There can be several tax consequences as a result of a transfer of a partnership interest during the year. This article discusses some of those tax issues applicable to the partnership.
Adjustments to the Basis of Partnership Property
Upon a transfer of a partnership interest, the partnership may elect to, or be required to, increase/decrease the basis of its assets. The basis adjustments will be for the benefit/detriment of the transferee partner only.
- If the partnership has a special election in place, known as an IRS Section 754 election, or will make one in the year of the transfer, the partnership will adjust the basis of its assets as a result of the transfer. IRS Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner.
- The partnership will be required to adjust the basis of its assets when an interest in the partnership is transferred if the total adjusted basis of the partnership's assets is greater than the total fair market value of the partnership's assets by more than $250,000 at the time of the transfer.
Ordinary Income Recognized by the Transferor on the Sale of a Partnership Interest
Typically, when a partnership interest is sold, the transferor (seller) will recognize capital gain/loss. However, a portion of the gain/loss could be treated as ordinary income to the extent the transferor partner exchanges all or a part of his interest in the partnership attributable to unrealized receivables or inventory items. (This is known as “Section 751(a) Property” or “hot” assets).
- Unrealized receivables – includes, to the extent not previously included in income, any rights (contractual or otherwise) to payment for (i) goods delivered, or to be delivered, to the extent the proceeds would be treated as amounts received from the sale or exchange of property other than a capital asset, or (ii) services rendered, or to be rendered.
- Inventory items – includes:
- Property held primarily for sale to customers in the ordinary course of a trade or business.
- Any other property of the partnership which would be considered property other than a capital asset and other than property used in a trade or business.
- Any other property held by the partnership which, if held by the selling partner, would be considered of the type described above.
Example – Partner A sells his partnership interest to D and recognizes gain of $500,000 on the sale. The partnership holds some inventory property. If the partnership sold this inventory, Partner A would be allocated $100,000 of that gain. As a result, Partner A will recognize $100,000 of ordinary income and $400,000 of capital gain.
The partnership needs to provide the transferor with sufficient information in order to determine the amount of ordinary income/loss on the sale, if any.
Termination/Technical Termination of the Partnership
A transfer of a partnership interest could result in an actual or technical termination of the partnership.
- The partnership will terminate on the date of transfer if there is one tax owner left after the transfer.
- The partnership will have a technical termination for tax purposes if within a 12-month period there is a sale or exchange of 50% or more of the total interest in the partnership's capital and profits.
Example – D transfers its 55% interest to E. The transfer will result in the partnership having a technical termination because 50% or more of the total interest in the partnership was transferred. The partnership will terminate on the date of transfer and a “new” partnership will begin on the day after the transfer.
Allocation of Partnership Income to Transferor/Transferee Partners
When a partnership interest is transferred during the year, there are two methods available to allocate the partnership income to the transferor/transferee partners: the interim closing method and the proration method.
- Interim closing method – Under this method, the partnership closes its books with respect to the transferor partner. Generally, the partnership calculates the taxable income from the beginning of the year to the date of transfer and determines the transferor’s share of that income. Similarly, the partnership calculates the taxable income from the date after the transfer to the end of the taxable year and determines the transferee’s share of that income. (Note that certain items must be prorated.)
Example - Partner A transfers his 10% interest to H on June 30. The partnership's taxable income for the year is $150,000. Under the interim closing method, the partnership calculates the taxable income from 1/1 – 6/30 to be $100,000 and from 7/1-12/31 to be $50,000. Partner A will be allocated $10,000 [$100,000*10%] and Partner H will be allocated $5,000 [$50,000*10%].
- Proration method – this method is allowed if agreed to by the partners (typically discussed in the partnership agreement). Under this method, the partnership allocates to the transferor his prorata share of the amount of partnership items that would be included in his taxable income had he been a partner for the entire year. The proration may be based on the portion of the taxable year that has elapsed prior to the transfer or may be determined under any other reasonable method.
Example – Partner A transfers his 10% interest to H on June 30. The partnership's taxable income for the year is $150,000. Under the proration method, the income is treated as earned $74,384 from 1/1 – 6/30 [181 days/365 days*$150,000] and $75,616 from 7/1-12/31 [184 days/365 days*$150,000]. Partner A will be allocated $7,438 [$74,384*10%] and Partner H will be allocated $7,562 [$75,616*10%]. Note that this is one way to allocate the income. The partnership may use any reasonable method.
Change in Tax Year of the Partnership
The transfer could result in a mandatory change in the partnership’s tax year. A partnership’s tax year is determined by reference to its partners. A partnership may not have a taxable year other than:
- The majority interest taxable year – this is the taxable year which, on each testing day, constituted the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50%.
Example – Partner A, an individual, transfers his 55% partnership interest to Corporation D, a C corporation with a year-end of June 30. Prior to the transfer, the partnership had a calendar year-end. As a result of the transfer, the partnership will be required to change its tax year to June 30 because Corporation D now owns the majority interest.
- If there is no majority interest taxable year or principal partners, (a partner having a 5% or more in the partnership profits or capital) then the partnership adopts the year which results in the least aggregate deferral.
Change in Partnership’s Accounting Method
A transfer of a partnership interest may require the partnership to change its method of accounting. Generally, a partnership may not use the cash method of accounting if it has a C corporation as a partner. Therefore, a transfer of a partnership interest to a C corporation could result in the partnership being required to change from the cash method to the accrual method.
As described in this article, a transfer of a partnership interest involves an analysis of several tax consequences. An analysis should always be done to ensure that any tax issues are dealt with timely.
If you or your business are involved in a transfer described above, please contact your Marcum Tax Professional for guidance on tax treatment.