Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!
Jeremy Wells: Let's wrap up this series on partnerships by looking at what really come down to be some of the most important questions. We've talked about some really important things with partnerships such as formation operations and capital accounts. But what we haven't gotten to yet are really [00:00:30] some of the most common things that we have to deal with, especially when we're preparing partnership returns. And that is outside basis distributions and eventually dispositions. Partnerships are difficult. A lot of partnerships don't make it. I've probably had to deal with partnerships falling apart, or partners acquiring the interests of the other partners and consolidating down into a sole member LLC or a sole proprietorship again. And so looking at dispositions of A partnership interests [00:01:00] and what all of that looks like. And the reason I'm putting what are really big topics on their own altogether is because they're all directly related. So partner basis is going to tell us about how we're going to treat those distributions and whether they're taxable or not. It's going to tell us what the tax effect of the of a disposition of a partnership interest is. So and a lot of dispositions work off of the distribution [00:01:30] rules. There are a lot of parts of dispositions that are treated as if they were distribution. So these concepts, although they're important in their own right, they're pretty closely related. So let's get into this with a case study. Uh, Jessica and Seth form lighthouse LLC as equal members.
Jeremy Wells: So this is going to be a multi member LLC, which for federal tax purposes is going to be treated by default as a partnership, but after a few years in [00:02:00] operation, the business has sustained significant losses. And although Seth remains committed to the effort, Jessica wants out. Jessica comes to you as her tax advisor for options and an explanation of the tax implications of her exit from the partnership. So what's this going to look like for Jessica? What are her options? Right. So in this episode, we are going to look at the following things. First of all, we're going to look at how to calculate [00:02:30] the basis of a partner's interest in a partnership. Then we're going to look at assessing the effects of partnership liabilities on outside basis. I've done a lot of episodes on S corporations and briefly mentioned stock bases versus debt bases. In partnerships, though, the rules are a bit different when it comes to how partnership liabilities affect partner basis in their interests [00:03:00] in the partnership, and this can often be a point of confusion between practitioners who are used to working with s corporations who start working with partnerships, or vice versa, those who are used to partnership rules and start working with s corporations, their very different rules. So in this episode, we're going to talk about how partnership liabilities affect partner basis in their interest in partnership. And then we're going to evaluate the tax effects of a partner's exit from a partnership.
Jeremy Wells: So first of all let's [00:03:30] talk about basis. And the main rule here. The main takeaway here is that partners, individual partners not partnerships are responsible for tracking the partner's basis in their partnership interest. So partners maintain those records of their adjusted bases of their interest in the partnership. And this is what is known as outside basis. We'll talk about inside basis also. But outside [00:04:00] basis is the partner's basis for their interest in the partnership. Also the holding periods of those interests. Because if we're talking about eventually either disposing of that interest or transferring that interest to someone else, then the holding period is going to matter because that interest is a capital asset in the hands of that partner. And then we're also going to talk about suspended losses [00:04:30] due to a lack of basis or other limitations. Right? So all of this comes back to this concept of outside basis. And the prior episode, we talked about capital accounts. Capital accounts are important for a lot of partnership level calculations and then how allocations are going to affect individual partners. But when it comes to the treatment of distributions and dispositions of interest. Basis is what matters and specifically outside basis. [00:05:00] Now a partner increases basis by contributions into the partnership and the sum of her distributive share of taxable income tax exempt income and excess depletion deductions. Although those are fairly rare and really only apply to a specific subset of kinds of businesses that I don't work with much in my practice, most of my colleagues don't work with oil and gas businesses in their practices.
Jeremy Wells: So for most small businesses, really what we're looking at is items of [00:05:30] income and gain are typically going to increase basis, along with contributions of cash or property into the partnership. On the other hand, a partner decreases basis but never below zero by distributions. The sum of her distributive share of losses and nondeductible non capital expenditures and then oil and gas property depletion deductions. Again, we're not [00:06:00] going to worry as much about that. That applies to a specific subset of businesses that typically don't show up in firms like mine or my colleagues. Now in the prior episode we talked about capital accounts. Capital accounts are essentially a measure of equity book equity in a partnership. Those can absolutely go negative. There is no restriction on the value in terms of where it falls on the number line. It can be above zero. It can be below zero. It can be at zero basis [00:06:30] can never be below zero. Partnerships and partners keep separate sets of records here. The partnership is going to compute taxable income under IRC section 701 and 703. And it's going to report each partner's distributive shares under section 702 talked about all of this in the prior episode. So the partnership maintains books reflecting its assets, [00:07:00] liabilities, income deductions and capital accounts.
Jeremy Wells: Each partner separately tracks the adjusted basis of her interest in the partnership. Like I said, that's known as outside basis under IRC section 705 and 722, along with any suspended losses under section 704 D, which we'll talk about here in a little bit. At risk amounts under section 465 and [00:07:30] then passive loss limitations under section 469. We'll talk about suspension of losses in uh in a minute as well. The main rule to keep in mind here is that a partner should not rely on the partnership to maintain individual partner level information regarding outside basis or suspended losses. Partnerships will often include this information in [00:08:00] their own records and in their own tax return preparation, especially for very small, closely held partnerships. A lot of times in my own firm, I'm preparing the partnership. Return the form 1065. I'm also preparing at least one of, if not all of the partners individual tax returns. So I have all of the information. I have all of the information about the partnership, about the individual partners. I track all of that together on both sides, both partnership and the individual partner side. If [00:08:30] you are an individual that is invested into a partnership, or even if you own a business that is a partner in a partnership, I would not rely on the partnership to track my individual basis. I would make sure that that is tracked inside of my own tax return year after year.
Jeremy Wells: In other words, I would be looking through the draft tax returns I'm getting from my tax professional and making sure that [00:09:00] along with my form 1040, I have worksheets. I have statements that are showing me the calculation of my partnership basis for that tax year. All tax softwares that I've seen will provide this. And when we bring a new client into our firm, if they have partnership income included in that, we're looking for that updated partnership basis calculation [00:09:30] or worksheet. A lot of that is fairly standardized. There are example or template worksheets included in the instructions for forms 1065 and the 1065 K ones. And a lot of tax softwares essentially replicate that template. So if you don't see that in your return, if you're a taxpayer who is a partner in a partnership, or if you're a tax preparer and that worksheet isn't generating with your clients, return to our [00:10:00] partners and getting k-1's. Then look in your software and figure out why that basis calculation isn't triggering. Sometimes it's because the original basis was never entered, and that's not triggering the creation of that worksheet. If no original basis amount is input, then the worksheet doesn't trigger even if there are current year adjustments to that. So you might need to go back and figure out what that original basis is. Plug [00:10:30] that into your software, and then that should generate the worksheet. Or if you're not sure about that, you can go to the partnership return preparer, ask if they have records of the partner's basis, at, at least from the partnership's perspective.
Jeremy Wells: That could be helpful. You can also go through K-1's historical K-1's for the partnership, use the capital account analysis, as well as the annual change in liabilities [00:11:00] that are reported on the K-1's to try to reconstruct basis. Reconstruction of partner basis is a whole separate issue. There is an entire IRS training manual on how to analyze and reconstruct partner basis. It's pretty significant workload. So if you are a tax professional and you bring on a client that is a partner in a partnership and they don't have a record of [00:11:30] their basis in the partnership, then I would definitely plan to start working on recreating that and communicate that to your new client. Let them know that this is a critical component of their return and that I recommend not preparing any more future returns until you have squared away. What their actual outside basis in that partnership is. Now the individual partner, again, not the partnership, the individual [00:12:00] partner has the burden of proof to show sufficient basis to deduct losses if she fails to maintain adequate records of her basis. And this is why I say that the individual partner is really the one who needs to be tracking this information, because if push comes to shove and that partner claims a loss and claims to have basis to cover those losses, then is going to be up to that individual partner to prove to the IRS or ultimately the courts that they actually [00:12:30] do have that basis.
Jeremy Wells: So there is a tax court memorandum. Cpe v Commissioner 2016 220 if a partner fails to track her outside basis. Then, like I said, you can reconstruct that using those prior year schedules. K one again, there's an IRS practice unit on partner's outside basis. If you work with partners and partnerships and you're not familiar [00:13:00] with that practice unit, I would search that IRS practice unit partner's outside basis there. It can be really helpful. There's a good breakdown of the authority, uh, and the authoritative and statutory regulatory background of partnership basis, as well as a guide on reconstructing basis. This is essentially a training manual for IRS employees on how to evaluate partner basis in their interest in partnerships. And so it's good for using that to think about how IRS [00:13:30] would examine a case like that. Now why do we worry so much about outside basis? Essentially it limits the deduction available for partnership losses. So partner can't deduct her distributive share of a partnership loss, including a capital loss in excess of her outside basis or the adjusted basis of her interest in the partnership calculated at the end of the partnership tax year. So again, basis cannot go [00:14:00] below zero. So if you have a partner who has basis that is less than the amount of her distributive share of partnership losses for the year, then there is going to be a limitation based on that basis.
Jeremy Wells: Those excess losses are suspended and carried forward into the following tax year. They become deductible [00:14:30] in a later year to the extent that the partner has sufficient outside basis at the end of that partnership year. So think about it this way. I'm a partner in a partnership, and in the current tax year that I'm preparing my return for early next year, my basis hits zero and I have losses in excess of that basis. So I can't take all of those losses. The excess [00:15:00] of the losses over what my basis was at the end of the tax year is suspended and carried forward into the following year. Now I have a couple options that following year. I can either contribute money or property into the partnership to increase my basis to cover those carried over losses, or if the partnership is profitable that year. And now my distributive share of the partnership's profit [00:15:30] is in excess of that carried forward loss from the prior year, then that carried forward loss would offset those current year profits. Right. But you can't take a loss in excess of your outside basis in the partnership. Now, if a partnership has losses in all categories of non separately and separately stated items, and a partner has limited losses due to basis, [00:16:00] then each category of loss is limited in the proportion it bears to the total losses, including disallowed losses from prior years.
Jeremy Wells: Basically, what does this mean? In the prior episode, we talked about separately stated items. So things like the capital losses or uh interest income is a separately stated item. But maybe also charitable contributions are another [00:16:30] example of a separately stated deduction. If the partnership passes through those items on the K one and the losses are suspended due to. Basis, then there has to be an allocation across all of those losses. Separately and non separately stated. In order to make sure that the suspended amount reflects the total [00:17:00] amount of loss. Now that all comes from IRC section 704 D as well as regulation section 1.7041 D. So all of these rules about suspended losses due to uh a lack of basis are contained there in that specific subsection and then that subsection of the regulations. So note that for an individual partner though, there are going [00:17:30] to be multiple layers of loss limitations that we have to keep in mind most of the time. For relatively straightforward and simple partners and partnerships, we can just stop with outside basis under section 704 D, however, there might be other limitations that come into play as well. Partnership basis is just one of the loss limitations we have to worry about. The ordering goes like this. First of all, as we look at outside basis, that's under [00:18:00] IRC section 704 D.
Jeremy Wells: Then we look at at risk basis under IRC section 465. Then we're going to look at the passive activity rules under IRC section 469. So if that partner is passive with respect to the partnership. And so if the partnership income or loss from this partnership is a passive activity for that individual partner, then we're going to have to take that into account [00:18:30] as well. And then finally for an individual we have the excess business loss limitation under IRC section 461 L, that has to be taken into account as well. So losses that don't meet the requirements for any of those limitations are suspended at that level. And it's actually possible that you can have losses suspended at one of those levels, but not the others, for example. Now that gets fairly complex. Honestly, I've never had a situation where I've had to worry about [00:19:00] it that from for a partner in my own practice. But it's important to keep in mind that there are multiple loss limitations occurring simultaneously for a lot of partners. And then finally, generally, a partner can't transfer suspended losses to another taxpayer. This is going to come up in the discussion toward the end of the episode again. But if you have a partner with a suspended loss that's being carried over and that partner either quits [00:19:30] the partnership or transfers her interest to another partner. That suspended loss generally is just going to be lost, um, forever.
Jeremy Wells: And so that might be something important to consider when it comes to tax planning for a partner who's considering that kind of exit from a partnership. Now, I went through this a little bit before, but the order of operations for determining outside basis begins [00:20:00] with a partner's initial outside basis, which is the adjusted basis of any property contributed in a section 721 tax deferred exchange. We talked about that in a prior episode. The cost of the interest if it was purchased. So if you purchased the partnership interest, however much you paid to acquire it, uh, determined under IRC section 1014, if it was inherited from an existing partner, uh, who, [00:20:30] who passed away or determined under IRC section 1015 if it was received by a by gift from a current partner. So that establishes the initial outside basis. Then we increase the basis by any positive adjustments. So that's going to be things like distributive share of profits or any separately stated items of income, or gain any [00:21:00] additional contributions into the partnership or an increase in that partner's share of partnership liabilities. And we'll talk about partnership liabilities more here in a little bit. Then we're going to decrease by non liquidating distributions for the year. And then finally decreased by any negative basis adjustments for the year such as non separately stated losses separately stated losses or deductions. Any decrease [00:21:30] in partnership liabilities, those sorts of things.
Jeremy Wells: So note that a partner's adjusted basis is calculated at the end of the tax year, unless there's a disposition, in which case we're going to calculate it as of the date of the disposition. But generally for a partner we're worried about calculating basis as of the end of the tax year. And we're going to take those distributions into account before any deductions and losses. So generally distributions during the tax year are treated [00:22:00] as if made on the final day of the tax year, except in a disposition. And they're going to be treated as made on the day, the date of the disposition. But from a tax planning perspective, it generally doesn't matter. When those distributions occur, they're all going to be treated as if they were made collectively on the final day of the year. When it comes to determining any adjustments to outside basis, if a partner disposes [00:22:30] of her interest during the tax year, either by a sale or an exchange or a liquidation, then the adjusted basis is going to be determined on that date. That comes from regulation section 1.7051 A one. Now, Revenue ruling 6694 clarifies this ordering process a bit. The ordering really is to achieve two different goals. So first of all, it preserves as much as possible the tax [00:23:00] free treatment of distributions. So notice in the ordering we increase basis by all of the positive adjustments. Then we subtract distributions non liquidating distributions. But then after that we subtract any deductions or losses.
Jeremy Wells: So we're going to subtract deductions and losses after we account for distributions. This preserves what should be the tax free nature [00:23:30] of partnership distributions as much as possible. Now, if the starting adjusted basis plus those positive adjustments is still less than the amount distributed, well then you've got distributions in excess of basis. That's going to be problematic. So you're going to wind up in a situation where those excess distributions are treated as capital gains income because they are distributions in excess of basis. And then you're also going to have losses and deductions [00:24:00] in excess of basis, because at that point basis would have been zeroed out after those excess distributions. And so all of those losses and deductions are going to be suspended and carried forward into the future year. Now the second goal here is that it allows partners some control over the timing of the use of their partnership losses. So, for example, a partner could trigger the use of a suspended loss in a high income year by making a capital contribution [00:24:30] to the partnership. So for example, if you know, coming up on the end of the year that you might have some, um, a suspended loss for that year, but you already have suspended losses from prior years. You don't just want to accumulate more and more suspended losses, especially if you're in a relatively high income year this year, which might put you into a relatively higher marginal tax bracket.
Jeremy Wells: So perhaps [00:25:00] you make a significant contribution into the partnership this year, which is going to allow you to use up some of those suspended losses from prior years, get your basis back down to zero essentially at the end of the year. But you will have gained the ability to use some of those suspended losses, non liquidating distributions of cash, reduce the partner's basis by the amount of cash distributed [00:25:30] and non liquidating distributions of other property. Reduce the partner's basis by the adjusted basis of the property. That's the rule under IRC section 733. So this is why it's important to keep good records at the partnership level of those contributed assets. Whatever the partnership's adjusted basis of those assets are when distributed, that's going to be the amount distributed to the partner. Now [00:26:00] partnership liabilities. This is where partnerships are significantly different from corporate entities, whether we're talking about a C corporation or even an S corporation for a partnership, any increase in a partner's share of partnership liabilities or any increase in a partner's individual liabilities by reason of the partner's assumption of partnership [00:26:30] liabilities, is treated as a contribution of money by that partner to the partnership. So in other words, if the partnership's liabilities increase and my share of those liabilities increase, I essentially my basis gets increased by that. It's as if I put money into the partnership. On the other hand, any decrease in a partner's share of partnership liabilities or any decrease in a partner's individual liabilities because [00:27:00] the partnership assumes those liabilities, is treated as a distribution of money by the partnership to the partner.
Jeremy Wells: So if I have a personal debt over some property that I contribute to the partnership, then the partnership's assumption of that liability is actually a reduction of my basis. Or if the partnership has a debt and it pays down the principal of that debt. That also reduces my basis. This is all IRC section 752, which [00:27:30] is all about liabilities and how they affect partner basis. So the inclusion of partnership liabilities is a key difference. Like I said, between a partner's basis versus a shareholder's basis in a corporate entity, it's also a key difference between a partner's basis and the partner's capital account. Remember back to the prior episode. Capital accounts are the equity portion of a partnership's accounting equation. Assets equal liabilities [00:28:00] plus capital. Capital and liabilities are separate concepts. But for basis capital and the partner's share of liabilities are combined essentially into determining their outside basis. In the partnership accounting equation that assets equal liabilities plus capital. Like I said, liabilities and capital are separate. [00:28:30] Their revenue ruling 8877 tells us that liabilities for a cash basis partnership do not include unpaid accrued expenses and accounts payable as a liability of the partnership. This is often a question that I see when it comes to thinking about what is listed on the partnership's balance sheet.
Jeremy Wells: As far as what liabilities do we [00:29:00] actually include? If the partnership is cash basis, then we're not going to include accrued liabilities. Essentially is the way to think about it. We're only going to include those cash basis liabilities. So let's broaden this discussion out then. What do we actually mean by a partnership liability. So it's an obligation if, when and to the extent that incurring the [00:29:30] obligation does any of the following. And if it does any of these things, then it is considered a partnership liability under regulation section 1.7521 A four. So it either creates or increases the basis of any of the Obligors assets or the obligers assets, including cash. So in other words, you borrow and you get some sort of asset as a result, right? This is usually, uh, you know, [00:30:00] borrowing, uh, taking out a loan in order to, or line of credit in order to get some cash or taking out a mortgage in order to purchase a piece of real estate. It could give rise to an immediate deduction to the obliger, or it could give rise to an expense that is not deductible in computing the obligers taxable income. It is not properly chargeable to capital, so an obligation is any fixed or contingent obligation to make payment without [00:30:30] regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code. All of that is straight out of that regulation that some dense tax there.
Jeremy Wells: There's actually quite a bit of discussion in the regulations and in the courts over what technically is a liability for purposes of partnership liabilities. Again, in my practice it's usually been relatively straightforward. We're talking about credit card balances, line of credit balances, mortgage balances, direct [00:31:00] loans to the partnership, these sorts of things, things that we just know are liabilities. A liability to property is subject to to the extent of the fair market value of such property, considered a liability of the owner of the property. This is important if you have a partnership where a partner contributes the asset to the partnership. In that case, then the liability and the asset are going to be linked in that way. Now contingent [00:31:30] obligations, I just want to mention these briefly because in my experience they're fairly rare. But there is some discussion of them. Contingent obligations not governed by the general rules in the the section 752 regulations are treated like built in losses of IRC section 704 C property, which we talked about in the prior episode. So in other words, this treats these obligations like capital account adjustments rather than actual partnership liabilities. Examples [00:32:00] of these obligations are environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options forward contracts, futures contracts and swaps. These are all weird kinds of things.
Jeremy Wells: Look at regulation section 1.7527 for more discussion on these. If you have. If you're working with a partnership that is involved in any [00:32:30] of these kinds of obligations. Now, the big question when it comes to partnership debt recourse and non recourse debt, what is the difference? First of all, and this is going to be a high level overview. There are going to be tons of more specific examples and discussion here. So take all of this as a high level overview. First of all generally a recourse debt is when any partner or related person bears the economic risk of loss. [00:33:00] So for example, the partnership agreement allocates losses to a specific partner or partners. A partner has a payment obligation such as a qualifying guarantee or pledges property as collateral non Nonrecourse debt is when no partner or related person bears the economic risk of loss. So, for example, a loan secured by real property owned by the partnership. Now, the regulations under IRC section 752 differentiate between [00:33:30] recourse and non recourse partnership liabilities. A partner's share of recourse partnership liabilities increases her basis to the extent that she bears the economic risk of loss as determined in a liquidation scenario. This is why it's important to make the distinction between recourse and non recourse debt. Because if a partner does not bear any economic risk of the loss because of a personal guarantee or putting up [00:34:00] some collateral that a different partner put up that collateral for it, then that share of the recourse debt should not increase that partner's basis if they're not going to suffer any of the economic loss for that debt.
Jeremy Wells: However, if it's a nonrecourse debt where the entire partnership bears the economic loss or the creditor bears the economic loss, and generally this is going to happen when you have a partnership [00:34:30] debt where the creditor, all the creditor can really do is, you know, either either yell at partnership or take back the asset that was, uh, that was sold to the partnership, these sorts of things. Then you're going to have a situation where no individual partner bears the economic risk of loss there. This can overlap with the general versus limited partner distinction, though not necessarily. That's going to depend on [00:35:00] state law. It's also going to depend on the partnership agreement. Sometimes you see a case where the partnership agreement says that only the sole general partner has responsibility for bearing the economic risk of loss. However, in an entity type such as a limited liability company. Most of the time you have all of the partners have limited liability. And so in that case, aside from the partnership agreement [00:35:30] and any specific personal guarantees or personal collateral, something like that, you're not going to have any individual partner bearing that economic risk of loss. And so it's going to be spread throughout the entire partnership. The the effect of non recourse debt is a bit complicated.
Jeremy Wells: And it's calculated as the sum of the partner's share of partnership minimum gain or the excess of a non recourse [00:36:00] debt over the attached properties book basis. That is a bit of a complicated rule. And again something that I haven't run into in my practice. Second, the taxable gain computed under IRC section 704. See the built in gain rule if the partnership disposed of all partnership property subject to one or more nonrecourse liabilities of the partnership in a taxable transaction in full satisfaction of the liabilities and for no other consideration. [00:36:30] So in other words, in a liquidation situation. And then three, the partner share of the excess nonrecourse liabilities, those not allocated under those first two steps of the partnership as determined in accordance with the partner's share of partnership profits. Fairly complex, fairly complicated process there to determine that. In general, though, for most relatively straightforward, simple partnerships for nonrecourse debt, we're looking at the partner's distributive [00:37:00] share of that economic risk of loss for those debts. So note that allocations of losses or deductions attributable to partnership non recourse liabilities. Can't have economic effect. That's why we have these relatively complicated rules for determining the effect of non recourse debt on basis. Because essentially the creditor alone bears the economic burden. The lender right. So [00:37:30] this concept of minimum gain replaces economic effect that we talked about in the prior episode. That substantial economic effect principle that doesn't really exist when it comes to non recourse debt.
Jeremy Wells: So we replace that essentially with this concept of minimum gain as the principal consideration here. Like I said before excess distributions result in gain recognition. So generally a partner doesn't recognize gain or loss on a partnership [00:38:00] distribution. However if a distribution of money including marketable securities treated as money under IRC section 731. See exceeds the partnership interest basis. Then the partner recognizes gain in the amount of the excess. So if my basis before distributions at the end of the year is $10,000 and I got $20,000 in distributions, non liquidating distributions of money from [00:38:30] the partnership, then the first $10,000 of that $20,000 distribution reduces my outside basis to zero. The next $10,000 of that distribution is in excess of basis. And that's essentially a capital gain. To me. A partner's adjusted basis in property received in a distribution is the same as in the hands of the partnership. However, the partner's adjusted basis [00:39:00] in the property can't exceed the adjusted basis in the partnership interest, less any money distributed in the same transaction. This is all from IRC section 731 and 732 here. So essentially for money, the amount distributed in excess of basis is a capital gain for other property. The adjusted basis in that property can't exceed the adjusted basis in the partnership interest [00:39:30] in general. And then finally exiting partners may recognize gain or loss when they when they leave the partnership.
Jeremy Wells: So partner who sells or exchanges partnership interest has to recognize gain or loss depending on the what they receive out of the partnership and then what their, uh, ending adjusted basis is. So 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 [00:40:00] asset, except where the sale involves the presence of ascites within the partnership that would generate ordinary income if sold. We're going to talk about this more here in just a minute. The gain or loss from the disposition of a partnership interest is the difference between the amount realized and the partner's adjusted basis in the interest or the outside basis immediately before the disposition. This is IRC section 741, [00:40:30] along with 751, which we'll talk about more here in a minute. Now, this brings up an interesting point, which is the forfeiture or abandonment of a partnership interest. I've had situations where this has happened. Sometimes partnerships are difficult. Sometimes you have two friends, two colleagues, two neighbors form a partnership. Everything's going great. At some point they realize they just don't get along. One of the partners just stops talking to the other [00:41:00] one. And usually in these situations, we deal with the one partner who keeps talking and keeps trying to reach out to the other partner, and we just can't get a hold of the other partner. That one just goes silent.
Jeremy Wells: This might be a situation where we've got a forfeited or abandoned partnership interest. And so that, you know, leaves us in a situation where we're trying to figure out what do we do about that? Well, it's a little bit more complicated than just, oh, we haven't heard from the other partner for six months. Let's just get them out of the books. Doesn't [00:41:30] quite work that way for tax purposes. If you do have a true abandonment of a partnership interest, that partner may qualify for abandonment loss treatment under IRC section 165. However, the abandoning partner has to demonstrate both the intent to abandon the partnership interest and some affirmative act of abandonment. So just disappearing, going silent is not enough to qualify for abandonment [00:42:00] treatment. A taxpayer can't take an abandonment loss if the taxpayer intends to hold and preserve property for possible future use, or to realize potential future value from the property. So the mere non use of an asset such as that interest in the partnership isn't sufficient to establish an act of abandonment. In other words, we need some actual affirmation, some sort of confirmation that that partner [00:42:30] is done with the partnership. This might be impossible to get, but it's necessary in order to show that there is an actual abandonment here. So a partner who forfeits her interest and has liabilities allocated to her, resulting in a decrease in her share of liabilities, is deemed to have received a cash distribution and the relinquishments considered a sale or exchange, resulting in a capital gain or loss.
Jeremy Wells: This is covered in revenue ruling 9380. [00:43:00] If you have a situation where you've got an abandonment of a partnership interest, or you have a partner exiting a partnership revenue ruling, 9380 is a good one to have on hand, and to read through. The gain or loss from an abandonment of a partnership. Interest is equal to the unrecovered basis. After accounting for relief from partnership liabilities under IRC section 752 D. Now a concept again that [00:43:30] is unique to partnerships, and that's important to keep in mind whenever we have distributions or an exit from the partnership is this concept of hot assets. And this is something that I see discussed a lot. Very rarely is it discussed entirely correctly. I'm just going to do a high level overview here. This is probably a topic to come back to in a future episode, but a sale or exchange of a partnership interest or a disproportionate Distribution [00:44:00] involving unrealized receivables or appreciated inventory items may generate taxable, ordinary gain or loss. I often hear this discussed as whenever you've got a distribution or a partnership exit, that the partnership has accounts receivable or inventory on the books, then you might have hot assets. That's a bit of an overgeneralization. We're specifically [00:44:30] looking at unrealized receivables and or appreciated inventory items. And then we're only looking at situations where we've got a sale or exchange of a partnership interest, or we've got disproportionate distributions of those items.
Jeremy Wells: This is going to trigger under IRC section 751, and then on the sale or exchange of an interest. See section seven. [00:45:00] 36. This is going to trigger a little bit of extra scrutiny, because we're going to have to allocate some of the distribution or some of the gain calculation on the sale or exchange of that partnership interest. We're going to have to allocate some of that to ordinary income, potentially as opposed to capital gain or loss. This effectively prevents the conversion of ordinary income [00:45:30] from those assets. Because accounts for unrealized accounts receivables is essentially cash basis revenue that hasn't been collected yet. And then also appreciated inventory items is again, cash basis revenue that hasn't been collected yet. And so that's going to be ordinary income. That's going to be non separately stated income for the business. And so if you were to sell your interest [00:46:00] in a partnership. Based on a valuation that took those unrealized receivables or that appreciated inventory into account, you would essentially be getting a capital gain based on what would have been ordinary income if you had stayed in the partnership. Irc section 751 says that's not fair. You need to treat part of that gain that would have been ordinary income [00:46:30] to you in the future as ordinary gain. Now, essentially, money or property received by an exiting partner in exchange for the partnership interest is attributed to those assets with that built in ordinary income potential.
Jeremy Wells: And that's essentially why they're known as hot assets, right? They have that potential for converting into ordinary income in the near future. So let's go back to this case study with Jessica Wright, Seth, and Jessica. They [00:47:00] founded that partnership several years of losses. Now Jessica wants out. She's got a few options. Let's just run through what these options are really quickly. First of all, she could just abandon the interest. You just walk away from the partnership. Or Seth could buy her interest for some nominal amount, let's say a dollar. The partnership itself, lighthouse LLC, could redeem her interest, or a third party could buy her interest so [00:47:30] she could sell her interest to someone who's going to step in as a partner. Now, often there's going to be some complexity with that last option due to the partnership agreement or due to state law. So for example, with an LLC, usually what I've seen in operating agreements is that a new partner can't join the partnership without the consent of all of the existing members. So anything that Jessica did in terms of bringing in a new partner or selling to a new partner would require Seth's consent. But we'll set all of that aside for [00:48:00] now and just assume that Seth is fine going along with whatever Jessica wants to do. Let's assume this for Jessica that she has $0 tax basis capital.
Jeremy Wells: She has $40,000 share of partnership liabilities. So that right there, if we take her capital and we take her share of the partnership liabilities, we can assume that she has $40,000 outside basis going into the year or going into the end of the year. I suppose there is some partnership assets with [00:48:30] section 751 ordinary income potential here. And Jessica also has $25,000 of suspended losses under section 704 D. So let's look at the first option abandonment. She affirmatively abandons her entire interest in lighthouse. She just tells Seth, I want out. I'm done. You can have the rest of my interest. I'm done. Her share of the partnership liabilities falls from $40,000 to zero. And so that's effectively treated as a [00:49:00] distribution under section 752 B, she abandons the interest with zero basis to recover. So there's no gain or loss there. And her exit does not release that $25,000 in suspended losses. She has no basis to use them. And so she doesn't get to use them. She effectively loses them now because she has no basis to recover and there's no gain or loss. There's also no abandonment loss under IRC [00:49:30] section 165. So even though she doesn't receive any actual cash, she does receive $40,000 of deemed money for federal tax purposes because she has that relinquishment of her share of the partnership liabilities. So she gets essentially some benefit there. She's no longer on the hook for that share of the partnership's Liability.
Jeremy Wells: An important thing to note here is that her leaving the partnership, which is actually an LLC, makes [00:50:00] it go from multi-member LLC to a single member LLC, changing the default treatment from a partnership to a disregarded entity under regulation section 301 7701 three B one. This is important to keep in mind whenever you have individuals leaving an LLC like this, it might cause a change in the federal tax treatment of that entity. In the second situation, let's say Seth buys Jessica's entire interest and let's say he gives [00:50:30] her what they think is a fair price of $10,000 cash. That is going to result in an amount realized with the $40,000 reduction in her share of the partnership liabilities, an amount realized of $50,000. But she has outside basis of $40,000. So that results in a preliminary gain of $10,000. But now, let's also assume that if lighthouse sold all of that section 751 property, those hot [00:51:00] assets for fair market value immediately before the sale, there'd be $6,000 of ordinary income allocated to Jessica in that case. Generally speaking, we would have to account for 6000 of that $10,000 gain being ordinary, with the remaining 4000 being capital in general. It might be more complicated than that, but that's generally how that rule [00:51:30] under section 751 work. Again, she loses those suspended losses. And because the entity goes from multi-member to single member, it would be treated as a disregarded entity following Jessica's exit.
Jeremy Wells: Next, let's look at a redemption. This is where the partnership not in not Seth, but the partnership is going to pay Jessica $10,000 cash to retire her interest in the partnership. This [00:52:00] is essentially economically going to look identical for Jessica. She's still going to wind up with the same calculation. Roughly. The difference is this is going to go through a different set of statutory steps, but effectively with the same result. Because the payor is different, it's the partnership instead of Seth A, an individual, a partner. So lighthouse itself is redeeming [00:52:30] the interest. We don't begin with the sale of partnership interest rules in section 741. Instead, she's going to receive a liquidating distribution. So she receives $10,000 of actual cash. And she gets that $40,000 reduction in her partnership, her share of liabilities. So under section 752 B that's treated as a distribution of money. And under section 731 A one she's going to recognize gain to the extent that the [00:53:00] money distributed exceeds her outside basis. And still that results in that $10,000 gain. It's it's a it's an identical result. It's just a different pathway to get there. We're still going to look at the analysis of those hot assets under section 751. However, there might be a difference here because what we're actually looking at is if there is a disproportionate shift between a partner's interest in those unrealized [00:53:30] receivables or appreciated inventory and other partnership property in general, we would still probably wind up with a similar result $6,000 of ordinary gain, $4,000 of capital gain.
Jeremy Wells: Again, Jessica can't use those suspended losses. And again, because we go from a multi member LLC to a single member LLC. We're going to wind up with a disregarded entity in the hands of Seth once this is done. And then finally sale to a third party. So let's look at a situation where Jessica is going to sell to Grady [00:54:00] her entire interest for $10,000 cash. And, and Grady now becomes a 50% partner along with Seth. Now in this situation, again, mathematically, economically, Jessica is going to wind up in a very similar position. She gets $10,000 cash. She has the $40,000 reduction in partnership liabilities, preliminary gain of $10,000 under section 741. That gains generally going to be [00:54:30] capital again. But under section 751, we still have to allocate between ordinary and capital for those hot assets. Now the question is for Grady what is his initial basis. His initial basis is going to be that $10,000 that he paid, but he's almost instantly going to be assigned that $40,000 share of liabilities that Jessica had as a 50% owner of the business. As long as there [00:55:00] is some sort of allocation, proper allocation of those liabilities to him. In other words, because Jessica has left the partnership, it's possible that maybe she had a personal guarantee on, uh, that or Seth had a personal guarantee on that debt or something complicates the situation.
Jeremy Wells: So this is a situation where we wouldn't automatically assume that Grady steps into Jessica's shoes, but rather we would want an updated partnership agreement, [00:55:30] and we would want to make sure that the partnership's creditors are aware of the change in ownership. Again, Jessica can't use those suspended losses. And Grady's, uh, replacement of Jessica as a partner Maintains the multi membership status of the LLC. So in this case it actually stays a partnership for federal tax law. That's one of the main differences structurally compared to the other situations. Okay let's wrap up with some key takeaways from this. First of all, partners, not partnerships, [00:56:00] need to be tracking their bases and their partnership interest, their outside basis. Don't rely on the partnership to take care of that for you. Carefully track outside bases as it's going to determine the ability to claim losses, whether distributions are going to be taxable or not, and the calculation of gain or loss on the exit from the partnership. Always be planning for an eventual exit from a partnership, even if you don't want that to happen, just go ahead and plan for [00:56:30] it. It never hurts to have that plan in place in case it does actually happen. Abandonment of a partnership interest can generate gain or loss for the exiting partner. It's not just a. You walk away and nothing happens. There might. There generally needs to be some sort of accounting for what that abandonment actually looks like for the exiting partner.
Jeremy Wells: And then finally look at the partnerships, underlying assets, tax bases and fair [00:57:00] market values of those assets, not just the balance sheet, especially not just the cash basis balance sheet to identify those. Section 751 hot assets when you're working with a partnership. So this wraps up what has turned into a four episode series on partnerships. I know there was a lot of high level overview of a lot of these concepts. There's obviously a lot more detail that could go into this. Subchapter K is probably one of, if not the most complicated and complex [00:57:30] parts of the Internal Revenue Code, along with all of the regulations and other guidance and authority that goes along with that. So obviously, everything couldn't be covered here. If you have ideas for partnership specific topics that you would like to hear covered in this show, please reach out. Let me know if you found value in this episode and the rest of this series. Let me know by liking and leaving a comment in your podcast application or on YouTube. For the next two [00:58:00] episodes, we're going to look at statutory and regulatory rules regarding confidentiality of taxpayer information. So we're going to look at things like IRC section 7216. The Federal Trade Commission Safeguards Rule Circular 230 and some other related considerations, especially in the age of outsourced and offshore workers, connected software applications and artificial intelligence. I'm really looking forward to that discussion. So be sure to like, follow and subscribe. [00:58:30] Thanks.