When entering a partnership, partners contribute items such as cash and property. If the latter is contributed, the individual can makes an IRC § 754 election and the property contributed is given a stepped up basis. For example, if I enter a partnership and contribute a building in which I have a basis of $75,000, under this election, the partnership picks up the asset for its FMV. If the FMV is $150,000, this sets up an “inside basis” in the partnership and an “outside basis” to the partner of $75,000.
The liquidation of a partner’s interest may represent their interest in the fair market value of the partnership’s assets, their interest in unrealized receivables or guaranteed payments for the interest. Here are a few other conditions accountants should be aware of:
To the extent that the payment represents the partner’s interest in the fair market value of the partnership’s assets, it is treated as a distribution to the partner under the normal distribution rules.
To the extent that the payment represents the partner’s interest in unrealized receivables, the partner will have ordinary income or loss.
To the extent that the payment is guaranteed, it is governed by the rules applicable under Code § 707(c).
A partnership is ordinarily treated as terminating for tax purposes (regardless of whether it actually terminates) if it stops doing business as a partnership or if 50 percent or more of the total interest in the capital and profits changes hands by sale or exchange within 12 consecutive months. Contributions of property in exchange for partnerships and gifts, bequests, inheritances and liquidations are not counted for purposes of this 50 percent test, even if the result is an even higher change.
A partner may withdraw from a partnership by either sale or liquidation of their interest. The former is taxable. The seller-partner will recognize ordinary income to the extent that the gain from the sale of their interest is attributable to unrealized receivables and inventory. The seller-partner’s capital gain or loss equals the difference between the amount the realized in the sale (reduced by the portion attributable to unrealized receivables and inventory) and the seller-partner’s adjusted basis in their partnership interest (also reduced by the portion attributable to unrealized receivables and inventory).
The buyer of the partnership interest will have a cost basis. By default, the buyer-partner will inherit the seller’s capital account. Because partnership assets may have appreciated or depreciated in value, this usually results in a disparity between the buyer-partner’s basis in the0ir partnership interest (the outside basis) and their allocation of the partnership’s basis in each of the assets owned by the partnership (the inside basis). To resolve this disparity, Code § 754 allows the partnership to make special basis adjustments to the inside basis of the partnership assets.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...