activity losses.

Issue Identification

Compare the tax position of the retiring partner to those of the continuing partners.  Differences in relative tax positions can motivate the partners to make unreasonable allocations between IRC section 736(a) and IRC section 736(b) payments.  For example, if the departing partner has a large and otherwise unused capital loss and the remaining partners have net operating losses or are in low tax brackets for the year, they would have an incentive to allocate as much as possible to IRC section 736(b) payments.  On the other hand, if the retiring partner has a large or expiring net operating loss and the remaining partners are in a high tax bracket for the year, the shift may be in favor IRC section 736(a).  While it is permissible to plan for such allocations, they must be reasonable.

When calculating the amount of payments received, a decrease in the retiring partner’s share of liabilities under IRC section 752(b) must be added to any actual cash payments received.

Be alert to the possibility that the liquidating payments may actually be a disguised sale of a partnership interest.  Payments received from a sale of a partnership interest can have significant tax differences from liquidating payments under IRC section 736.  Recall that payments under IRC section 736(b) do not result in gain to the partner except to the extent they exceed his/her outside basis, while the sale of a partnership interest in installments will require an apportionment of gain to the yearly payments received.

On partnership returns with a departing partner, look for a reduction to goodwill on the balance sheet and guaranteed payments on the departing partner’s Schedule K-1. The presence of a Notice of Inconsistent Treatment, Form 8082, (TEFRA partners) or Disclosure Statement, Form 8275, (in the case of non-TEFRA partners) referring to IRC section 736 may be an indication that the retiring partner is allocating retirement payments between IRC sections 736(a) and 736(b) in a manner inconsistent with that of the partnership or other partners.

Documents to Request

  1. Partnership agreement; 
  2. Property fair market value determinations; 
  3. Copy of departing partner’s return; 
  4. Copy of the remaining partners’ returns (or at least those with the greater participation); 
  5. If necessary, substitute RTVUE/BRTVUE or MACS print; 
  6. Partnership IRC sections 736(a) and 736(b) allocation workpapers.

Interview Questions

Interview questions may include questions concerning:

  1. allocations which seem misclassified or unreasonable; 
  2. fair market value determinations which appear under or over valued;
  3. the methodology of valuing major assets of the partnership; 
  4. whether the departing partner was relieved of debt and whether the debt was properly treated as a cash payment under IRC section 752(b);
  5. whether the retiring partner is severed from the partnership (complete liquidation required).

Gift or Charitable Contribution of a Partnership Interest

A gift of a partnership interest or a contribution of a partnership interest to a charitable organization can result in the recognition of income to the donor.  This section covers both transactions.

Gift of a Partnership Interest

A gift of a partnership interest is usually a family affair.  IRC section 704(e)(3) provides that the purchase of a partnership interest in a family partnership by one member of a family from another shall be considered to be created by a gift from the seller.  IRC section 704(e)(2) addresses the allocation of distributive share where the partnership interest is created by gift.  Of course, the gift of a partnership interest to a family member can be other than an interest in a family partnership.

The gift of a partnership interest may have a tax impact on the donor.  The following factors should be considered when determining whether an issue is present:

  • Whether the partnership interest transferred was properly valued;
  • Whether the adjusted basis of the partnership interest was correctly stated;
  • Whether allocation of the distributive share of partnership items between the donor and donee was correctly computed;
  • Whether the transfer resulted in debt relief to the donor;
  • Whether debt relief results in a deemed sale of a partnership interest;  
  • Whether the allowance of suspended passive activity losses was correctly computed;
  • Whether there is a gift tax return requirement and a gift tax liability

The gift of a partnership interest free of liabilities (that is, has no share of partnership liabilities under IRC section 752) is not subject to income tax.  If the partnership interest is encumbered by debt, or the donor partner shares in partnership liabilities pursuant to IRC section 752, there is potentially a taxable event.

Gift of a Partnership Interest Encumbered by Debt

When a partnership interest which is encumbered by debt is transferred to a donee who accepts the interest subject to the debt (or assumes the liability of the donor), the decrease in the donor’s share of liabilities under IRC section 752(b) converts what would otherwise be a nonrecognition event into a sale or exchange.  Where this results in gain, the gift of the partnership interest is split into two parts, one part gift and the other part sale.  The donor realizes gain to the extent the amount realized (the debt relief) exceeds the adjusted basis of his/her partnership interest.

However, no loss is recognized in such a transfer if the amount realized is less than the adjusted basis (Treas. Reg. section 1.1001-1(e)(1)).  The following examples are found in Treas. Reg. section 1.1001-1(e)(2) and are applicable to gifts of partnership interests.

Example (1). A transfers property to his son for $60,000. Such property in the hands of A has an adjusted basis of $30,000 (and a fair market value of $90,000).  A's gain is $30,000, the excess of $60,000, the amount realized, over the adjusted basis, $30,000.  He has made a gift of $30,000, the excess of $90,000, the fair market value, over the amount realized, $60,000.

Example (2). A transfers property to his son for $30,000.  Such property in the hands of A has an adjusted basis of $60,000 (and a fair market value of $90,000).  A has no gain or loss, and has made a gift of $60,000, the excess of $90,000, the fair market value, over the amount realized, $30,000.

Example (3).  A transfers property to his son for $30,000.  Such property in A's hands has an adjusted basis of $30,000 (and a fair market value of $60,000).  A has no gain and has made a gift of $30,000, the excess of $60,000, the fair market value, over the amount realized, $30,000.

Example (4). A transfers property to his son for $30,000.  Such property in A's hands has an adjusted basis of $90,000 (and a fair market value of $60,000).  A has sustained no loss, and has made a gift of $30,000, the excess of $60,000, the fair market value, over the amount realized, $30,000.

Ordinarily, a gain realized on the sale of a partnership interest is treated as capital gain. However, if the partnership has IRC section 751 “hot assets” a portion of the gain will be treated as ordinary income.

The basis of the partnership interest to the recipient (donee) is determined under the general guidelines of IRC section 1015.  The unadjusted basis to the donee of a partnership interest transferred in part by gift and in part by sale is the greater of:

  1. the amount paid by the transferee, including the debt assumed or taken subject to by the donee, where the amount of the debt assumed exceeded the transferor’s adjusted basis at the time of the gift, or
  2. the transferor’s adjusted basis at the time of the gift.

See Treas. Reg. section 1.1015-4(a)(1).

If the payment of gift tax is required, gift tax is calculated on the amount by which the fair market value of the transferred partnership interest exceeds the debt relief to the donor.  Payment of gift tax increases the donee’s basis in the partnership interest (IRC section 1015(d)).  If the gift tax is paid by the donee, the donor realizes taxable income. Diedrich v. Commissioner, 457 U.S. 191 (1982), 

Gift of a Partnership Interest Unencumbered by Debt

The basis of the gift of a partnership interest in the hands of the donee when the partnership interest is not encumbered by debt is generally determined as follows:

  1. For purposes of determining future gain, the donee’s takes a carryover adjusted basis from the donor.
  2. For the purpose of determining future loss, the donee’s takes a carryover adjusted basis from the donor, except that if the donor’s adjusted basis was greater than the fair market value of the property at the time of the gift, the basis to the donee is limited to the fair market value at the time of the gift.

Effect on Passive Losses

The gift of a partnership interest with accumulated suspended passive activity losses will not trigger an allowance of the losses to the donor or donee.  See IRC section 469(j)(6)(B).  The suspended passive activity losses are instead added to the donor’s adjusted basis in his/her partnership interest immediately before the transfer.  This step up in basis carries over to the donee under the general rules of IRC section 1015.  See IRC section 469(j)(6)(A).  The step-up is to the donor’s outside basis in the partnership under IRC section 705, rather than the partnership’s inside basis in its assets.  Any tax benefits to the donee are deferred until such time as the partnership interest is disposed of in a taxable transaction.

Moreover, the step-up in the donor’s outside basis has limits.  If the addition to the donee’s basis resulting from unused passive losses exceeds the fair market value of the partnership interest at the time of the gift, and the donee subsequently disposes of the interest in a taxable transaction resulting in a loss, the donee’s basis is limited to the fair market value at the time of the gift.

Contribution of a Partnership Interest to Charity

The contribution of a partnership interest to a charitable organization may raise issues, particularly in situations where the partnership has liabilities or has ordinary income property.  When a partnership interest is encumbered by debt, the bargain sale provisions of IRC section 1011(b) may require the donor to recognize income.

When a partner contributes an interest in a partnership that has liabilities to a charitable organization, the transaction is bifurcated into a charitable contribution and a sale.[9]    The amount of the charitable contribution is equal to the amount by which of the fair market value of the partner’s share of partnership assets exceeds the partner’s relief of debt under IRC section 752(b).  In other words, the charitable contribution amount equals the partner’s net equity value in the partnership.

For the sale portion of the transaction, the amount of the debt relief is considered to be the amount realized per IRC section 752(d).  IRC section 1011(b) requires the donor’s basis to be prorated between the portion deemed contributed and the portion deemed sold based on the fair market value of each.  The basis that the donor is able to use in calculating his/her gain must bear the same ratio to the total basis that the sales price bears to the total fair market value of the partnership interest.  In some instances, the “sales price” will simply equal the amount of the donor-partner’s relief of debt.  If this is the case, then the basis of the portion sold will equal the donor’s total adjusted basis multiplied by a fraction in which the numerator is the relief of the liabilities and the denominator is the fair market value of the partnership interest.

Example 7-4
 
D, an individual, has an interest in a general partnership, Delta.  On December 31, 2006, he contributed his partnership interest, subject to his share of partnership liabilities, to a recognized charitable organization under IRC section 170(c).  At the time of the contribution, the fair market value of D's interest was $50,000.  The partnership had no assets that would generate ordinary income if sold.  D held his partnership interest for more than one year.  His basis in his partnership interest at the time of contribution was $40,000 computed as follows:

Capital contribution of cash                                              $50,000
Less: D’s share of losses from partnership operations        (40,000)
Plus:  D’s share of partnership liabilities                               30,000
Adjusted Basis                                                                 $40,000
                                                                                        ======

Under IRC section 752(d), the relief in liabilities for D upon contribution of the partnership interest is $30,000.  Therefore, the bargain sale portion is calculated as follows:

 Amount Realized   =  $ 30,000  = 60%
 Fair Market Value      $50,000

 

Amount Realized                                                                   $30,000
Less: Basis in partnership interest [60% x $40,000]                (24,000)
Gain on bargain sale                                                              $  6,000  
                                                                                             =======

The amount of the charitable contribution is the fair market value of the partnership interest ($50,000), less the amount deemed sold ($30,000), or $20,000
         
In this example, the gain is capital gain.  However, if the partnership had any IRC section 751 assets, a portion of the gain would have been ordinary.  If IRC section 751(c) assets are involved, the gain may be part ordinary and part capital.  Treas. Reg. sections 1.1011-2(c) and 1.170A-4(d) provide several examples. 

Effect of IRC Section 751 “Hot Assets”

The presence of IRC section 751 assets impacts the deductible amount of the charitable contribution.  To the extent a sale or exchange of the charitable contribution portion would have generated ordinary income, the amount of the deduction would be reduced under Treas. Reg. section 1.170A-4(c)(3).

 In order to determine the allowable charitable deduction for the contribution of property, including a partnership interest, it must be determined whether and to what extent the property would, if sold, give rise to ordinary income or capital gain.  Under IRC section 170(e)(1), a charitable contribution of property is reduced by the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution).  Thus, to the extent a sale of a partnership interest by the donor would have resulted in ordinary income due to the presence within the partnership of IRC section 751 “hot assets”, the amount of the charitable contribution is reduced. 

Accumulated Passive Activity Losses

The charitable contribution of a partnership interest will not result in an allowable deduction of suspended passive activity losses to the donor.  The suspended passive activity losses are added to the donor’s basis at the time the partnership interest is contributed.  If there is any tax benefit to be gained, it will be through a larger basis to be used in a bargain sale calculation.

Examination Techniques

The contribution of a partnership interest can involve the basic issues inherent in the charitable contribution of property, including those involving valuation, use by the donee, and other common issues that arise under IRC section 170.  Examiners should, if necessary, seek the assistance of specialists from the Tax Exempt and Governmental Entities (TEGE) division. 

Some common audit steps include:

  • Verification of the partner’s basis in the partnership; 
  • Calculating the partner’s share of debt, if any;
  • Ascertaining if the partner was relieved of debt as a consequence of donating the property, and application of the bargain sale rules, if warranted;
  • Determining if ordinary income was inherent in the contributed interest;
  • Allocating the sale portion between ordinary and capital gain;
  • Determining the amount allowable as a contribution.

As with any type of disposition that represents a final disposition of a partnership interest, proper treatment of accumulated passive activity losses should be verified.

Issue Identification

  • The initial indication that a partner has contributed his or her partnership interest should be evident from the appearance of a contribution deduction on the partner’s return.  Where a partnership interest has been gratuitously transferred, item J of the contributing partner’s Schedule K-1 may show the addition of new partners.  Also, the donor’s Schedule K-1 may be checked as final. 

    Determine if the partnership has any liabilities or IRC section 751 assets.
  • If valuation of the partnership interest is a potential significant issue, consider a referral to an engineer or valuation specialist.
  • The likelihood that the donor partner may not have reported gain from making the gift or gain on the bargain sale will be indicated by the absence of the transaction on the partner’s Schedule D.
  • If the partner is a limited partner, look for passive activity loss adjustments.  The former partner should not have claimed a deduction for accumulated passive activity losses.
  • If the partnership agreement prohibits the gift or contribution of a partnership interest, the departing partner may be treated as having abandoned the partnership interest.  Refer to the section on “Abandonment of a Partnership Interest.”
  • The gift of a partnership interest with a negative capital account is an indication that the interest was encumbered by debt.  The bargain sales rules may be implicated. 

Documents to Request

  1. Partnership agreement;
  2. Prior and subsequent year partnership tax returns;
  3. Form 8308 (if required and not attached to the return).  Form 8308 is required to be filed when a partnership interest is transferred and the partnership has IRC section 751 assets;
  4. Calculation of the donor partner’s basis;
  5. Documents concerning fair market value determination;
  6. Transfer agreement between the donor and the donee, including any provisions for debt assumption;
  7. Donor partner’s tax return for the year at issue;
  8. Copy of donee’s return;
  9. Partner’s bargain sale calculation including calculation for built-in depreciation recapture and other IRC section 751 considerations;
  10. Copy of Gift Tax return(s) filed.

Interview Questions

  1. How was the fair market value of the partnership interest determined?
  2. What is the relationship between the donor and donee?
  3. What happened to the donor partner’s share of liabilities?
  4. Was the donor partner liable for recourse debt?  Did the partner remain liable for the debt after donating the partnership interest?

Supporting Law

IRC, Subchapter K:  Sections 704, 705 731, 751 and 752.
IRC sections 170, I 469, 501(c), 1001, 1011, and 1015.
Supporting regulations and specific regulations cited above.

Rev. Rul. 75-194, 1975-1 C.B. 80, Charitable Contribution of a Limited Partnership Interest

The donation of a partner’s interest in a limited partnership to a charitable organization was deductible after reductions required by IRC section 170(e)(1).  The fair market value of the donating partner’s share of partnership assets exceeded his/her share of partnership liabilities thereby creating a charitable contribution deduction under IRC section 170.  However, at the time of the contribution, the amount of the contributing partner’s share of partnership liabilities was be treated as an amount realized by the partner in a bargain sale transaction.  The contribution resulted in both a gain from a bargain sale and a charitable contribution deduction.

This ruling has been codified as Treas. Reg. section 1.1011-2(c), example 4.

Diedrich v. Commissioner, 457 U.S. 191 (1982), aff’g 643 F.2d 499 (8th Cir. 1981), Rev’g T.C. Memo 1979-441.

The Supreme Court affirmed the determination of the Court of Appeals for the 8th Circuit. The donor of a gift realized taxable income to the extent that the gift taxes paid by the donee exceeded the donor’s adjusted basis in the property.  Although the property in this case was corporate stock rather than a partnership interest, the result should not differ in the case of a partnership interest or LLC membership interest.

Goodman v. U.S., 1999 WL 1424985, 85 A.F.T.R.2d 2000-438 2000-1, U.S.T.C. (1999), (S.D.Fla. Dec 22, 1999) (NO. 98-869-CIV-HURLEY)

The U.S. District Court for the Southern District of Florida concluded that IRC sections 752(d) and 1011(b) required a partner, under the facts of the case, to treat the contribution of a partnership interest to a charitable organization as a bargain sale.  The taxpayer’s argument that IRC section 1011(b) applies only to sales and not to gifts, was rejected. In reaching its decision, the Court cited, among other authorities, Rev. Rul. 75-194.

ABANDONMENT OF A PARTNERSHIP INTEREST

The partnership agreement may contain a set of specifications whereby the partnership will consider the partner to have forfeited the partnership interest.  This may include, but is not limited to, failure to keep up with payments under the subscription agreement.  The forfeiture of a partnership interest generally has the same tax consequences as abandonment.

Abandonment of an asset occurs when a taxpayer abandons property and receives nothing in return.  If he/she receives deemed consideration, the loss is a capital loss from a deeded sale or exchange of the partnership interest.  An understanding of the facts and circumstances present at the time of the abandonment is crucial in determining whether the actions of the partner constitute abandonment or sale of the partnership interest. [10] 

Neither the Internal Revenue Code nor the regulations provide a procedure for abandonment.  Both the Service and Courts have ruled that there must be some overt action on the part of the partner to make clear to the partnership, general partner and third parties, the partner’s intent to surrender the partnership interest.  See A.J. Industries, Inc., 503 F.2d 660, 9th Cir. 1974); Rev. Rul. 93-80, 1993-2 CB 239; Rev. Rul. 2004-58, 2004-1 CB 1043.

Once it is determined that the partner abandoned the partnership interest, it must be established whether the abandonment is a closed and completed transaction.  Treas. Reg. section 1.165-1(b) provides that to be allowable the loss must be evidenced by a closed and completed transaction, fixed by identifiable events and actually sustained during the year.  This is determined by taking into account all of the facts and circumstances. 

The amount of an abandonment loss is calculated as the total of the abandoning partner’s unrecovered basis. The abandonment may even result in gain if at the time of the abandonment the partner was relieved of liabilities in excess of his/her basis in the partnership interest.  Moreover, if there is a gain on abandonment and the partnership holds IRC section 751 “hot” assets, the gain on the deemed sale could result in ordinary income.

Worthlessness is often the result of hopeless insolvency; that is, the partnership’s liabilities exceed the value of its assets and there is no reasonable expectation of a return to solvency.  A partner’s ability to take a worthless partnership interest deduction depends upon whether the partnership interest is completely worthless, when the interest became worthless, and whether worthlessness resulted from a closed and completed transaction. In order to obtain a tax loss, a partner must take affirmative steps to abandon a worthless partnership interest.[11]

Ordinary vs. Capital Loss Treatment

Generally, a loss from the worthlessness of an asset is an ordinary loss due to the absence of a "sale or exchange," within the meaning of IRC section 1222, whether or not the asset is a capital asset.  However, if the loss results from a sale or exchange, the loss will result in a capital loss.  For example, if a taxpayer receives a deemed distribution in the context of abandoning an asset, the transaction will be classified as a deemed sale or exchange and he/she will have a capital loss.  See Rev. Rul. 93-80, 1993-2 C.B. 239.

If a partnership has liabilities and all or a portion of those liabilities are allocated to a partner who forfeits or abandons his/her interest, and if the transaction results in a decrease in his/her share of liabilities under IRC section 752(b), he/she will be deemed to have received a cash distribution, and the relinquishment of his/her interest is considered a sale or exchange.  Walking away from a partnership in this manner will result in a capital loss.  Courts have ruled that even a de minimus amount determined in any way to be compensation for the partnership interest will cast the transaction as a sale. 

The amount of an abandonment loss is calculated as the total of the abandoning partner’s unrecovered basis.  The abandonment may even result in gain if at the time of the abandonment the partner was relieved of liabilities in excess of the partner’s basis in the partnership interest.  Moreover, if there is a gain on abandonment and the partnership holds IRC section 751 “hot” assets, the gain on the deemed sale could result in ordinary income.

Examination Techniques

The examination techniques employed used should determine whether or not:

  • the abandonment is genuine;
  • the facts and circumstances indicate a closed and completed transaction;
  • the abandoning partner was relieved of his share of partnership liabilities;
  • the abandoning partner was, in any way, compensated for his/her partnership interest;
  • the gain or loss was properly calculated.

Issue Identification

The abandonment issue can be identified on either the partner’s tax return or the partnership return.  An individual partner should be expected to report the transaction on Schedule D or E, depending on how the loss was treated (capital v. ordinary).  If the activity was passive, the balance of carryover passive activity losses from this particular entity will be deducted under IRC section 469(g)(1) and Treas. Reg. section 1.469-2T(d)(5).

The partnership return may not specifically indicate that interest was “abandoned.” However, a review of the partners’ schedules K-1, item J, “Analysis of partner’s capital account,” may reveal that a partner’s capital account has been reduced to zero.  A review of the departing partner’s prior year schedule K-1 may indicate an allocation of partnership liabilities.  See item F, “Partner’s share of liabilities.” If so, compare it to the current year entry in item F.  If the partner’s final schedule K-1 reports nonrecourse liabilities in item F, determine whether the liabilities were reallocated among the remaining partners.  If the departing partner’s final Schedule K-1 reports recourse debt, determine whether the partner’s liability extends beyond his/her participation in the partnership.  Any reallocation from non-recourse to recourse debt allocable to the departing partner, the facts and circumstances of such a reallocation should be closely examined, since this may be an attempt to eliminate a deemed sale or otherwise make it appear that the partner has not received a relief of liabilities when the facts may be otherwise.

Consider whether the partnership undertook steps in anticipation of the abandonment to clear the path for treating the loss as ordinary instead of capital.  If so, consider whether the steps can be collapsed under the step transaction doctrine or otherwise recharacterized to reflect actual substance versus form.  See Tapper v. Commissioner
T.C. Memo. 1986-597 (1986).

Examination Techniques

  • Compare the partnership’s balance sheet (schedule L) for the year under examination with that of the subsequent year.  Ascertain if the partner’s share of debt has retained by the partnership.  Also look for the presence of IRC section 751 assets in existence at the time of abandonment.
  • Review schedule M-2 for the reconciliation of capital accounts in the absence of the departing partner.
  • Review the Schedules K-1 contained in the partnership tax return for the year subsequent to the claimed abandonment.  The inclusion of a Schedule K-1 for the “abandoning” partner is an indication that the partnership and other partners continue to treat the taxpayer as a partner.  The preparation of a Schedule K-1, along with a failure to recognize the abandonment by amendment to the partnership agreement, should raise doubts as to whether there was a clear intent to abandon.
  • Determine if the partner received a final Schedule K-1.  Is the partner continuing to receive Schedule K-1?
  • Determine if the partner filed Form 8082, Notice of Inconsistent Treatment (TEFRA partners only) or a Form 8275, Disclosure Statement, (Non-TEFRA partners).
  • If the issue is worthlessness of a partnership interest, ascertain whether the other partners claimed worthlessness deductions.  If the facts relevant to worthlessness are the same for all partners in the partnership, a claim of worthlessness by just one partner is suspect and may constitute a whipsaw issue.
  • Determine if the partnership is still in operation.  If the partnership return is still being filed but the facts indicate the partnership is worthless or appears to have become inactive, consider whether the partnership return gives the appearance of being a “zombie.”  Zombie partnerships occur when leveraged tax shelter partnerships “burn out” and the termination of such a partnership might result in gain to the partners.  To prevent this result, the partnership is held open indefinitely, conducting minimal if any trade, business, or investment activities.  If a “zombie” partnership issue is to be developed, contact the Partnership Technical Advisor.

Documents to Request

  • Partnership agreement;
  • Prior and subsequent year partnership tax returns;
  • Correspondence submitted by the abandoning partner to the partnership advising of the forfeiture or abandonment of his/her interest;
  • Copy of partnership response to correspondence regarding forfeiture or abandonment; 
  • Copies of all internal financial statements of the partnership;
  • Copies of all evidence of debt or other partnership liabilities or liabilities incurred by partners in connection with partnership activities. 

Interview Questions

  1. Is there a provision in the partnership agreement that provides a means by which a partner can abandon his or her partnership interest or will be deemed to have forfeited his/her partnership interest? 
  2. Was the departing partner allocated a share of partnership debt?
  3. Was the debt recourse or non-recourse or both?
  4. How was the departing partner’s allocation of unsatisfied debt treated by the partnership upon departure of the partner?
  5. Was the departing partner compensated for his/her partnership interest by the partnership or any of its partners?
  6. At the time of abandonment, did the departing partner have any claims against the partnership or any of its partners in respect of his/her partnership interest?
  7. If the departing partner had a negative capital account, did he/she satisfy the negative capital account?  How?

Supporting Law

Rev. Rul. 93-80, 1993-2 C.B. 239

A loss incurred on the abandonment or worthlessness of a partnership interest is an ordinary loss if sale or exchange treatment does not apply.  If there is an actual or deemed distribution to the partner, or if the transaction is otherwise in substance a sale or exchange, the partner’s loss is capital (except as provided in section 751(b) of the Code).  For purposes of determining whether or not IRC section 752(b) applies to create a deemed distribution upon abandonment or worthlessness, liability shifts that take place in anticipation of such event are treated as occurring at the time of the abandonment or worthlessness under general tax principles.

Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), rev’g 93 T.C. 553 (1989)

The Fifth Circuit, in overruling a decision of the Tax Court, discussed the application of the worthlessness and abandonment doctrines.  The court characterized the determination of worthlessness as having both objective and subjective elements.

Citron v. Commissioner, 97 T.C. 200 (1991)

The Tax Court ruled that the partner had abandoned his interest and, in the absence of partnership liabilities, the loss on abandonment was an ordinary loss under IRC section 165(a).

O’Brien v. Commissioner, 77 T.C. 113 (1981)

When a partner terminated his partnership interest by abandoning it, he was relieved of his full share of the partnership's nonrecourse liabilities.  As a result of the decrease in liabilities under section 752(b) the partner was considered to have received a distribution of money from the partnership equal to his share of the partnership liabilities.  Under section 731(a)(2), the deemed distribution liquidated his interest in the partnership and the resulting loss was considered as a loss from the sale or exchange of his partnership interest.  Therefore, the loss was a capital loss rather than an ordinary loss.

La Rue v. Commissioner, 90 T.C. 465 (1988)

The Tax Court stated that the touchstone for sale or exchange treatment is consideration. If, in return for assets, any consideration is received, even if nominal, the transaction will be classified as a sale or exchange.

Tapper v. Commissioner, T.C. Memo. 1986-597 (1986)

The sale of a partnership's sole asset and subsequent liquidation was found to be an integrated series of steps in the same transaction.  Accordingly, the partners were treated as receiving cash distributions upon the liquidation of their partnership interests, with the result that their losses were capital losses.


[1] See Section 833(b)(1) of the American Jobs Creation Act of 2004, P.L. 108-357

[2] Any discussion in this section is applicable to either a retiring partner or a deceased partner’s successor in interest, even when only one or the other is indicated.

[3]  See Boris I. Bittker and Lawrence Lokken,  Federal Taxation of Income, Estates and Gifts, at Chapter 88.03 (RIA 2007). 

[4] See Chapter 4

[5] See IRC sections 736(b)(2) and (3)

[6] As defined by IRC Section 751(c) – note that recapture items are not treated as unrealized receivables for purposes of IRC section 736(b)(2).

[7]   If the partnership agreement provides for such payments, they fall under IRC section 736(b).  See Treas. Reg. section 1.736-1(b)(3).

[8]  A basis step-down is required for any “substantial built-in loss” irrespective of any IRC section 754 election or non-election.  See Section 833(a) of the American Jobs Creation Act of 2004, P.L. 108-357

[9]  See Rev. Rul. 75-194, 1975-1 C.B. 80; Treas. Reg. section 1.1001-2(c) Example 4
 
[11] See Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), for a comprehensive discussion on worthlessness of a partnership interest.
 
Page Last Reviewed or Updated: 06-Nov-2014