Applying the rules governing distributions of marketable securities.
Before 1994, Chuck's proposal would have been quite beneficial from his standpoint. He would have recognized no gain on the liquidation of his interest in Royal Monarch, because he would have received no money. He would have received the stock with a $5,000 basis (his basis in his partnership interest). Moreover, the stock would have been nearly as liquid as cash, and would have allowed Chuck to determine when he would recognize the gain from the liquidation of his partnership interest.
This is no longer the case, however. Sec. 731(c), added in late 1994, changed the taxation of distributions of marketable securities. Under this provision, to determine (1) whether gain or loss is recognized on a distribution to a partner and (2) the recognition of precontribution gain for distributions to contributing partners, distributions of marketable securities ordinarily will be treated as distributions of money in an amount equal to the fair market value (FMV) of the securities on the distribution date. As a consequence, in general, the distributee will recognize gain to the extent the securities' FMV exceeds the distributee's basis in his partnership interest. Under this general rule, Chuck would recognize $25,000 of gain on this liquidating distribution, the amount by which the "money" distributed--$30,000 (the FMV of the marketable securities)--exceeds his basis in his Royal Monarch interest. Because the stock was not an "unrealized receivable" or an "inventory item," the gain would apparently be capital gain.
The general rule of Sec. 731(c) is subject to a number of exceptions. Under certain circumstances, the rule may not apply if the distributed security had been contributed to the partnership by the distributee partner or if the security was not a "marketable security" when acquired by the partnership. Also, the distribution is exempt if the partnership is an "investment partnership" and the distributee partner is an "eligible partner" (Sec. 731(c)(3)). For this purpose, an "investment partnership" is a partnership that has never been engaged in a trade or business (other than investing, dealing or trading in investment assets) and the assets of which have always consisted of some combination of permitted investment assets (such as stock, financial instruments and the like). An "eligible partner" is a partner who did not contribute any assets to such a partnership other than those described in the definition of investment partnership (so long as such partner was not a transferor or transferee in a nonrecognition transaction involving the transfer of any portion of a partnership interest for which the transferor was not an eligible partner). For securities acquired in a nonrecognition transaction, if the value of money and marketable securities distributed in a nonrecognition transaction is less than 20% of the total value of all property transferred and the partnership distributed the security within five years of either the date of acquiring the security or (if later) the date the security became marketable, none of the distributed security will be treated as money under Sec. 731(c).
In this case, however, when Royal Monarch purchased the stock, IBN-TELco was publicly traded. Moreover, because it had invested in real estate as well as in limited partnerships conducting other business ventures, it did not qualify for the "investment partnership" exception. As a consequence, the exceptions listed above would not be available to Chuck and Royal Monarch.
Sec. 731(c) also contains a "gain limitation," under which a distributee does not recognize gain attributable to his share of the partnership's net appreciation for securities of the same class and issuer as those distributed. Sec. 731(c)(3) reduces the amount of securities treated as money by the excess of (1) the partner's distributive share of any net gain that would result from the sale of all securities of same class and issuer held by the partnership immediately prior to the distribution for their FMV at the time of the distribution over (2) the partner's distributive share of any net gain that would result from the sale of all such securities held by the partnership immediately after the distribution for the same FMV. According to Regs. Sec. 1.731-2(b)(1), all marketable securities held by a partnership are treated as marketable securities of the same class and issuer as the distributed security.
The limitation applies here. If Royal Monarch sold all of its IBN-TELco stock, it would recognize $27,000 of gain (the amount by which the $30,000 FMV exceeds its $3,000 basis). Of this, one third--$9,000--would be allocated to Chuck. Royal Monarch would hold no such stock after the distribution. Under the gain limitation rule, therefore, the amount of securities treated as money would be reduced by this $9,000 to $21,000, reducing Chuck's gain on the distribution from $25,000 to $16,000.
If this distribution were made, Chuck would acquire a $21,000 basis in the distributed IBN-TELco stock, which is the sum of the $5,000 basis he would have acquired under the general rules for determining the basis of distributed properties in a liquidating distribution plus the $16,000 gain recognized because the securities were marketable.
Because of this "marketable securities equals money" rule, if Chuck wants to avoid gain recognition on the distribution, his tax adviser should suggest the parties consider distributing another mix of assets. This mix should include other investment assets that will be treated as property. This could include marketable securities not marketable when acquired by Royal Monarch or perhaps stock purchased through a private placement, but which might go public in the near future.
If Chuck wishes to avoid recognizing gain on the liquidation of his partnership interest in Royal Monarch Company, the tax adviser should counsel against distributing all 300 shares of the partnership's IBN-TELco stock to Chuck.
Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 13th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1999.
Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA
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|Title Annotation:||case study; partnership distributions|
|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2000|
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