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Partnership Exit Strategies
Professor Howard E. Abrams
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Simple Distributions: Facts
X and Y form the XY partnership as equal partners, each contributing cash of $100. The partnership purchase two capital assets, each for $100. Asset # 1 increases in value to $200 while Asset # 2 increases in value to $190. If each asset is sold, there will be a combined gain of $190, reported equally by the two partners. Thus, each will report a gain of $95, and if they now distribute the partnership’s cash in liquidation, there will no further gain or loss. What if Asset $ 2 is distributed to X in a nonliquidating distribution and then the partnership sells Asset #1?
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Simple Distributions: Analysis
X Y CA OB 100 Formation 45 Book-Up of Asset #2 -190 -100 Distribution of Asset #2 50 Sale of Asset #1 5 195 150 Totals Assets Book Value Adj. Basis Value Cash 200
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Simple Distributions: Analysis
EO TO CA OB 100 Formation 45 Book-Up of Asset #2 -190 -100 Distribution of Asset #2 50 Sale of Asset #1 5 195 150 Totals Assets Book Value Adj. Basis Value Cash 200
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Making Gain Disappear: Facts
Facts: X and Y each contribute $100 to the XY partnership. XY purchases a nondepreciable asset for $200, and when it increases in value to $1,000, Y is ready to exit the venture. The partnership has an election under section 754 in effect. Y can sell to a third party for $500, receive a liquidating distribution of $500, or some combination of each. Does it matter? (Ignore the collapse of XY if Y receives a liquidating distribution.)
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Distribution Followed by Sale
Suppose the partnership borrows $490, guaranteed only by X. The loan proceeds are distributed to Y, reducing Y’s interest in the venture from $500 to $10. Y then sells her remaining interest to Z for $10. On the distribution, Y recognizes a gain of $390; on the sale, Y recognizes an additional gain of $10. Thus, for Y this offers no benefit.
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Making Gain Disappear: Analysis
X Y Z CA OB 100 Formation 490 Borrowing 400 Book-Up -490 Distribution --- 10 Purchase by Z 205 Sale of Property -205 743(b) Adjustment Debt Repayment 500 305 Totals Gain on sale of property equals only $410 because distribution to Y triggered a positive inside basis adjustment of $390 under section 734(b).
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Benefit to X As a result of the leveraged distribution, the partnership is entitled to an inside basis adjustment of $390 under section 734(b). On the sale of Y’s stub interest to Z, Z takes a cost basis of $10 and enjoys an inside basis adjustment of $205 under section 743(b). When the asset is sold, there is a taxable gain of $410 (amount realized of $1,000 less cost of $200 plus 734(b) adjustment of $390).
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Benefit to X: Continued
Of the taxable gain of $410, $205 is allocable to X and $205 to Z; Z’s share is offset by Z’s 743(b) adjustment. If the debt is then repaid out of the sale proceeds, XZ will own cash of $510. X’s capital account will equal $500 and Z’s capital account will equal $10. But X has been taxed on only $205 rather than on $400 (X’s outside basis is only $305).
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What Happened? When cash is distributed to a partner, any gain recognized by the distributee yields a common inside basis adjustment under 734(b) benefitting all the partners. This is a shifting of basis from the distributee to the other partners, for no net benefit: positive deferral for the other partners and negative deferral for the distributee. But when the distributee exits, the negative deferral ends. Note: There is a similar play under section 704(c) if one of the partners is likely to leave to venture early: screw the exiting partner because the pain disappears upon a taxable exit.
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Partial Disposition Making Gain Disappear: Facts
X and Y own 60% and 40% of the profits and losses of XY-LLC. The partnership owns a single nondepreciable capital asset with inside basis and book value of $0 and fair market value of $2,000. Each partner has a $0 capital account and outside basis, and the partnership has an election under section 754 in effect. XY borrows $500, secured by its property and guaranteed by both partners. The debt is allocated 60% to X and 40% to Y, and the loan proceeds are distributed in the same percentages, $300 to X and $200 to Y. Y then sells half her partnership interest to Z for $300, the fair market value of the sold portion. There is no debt shift.
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Partial Disposition Making Gain Disappear: Analysis
X Y Z CA OB Initial values 300 200 Borrowing 1200 800 Book-up -300 -200 Distribution Purchase by Z 900 Totals Y sells half of her interest for its value of $300. No debt shifts from the sale. Y’s gain on the sale equals $300. Immediately before the sale, Y’s built-in gain equaled $800. How much of that gain moves to Z? Note that Y recognized a gain of $300 on the sale to Z. Note also that Z’s inside basis adjustment under section 743(b) will equal Z’s share of the built-in gain in all events.
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Shifting Half the Built-In Gain?
X Y Z CA OB 900 300 Initial values 1200 400 Sale of property -400 743(b) adjustment -300 -200 Debt repayment 200 Totals If half of Y’s built-in gain is shifted to Z, then when the property is sold, the $2,000 of tax gain will be allocated $1,200 to X, $400 to Y, and $400 to Z, with Z’s share offset by the 743(b) adjustment. Since Y reported only a $300 gain on the sale to Z, this means $100 of appreciation in the asset has gone untaxed (note the book/tax disparity for Y).
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Partnership Exit Strategies
Professor Howard E. Abrams
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