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What are the Tax Rules when a Partnership Interest is Liquidated?

Jun 10th 2019
Founder/CEO CWSEAPA PLLC
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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.

Replies (13)

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By wflora
Jun 11th 2019 19:37

The first paragraph of this article is blatantly wrong. There is no basis step-up when property is contributed in exchange for a partnership interest. Section 754 does not apply here.
The second paragraph, third bullet point is incorrect. The new tax law repealed Section 708(b)(1)(B), which caused a termination of a partnership if the 50% test was met.
Is anybody reviewing or editing this material?

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Replying to wflora:
Craig Smalley
By Craig W. Smalley, EA
Jun 11th 2019 22:19

Apparently you are. So show me where I’m wrong here

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Replying to Craig Smalley:
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By wflora
Jun 11th 2019 23:48

I think I laid it out in my comment. Sec. 754 doesn't apply to a contribution to a partnership. There is no basis step-up. The partners basis carries over to the partnership.

Sec. 708(b)(1)(B) was repealed beginning with 2018. The 50% test doesn't apply any more for terminating a partnership.

Maybe I'm wrong. Let me know.

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Replying to wflora:
Craig Smalley
By Craig W. Smalley, EA
Jun 12th 2019 00:04

You honestly, say I’m wrong, call out the integrity of this publication, then want me to do your research for you?

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Replying to Craig Smalley:
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By wflora
Jun 12th 2019 00:29

I think you're the one who needs to do the research.

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Replying to wflora:
Craig Smalley
By Craig W. Smalley, EA
Jun 12th 2019 00:52

You are obviously new at this, so let me tell you how adults would handle this. First of all have you ever in your life heard of a Section 754 election? As quoted by the code it states:

“26 U.S. Code § 754. Manner of electing optional adjustment to basis of partnership property

U.S. Code

If a partnership files an election, in accordance with regulations prescribed by the Secretary, the basis of partnership property shall be adjusted, in the case of a distribution of property, in the manner provided in section 734 and, in the case of a transfer of a partnership interest, in the manner provided in section 743. Such an election shall apply with respect to all distributions of property by the partnership and to all transfers of interests in the partnership during the taxable year with respect to which such election was filed and all subsequent taxable years. Such election may be revoked by the partnership, subject to such limitations as may be provided by regulations prescribed by the Secretary.”

I won’t go any further. Did you HAPPEN to see where you can make the election either BEFORE, or AFTER? Proving that the first paragraph would be 100% correct. I won’t go any further, as my point is proven.

I think you owe this publication an apology.

Bob Dylan had a quote “I’ll know my words before I start singing.” Before you call a professional out, much less the integrity of a publication, please think about this little discussion. Have a nice life

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Replying to Craig Smalley:
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By wflora
Jun 12th 2019 01:11

Not only are you wrong, you're also in need of help.

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By Carrie Stemke
Jun 12th 2019 01:05

Hi Everyone! William, we do indeed review and edit each and every article posted on our site, and we appreciate your input.

Debates about relevant topics are encouraged, but please consider this a friendly reminder to keep them respectful.

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Replying to Carrie Stemke:
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By wflora
Jun 12th 2019 01:23

Thanks Carrie. I'm trying but Craig seems to think that by downgrading me, he can prove his point.
Tell Mr. Smalley that I'm not new at this. I've been practicing since 1964. I am an active member of the California Bar and an active CPA in California. I was a tax partner at PwC until retirement. I think he should spend more time reading one of the partnership treatises, instead of steamroller someone who is pointing out a technical error. Maybe he learned this technique from our current president.

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Replying to wflora:
Craig Smalley
By Craig W. Smalley, EA
Jun 12th 2019 15:09

I would like to take a moment to apologize for my responses. If you look at the first response you made, it was pretty aggressive. I deal with a lot of trolls on Social Media and seemingly everywhere else. As I pointed out, a Section 754 election has been around for quite a long time. It is the reason for concern amongst estate planners forming family limited partnerships. For example, if I had a building with a basis of $100 contributed it to an FLP, when the FMV was $200. I have successfully, stepped up the basis, contributed the excess to my family members in my lifetime, and removed the asset from my taxable estate. The only thing to consider is the gift tax associated with the step up and the distribution of limited partnership interests.

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Replying to Craig Smalley:
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By wflora
Jun 12th 2019 16:32

I would also like to apologize for the tone of my opening comment. I was sitting in the middle of a heat wave in Northern California, without air conditioning and I think my "senior brain" boiled over.
To my point on the basis step-up. "Contributing" appreciated property to a partnership does not step up the basis to its FMV, even if a 754 election is made. Section 754 is available only when Section 743 or 734 applies. 743 applies when a partner sells his/her interest or dies. Section 734 applies when a partnership distributes property to a partner (the most common being when a partner is bought out or liquidated). These are the two areas where a 754 election can be made. When property is contributed to a partnership, there is usually no gain or loss on the contribution, under sec. 721 and the partner's basis in the contributed asset carries over to the partnership under Section 723. In the family partnership setting, the "basis step-up" usually occurs when the older partner dies and the partnership makes the 754 election.
Again, I apologize for the tone of my opening comment yesterday. The temperature has cooled down somewhat in Northern California this morning, thus lowering my senior "cranky reading" to a more manageable level.

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Replying to Craig Smalley:
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By wflora
Jun 12th 2019 17:12

Craig: I'm confused. Are you agreeing with me, or disagreeing with me?

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