Avoiding a deemed sale under sec. 751 when admitting a new partner.

Facts

The Gamma Consulting Co. is a cash-basis partnership with two partners, Steve and Stuart. The partnership is considering admitting a new partner, Mary, for a contribution of $9,000 and her assumption of an equal share of the partnership debt. The balance sheet on the date of Mary's admission to the partnership is illustrated in the chart at right.

Gamma Consulting Co. Balance Sheet

                                   Fair
                    Adjusted      market
                     basis        value
Cash               $ 3,000      $ 3,000
Accounts
 receivables            --       12,000
Fixed assets
 (net of
 depreciation)      21,000       21,000
                   $24,000      $36,000
Note payable       $18,000      $18,000
Capital:
 Steve               3,000        9,000
 Stuart              3,000        9,000
                   $24,000      $36,000

Steve and Stuart want to know if there will be any adverse tax effects if they admit Mary to the partnership.

Issue

What are the tax effects on Gamma, Steve and Stuart from Mary's proposed contribution?

Analysis

Sec. 721(a) provides that no gain or loss is recognized by a partnership or the contributing partner on a contribution of property to a partnership. However, several other Code sections can combine to cause gain to be recognized when the partnership has an interest in Sec. 751 assets.

Sec. 751(b)(1)(B) provides that if a partner receives cash in exchange for an interest in Sec. 751 property, a deemed sale occurs between the partnership and the partner. Although Steve and Stuart are not receiving any cash on Mary's admission to Gamma, they will be deemed to receive a cash distribution due to the reduction in their shares of partnership liabilities. To the extent that the deemed cash distribution is considered to be in exchange for Sec. 751 property, Steve and Stuart may have to recognize gain or loss.

The cash-basis receivables of Gamma clearly satisfy the definition of Sec. 751 property. As a result of the proposed admission of Mary, Steve and Stuart receive a deemed cash distribution of $3,000 each (the reduction in their share of partnership debt from $9,000 to $6,000). They also will reduce their interests in the zero-basis receivables by $2,000 (reduction from $6,000 to $4,000). As a result, Steve and Stuart are deemed to have received $3,000 each of cash, $2,000 of which is treated as being exchanged for $2,000 of zero-basis receivables. The remaining $1,000 is treated under the general rule of Sec. 731.

As proposed, the admission of Mary would result in Steve and Stuart recognizing $2,000 each of ordinary income from a deemed sale of zero-basis receivables.

The tax adviser should advise Steve and Stuart to amend the partnership agreement to provide that all gain on the zero-basis receivables as of the date of Mary's admission be allocated to Steve and Stuart. In this manner their interests in the zero-basis receivables are not reduced as a result of Mary's admission as a partner.

Conclusion

As proposed, the admission of Mary results in ordinary gain to the existing partners. The tax adviser can suggest that the partnership aggreement be amended to provide that the gain on the zero-basis receivables be allocated to Steve and Stuart. In this manner, their share of Sec. 751 property is not reduced as a result of Mary's admission as a partner and no gain is recognized until the receivables are subsequently collected.