IRS Large Business & International (LB&I) has released an updated Practice Unit on issues related to liquidating distributions of a partner’s interest that may come up during audits of partners and partnerships.
Practice Units are developed through internal collaboration and serve as both job aids and training materials on tax issues for IRS employees (referred to in this article as revenue agents or auditors). (IRS website: Practice Units)
Background—payments for partnership property.
Partnership distributions that liquidate a partner’s entire interest in a partnership are called liquidating distributions. In a liquidating distribution, to the extent payments are received by a partner for its interest in partnership property, the payments are taxable under the rules applicable to nonliquidating distributions. (Code Sec. 736(b)(1))
In allocating liquidating distribution payments to the partner’s interest in partnership property, generally, the valuation placed by the property in an arm’s length agreement among the partners will be regarded as correct. (Reg § 1.736-1(b)(1))
Special rules apply if capital is not a material income-producing factor for the partnership, and the partner receiving the liquidating distribution was a general partner in the partnership. (Code Sec. 736(b)(3)) In that case, amounts paid by the partnership for the partner’s share of unrealized receivables or goodwill, except to the extent that the partnership agreement provides for a payment with respect to good will. (Code Sec. 736(b)(2))
Under these rules, the partner recognizes gain to the extent money (or deemed money) distributed exceeds the partner’s outside basis in its partnership interest. Loss is recognized to the extent the partner’s outside basis exceeds money distributed and the basis of any unrealized receivables, or inventory (“hot assets”). A partner will not recognize a loss on a liquidating distribution if it receives any property other than money or hot assets. (Code Sec. 731)
A liquidating distribution of partner’s interest in a partnership that includes a disproportionate amount of hot assets may trigger ordinary income, gain, or loss to both the partnership and its partners. (Code Sec. 736(b)(2); Code Sec. 751(b))
Background—payments not in exchange for partnership property.
Liquidation payments that are not in exchange for partnership property are treated either as distributive shares of partnership income (if the amount is determined with regard to partnership income) or as guaranteed payments (if the amount is determined without regard to partnership income). (Code Sec. 736(a))
Background—basis of distributed assets.
In a liquidating distribution, the outside basis of the distributee partner must be allocated to all the assets received in the distribution. Basis is always allocated first to money. The basis allocated to the other property distributed to a partner is generally a carryover basis from the partnership’s inside basis. However, in the event there is insufficient outside basis to give each asset a carryover basis, the shortfall must be allocated. That shortfall is first allocated to the assets other than unrealized receivables and inventory. If those assets’ bases are reduced to zero, then the shortfall is allocated to the hot assets, reducing their bases. (Code Sec. 732)
Following a distribution where a partner recognizes gain or loss or the basis of distributed assets is adjusted from their carryover bases, an inside/outside basis disparity is created. If a partnership has a Code Sec. 754 election in effect or if the distribution resulted in a substantial basis reduction (that is, the sum of the loss recognized and basis reduction were more than $250,000), this disparity is resolved by adjusting the basis of the assets remaining in the partnership. (Code Sec. 734)
A partnership has a substantial built-in loss that requires basis adjustment to partnership assets on a transfer of a partnership interest if either
- The partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value (“FMV”) of the property, or
- The transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their FMVs immediately after the transfer. (Code Sec. 743(d)
A partner’s holding period for partnership property distributed to it includes the period the partnership held the property. (Code Sec. 735(b))
Background—net investment income tax.
A 3.8% net investment income tax (NIIT) is imposed on individuals’ net investment income (NII), which includes interest, dividends, annuities, royalties, rents, and capital gains. Business income is generally exempt, but income from passive activities and financial instrument and commodity trading is subject to the tax. (Code Sec. 1411)
Initial factual development.
Assume an IRS employee is conducting the audit of a partner who received a liquidating distribution and must determine whether the partner properly reported gain or loss.
The employee should identify whether the distribution was cash or property. This and other relevant information can be obtained by reviewing the following items: Form 1065 (U.S. Return of Partnership Income) and its associated schedules, the partnership agreement, distribution agreements, the partner’s outside basis calculation, the partnership depreciation schedule (to determine the basis of the asset distributed to the partner), and the appraisal of any hot assets distributed.
The Practice Unit addresses three issues that might need additional factual development.
Issue 1: Did the partner recognize gain or loss from a cash or property distribution in liquidation of his partnership interest? To address this issue, an auditor should first determine if the distribution was current (nonliquidating) or liquidating. The auditor should also determine if the distribution was part of a disguised sale and the purpose of the distribution (whether it was a distributive share of partnership income, a guaranteed payment, or in exchange for partnership property). Next, the auditor should determine whether the distribution included hot assets. The auditor should determine if marketable securities (which would be treated as cash and affect calculation of gain or loss) were distributed.
The auditor should also verify the partnership basis in the property distributed and the partner’s basis in its partnership interest. To verify the latter, the auditor can do the following: review prior year partnership returns; request the distributee partner’s outside basis schedule; verify prior changes in partners’ capital contributions and purchase interests in the partnership; verify that the distributee partner reported any gain resulting from partnership distributions in excess of basis as income; request partnership tax capital account details, including schedules, documents, and workpapers showing contributions, distributions and allocations for each partner for the current and prior seven years; inquire about the tax basis of contributed property; obtain a copy of each partner’s tax capital account; and obtain a schedule showing how liabilities were allocated among partners.
IRS cautions that a series of distributions resulting in a liquidation can take place over more than one tax year, so auditors should look at subsequent year distributions to determine if a liquidating distribution took place.
If there was a distribution of money or property within two years of contribution of money or property by the distributee partner, the disguised sale rules presume a disguised sale occurred involving the distributee partner.
When inspecting a partner’s return, an auditor should be alert to losses claimed in a liquidating distribution where the partner continues to hold a partnership interest. A partner must completely liquidate its interest before a loss on the liquidation is allowable.
Revenue agents should remember that gains from the sale of interests in partnerships, including a partner’s liquidation gains (to the extent the partner was a passive owner) are considered NII, for purposes of the NIIT.
Issue 2: What is the partner’s basis in property received in liquidation of his interest? When the auditor is examining this issue, he or she should determine the partnership’s pre-distribution (inside) basis in property distributed by verifying
- The purchase price of assets purchased by the partnership,
- The tax depreciation claimed by the partnership, and
- The basis of property contributed by partners.
IRS also said the revenue agent should determine if the partnership has made a Code Sec. 754 election by reviewing the partnership agreement for the identification of a Code Sec. 754 election and prior year Forms 1065. The auditor can look at whether question 12 of Schedule B, Form 1065 indicates a Code Sec. 754 election.
Then, the auditor should request the basis adjustment calculations and review the tax depreciation schedule and the asset appraisal report.
If there was no Code Sec. 754 election, the revenue agent should determine whether a substantial basis reduction or substantial built-in loss adjustment occurred on the transfer of a partnership interest in the current year or previous year.
The auditor should also look at whether the partnership has revoked any Code Sec. 754 elections.
The revenue agent should identify the type of assets distributed to the distributee partner and determine if the distributee partner assumed liabilities associated with distributed assets. The auditor should also verify the assets distributed to the partner in liquidation by requesting a list of assets distributed, requesting a liquidation agreement from the partnership, and considering interviewing partners if the liquidation agreement is not available.
IRS cautions that the basis of hot assets in the hands of a partner cannot exceed their inside basis in the hands of the partnership.
Issue 3: What is the character and holding period of the property distributed? IRS says the revenue agent should develop additional facts useful in addressing this issue by determining when and how the partnership obtained the property. He or she should request a list of assets distributed, as well as the liquidation agreement and any relevant workpapers or correspondence.
Reviewing the partnership’s tax depreciation schedule will enable the auditor to verify tax depreciation claimed by the partnership and its holding period in property contributed by the partners.
The revenue agent should consider interviewing the partners of the partnership if the preceding items are not available and requesting correspondence with the partners.
The auditor also needs to determine if any of the distributed property are hot assets, which give rise to ordinary income (or loss). He or she should verify how the partnership acquired the property distributed to the partner, which could affect the partner’s holding period.
To continue your research on partnership liquidating distributions, see FTC 2d/FIN ¶B-4100 et seq. For partnership audits, see FTC 2d/FIN ¶T-2400 et seq.
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