Section 741 provides that the gain or loss recognized
from the sale or exchange of a partnershipinterest is
captial gain except to the extent that §751 applies.
Consequently the starting point for characterizing a
sale or exchange of a partnership interest begins in
§751.
Section 751(a) provides that the consideration received
by a selling partner in exchange for all or part of
his or her interest in the unrealized receivables or
inventory items (a.k.a. "Hot Assets") of the
partnership shall be treated as a sale of an ordinary
income producing asset. The balance of the sale will
be treated as a sale of a capital asset. Thus, understanding
the definition of Hot Assets is imperative to properly
classifying the sale of a partnership interest.
Unrealized
Receivables
One of the hot
assets that triggers ordinary income is the unrealized receivable
which is defined as the right to payment for past or future
sales of goods or services not previously includable in income.
This classification is necessary to insure that ordinary income
will not be avoided when a partnership is sold with cash basis
receivables. With certain exceptions, only partnerships on
a cash basis generate income from unrealized receivables upon
sale of the partnership interest. IRC
Sec. 751(c)(1) and (2).
Example
1 
|
T sells
his entire interest in the ST partnership to R for
$7,500. T's basis in the partnership is $3,000 and
the partnership has the following balance sheet:
| Assets |
Basis
|
FMV
|
| Acct. Receivable |
$0
|
$8,000
|
| Investment Land |
6,000
|
7,000
|
TOTAL
|
$6,000
|
$15,000
|
| |
|
|
| Liab &
Capital |
Basis
|
FMV
|
| S Capital |
$3,000
|
$7,500
|
| T Capital |
3,000
|
7,500
|
TOTAL
|
$6,000
|
$15,000
|
T's total
gain is $4,500 ($7,500 - 3,000) of which $4,000 is
ordinary income (1/2 * $8,000 accounts receivable)
and the remaining $500 is capital gain.
Note that
the ST partnership is on a cash basis because the
accounts receivable have a zero basis.
|
The definition
of unrealized receivables is not, however, limited to situations
involving rights to future payments. The statutory definition
includes a host of partnership assets which, if sold, would
give rise to ordinary income. IRC Sec. 751(c)
Flush Language
Depreciation
recapture as an unrealized receivable
One of the most
overlooked, yet common, unrealized receivables is depreciable
property subject to depreciation recapture under Section 1245
and 1250. If the partnership owns assets which are subject
to recapture of depreciation, only the amount of the recapture
potential and not the entire gain is considered to be an unrealized
receivable on the sale of the partnership interest.
The term Section
1245 property includes all depreciable property other than
buildings or their structural components. The term Section
1250 means any real property other than property described
in Section 1245. The basis of Section 1245 and 1250 recapture
is zero. Regs. Sec. 1.751-1(c)(5)
Example
2
|
The BC
Partnership has the following Balance Sheet:
|
Assets
|
Basis
|
FMV
|
| Accounts Receivable |
15,000
|
15,000
|
| Machine ($8,000 recapture) |
33,000
|
45,000
|
|
Total
|
$48,000
|
$60,000
|
| A Capital |
24,000
|
30,000
|
| B Capital |
24,000
|
30,000
|
|
Total
|
$48,000
|
$60,000
|
If C sells
his entire interest for $30,000, he will have a realized
gain of $6,000 ($30,000 - $24,000). Of this amount
$4,000 will be taxed as ordinary income (1/2 of the
$8,000 recapture). The remaining $2,000 is attributable
to the Section 1231 gain remaining in the machine
and will be taxed to C as a capital gain.
|
Note
|
Sections
1245 and 1250 recapture must be computed separately
for each property. Thus, a selling partner may have
to recognize ordinary income even though the aggregate
fair market value of all the Section 1245 and 1250
properties produce an overall loss.
|
Inventory
and Substantially Appreciated Inventory
The second category
of hot assets that triggers ordinary income attention is
the substantially appreciated inventory item. In order for
inventory to be a Hot Asset, the 1997 Act eliminated the
requirement that inventory be substantially appreciated
in order to give rise to ordinary income for sales
and exchanges under Sec. 751 (a). Thus, all inventories
become Hot Assets.
Note, however,
there has been no change with respect to distributions under
Sec. 752(b). Thus, the requirement that inventory be substantially
appreciated continues to apply to those types of distributions.
Substantial appreciation will not be discussed in this module.
Section
751 Bifurcations
In making the
necessary computations under Section 751, the basis used
for unrealized receivables and for all inventory after August
5, 1997 is the same as the inside basis. Of course, the
inside basis for an unrealized receivable for rendering
services would generally be zero. The value allocated to
the assets in the contract of sale of the partnership will
generally be regarded by the IRS as correct, provided those
values represent fair market values. Otherwise, competent
appraisals may be necessary to ascertain value.
After the values
and bases of all assets have been determined, the assets
must be divided into two components;
-
Section
751 hot assets, and
-
other
assets (i.e., capital and Section 1231 assets).
Example
3
|
XYZ has
the following Balance Sheet:
|
Assets
|
Basis
|
FMV
|
| Cash |
$10,000
|
$10,000
|
| Accounts Receivable |
0
|
13,000
|
| Inventory |
12,000
|
20,000
|
| Equipment* |
20,000
|
28,000
|
| Land |
50,000
|
45,000
|
| Investments |
7,000
|
13,000
|
|
Total
|
$99,000
|
$129,000
|
*Includes
$6,000 recapture of depreciation
Partner
X with a basis of $33,000 sells a one-third interest
in XYZ for $43,000. Although it appears X has realized
a $10,000 gain, the assets must be divided in order
to determine their character.
Assuming
all the Section 751 inventory items are hot assets
, the assets of the partnership would be split as
follows:
|
Hot
(751) Assets
|
Basis
|
FMV
|
| Accounts Receivable |
0
|
13,000
|
| Inventory |
12,000
|
20,000
|
| Equipmentn Deprec |
- 0 -
|
6,000
|
|
Total
|
$12,000
|
$39,000
|
|
Other
(741) Assets
|
Basis
|
FMV
|
| Cash |
$10,000
|
$10,000
|
| Equipment |
20,000
|
22,000
|
| Land |
50,000
|
45,000
|
| Investments |
7,000
|
13,000
|
|
Total
|
$87,000
|
$90,000
|
As a result
of the sale, Partner X must recognize $9,000 as ordinary
income (1/3 * ($39,000 - $12,000)) and $1,000 as capital
gain (1/3 * ($90,000 - $87,000)).
|
Section
751 does not impose a ceiling
Realized gain or
loss is ordinarily measured by the difference between the
amount realized by a partner and that partners outside basis.
However, the existence of hot assets can create a situation
where more ordinary income is recognized than the amount of
the realized gain (i.e., the ceiling is surpassed). When this
happens, the counter-balancing effect is recognition of a
capital loss on the sale of the partnership interest.
Example
4
|
The AB
partnership is on the cash basis and has unrealized
accounts receivable of $15,000 with a basis of zero.
A's proportionate interest in the hot assets is $7,500.
A's outside basis is $20,000 and the entire partnership
interest is sold for $23,000 resulting in a realized
gain of $3,000. A must first allocate $7,500 of the
sales price to the unrealized receivables, the basis
of which is zero. Thus, $7,500 of ordinary income
must be recognized. The remaining $15,500 of the sale
price is allocated to the balance of the partnership
interest that has a remaining basis of $20,000. Accordingly,
A has a $4,500 capital loss on the balance of the
partnership interest ($15,500 -$20,000),
Note
The amount realized ceiling of $3,000 less the ordinary
income of $7,500 provides a counter-balancing capital
loss of $4,500.
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