Partnership Interest Sale
Many partnership agreements require that a partner who wishes to dispose of his interest in the partnership do so by surrendering it to the partnership in exchange for a liquidating distribution. Many partnership agreements do not allow the unrestricted sale to the public since the remaining partners do not want to be forced to accept anyone who may not be desirable for the business, who may not have the requisite skills, or who may not get along with the other partners. The partnership agreement will also often contain a formula for determining the liquidating distribution that reduces the partner's basis in the partnership to 0.
Liquidating distributions are based on the fair market value (FMV) of a partner's capital account, so the partnership property must be revalued and unrecorded intangible assets, such as goodwill, must be included. The value of the liquidating distribution = the amount received by the withdrawing partner + any extinguished apportioned debt.
However, where the sale of a partnership interest is allowable, the interest can be sold in whole or in part at a profit or a loss. Because tax law views a partnership both as an entity and as an aggregate of partners, the sale of a partnership interest may result either in a capital gain or loss or all or a portion of the gain may be taxed as ordinary income. This differs from the sale of corporate stock which is viewed as a separate entity from the shareholders, in which the sale results only in a capital gain or loss.
When a partnership interest is sold, gain or loss is determined by the amount of the sale minus the partner's interest, often called the partner's outside basis. However, because some of the partnership's taxable items flow through to the partner, part of the gain or loss may be due to specific items that are taxed as ordinary income or loss.
Liabilities. When a third-party buys a partnership interest, the buyer generally assumes the selling partner's share of indebtedness of the partnership, and thus, is added on to the sale price. So if a partner sells his interest for $50,000 in which he also shares the indebtedness of the partnership to the extent of $15,000, then the purchase price of the partnership = the amount paid + the amount of indebtedness assumed by the buyer, i.e., $65,000.
Income allocation. When a partnership interest is sold, the selling partner's tax year closes with respect to the selling partner and income from the partnership interest is allocated between the buying partner and the selling partner in direct proportion to the intervals of time that each party owns the partnership interest with respect to the partnership year. The selling partner must claim the income for the year in which the sale closes rather than at the end of the partnership year, which is the usual case.
Example: Income Allocation
The tax year for ABC partnership ends on March 31, 2020. John, a partner of ABC partnership, sells his stake to Amy on September 30, 2019 for $40,000. John's share of the partnership income is $10,000 and his outside basis in the partnership is $12,000. The allocation of income increases John's outside basis in the partnership by $10,000, giving him a basis of $22,000 in the partnership. Therefore, he must recognize a gain of $18,000 (= $40,000 − $22,000) in 2019.
A partnership that has unrealized receivables and inventory, i.e., hot assets, that, when sold by the partnership, causes it to recognize ordinary income complicates the taxation of the selling partner's interest, since some of the gain or loss may be ordinary rather than capital. The selling partner must recognize the income just as if those assets were sold, with the ordinary income being allocated to the partner. This rule prevents the conversion of ordinary income into capital income that is usually taxed at a lower rate through the sale of the partnership interest.
Unrealized receivables consist of accounts receivable of a cash basis partnership and anything that is sold that is subject to depreciation recapture rules. Concerning partnership property, inventory consists of all property except money, capital assets, and §1231 assets. Therefore, receivables of an accrual basis partnership would be includable as inventory, since receivables are neither capital assets nor §1231 assets.
Example: Calculating the Gain of a Partnership Interest Sale where the Partnership has Hot Assets
A partner, with a 1/3 interest in a partnership, sells his interest for $50,000. Given the facts listed in the table below, calculate the selling partner's taxable gain.
|Partnership Interest Sale||$50,000|
|Partnership Interest %||1/3|
|Total gain||$30,000||= Sale Price − Partner's Outside Basis|
|Ordinary Income||$4,000||= (Inventory FMV − Adjusted Basis of Inventory) × Partnership Interest %|
|Capital Gain||$26,000||= Total Gain − Ordinary Income|
The buyer's outside basis in the partnership interest = the purchase price, even if the selling partner had to recognize ordinary income based on hot assets. The partnership's inside basis remains unchanged. IRC §743