TAX PLANNING FOR THE DISPOSITION OF PARTNERSHIP INTERESTS S

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1 TAX PLANNING FOR THE DISPOSITION OF PARTNERSHIP INTERESTS S by Richard A. Shaw Higgs, Fletcher & Mack LLP 401 West A Street, Suite 2600 San Diego, California (619) shawr@higgslaw.com I. INTRODUCTION The disposition of a partnership interest may result from various different types of transactions which affect the partner's respective interest in the partnership. A. Direct Dispositions The interest may be reduced or terminated by many direct means: 1. Sale of the partner's interest; 2. An exchange of the partner's interest; 3. By retirement of the partner's interest; 4. A gift of the partner's interest; 5. A transfer by reason of death; or 6. By liquidation of the partnership. B. Indirect Dispositions As a result of the complex aggregation and entity rules that apply to partnerships, the partner's interest in the partnership may be affected as a result of various transactions within the partnership, and would be affected as a result of the distribution of assets by the partnership followed by the subsequent disposition of those assets by the partner. C. Entity Versus Aggregate Principles Generally, entity principles are used in Subchapter K in dealing with the disposition of the interests of partners.

2 1. The Partner's Interest for Federal Income Tax Purposes However, the partnership taxation regime borrows from both aggregate and entity concepts, which results in a hybrid entity concept. The interest of each partner in the partnership is treated as a separate intangible asset rather than as an aggregate of the assets of the partnership. As a consequence, normal tax rules that are applied on the sale of a separate intangible asset will be applied in determining the character of gain, applicable basis, and holding period of the partner's interest transferred. 2. Special Aggregate Ownership Rules There are a number of special exceptions where the interest of each partner is treated as an aggregate of the assets of the partnership. This is particularly the case with respect to unrealized receivables and inventory. I.R.C a. Each partner is treated as owning his or her separate proportionate share of the underlying unrealized receivables and inventory of the partnership. b. Under this aggregate approach, the selling partner will be treated as if he had sold the underlying assets instead of his partnership interest, as to that portion of the transfer of partner's interest in the partnership which is attributable to the unrealized receivables and inventory. D. Defining a Partner s Interest Under Partnership Law 1. Uniform Partnership Act a. U.P.A. Section 26, Nature of Partner's Interest in Partnership "A partner's interest in the partnership is his share of the profits and surplus, and the same is personal property." b. U.P.A. Section 18, Rules Determining Rights and Duties to One Another a."each partner shall be repaid his contributions, whether by way of capital or advances to the partnership property and share equally in the profits and surplus remaining after all liabilities, including those to partners are satisfied; and must contribute toward the losses, whether of capital or otherwise, sustained by the partnership according to his share of profits." b."all partners have equal rights in the management and conduct of the partnership business."

3 c. U.P.A. Section 27, Assignment of Partner's Interest On the assignment of a partner's interest in the partnership, the assignee is merely entitled to receive the profits to which the assigning partner may otherwise be entitled in accordance with his contract. d. Revised Uniform Partnership Act The National Conference of Commissioners on Uniform State Laws approved a revised "Uniform Partnership Act (1992)" on August 5, Revised Uniform Limited Partnership Act a. R.U.L.P.A. Section 403, General Powers and Liabilities (1)"Except as provided in this Act or the partnership agreement, a general partner of a limited partnership has the rights and powers and is subject to the restrictions of a partner in a partnership without limited partners." (2)"Except as provided in this Act, a general partner of a limited partnership has the liabilities of a partner in a partnership without limited partners to persons other than the partnership and the other partners. Except as provided in this Act or in the partnership agreement, a general partner of a limited partnership has the liabilities of a partner in a partnership without limited partners to the partnership and to the other partners." b. R.U.L.P.A. Section 404, Contributions by General Partner "A general partner of a limited partnership may make contributions to the partnership and share in the profits and losses of, and distributions from, the limited partnership as a general partner. The general partner also may make contributions to and share in profits, losses and distributions as a limited partner." c. R.U.L.P.A. Section 503, Sharing of Profits and Losses The profits and losses of a limited partnership shall be allocated among the partners and among classes of partners, in the manner provided in writing in the partnership agreement. Absent a written allocation, profits and losses are allocated on the basis of the value on the contributions made by each partner to the extent they have not been returned to the partner.

4 d. R.U.L.P.A. Section 702, Assignment of Partnership Interest A partnership interest is assignable in whole or in part, except as otherwise provided in the partnership agreement. An assignee is entitled to receive only the distribution to which the assignor would be entitled. e. R.U.L.P.A. Section 704, Right of Assignee to Become Limited Partner An assignee of a partnership interest, including an assignee of a general partner, may become a limited partner if and to the extent that the assignor gives the assignee that right under the partnership agreement or if all other partners consent. An assignee who becomes a limited partner has the rights and powers and is subject to the restrictions and liabilities of a limited partner under the partnership agreement. II. SALE OR EXCHANGE OF A PARTNER S PARTNERSHIP INTEREST A. General Rule Generally, a partner holds his or her partnership interest for investment. As a capital asset, the sale or exchange of a partner's interest will result in capital gain or loss to the transferor partner. I.R.C. 741(a). 1. Significance of Capital Gain or Loss Treatment a. Net capital gains are subject to a maximum individual rate of 28%, as compared to a maximum ordinary income rate (39.1 in 2002). I.R.C. 1(h) and 1222(11). Corporations are subject to a maximum capital gain rate of 35%, which is the same as the maximum ordinary income rate without regard to the 5% surtax imposed by section 11(b)(1). I.R.C. 1201(a). b. Losses from a sale or exchange of capital assets are allowable only to the extent of gains from sales or exchanges, plus, in the case of non-corporations, an additional $3,000 of ordinary income. I.R.C. 1211(a) and (b). c. Net capital losses for non-corporate shareholders in excess of $3,000 of ordinary income is carried forward indefinitely for future taxable years until exhausted. Corporate capital losses can be used currently only to offset current capital gains. Corporate net capital losses are carried back three years and then forward for five taxable years.

5 I.R.C. 1212(a) and (b). B. Existence of a Sale or Exchange The sale or exchange occurs when there has been a conveyance of the benefits and burdens of ownership. Roth v. Comm., 321 F.2d 607 (9th Cir. 1963) (a law firm's written agreement purporting to "sell and assign its entire interest [a 3.2% interest] in a partnership" to a corporation was held to lack economic significance where the law firm under the agreement retained its 3.2% share of current income and residual value attributable to the transferred interest. Since the transaction lacked economic substance, amounts attributable to the transferred interest were held not entitled to capital gains treatment). See Holt v. Comm., 303 F.2d 687 (9th Cir. 1962); Haggard v. Wood, 298 F.2d 24, 2628 (9th Cir. 1961). 1. Nominal Interest Retained by Transferor Partner A transfer will be treated as a sale or exchange even though the assignor has retained a nominal interest under state law, if there has been an irrevocable assignment under which the assignee is entitled to share in profits and losses and to receive all distributions to which the assignor would have been entitled, and where the assignor agrees to exercise any residual powers solely in favor of the assignee. Rev. Rul. 77-, C.B Abandonment or Worthlessness of Partnership Interest The abandonment or worthlessness of a partnership interest may result in either an ordinary loss deductible under section 165(a), or a capital loss arising from the sale or exchange of a capital asset. The regulations under section 165 provide that a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. Section 165(f) of the Code provides that losses from sales or exchanges of capital assets are allowed only to the extent allowed in sections 1211 or Under section of the regulations, however, absent a sale of exchange, a loss that results from the abandonment or worthlessness of nondepreciable property is an ordinary loss even if the abandoned or worthless asset is a capital asset (such as a partnership interest). a. Ordinary Loss Treatment The abandonment by a partner of his interest in the partnership, or forfeiture under the terms of the partnership agreement, will result in an ordinary loss under section 165(a) unless the conditions for a sale or exchange have been satisfied. Rev. Rul. 9380, I.R.B. 5 Nov. 29, 1993); Rev. Rul , C.B. 51; Tejon Ranch Co. v. Comm., T.C.M , 49 T.C.M. 5; Citron v.

6 Comm., 97 T.C. 200 (1991). (1) The Service no longer follows Revenue Ruling 76189, C.B. 181, where the Service earlier ruled that capital loss treatment was required even though the partnership had no assets or liabilities, since section 731 must be applied "as if an actual distribution had taken place." This former ruling was applied in Pinson v. Comm., T.C.M , 59 TCM 554. b. Capital Loss Treatment A capital loss will result if the abandonment or worthless-ness of the partnership interest is treated as a sale or exchange of a capital asset. Rev. Rul. 9380; I.R.B. 5 (Nov. 29, 1993). c. Sale or Exchange Treatment Under Section 731 A sale or exchange by the partner of his partnership interest will be deemed to exist if there is an actual distribution or deemed distribution to the partner under section 731. The loss would then be recognized to the partner under section 741. (1) General Rule Section 731(a) provides that if there is a distribution by the partnership to a partner in liquidation of the partner's interest in the partnership, any loss that is recognized will be considered as loss arising from the sale or exchange of the partnership interest. Section 741 provides that in the case of a sale or exchange of a partnership interest, loss is recognized by the transferor partner and is generally considered as a sale or exchange of a capital asset (except for hot assets under section 751). (a) No loss is recognized if property other than money, unrealized receivables or inventory is distributed. I.R.C. 731(a)(2). Certain marketable securities are treated as money. I.R.C. 731(c). (2) Impact of Liabilities If the partnership has liabilities, section 752(b) will treat the release of liabilities arising from abandonment as a distribution of money to the partner. Any such deemed distribution will cause any loss recognized from the abandonment to be a capital loss arising from the sale or exchange of a partnership