Selling vs. liquidating a partnership interest.

Facts: The Beta Partnership is an accrual-basis partnership with three partners (Jackie, Kevin and Linda). Jackie is considering disposing of her partnership interest. If she were to dispose of her interest currently, she would recognize $5,000 of ordinary income based on the following balance sheet:

Beta Partnership Balance Sheet

                         Adjusted
                          Basis        FMV

Cash                     $12,000     $12,000
Inventory                 45,000      60,000
Fixed assets
 (net of depreciation)    42,000      48,000
Total                    $99,000    $120,000

                         Adjusted
                          Basis        FMV

Capital
 Jackie                  $33,000      40,000
 Kevin                    33,000      40,000
 Linda                    33,000      40,000
Total                    $99,000    $120,000

Jackie wants to know if there is a way she can reduce the amount of ordinary income she will recognize on the sale of her interest; Sec. 751 (a) provides that the deemed sale of unrealized receivables and inventory results in ordinary income recognition. Alternatively, she would like to know if there is a way to reduce the ordinary income she would recognize if her interest is liquidated by the partnership; in a liquidation, under Sec. 751 (b)(1), a deemed sale of unrealized receivables and substantially appreciated inventory results in ordinary income recognition. However, the definition of what constitutes "substantially appreciated inventory" does provide some planning opportunities to avoid the recognition of such ordinary income. Issue: Can Jackie reduce the amount of ordinary income recognized from the disposition of her partnership interest?

Analysis

Beta does not own any unrealized receivables. As part of the Tax Reform Act of 1997 (TRA '97), Congress amended Sec. 751 and deleted the previous requirement that inventory had to be substantially appreciated for it to be Sec. 751 property. This change was for sales or exchanges of partnership interests that take place after Aug. 5, 1997 and fall under the provisions of Sec. 751(a). Under this change, property merely has to satisfy the definition of inventory to be treated as Sec. 751 property. However, distributions under Sec. 751(b) still follow the rule that inventory must be substantially appreciated to be considered a "hot asset." Thus, if Jackie is contemplating a sale of her Beta interest, there is no way to avoid ordinary income treatment, as long as the partnership has appreciated inventory of any kind.

If Jackie liquidates her partnership interest (i.e., she receives a liquidating distribution), some planning options exist. Ordinary income will be triggered in a distribution only if there is a disproportionate distribution of unrealized receivables or substantially appreciated inventory. (In this case, there are no unrealized receivables.)

For inventory to be considered substantially appreciated, its fair market value (FMV) must exceed 120% of its adjusted basis in the hands of the partnership. If Jackie's interest is liquidated with a pro rata distribution of Sec. 751 property, she must receive her share of the inventory. Consider the following strategy to avoid having to receive any Sec. 751 property as part of Jackie's liquidating distribution.

The Beta Partnership inventory's FMV is equal to 133% of its basis to the partnership ($60,000/$45,000). If Beta were to sell 40% of its inventory on account (it is critical the sales be on account and not for cash), generating $24,000 of accounts receivable, Beta's balance sheet would be as follows:

Beta Partnership Balance Sheet (Post-sale)

                  Adjusted
                   Basis         FMV

Cash               $12,000     $12,000
Accounts
receivable          24,000      24,000
Inventory           27,000      36,000
Fixed assets
 (net of
 depreciation)      42,000      48,000
Total             $105,000    $120,000

                  Adjusted
                   Basis         FMV

Capital
Jackie             $35,000     $40,000
Kevin               35,000      40,000
Linda               35,000      40,000
Total             $105,000    $120,000

As a result of the inventory sate on account, Beta would recognize $6,000 of ordinary income. This income would be allocated to each partner's capital account, resulting in an increase of $2,000.

Under Sec. 751(d)(1) and (2), the accounts receivable mint be included in the definition of "inventory," as Beta is an accrual-bash taxpayer. If the inventory is tested for substantial appreciation after the sale, it will not pass the test:

FMV of accounts
receivable and
inventory/           $36,000 + $24,000/
Basis of accounts  = $27,000 + $24,000
receivable and
inventory            = 117.6%

After the sale, the FMV of the inventory is not in excess of 120% of its adjusted basis. Thus, the inventory is not substantially appreciated and Beta has no Sec. 751 property.

Warning: In December 1994, the Treasury issued final partnership anti-abuse regulations. Actions taken to avoid certain bright line tests (e.g., substantially appreciated inventory) may run afoul of these regulations. Care needs to be taken when actions such as those suggested are contemplated.

Conclusion

Sale. Beta owns inventory. Since the TRA '97, the inventory does not have to be substantially appreciated in a sale transaction for it to be considered Sec. 751 property. Thus, the proposed sale by Jackie offers no opportunity for her to avoid recognizing ordinary income.

Liquidation. If Jackie's partnership interest is liquidated After the proposed sale of a limited amount of inventory on account, Beta would have no Sec. 751 property, and Jackie can liquidate her interest without recognizing ordinary income. There is no need to determine if the distribution is pro rata, became the partnership has no Sec. 751 property. Thus, Jackie can liquidate her interest without recognizing the potential $5,000 of ordinary income under the collapsible partnership rules. The price for this is that each of the partners (including Jackie) must recognize $2,000 of ordinary income from the disposition of $24,000 of inventory. Also, Kevin and Linda assume the responsibility for the remaining $3,000 of ordinary income that Jackie would have had to recognize under the Sec. 751 rules. The ordinary income potential inherent in the inventory has not disappeared; it has been reallocated to the remaining partners. Therefore, if Beta sells $24,000 of its inventory on account and Jackie then liquidates her partnership interest, she recognizes her $2,000 share of the resulting income, but avoids reporting a $5,000 ordinary gain under the collapsible partnership rules. Kevin and Linda each have to recognize $2,000 of ordinary income from the sale of the inventory (which they would have done eventually); in addition, they each have to assume the burden of recognizing their share of the $3,000 of ordinary income Jackie avoided recognizing.

Thus, a partnership liquidation can achieve Jackie's objective, but at the price of Kevin and Linda recognizing $3,000 of ordinary income (which Jackie would be able to avoid).

Editor's note: This case study has been adated from "PPC Tax Planning Guide--Partnerships," 12th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood And Richard D. Thorsen, published by Practitioners Publishing Company, Forth Worth, Tex., 1998.

Albert B. Ellentuck, Esq.

Of Counsel King and Nordinger, L.L.P. Washington, DC3