Under what circumstances will a partner recognize a gain in a liquidating distribution?
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Study Outline For: Current Distributions Overview: There are three basic types of distributions that can result from a partnership, and different sets of rules govern the income tax consequences of each. These types include:
The statutory provisions which govern the treatment of partnership distributions are contained in Sections 731 through 733 of the Code. Section 731 controls the extent to which gain or loss will be recognized on partnership distributions. Section 732 provides the rules for determining the basis of property received in a distribution. Section 733 provides the rules for determining the effect of distributions upon the distributes partner's remaining basis in the partnership interest. Section 731:Gain or loss recognition When a partner receives a distribution, Congress generally wanted it treated as a tax-free return of capital because a partner is taxed each year on a distributive share of partnership income, whether or not any actual distribution is made. Consequently, the general rule of Section 731 is that no gain or loss is recognized by the partner or the partnership in a distribution of cash or property. There are, however, two exceptions to this general rule. Exception 1 - partner gain recognition: When a partnership distribution is in the form of cash, gain must be recognized by the distributee partner to the extent that the money received exceeds the partner's adjusted basis in the partnership interest at the time of the distribution. The computation of gain is made without regard to any other property that may be
distributed concurrently. Any gain recognized in a distribution is treated as gain from the sale or exchange of a partnership interest which is ordinarily a capital gain or loss. NOTE: Beginning in 1995, marketable securities are treated as cash for purposes of Section 731(a)(1). Exception 2 - partner loss recognition: A loss may not be recognized by the distributes partner unless the distribution results in the liquidation of the partner's entire interest in the partnership. Thus, losses will never be recognized in current distributions. IRC Sec. 731(a)(2) While Section 731(a)(1) recognizes marketable securities as cash, Section 731(a)(2) does not. Thus, no loss can be recognized on a distribution of marketable securities. Section 732: Partner's basis of property received If a partnership distributes property other than money, the partner generally takes the same basis in the property that the partnership had immediately prior to the distribution. In a current distribution, the distributes partners outside basis in the partnership must be reduced by the sum of:
However, the distributes partner's basis may never be reduced below zero. Therefore, the basis of the property received cannot exceed the outside basis of the partnership interest, reduced by any money distributed in the same transaction. The result may be that some of the basis of the distributed property could disappear. IRC Sec. 732(a)(2)
Section 733: Partner's remaining basis A partner's remaining basis in a partnership is determined by first reducing the partner's outside basis by the amount of any money distributed and the adjusted basis of any property other than money distributed. Recall, however, that a distribution cannot reduce a partner's basis in the partnership interest below zero. Consequently, if the basis of property distributed exceeds the partner's outside basis in the partnership, the partner's outside basis for the remaining interest is zero. Holding period.Section 735(b) states that the holding period of property received in a distribution includes that of the partnership as determined under Section 1223. Effect on partnership. The partnership generally recognizes no gain or loss on current or liquidating distribution of property, including money, to a partner.Character of gain or loss.Gain or loss recognized as a result of a distribution is considered a gain or loss from the sale or exchange of a partnership interest. Actual interest.Note that a partners adjusted basis in a partnership interest is not the same thing as the partners actual (Capital & Profits percentage) interest in the partnership. Although distributions or allocation of partnership losses may reduce a partners basis in the partnership interest to zero, the continuing interest in the partnership remains the same (e.g., 25% interest).
Liquidating distributions Overview The term liquidating distribution means the termination of a partner's entire interest in the partnership by means of a distribution, or a series of distributions, from the partnership to the partner. Regs. Sec. 1.761-1(d) Liquidating distributions can take several forms. They can be either in cash or in kind, or they can be either in lump-sum or a series of distributions. In addition, liquidating distributions are classified into two categories: General Rule Any liquidating distributions that are not made to a retiring partner or deceased partners successor in interest fall within the general liquidating distribution rules of Code Sections 731 to 735. Liquidating distributions are very similar to nonliquidating (current) distributions in that both are generally treated as a tax-free return of capital. However, in some circumstances, a liquidating distribution may have the same effect for tax purposes as the sale of a partnership interest, and the parties may be required to recognize gain or loss. Because the treatment of liquidating and current distributions is so similar, this subchapter examines only a comparison of the differences concerning:
When loss is recognized Unlike gains, losses may be recognized with a liquidating distribution, and then only if the liquidating distribution consists solely of cash and/or Section 751 ordinary income assets. Loss is recognized to the extent that a partners basis exceeds the sum of the cash and the basis of the Sec. 751 property received. IRC Sec. 731(a)(2)
Adjusted basis of property received Unlike current distributions, the basis of property received in liquidation is the adjusted basis of the partner's interest in the partnership reduced by any cash distributed. When two or more properties are distributed by a partnership, the partner's adjusted basis in the partnership (reduced by any cash distributed) must be allocated to the distributed properties. IRC Sec. 732(c) Effective for partnership distributions after August 5, 1997, the Taxpayer Relief Act of 1997 modified the manner in which basis allocations are made under Section 732(c). Under this new legislation, a partners outside basis is allocated under the following rules: Step 1.
Step 2.
Step 3.
Step 4.
Distributions to retiring or deceased partners Section 736 was enacted in 1954 as a simplifying measure to govern payments made by a partnership to a retiring or deceased partner's successor in interest. Unfortunately, the attempt at simplicity led only to complexity. Section 736 has become one of the most complex sections in Subchapter K. Although this topic is beyond the scope of this module, a brief explanation follows. A partnership does not terminate upon the death of a partner because the decedent's successor in interest is recognized as a partner until the interest is liquidated. Similarly, a retiring partner is recognized as a partner until his retirement is complete. Thus, Section 736 was necessary to classify payments by the partnership as either winding down payments (Section 736(a)) or payments for the partnership interest (Section 736(b)). Winding down payments - Section 736(a) Payments which are not covered by Section 736(b) are to be considered winding down payments and fall within the rules of Section 736(a). These payments are treated as distributions of income or guaranteed payments and are taxable to the retiring partner or deceased partner's successor in interest as ordinary income, Payments that are considered 736(a) payments will reduce the other partners' distributive shares of partnership income. Partnership interest payments - Section 736(b) Payments made for a partner's interest in partnership property are treated as Section 736(b) payments and are taxed under the same provisions which apply to current (nonliquidating) distributions. However, payments made for a. unrealized Receivables, b. substantially Appreciated Inventory, and C. goodwill (with exceptions), are treated as Section 736(a) payments. Thus, Section 736(b) payments only apply to capital gain or loss properties.
Overview While Congress, as a general rule, has done everything possible to allow partnerships to avoid recognition of any gain or loss on the distribution of their properties, there are certain exceptions to this generous policy. The first exception is found in Section 751(b) and deals with the notion of disproportionate distributions. This issue is summarized at the end of this section. A second set of exceptions is the result of what is affectionately referred to as mixing bowl transactions. Mixing bowl Mixing bowl transactions generally involve a partner transferring appreciated property to a partnership and the partnership either distributing the contributed property to another partner or distributing substitute property to the contributing partner. The thrust of the mixing bowl transaction is to mix up the identity and tractability of an asset and take advantage of the nonrecognition rules that apply to contributions and distributions made by a partnership. Two sections, 704(c) and 737, were modified and created to override the nonrecognition treatment of certain distributions. Mixing bowl modifications of Section 704(a) Section 704(c)(1)(B) was the first of the two mixing bowl exceptions enacted, It came as a result of Section 704(c)(1)(A), which required that a partner recognize gain or loss on a disposition of partnership property if the partner had contributed the disposed property to the partnership and it contained any precontribution (i.e., built-in) gains or losses. However, as originally enacted, Section 704(c)(1)(A) was limited to sales of contributed property. Therefore, a contributing partner could avoid the recognition rules if the partnership distributed the contributed property to another partner rather than sold it. As a result of the distribution, the partnership did not recognize any gain or loss, the contributing partner was not taxed on the distribution, and any built-in (precontribution) gain or loss was shifted to the distributes partner through a transferred basis. IRC Sec. 704(c)(1)(A); Sec. 731; Sec. 732 In an effort to eliminate this type of mixing bowl transaction, Congress provided in Section 704(c)(1)(B) that if property contributed by one partner is distributed to another partner within seven years of its contribution to the partnership, the contributing partner is treated as recognizing any precontribution gain or loss as if the partnership had sold the property for its fair market value at the time of the distribution. The character of the gain or loss is the same as if the partnership had sold the contributed property to the distributes partners. Accordingly, Section 724 also would apply in determining the character of gain or loss on contributed unrealized receivables, inventory items and capital loss property. For property contributed to a partnership before June 8, 1997, the holding period was five years instead of seven. The contributing partner's outside basis is increased or decreased by the amount of gain or loss recognized as a result of the distribution. To avoid double taxation of any gain or loss, the partnership's adjusted basis in the property is increased or decreased immediately, prior to the distribution to reflect the gain or loss to be recognized by the contributing partner.
The general rule of Section 704(c)(1)(B) is subject to two statutory exceptions:
Recognition of Precontribution Gains The second type of mixing bowl transaction involves a partner who contributes appreciated property to a partnership and receives a distribution of dissimilar property. In such an instance, the contributing partner would have swapped properties in a nonrecognition transaction without triggering any gain or loss; and all for the mere cost of a substituted basis. New Section 737 is the latest step in the continuing legislative and regulatory war on the use of partnerships to affect sales of property in a tax-deferred manner. The Enactment of Section 737 In general, Section 737 attacks the "substituted basis" problem by requiring a partner to recognize gain upon the receipt of a partnership distribution in an amount equal to the lesser of
Net precontribution gain is defined as the difference between the fair market value of all properties contributed by the partner and the aggregate tax basis at the time of the contribution, as adjusted for subsequent depreciation, depletion, etc. IRC Sec. 704(c)(1)(B) In order to give rise to net precontribution gain, however, the property must have been contributed by the distributes within seven years of the distribution and must still be held by the partnership immediately before the distribution. IRC Sec. 737(b) In general, precontribution gains and losses are netted with respect to all contributions occurring within the seven-year period. The effect of these rules is to limit the application of Section 737 to those situations where the distribution occurs within five years of the contribution and where the built-in gain has not already been recognized and taxed to the contributing partner under Section 704(c). For contributions after June 8, 1997, the Taxpayer Relief Act of 1997 extends the five-year period to seven years. The character of any gain recognized under Section 737 is determined by reference to the proportionate character of the net
precontribution gain. This means that any gain recognized may consist of a combination of long-term capital gain, Section 1231 gain, ordinary income, etc. This is in contrast to Section 731, which generally characterizes gains resulting from cash distributions in excess of basis as capital gains.
Special basis adjustments In order to eliminate the potential for double taxation, Section 737(c) provides two special basis adjustment rules.
Exceptions and Special Rules Section 737 contains two major exceptions (both statutory and through the Committee Reports) that deal with distributions of property previously contributed by the distributes partner. The purpose of these two rules is to prevent the avoidance of taxation of precontribution gain under Section 737 (and also, presumably Section 704(c)(1)(6)) through the use of tiered partnerships or the stuffing of contributed equity interests. First, gain recognition is not required to the extent the partnership distributes property that had been contributed by the distributes partner. However, the application of this rule is limited in cases where the distributed property consists of an interest in an entity (i.e., ownership is a corporation or partnership). In such cases, gain must be recognized under the general rule to the extent that the value of the entity has appreciated, as a result of property being contributed to the entity, after the interest in the entity had been contributed to the partnership. IRC Sec. 737(d)(1)
Second, a similar rule provides that if contributed property is distributed indirectly to a partner other than its contributor, the contributing partner is subject to tax on the net precontribution gain as if the property had been distributed directly rather than indirectly. Conference Committee Report on H.R. 776.
Coordination with other statutory provisions Section 737(c)(2) provides that the Section 737 gain recognition rule does not apply to the extent that Section 751(b) applies to the distribution. Additionally, the Committee Reports provide that the general Section 737 rules are not triggered by a constructive termination of a partnership under Section 708(b)(1)(B). Instead, partners will recognize gain in connection with any distribution of partnership property within seven years following the constructive termination. Coordination with Other Statutory Provisions Section 737(c)(2) provides that the Section 737 gain recognition rule does not apply to the extent that Section 751(b) applies to the distribution. Additionally, the Committee Reports provide that the general Section 737 rules are not triggered by a constructive termination of a partnership under Section 708(b)(1)(B). Instead, partners will recognize gain in connection with any distribution of partnership property within seven years following the constructive termination. Adjustment to basis of partnership property - �734(b). Section 734(a) contains the general rule that the basis of partnership property shall not be adjusted as the result of a distribution of money or property to a partner unless a �754 election is in effect with respect to such partnership. If a �754 election is in effect, �734(b) provides that a partnership shall adjust (increase or decrease) the basis of its remaining properties as the result of a distribution of money or property to a partner.�A Section 734(b) basis increase equals:
A Section 734(b) basis decrease equals:
A �734(b) basis adjustment belongs to all the partners and is made to the common inside basis of partnership property of the same class. �Section 734(b) basis adjustments are allocated among the partnership properties under �755. The Rules of �755 Allocation of Section 734(b) basis adjustments must be allocated to the correct class of partnership and are made under the operating rules of Reg.1.755-1(c). The two classes of partnership property are capital gain property (capital assets and Section 1231(b) assets) and ordinary income property (all other property including unrealized receivables). All basis adjustments resulting from the recognition of capital gain or loss by the distributee partner who receives cash are allocated to capital gain property while all basis adjustments resulting from other distributed property is allocated to remaining property in the partnership of the same class. Once a basis allocation is determined for a class of property then a second allocation must be made to specific properties within that class.Basis Increases:�� A basis increase is allocated to: 1. Relative amounts of unrealized appreciation in each property; and
Basis Decreases:�� A basis decrease is allocated to: 1. Relative amounts of unrealized depreciation in each property;
If a partnership cannot make a Section 734(b) basis adjustment because the partnership does not own property of a similar class, or because the bases of all property of a similar class have been reduced to zero, the adjustment will be made when the partnership subsequently acquires property of a similar class. �If the basis adjustment is to depreciable property, then an increase in the basis of recovery property under �168 is treated as newly-purchased property placed in service in the year of distribution and depreciation is calculated accordingly. ��Decreases in the basis of recovery property simply decrease the depreciation deductions with respect to the property. The decrease occurs proportionally over the remaining recovery period of the property. Special Basis Adjustment To Transferee Partner - �732(d) An often overlooked exception exists which allows a distributee partner, in certain situations, to adjust the� basis of distributed assets as if the Section 754 election had been in effect the day the partner acquired his or her interest in the partnership.� �This rule applies when (1) the partner purchases, exchanges, or inherits his interest, (2) no Section 754 election has been made, and (3) the property is distributed within two years after the partner acquires his interest. The election is intended to allow for a clear reflection of the assets� FMV at the time the interest was acquired.
Although, in most cases, IRC Sec. 732(d) applies to distributed property only at the partner�s election, the IRS has the authority to require the application of IRC Sec. 732(d) if the property�s FMV is greater than 110% of the partnership�s adjusted basis at the time of the transfer. The IRS may make the Section 732(d) allocation even though the distribution occurs more than two years after the partner acquired the partnership interest. Regulations make this allocation mandatory if: 1. upon liquidation of the partnership interest immediately after acquisition, the general basis allocation rules would have shifted basis from nondepreciable property to depreciable property, and 2. the basis to the transferee partner would be changed by an optional basis adjustment if a Section 754 election had been in effect. For distributions made on or after December 15, 1999, if a transferee partner notifies a partnership that it plans to make the election under IRC Sec. 732(d) or if a partnership makes a distribution that requires the Section 732(d) adjustment be made, the partnership must provide the transferee with the information necessary to compute its basis adjustment.Disproportionate Distributions - Statutory Framework of §751(b) Section 751(b) was designed for distribution transactions that affect the percentage ownership of ordinary income property. This provision is intended to ensure that gain inherent in ordinary assets will be taxed as ordinary income. Thus, the purpose of Section 751(b) is to prevent:
This partnership abuse is deemed to occur when a partner receives a disproportionate distribution. A disproportionate distribution
occurs when a partner receives more than a proportionate share of hot assets or other property, and less than a proportionate share of the remaining class of property. Hot assets include unrealized receivables and substantially appreciated inventory. Other property consists of all property other than hot assets, including cash. If a partner receives a distribution of partnership property in
liquidation of all or a portion of a partnership interest, and the property received does not constitute a pro rata share of the partner's interest in hot assets , as well as other property, then the distribution will be treated as a deemed sale or exchange between the distributes partner and the partnership. Application of Section 751(b) In order for Section 751(b) to apply, the following events have to occur:
Section 751(b) will not apply when the following events occur:
Deemed sale effects of Section 751(b) When a distributes partner's interest in hot assets increases, the following is deemed to occur:
When a distributes partner's interest in other property increases, the following is deemed to occur:
Under what conditions will a partner recognize a gain in a liquidating distribution quizlet?Under what conditions will a partner recognize gain in a liquidating distribution? In the situation in which a partnership distributes only money and the amount exceeds the partner's basis in her partnership interest, she will recognize a gain equal to the excess.
Under what circumstances can a partner recognize both gain and loss on the sale of a partnership interest?A partner may recognize both gain and loss on the sale of a partnership interest in the situation where a partner's share of the unrealized gain in hot assets is greater than his total gain or loss on the sale of his partnership interest.
Under what circumstances is a partnership liquidated?A partnership liquidation happens where the partners have decided that the partnership has no viable future or purpose, and a decision may be made to cease trading and wind up the business.
What is considered a liquidating distribution?A liquidating distribution (or liquidating dividend) is a type of nondividend distribution made by a corporation or a partnership to its shareholders during its partial or complete liquidation. Liquidating distributions are not paid solely out of the profits of the corporation.
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