1. When Partners Go Their Separate Ways: A Case Study
Howard E. Abrams
Professor, Emory Law School
Visiting Professor, University of San Diego School of Law

2. Exit Issues Recognition of Income and Loss
Character of Recognized Gain or Loss
Inventory that is Not “Substantially Appreciated”
Unrecaptured Section 1250 Gain
Tax Consequences to Remaining Partners
Tax Consequences to the Buyer

3. Allocation of Partnership Tax Items
A partner’s share of the partnership’s tax items is called the partner’s “distributive share.”
When book and tax items occur simultaneously, they must be allocated together in accordance with the “substantial economic effect” test of § 704(b).
When the book items occurs first, it must be allocated in accordance with the “substantial economic effect” test and then the tax item must follow when recognized by the partnership. § 704(c).
Allocation of tax credits and nonrecourse deductions can never have “substantial economic effect.”

4. Allocations Under Section 704(b)
Properly maintained capital accounts.
Liquidation proceeds distributed according to positive capital account balances.
Either an unlimited capital account deficit restoration obligation or a limited DRO and
Capital account look-ahead;
No allocation of deduction can drive the capital account more negative than the limited DRO; and
Qualified Income Offset provision in the partnership agreement.

5. Allocations Under Section 704(c)
Addresses book/tax disparity caused by contribution of appreciated or loss property (a “forward” layer) or by a book-up of existing property (a “reverse” layer).
Special rules substitute loss of depreciation deductions for recognition of tax gain.
Ceiling limitation can be addressed by the traditional method, by the traditional method with curative allocations, or by the remedial allocation method.

6. Capital Account Maintenance
Contributed property must be booked into the partnership at current fair market value.
Distributed property must be booked to fair market value immediately prior to the distribution.
Non-pro rata distributions and contributions permit but do not require a revaluation of assets and a restatement of capital accounts.
Distributions reduce capital accounts.
Tax credits do not affect capital accounts.

7. Book-Up example
X and Y each contribute $100 to the XY LLC in exchange for a 50% interest in profits and losses. The partnership agreement complies with the alternate test for economic effect, and neither member has an obligation to contribute additional funds to the venture. XY purchases nondepreciable asset #1 for $80 and nondepreciable asset #2 for $120. When asset #1 has increased in value to $300 and asset #2 has increased in value to $400, XY distributes asset #1 to X in a nonliquidating distribution. The partnership does not elect to book asset #2 to fair market value. Under the partnership agreement, the books of the venture would become:
______X______ _____Y______
CA OB CA OB
$ 100 $ $ $ 100 Initial values
Mandatory book-up of asset #1
( 300) ( 80) Mandatory book-out of asset #1
($ 90) $ $ $ 100 Final values

8. Book-Up example continued
To comply with the alternate test for economic effect, the books must become: ______X______ _____Y______ CA OB CA OB $ 100 $ 100 $ 100 $ 100 Initial values Mandatory book-up of asset #1 ( 300) ( 80) 0 0 Mandatory book-out of asset #1 $ 0 $ 20 $ 120 $ 100 Final values

9. Book-Up example continued
If asset # 2 is sold by the partnership in a subsequent year and if the gain is divided equally, the books will become: ______X______ _____Y______ CA OB CA OB $ 100 $ 100 $ 100 $ 100 Initial values Mandatory book-up of asset #1 ( 300) ( 80) 0 0 Mandatory book-out of asset # Sale of asset #2 $ 140 $ 160 $ 260 $ 240 Final values

10. Book-Up example continued
If the partnership had elected to book asset #2 to fair market value immediately prior to the distribution of asset #1, the final books would read:
______X______ _____Y______
CA OB CA OB
$ 100 $ $ 100 $ 100 Initial values
Optional book-up of asset # 2
Mandatory book-up of asset #1
(300) ( 80) Mandatory book-out of asset #1
Sale of asset #2
$ $ $ 350 $ 240 Final values

11. Contributions
Property: Tax-free to all parties, with basis carried into partnership interest and inside basis. Capital account credited with net equity contributed.
Services: Taxable if contributed in exchange for a capital interest; tax-free if contributed in exchange for a share of future profits only (assets must be revalued immediately prior to contribution).
The Carried Interest Controversy: The President’s tax proposal includes changes to the taxation of a profits interest received in exchange for a contribution of services.

12. Outside Basis
Outside basis includes the adjusted basis of contributed property less adjusted basis of distributed property plus distributive share of income less distributive share of loss.
Partnership Debt:
An increase in share of debt is treated as contribution of cash for outside basis (but not for capital account).
A decrease in share of debt is treated as distribution of cash for outside basis (but not for capital account).
Note: the regulations do not provide a direct way of computing a change in debt share but only actual debt shares at any point in time.

13. Nonliquiding Distributions
Gain is not recognized except to the extent that distributed cash (including marketable securities) exceeds outside basis.
Loss cannot be recognized on nonliquidating distribution.
Asset basis carried over so long as outside basis can absorb the reduction.

14. Dispositions Gain or loss general capital under § 741.
Full ordinary income look-thru under § 751(a).
Full capital gain rate look-thru under § 1(h).
Can trigger a technical termination.

15. Disposition example
T has a $275,000 adjusted basis in a one-quarter interest in the P partnership when P owns the following:
Land with adjusted basis of $300,000 and value of $400,000.
Building with adjusted basis of $0, value of $2,000,000, and unrecaptured § 1250 gain of $1,200,000.
Inventory with adjusted basis of $800,000 and value of $640,000.
If T sells the interest for $760,000, there is total gain of $485,000 of which $225,000 is 15% capital gain, $300,000 is 25% capital gain, and $40,000 is an ordinary loss.
If T sells the interest for only $750,000, then the 15% capital gain is reduced to $215,000. See Reg. §1.1(h)-1(b)(3)(ii).

16. Liquidating Distributions
Gain equals the excess, if any, of distributed cash over outside basis.
Loss cannot be recognized if the distribution includes a capital asset or an asset described in § 1231.
In general, outside basis is pushed into asset basis.
Ordinary income look-thru under § 751(b) to the extent of unrealized receives and other ordinary-income assets if “substantially appreciated” as a group.
Note: the redemption of a partnership interest is not a sale or exchange and so cannot trigger a technical termination.

17. Distribution example
T has a $275,000 adjusted basis in a one-quarter interest in the P partnership when P owns the following:
Land with adjusted basis of $300,000 and value of $400,000.
Building with adjusted basis of $0, value of $2,000,000, and unrecaptured § 1250 gain of $1,200,000.
Inventory with adjusted basis of $800,000 and value of $640,000.
If T receives a liquidating distribution of $760,000, there is total gain of $485,000, all of which is 15% capital gain.

18. Base Case: Liquidating Distribution of Cash
Triggers an actual termination of the venture once the exiting partner is fully paid.
The distribution amount should be equal to the exiting partner’s capital account (adjusted for unrealized book appreciation and loss) but the regulations contemplate the possibility of other amounts.
Ordinary income equal to the extent of share of unrealized receivables and substantially-appreciated inventory and inside basis increase of the same amount.
Capital gain is taxed at 15%.
Inside basis increase for capital gain if election under § 754 in effect or is made on final return.

19. Base Case: Will Form Be Respected?
Assets received as a distribution take a tacked holding period.
In Rev. Rul. 99-6, the Service ruled that the purchase of one interest by the other partner would be treated as an asset purchase to the purchaser to limit tacking to half the assets.
There is no law recharacterizing cash to one partner and assets to the other, but the possibility of recharacterization based on Rev. Rul is a possibility.
Can this risk be minimized by distributing a note to the exiting partner, paid off over time? Probably.

20. Alternative 1: Distribution of Property
No gain or loss on distribution unless cash plus liabilities exceeds outside basis.
Possible application of § 751(b) if distribution works a swap of ordinary unrealized receivables or substantially-appreciated inventory.
Outside basis pushed into assets.
Full ordinary income and loss on sale under § 735 if sale within five years. – Consider converting inventory to capital asset prior to distribution if possible.
Direct application of multiple capital gain rates.

21. Alternative 2A: Sale of Interest to Other Partner
Amount realized includes share of debt.
Installment sale allowed subject to limitations.
Rev. Rul on inventory (see § 453(b)(2)).
Section 453(i)(1) on recapture.
Full ordinary income pick-up under § 751(a).
Capital gain rate look-thru.
Asymmetric recharacterization under Rev. Rul Cost basis in assets deemed purchased.

22. Alternative 2B: Sale of Interest to Third Party
Sale taxed the same to exiting partner regardless of the purchaser.
Inventory captured as ordinary income.
Sale can trigger technical termination. (Note that technical termination does not affect amortization of intangibles under § 197.)
Positive outside basis for purchaser only if § 754 election in effect or mode on partnership return.

23. Exit By Both Partners: Sale of Assets
Gain or loss recognized:
Full ordinary income recognition under § 751(a).
Multiple capital gain rates under direct application of § 1(h).
Consider application of § 724 on sale of contributed property:
Inventory by contributing partner;
Built-in capital loss at time of contribution.
Bifurcated holding period of partnership interest irrelevant.
Distribution of cash generally will not trigger gain or loss.

24. Exit By Both Partners: Distribution of Assets
Distribution generally tax-free.
Ordinary income on sale captured by § 735 for 5 years.
Distribution of contributed property can be taxable to contributing partner.
Distribution to partner who contributed appreciated property within 7 years may trigger taxation of built-in gain.
Joint sale of assets may be recharacterized as sale by the partnership.

25. Exit by Both Partners: Joint Sale of Interests
For sellers:
Gain or loss recognized.
Full ordinary income pick-up under § 751(a).
For buyer: recharacterization as purchase of assets.
Cost basis in all assets.
Complete depreciation restart including intangibles.

26. Dispositions After Distributions
Facts: X owns 60% and Y owns 40% of the XY-LLC. XY owns a single, nondepreciable asset with adjusted basis and book value of $0 and value of $2,000. Each partner has a $0 outside basis and capital account, and no partner has a deficit restoration obligation.

27. Full Sale with Debt Shift to ZX Y Z CA OB
Initial values
300
200
Borrowing
1200
800
Book-up
-300
-200
Distribution
600
Purchase by Z
900
Totals
XY borrows $500 against its asset and distributes the proceeds to X and Y. Y then sells her partnership interest to Z, and Y’s share of the liability shifts to Z. Y’s gain equals $800. Z has an outside basis of $600 + $200 and Y’s capital account of $600. Z enjoys an inside basis adjustment of positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on nothing.

28. Full Sale Without Debt Shift to ZX Y Z CA OB
Initial values
300
200
Borrowing
1200
800
Book-up
-300
-200
Distribution
600
Purchase by Z
900
Totals
XY borrows $500 against its asset and distributes the proceeds to X and Y. Y then sells her partnership interest to Z, and Y’s share of the liability shifts to X. Y’s gain equals $800. Z has an outside basis of $600 and Y’s capital account of $600. Z still enjoys an inside basis adjustment of positive $800. Thus, if the asset is sold, X is taxed on $1200 and Z on nothing.

29. Partial Sale Without Debt ShiftX 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.

30. 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). Only $300 of the built-in gain should have shifted on the partial sale from Y to Z, leaving $500 of gain for Y on asset sale.

31. Shifting Only the Right GainX Y Z CA OB
900
300
Initial values
1200
500
Sale of property
-300
743(b) adjustment
-200
Debt repayment
Totals
If only $300 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, $500 to Y, and $300 to Z, with Z’s share offset by the 743(b) adjustment. Now, Y does not escape any gain. Note that Z’s capital account, outside basis, and net income recognition are unaffected.

32. Sell, Distribute or Both
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.
Y can sell to Z 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.)

33. Sale by Y to Z
On the sale, Y recognizes a gain of $400. Z takes a cost outside basis of $500 and a capital account of $100. Z enjoys a $400 inside basis adjustment under section 743(b). There is no effect on X, so if the property is then sold by the partnership, X will recognize a gain of $400. Z is protected by the 743(b) adjustment.

34. Distribution to Y
On the distribution, Y recognizes a gain of $400. There is a $400 common inside basis adjustment under section 734(b), so that when the asset is sold, the gain to X will equal $400 (amount realized of $1,000 less adjusted basis of $600).
Same basic result as the sale.

35. 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 improvement.

36. 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).

37. 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, XY 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).

38. 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 then the distributee exits, ending the negative deferral.

39. Distribution to Y X Y CA OB 100 Formation 490 Borrowing 400 Book Up
490
Borrowing
400
Book Up
-490
-100
Distribution -> Gain of 390
500
590 10
Totals
Asset
Book
Basis
Debt
Property
1,000
(490)