Several Simple Examples of Partnership Exchange Tax Issues (Part 2) Terence Floyd Cuff Terry Cuff is of counsel at the Los Angeles office of Loeb & Loeb, LLP. Mr. Cuff s early practice in law was concentrated in tax problems of the entertainment industry, principally film and music. Mr. Cuff s practice later shifted to corporate tax problems, tax problems of real estate investment trusts, and tax problems related to the early cable television industry. His practice now spans the spectrum of real estate and partnership tax and tax problems of real estate investment trusts. Mr. Cuff writes and lectures about a wide variety of partnership and real estate tax problems. He recently has particularly focused most of his writing and lecturing on problems involved in drafting partnership and LLC agreements, problems of Section 1031 exchanges, and problems of structuring and presenting Excel spreadsheets in the real estate, finance, and tax areas. He has spent extensive time writing and lecturing about techniques that lawyers use to undermine the planned economics of partnerships and LLCs. 2015 Terence Cuff IN PART 1 of this article, we discussed: Boot in a partnership exchange; Exchanges of LLC interests; Simple exchange by LLC; Simple deferred exchange by LLC; and Sale of partnership interest midway through exchange; Terminating sale of partnership interest midway through exchange. This Part will discuss: Redemption of a partner midway through an exchange; Allocation of gain from an exchange; and Combined exchange and installment sales. REDEMPTION OF PARTNER MIDWAY THROUGH AN EXCHANGE Example 8. Partnership is a partnership of Leonardo, Fernando, and Columbo. Each owns a 1/3 rd interest in a partnership. This is a diagram of the partnership. The Practical Tax Lawyer 23
24 The Practical Tax Lawyer Spring 2015 Partnership transfers relinquished property in a Section 1031 exchange. Leonardo sells her 1/3 rd partnership interests to Donatello. Partnership then redeems Columbo s 1/3 rd interest. Partnership completes exchange after the redemption. Is there a good exchange? The sale or exchange of a 50 percent or greater interest in a partnership causes the tax termination of the partnership under Section 706. We explored in discussing Example 7 the effects of the tax termination of a partnership on a pending exchange. Does the partnership terminate in Example 8? It should not. The critical point of focus is the term sale or exchange. The rules of Section 706 for terminating a partnership for tax purposes depend on a sale or exchange of a 50% or greater interest in partnership profits and capital. The sale of the partnership interest by Leonardo clearly is a sale or exchange. Is the redemption of Columbo s interest also a sale or exchange? Regulations under Section 706 clarify that the redemption of a partner is not a sale or exchange that can cause the tax termination of a partnership. 1 ALLOCATION OF GAIN FROM A PARTNERSHIP Example 9. Partnership has three equal partners. This is their balance sheet: 1 Treas. Reg. 1.706-1(c)(1) ( (1) General rule. Section 706(c) and this paragraph provide rules governing the closing of partnership years. The closing of a partnership taxable year or a termination of a partnership for Federal income tax purposes is not necessarily governed by the dissolution, liquidation, etc., of a partnership under State or local law. The taxable year of a partnership shall not close as the result of the death of a partner, the entry of a new partner, the liquidation of a partner s entire interest in the partnership (as defined in section 761(d)), or the sale or exchange of a partner s interest in the partnership, except in the case of a termination of a partnership and except as provided in subparagraph (2) of this paragraph. In the case of termination, the partnership taxable year closes for all partners as of the date of termination. See section 708(b) and paragraph (b) of section 1.708-1. ).
Partnership Exchange Tax Issues 25 Cash $200,000 $200,000 $0 Improvements $3,000,000 $5,000,000 $2,000,000 Land $1,300,000 $1,820,000 $520,000 Total $4,500,000 $7,020,000 $2,520,000 Nonrecourse Debt $6,000,000 $6,000,000 $0 Capital Columbo ($500,000) $340,000 $840,000 Total $4,500,000 $7,020,000 $2,520,000 Partnership undertakes an exchange of its real property. The partnership receives $340,000 in cash in exchange and has $200,000 in new cash from operations unrelated to the exchange. Partnership will distribute $340,000 in cash to Columbo in redemption. Partnership amends the partnership agreement to allocate exchange gain entirely to Columbo. This is the partnership balance sheet immediately before the gain allocations:
26 The Practical Tax Lawyer Spring 2015 Capital Columbo ($500,000) $340,000 $840,000 Unallocated Gain $340,000 $0 ($340,000) Unallocated Operating Income $260,000 $0 ($260,000) The partnership might allocate all of the taxable gain from the exchange to Columbo in accordance with the partnership agreement. This creates this balance sheet result: Capital Columbo ($160,000) $340,000 $500,000 Unallocated Gain $0 $0 $0 Unallocated Operating Income $260,000 $0 ($260,000)
Partnership Exchange Tax Issues 27 The remaining operating income presumably would be allocated 1/3 rd to each partner under the partnership agreement. This creates this balance sheet: Capital Leonardo ($413,333) $340,000 $753,333 Capital Fernando ($413,333) $340,000 $753,333 Capital Columbo ($73,333) $340,000 $413,333 Unallocated Gain $0 $0 $0 Unallocated Operating Income $0 $0 $0 Notably, the allocation to Columbo does not cause Columbo s capital account to come anywhere close to the amount that Columbo will receive in liquidation. Some advisors find this troubling. This allocation may fail to satisfy partners interests in the partnership. The Partnership could allocate all income from its final year to Columbo. This would result in this balance sheet: