Another Mess

Congress has only a few days to avert a “shutdown” of the federal government.[i]

It’s not looking good in the House, as Speaker McCarthy has struggled to bring certain members of the majority into line, while more moderate members of his party have displayed a willingness to reach across the aisle to secure a temporary funding bill.[ii]

Meanwhile, it seems that the members of the minority[iii] have been content to watch the GOP’s drama unfold.

On the other side of the Capitol, the majority leader announced late last night that the Senate had approved a bipartisan continuing resolution – basically, a temporary spending bill – that would allow the federal government to continue operating until Nov. 17.[iv]

This morning, however, the Speaker announced that he will not bring the Senate’s bill to the House floor for a vote.[v] Instead, he plans to bring a separate GOP-backed bill to a vote in the House on Friday, leaving only one day for negotiations with the Senate before the government “shuts down.”

Under these circumstances, one shouldn’t be surprised by reports that the IRS has prepared a contingency plan pursuant to which workers will be furloughed in the event of a shutdown.[vi]

Partnership Enforcement

Contrast the foregoing with what must have been the mood at the IRS last week when the agency unveiled its plans to establish a new work unit within the Large Business and International division.

According to the IRS, this new work unit will focus its enforcement efforts on complex partnerships which, the IRS explained, are frequently used by high-income and high-wealth individuals to avoid the payment of taxes.[vii]

In furtherance of these plans, the IRS also announced the opening of more than 3,700 positions to help with the examination of such partnerships and individuals.[viii]

Time to Brush Up

Assuming Congress puts together a short-term stopgap measure to keep the government operating, and assuming the two Chambers can find some common ground that will allow them to pass a budget by yearend,[ix] and assuming that budget does not eviscerate the funding provided to the IRS under the Inflation Reduction Act,[x] then taxpayers can expect the IRS will follow through on its stated plans to crack down on what it believes has been the abuse by wealthy taxpayers of the partnership structure for the purpose of improperly avoiding taxes.

In anticipation of this scenario, tax advisers will want to review the sometimes convoluted rules that apply to the taxation of partners and their partnerships – not just for the purposes of identifying and avoiding potential tax issues or of defending against possible challenges on audit, but also for the purpose of taking advantage of what the Code and the IRS have determined are legitimate tax planning strategies.

Installment Sale?

One set of rules that is often misunderstood involves the liquidation (or redemption) of a partner’s entire interest in a partnership; specifically, the application of the installment method to determine the gain recognized by a departing partner when at least one payment by the partnership to such partner is made after the close of the taxable year in which such partner’s interest is liquidated as a matter of state law – an installment sale.[xi]

It may be that some are confusing the tax treatment of such a liquidation – that is effectuated through a series of distributions by the partnership made over several years – with the cross-purchase of a departing partner’s interest in the partnership, or the redemption of a departing shareholder’s shares of stock in a corporation, in exchange for one or more deferred payments[xii] by an acquiring partner or by the corporation, as the case may be.[xiii]

Thus, it is often the case that neither the departing partner nor the acquiring partnership has thoroughly considered the income tax consequences of these liquidating distributions. As a result, their assessment of the economic results of the liquidation may not be accurate.

What’s the Payment For?

Before considering the tax treatment of such liquidating distributions, we must first determine whether the transfer to the departing partner is treated as a distribution in respect of their partnership interest or something else.

Indeed, the payments made by a partnership to a departing partner may represent several items. Thus, the parties to the transaction are required to allocate these payments between the value of the partner’s interest in partnership assets and other items.[xiv]

Section 736(b) Distributions

The value of the partner’s share of the partnership’s assets must first be determined. These include all tangible and intangible assets of the partnership. The valuation placed by the partners upon a partner’s interest in partnership property, in an arm’s-length agreement, will typically be regarded as correct.[xv]

Where money is paid by the partnership to the partner for their interest in partnership assets, the payment is treated as a distribution by the partnership, and the partner recognizes gain to the extent that the amount distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.[xvi] The gain is treated as being realized from the sale or exchange of a capital asset.[xvii] For these purposes, the partner’s “relief” from his share of partnership liabilities, which is generally deemed to occur in the year he withdraws from the partnership under local law, is treated as a distribution of money.[xviii]

However, there are exceptions to this capital-asset-sale treatment. For example, to the extent the money received by the departing partner in exchange for their partnership interest is attributable to the partner’s share of the partnership’s substantially appreciated inventory, the partner will be treated as having sold or exchanged such inventory and will realize ordinary income.[xix] To the extent the payments are made for the partner’s share of unrealized receivables, where capital is a material income-producing factor for the partnership, once again the partner will realize ordinary income.[xx]

Other Payments – 736(a)

Certain other assets receive special treatment, depending on the nature of the partnership’s business and of the departing partner’s involvement therein. Thus, in the case of a service partnership,[xxi] a payment for partnership assets will not include the partner’s share of partnership goodwill unless the liquidation agreement specifically provides for a reasonable payment for goodwill and the retiring partner was the equivalent of a general partner.[xxii] If these criteria are not satisfied, then any payment that would otherwise cover partnership goodwill would, instead, be treated as a guaranteed payment, producing ordinary income to the retiring partner and a deduction to the partnership.[xxiii]

The portion of the payments made to a retiring partner for his share of unrealized receivables (where the business is not capital intensive) or goodwill (with certain exceptions), or otherwise not in exchange for his interest in other partnership assets, will be considered either a distributive share of partnership income if the amount is determined with regard to the income of the partnership, or a so-called “guaranteed payment” if the amount is determined without regard to partnership income. In either case, the retiring partner realizes ordinary income. To the extent they are considered as a distributive share of partnership income, the payments reduce the distributive shares of the remaining partners. To the extent the payments are considered guaranteed payments, they are deductible by the partnership.

Liquidating a Partner’s Interest

For purposes of this post, it is assumed that the payments by the partnership to a departing partner in liquidation of their interest will be made in cash and will be characterized as made in exchange for such partner’s interest in partnership property and, so, will be treated as distributions by the partnership.

Installment Reporting?

As indicated above, the Code provides that the departing partner will recognize gain – treated as being realized from the sale of a capital asset – to the extent that the amount distributed exceeds their adjusted basis for the liquidated partnership interest immediately before the distribution.[xxiv]

Considering the liquidating distribution is treated as made in exchange for the partnership interest, it is understandable for one to conclude that a series of liquidating distributions constitutes an “installment sale,” meaning a disposition of property where at least one payment is to be received after the close of the taxable year in which the liquidation or disposition occurs.[xxv] Consequently, the gain from such a sale would be reported under the installment method.[xxvi]

Under this reasoning, the gain from the sale of the interest that is recognized for any taxable year is that proportion of the payments received in that year which the gross profit (basically, the gain realized or to be realized when payment is completed) bears to the total contract price.[xxvii] In other words, a portion of the selling partner’s basis is recovered with each payment, and the partner recognizes gain on each payment to the extent such payment exceeds the allocable portion of the partner’s basis.

This conclusion, however, is incorrect. To understand why installment reporting does not apply to the liquidating distributions of a partner’s interest, let’s consider the basic elements of such a transaction.[xxviii]

Tax Analysis

The term “liquidation of a partner’s interest” means the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions, to the partner by the partnership.[xxix]

A series of distributions will come within the meaning of this term whether they are made in one year or in more than one year. Where a partner’s interest is to be liquidated by a series of distributions, the interest will not be considered as liquidated for tax purposes until the final distribution has been made.[xxx]

Thus, notwithstanding that the departing partner ceases to be a partner under state law at the time that the liquidating transaction closes, the departing partner will continue to be treated as a partner for purposes of the Code’s partnership tax rules until their interest in the partnership has been completely liquidated.[xxxi]

For example, if one of the partners of a two-partner partnership leaves the partnership under a plan whereby the departing partner is to receive liquidating payments, the partnership will not be considered terminated until the departing partner’s entire interest is liquidated, since the departing partner continues to hold a partnership interest in the partnership until that time.[xxxii]

Payments made in liquidation of the entire interest of a departing partner will be considered as a distribution by the partnership to the extent made in exchange for such partner’s interest in partnership property.[xxxiii]

The amount of gain with respect to such payments for a departing partner’s interest in partnership property for each year of payment is determined under the rules applicable to partnership distributions, generally.[xxxiv]

In other words, gain with respect to such liquidating distributions[xxxv] will be recognized by the departing partner to the extent that the amount of money distributed to the partner exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.[xxxvi] Stated differently, no gain shall be recognized to the partner until the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.[xxxvii]

The timing of the recognition of gain with respect to such payments is also determined under the rules generally applicable to partnership distributions. Thus, the reporting of gain will be deferred until the departing partner’s entire basis for their partnership interest has been recovered. In other words, the general rule is that liquidating payments are reported according to a cash basis, cost recovery method of accounting.[xxxviii]

In Sum

Under the foregoing rules, cash distributions made in liquidation of a departing partner’s entire interest in the partnership will first be applied to reduce the partner’s entire basis in such interest. Distributions received after the recovery of such basis will be taxable to the partner.

Thus, in the case of a departing partner with a not insignificant basis for their partnership interest, the effect of these rules is to afford the partner the opportunity to defer the recognition of gain from the liquidation of their interest.

What’s more, because this deferral does not arise under the installment sale regime but, rather, is a function of the partnership distribution rules, described above, under which the departing partner remains a partner for tax purposes until the final distribution, the various rules otherwise applicable to an installment sale should not be a concern.[xxxix]

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] For all intents and purposes, Congress has already been shut down for years.

[ii] Last night, the House agreed (by a vote of 216-212) to advance consideration of four spending bills.

[iii] I believe there are still some sane members of the Party, though they are remarkably quiet. Maybe they’re afraid of being canceled or that Schumer will promise that they will “pay the price” for having “released the whirlwind.”

[iv] The vote was 77 to 19. This bill will have to be brought to the Senate floor today or tomorrow for a vote before being sent to the House.

The Senate needs to attach its proposal to a House-passed bill. Remember, according to Art. I, Sec. 7, Clause 1 of the Constitution, “All Bills for raising Revenue shall originate in the House of Representatives.” It appears that a Federal Aviation Administration bill may be the legislative vehicle selected for this purpose.

[v] Speaker McCarthy is insisting that the bill include measures that address the southern border crisis. Someone has to do something about it. I can’t figure out why both Chambers aren’t clamoring for immediate action to secure the border and to reverse, as much as possible, the damage already done.

[vi] https://federalnewsnetwork.com/government-shutdown/2023/09/irs-to-partially-close-if-government-shutdown-happens-reversing-earlier-plans-union-says//.

[vii] https://www.irs.gov/newsroom/irs-to-establish-special-pass-through-organization-to-help-with-high-income-compliance-efforts-new-workgroup-to-blend-current-employees-and-new-hires-to-focus-on-complex-partnerships-other-key-areas#:~:text=As%20part%20of%20larger%20transformation,income%20and%20high%2Dwealth%20individuals..

[viii] “We are honing-in on areas where we believe non-compliance among our wealthiest filers has proliferated over the last decade of IRS budget cuts, and pass-throughs are high on our list of concerns.”

In support of these efforts, the IRS stated that it will be employing improved technology as well as Artificial Intelligence to help IRS compliance teams better detect tax cheating, and identify emerging compliance threats.

[ix] Query, who in the Administration would sign the bill in the event our already incapacitated President cannot? It appears Vice President Harris is also lacking capacity. According to the Presidential Succession Act of 1947, the Speaker of the House is next in line. Wouldn’t that be ironic?

[x] Pub. L. 117-169.

[xi] IRC Sec. 453.

[xii] Whether provided under the terms of an agreement or evidenced by a promissory note.

[xiii] In the case of a cross-purchase of a partner’s partnership interest, or in the case of a complete redemption of one shareholder’s shares of stock, installment reporting under IRC Sec. 453 is available

By contrast, where a corporation makes a series of liquidating distributions to its shareholders, a shareholder does not recognize gain until they have recovered all of their basis. Rev. Rul. 84-48.

[xiv] Reg. Sec. 1.736-1(a)(2). Specifically, the payments must be allocated between (i) payments for the value of the departing partner’s interest in partnership assets, except unrealized receivables and, under some circumstances, good will, and (ii) other payments. IRC Sec. 736. The amounts paid for his interest in assets are treated in the same manner as a distribution under IRC Sec. 731 and, where applicable, Sec. 751 (dealing with “hot assets”). IRC Sec. 736(b).

[xv] Reg. Sec. 1.736-1(b)(1).

In general, the remaining partners are allowed no deduction for these payments, though it may be possible to amortize or depreciate them (subject to anti-churning rules) if the partnership has a Sec. 754 election in effect.

[xvi] IRC Sec. 736(b)(1), Sec. 731(a).

[xvii] IRC Sec. 741.

[xviii] IRC Sec. 752(b).

[xix] IRC Sec. 751(b)(1)(A)(ii).

[xx] The partnership itself should not realize any income on the subsequent sale of such inventory or collection of such receivables.

[xxi] Where capital is a not material income-producing factor for the partnership.

[xxii] IRC Sec. 736(b)(

[xxiii] IRC Serc. 736(a).

[xxiv] IRC Sec. 736(b)(1), Sec. 731(a).

For the tax treatment of current distributions, see https://www.jdsupra.com/legalnews/current-partnership-distributions-when-9602065/.

[xxv] IRC Sec. 453(b).

[xxvi] IRC Sec. 453(a).

[xxvii] IRC 453(c).

[xxviii] Again, it is assumed for purposes of this post that the payments by the partnership to a departing partner in liquidation of their interest will be characterized as payments made in exchange for such partner’s interest in partnership property and, so, will be treated as distributions by the partnership.

[xxix] Reg. Sec. 1.761-1(d).

[xxx] Reg. Sec. 1.761-1(d).

[xxxi] Reg. Sec. 1.736-1(a)(1)(ii).

[xxxii] Reg. Sec. 1.736-1(a)(6). See IRC 708.

[xxxiii] Reg. Sec. 1.736-1(b)(1).

[xxxiv] See IRC Sec. 731(a) and Sec. 741, except to the extent IRC Sec. 751(b) applies. Reg. Sec. 1.736-1(b)(6).

[xxxv] Under IRC Sec. 736(b).

[xxxvi] Payments described under IRC Sec. 736(b) are taken into account by the recipient departing partner for their taxable year in which such payments are made. Reg. Sec. 1.736-1(a)(5).

[xxxvii] Reg. Sec. 1.731-1(a)(1)(i): This rule is applicable both to current distributions and to distributions in liquidation of a partner’s entire interest in a partnership.

Under IRC Sec. 731(a)(2), loss on the complete liquidation of a departing partner’s interest is recognized to the extent of the excess of the basis of such partner’s interest in the partnership over the amount of money distributed to the partner. IRC Sec. 731(a)(2). In the case of a series of liquidating distributions, the loss is not recognized until the final distribution.

[xxxviii] However, where the total of section 736(b) payments is a fixed sum, a retiring partner may elect (in his tax return for the first taxable year for which he receives such payments), to report and to measure the amount of any gain or loss by the difference between: the amount treated as a distribution under section 736(b) in that year, and the portion of the adjusted basis of the partner for his partnership interest attributable to such distribution (i.e., the amount which bears the same proportion to the partner’s total adjusted basis for his partnership interest as the amount distributed under section 736(b) in that year bears to the total amount to be distributed under section 736(b)).In other words, the retiring partner may elect to recognize gain ratably over a series of payments.

A part of the total gain under section 736(b) is apportioned among the installment payments by allocating to each installment that portion of the basis of the liquidated partnership interest that bears the same ratio to the retired partner’s total basis as the amount of the installment bears to the total amount payable under section 736(b).

A recipient who elects under this subparagraph shall attach a statement to his tax return for the first taxable year for which he receives such payments, indicating his election and showing the computation of the gain included in gross income. Reg. Sec. 1.736-1(b)(6).

[xxxix] For example, the interest charge rules under IRC Sec. 453A; the disposition rules under IRC Sec. 453B; and the imputed interest/OID rules under IRC Sec. 483 and Sec. 1274.