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Computing capital gains on sales of partnership and S corp. interests.

Regs. Sec. 1.1(h)-1, (1) effective Sept. 21, 2000, addressed the application of look-through capital gains to sales of interests in, partnerships, S corporations and trusts. These regulations will have a major effect on how practitioners approach characterizing gain or loss on the sale of partnership or S corporation interests. All examples and conclusions in this article are consistent with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA); the EGTRRA does not change the capital gain tax rates or otherwise affect this article's planning suggestions and analyses.

Historically, practitioners have viewed partnership interests and S stock as capital assets and generally have treated their sale as resulting in long- or short-term capital gain or loss. For partnerships, Sec. 751(a) has long recharacterized some of the long-term capital gain to ordinary income. While practitioners may have been aware of the potential existence of Sec. 751 "hot assets" when an interest was sold or exchanged, as a practical matter, they often were unable to acquire sufficient information to compute the gain that should have been Sec. 751 ordinary income.

The new regulations were written pursuant to Congressional mandate (2); thus, they are legislative regulations with the force of law. Tax professionals who had bypassed the complexities surrounding sales or exchanges of partnership interests. (treating the transactions as resulting in capital gains or losses) now have clear and unavoidable guidance from the regulations and their examples. Moreover, under the regulations, S corporations and their owners will have to cope with the intricacies of the lookthrough recognition provisions for the first time. As an additional incentive to pursue an in-depth understanding of these rules, the increased popularity of limited liability companies (LLCs) as substitutes for incorporated entities has increased the importance of the partnership taxation rules. Unfavorable outcomes under these regulations are potentially the greatest for such entities.

This article analyzes the new regulations, along with associated compliance challenges and planning opportunities. It begins with a brief overview of current capital gain rules before examining the regulations' application to capital gain recognition of sales of partnership and S corporation interests, and offers caveats and planning ideas.

Overview

Prior to the Taxpayer Relief Act of 1997 (TRA '97), net capital gain, defined in Sec. 1222(11) as the excess of net long-term capital gain over net short-term capital loss, was taxed at the individual's marginal rate, up to a maximum 28% (see Exhibit 1 at right). The pre-TRA '97 capital gain rules provide a foundation for understanding the post-TRA '97 rules (and their interpretations) as they apply to sales or exchanges of passthrough ownership interests under the new final regulations.

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After the TRA '97, as amended by the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98), the general netting process outlined in Exhibit 1 is maintained. However, in general under Sec. 1(h), for noncorporate taxpayers (individuals, estates and trusts), a maximum 20% rate applies to adjusted net capital gain. A 10% rate applies to adjusted net capital gain otherwise taxed at a 15% rate. "Adjusted net capital gain" is net capital gain (as defined under pre-TRA '97 law) minus gain attributable to the sale or exchange of (1) collectibles and (2) Sec. 1202 small business stock, to the extent the gain is included in income. A maximum 28% rate applies to gain attributable to collectibles and small business stock. A maximum 25% rate applies to unrecaptured depreciation from Sec. 1250 real estate held for more than one year.

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Beginning in 2001, eight percent and 18% rates, apply to gain from certain property held more than five years. (3) Exhibit 2 on p. 30 illustrates these rules and clarifies that the 20% and ten-percent rates (and, beginning in 2001, the 18% and eight-percent rates) apply only to adjusted net capital gain.

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Twenty-five Percent Gain

Under Sec. 1(h)(1)(D), a 25% rate applies to unrecaptured Sec. 1250 gain on property held more than one year. "Unrecaptured Sec. 1250 gain" is defined by Sec. 1(h)(7)(A) as the amount of gain (beyond that treated as ordinary income) that would be treated as ordinary income if depreciation on Sec. 1250 property were subject to 100% recapture. For purposes of the general capital-gain recognition rules, a ceiling limits unrecaptured Sec. 1250 gain to the sum of the ordinary income recognized and the total depreciation taken. The excess gain over this amount is Sec. 1231 gain, which, subject to the lookback rules, is taxed at a maximum 20% rate. The lookback rules apply before the Sec. 1231 gain can enter into the long-term capital gain netting process. The taxpayer must look back over a five-year period and recharacterize Sec. 1231 gain as ordinary income to the extent of any net Sec. 1231 losses reported during the five-year lookback period.

Twenty-eight Percent Gain

According to Sec. l(h)(5), a 28% rate applies to (1) capital gains and losses from the sale or exchange of collectibles held for more than one year and (2) Sec. 1202 gain (50% includible) on the sale of stock of certain small business corporations. Collectibles are defined in Regs. Sec. 1.1(h)-1(b)(2) by referring to Sec. 408(m) (without the exception provided in Sec. 408(m)(3) for certain gold, silver and platinum coins). The definition includes items typically thought of as collectibles (e.g., art, stamps, coins, wine and antiques).

Treatment of Capital Losses

Any excess of losses over gains from computing 28% gain may first be used to reduce unrecaptured Sec. 1250 gain and then to offset 20% gain. The excess of short-term losses over short-term gains are used first to reduce 28% gain, then 25% gain, and finally, 20% long-term gain. These netting rules generally operate to provide the most taxpayer-favorable outcome. (See Examples 1 and 2 on p. 30.)
Example 1: H sells the following capital assets in 2002:

 Holding Adjusted Fair market
Asset period basis (AB) value (FMV)

Collectibles * 3 years 1,000 3,000
Sec. 1250 property
 (original cost,
 $80,000) ** 8 years 50,000 100,000
Other property *** 9 months 20,000 40,000
Totals $71,000 $143,000

 Capital
Asset Gain gain rate

Collectibles * 2,000 28%
Sec. 1250 property
 (original cost, 30,000 25%
 $80,000) ** 20,000 20%
Other property *** 20,000 None
Totals $72,000

* Collectibles gain of $2,000 is long-term and taxed at a
maximum 28% rate.

** The difference between the $50,000 AB and the $80,000 cost of the
Sec. 1250 property represents unrecaptured depreciation, taxed at a
maximum 25% rate. The property appreciated in value from its $80,000
original cost to $100,000, for a 20% Sec. 1231 gain of $20,000
(subject to the Sec. 1231 lookback rules).

*** Other property is short-term and gets no reduced capital gain
rate; it will be taxed at H's regular marginal tax rate.


Lookthrough Capital Gains

Sales/Exchanges of Long-term Interests

Regs. Sec. 1.1(h)-1 applies to the sale or exchange of partnership interests, S stock and trust interests held for more than one year. The sale or exchange of any portion of an interest deemed to have a short-term holding period is not subject to the lookthrough provisions. However, sales of interests held short-term can still result in income recharacterization. Nonetheless, under these rules, even a partner with no gain or loss on the sale or exchange of a partnership interest may recognize ordinary income and capital or ordinary loss and capital gain on the transfer. (4)

Definition

Generally, capital gain attributable to the sale or exchange of an interest in a passthrough entity held for more than one year is long-term (20%) capital gain. Under Regs. Sec. 1.1(h)-1(a), when a partnership interest is sold or exchanged, the selling partner's recognized gain or loss may consist of four components:

1. Sec. 751(a) ordinary income.

2. Collectibles gain (28%), but not loss.

3. Unrecaptured Sec. 1250 gain (25%).

4. Residual long-term capital gain (20%) or loss.

On the sale or exchange of an S interest, the selling shareholder may recognize gain or loss characterized as:

1. Ordinary income under Secs. 304, 306, 341 and 1254.

2. Collectibles gain (28%), but not loss.

3. Residual long-term capital gain (20%) or loss. (See Exhibit 3 below.)

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Regs. Sec. 1.1(h)-1(b) defines a partner's lookthrough capital gain on the sale of a partnership interest as the sum of his collectibles gain and unrecaptured Sec. 1250 gain. Under Regs. Sec. 1.1(h)-1(c), a partner's residual long-term capital gain or loss is the long-term capital gain or loss that he would recognize under Sec. 741 (pre-lookthrough long-term capital gain or loss), minus his lookthrough capital gain.

An S shareholder's lookthrough capital gain is only his proportionate share of collectibles gain. Pre-lookthrough gain is the long-term capital gain that the shareholder would recognize on the sale of his S stock. The residual long-term gain or loss is the pre-lookthrough gain minus the selling shareholder's lookthrough capital gain. (5)

Sec. 751 Ordinary-income Recognition

Ordinarily, the sale or exchange of a passthrough interest results in capital gain or loss; an exception exists for sales or exchanges of partnership interests. Under the Sec. 751(a) hot asset rule, an amount received in exchange for a partnership interest generally will be ordinary income, to the extent attributable to unrealized receivables and inventory. Sec. 1250 property is treated as an unrealized receivable for Sec. 751 purposes to the extent of the amount that would be recaptured as Sec. 1250(a) ordinary income. Hot assets are deemed sold for their FMV; ordinary income realized from a deemed sale is allocated to the selling partner in proportion to the interest sold.

Collectibles

Regs. Sec. 1.1(h)-1(b)(2)(ii) provides that, when a taxpayer sells or exchanges an interest in a passthrough entity that holds collectibles, rules similar to Sec. 751(a) apply to determine the capital gain attributable to certain unrealized collectibles gain. On a sale of a passthrough interest, the regulations look to the collectibles gain that would be allocated to the taxpayer had the partnership or S corporation sold all of its collectibles at FMV in a fully taxable transaction immediately before the sale or exchange of the interest. The entity's holding period in the collectibles is irrelevant in determining the short- or long-term character of the collectibles gain reported under the lookthrough rules; rather, the selling partner's or shareholder's holding period in the interest sold or exchanged controls characterization.

Unrecaptured Sec. 1250 Gain

When a partnership interest is sold, the selling partner must take into account the entire allocable share of Sec. 1250 capital gain in determining the unrecaptured Se& 1250 gain, as if the partnership had sold its Sec. 1250 property for the selling partner's net Sec. 1231 gain. (As defined in Sec. 1231(c)(3), the transferor partner's allocable share of Sec. 1250 capital gain in partnership property is not Sec. 1231 gain, regardless of whether the partnership property is used in a trade or business (as defined in Sec. 1231(b).) Thus, in contrast to the outcome in Example 1 above, any gain above the ordinary income (recapture) component of Sec. 1250 property will be taxed to a selling partner as unrecaptured Sec. 1250 gain, subject to a maximum 25% rate. Property that, if actually sold by a partnership, would qualify for Sec. 1231 treatment (after considering the Sec. 1231 lookback rules), will be taxed at a higher rate to partners selling their partnership interests.

Illustrations

All entities are treated equally under the regulations, as long as they have no inventory or unrealized receivables, no unrecaptured Sec. 1250 gain and no appreciated collectibles. Thus, the tax result in Example 3 below would be the same for any passthrough entity interest sold or exchanged.

Example 3: Several years ago, R contributed $10,000 for a limited partnership interest in RK Partnership. He made no subsequent contributions to capital; thus, his holding period for his interest is 100% long-term.

After being allocated his share of income and deductions for 2002, R sells his interest for $10,000. R's adjusted basis in his partnership interest at the end of 2002 is $20,000, which includes his $15,000 share of RK liabilities. RK has no unrealized receivables or inventory items.

R's amount realized from the sale is $25,000 ($10,000 + $15,000 liability relief). He will report $5,000 ($25,000 realized - $20,000 basis) as a long-term capital gain taxed at a maximum 20% rate on Schedule D.

While collectibles may be relatively rare in the business setting, virtually all businesses are likely to have some inventory or unrealized receivables; many will own property that, if sold, would generate unrecaptured Sec. 1250 gain. The tax outcomes from sales of ownership interests differ among passthrough entities under the new regulations. A partner's lookthrough capital gain is the sum of his collectibles gain and Sec. 1250 capital gain; an S shareholder's or trust beneficiary's lookthrough capital gain is only his share of collectibles gain.

Example 4: J, a 40% partner in BJ partnership, sells her partnership interest to D for $20,000. J's basis at the time of the sale is $10,000, which includes her $2,000 share of BJ liabilities. The partnership has a $1,000 basis and $9,000 FMV in collectibles. In addition, it determines that it has $15,000 of unrecaptured Sec. 1250 gain on modified accelerated cost recovery system (MACRS) real estate used in its business. BJ has $3,000 of unrealized receivables. J has held her partnership interest more than one year and has made no capital contributions for more than a year.

Following the procedure in Exhibit 3, J first calculates the realized gain on the sale. Her amount realized is $22,000 (the cash received plus the liabilities of which J is relieved). Subtracting J's $10,000 basis in her partnership interest, she realized $12,000 gain on the sale. J has a 100% long-term holding period in her partnership interest; thus, none of the gain is short-term.

J's share of the unrealized receivables is $1,200; she will report $1,200 of ordinary income. The difference between the realized long-term capital gain in step 2 and the Sec. 751 ordinary income in step 3 is $10,800 ($12,000 - $1,200), the pre-lookthrough long-term gain.

J must report her share of the collectibles gain that would be recognized if the partnership sold the assets for FMV. She will report $3,200 (40% x $8,000) on Schedule D as 28% gain.

J must report her share of the unrecaptured Sec. 1250 gain that would be recognized if the partnership sold the assets for FMV. She will report $6,000 (40% x $15,000) on Schedule D as 25% gain.

J's pre-lookthrough gain eligible for long-term capital gain is $10,800; this is reduced by collectibles gain ($3,200) and unrecaptured Sec. 1250 gain ($6,000). Thus, J will report $1,600 of residual long-term capital gain on Schedule D, taxed at a maximum 20% rate.

Example 5: The facts are the same as in Example 4, except that J is a 40% shareholder in BJ Corp., an S corporation. Sec. 751 applies only to partnerships. In addition, S corporations are not subject to lookthrough reporting of unrecaptured Sec. 1250 gain. J characterizes her gain as follows:

1. She does not include in her basis her share of liabilities, so her stock basis is $8,000. She is not relieved of any liabilities on the sale, so her amount realized is the cash received, $20,000. Her gain realized is $12,000, and is 100% long-term.

2 Sec. 751 ordinary-income recharacterization does not apply. The pre-lookthrough gain equals the realized gain, $12,000.

3. J must report her share of the collectibles gain that would be recognized had BJ sold the assets for FMV; thus, she will report $3,200 (40% x $8,000) on Schedule D as 28% gain.

4. The unrecaptured Sec. 1250 gain lookthrough rule does not apply.

J's pre-lookthrough gain eligible for long-term capital gain was $12,000. This is reduced by the collectibles gain ($3,200); thus, J will report $8,800 of residual long-term capital gain on Schedule D, taxed at a maximum 20% rate.

The transactions described in the regulations have tangibly different results for partnerships and S corporations. J, the partner in Example 4 above, will report $1,200 of ordinary income, $3,200 of 28% gain, $6,000 of 25% gain and $1,600 of long-term (20%) capital gain. J, the S shareholder in Example 5 above, will report $3,200 of 28% gain and $8,800 of long-term (20%) capital gain. Assuming a 31% rate on ordinary income, J the S shareholder retains $9,344 of after-tax gain on the sale of her S stock; as a partner, she retains an after-tax return of only $8,912.

However, although the S corporation transaction is more advantageous for the selling shareholder, D (the stock's new owner) has paid FMV for J's shares, which presumably reflect the proportionate share of the corporate assets' FMVs. J has paid tax on her share of the inherent gain in the collectibles. Because there is no S corporation equivalent to a Sec. 754 election, D will pay tax on that appreciation again should the S corporation sell the assets. Thus, the regulations add a "stealth" double tax to the S regime. D would likely discount her offering price for the S shares compared to the price she would offer for her partnership interest if the partnership had a Sec. 754 election in place, passing at least a portion of the double-tax liability back to J in the form of a lower return on the sale of her interest.

For partnership interest sales, the procedural rules outlined in Exhibit 3 maximize the ordinary income that a partner will report on the sale of a partnership interest.

In Example 6 on p. 34, M's amount realized from the sale of his partnership interest includes the cash received plus the liabilities of which he is relieved. His $20,000 amount realized, less his $15,000 basis, yields a $5,000 realized gain. M has a 100% long-term holding period; however, the gain realized on the sale of his partnership interest is not long-term capital gain. Moreover, M's $5,000 economic gain is the maximum gain that should currently be

subject to tax. However, because he has a short-term capital loss from other investments up to the $3,000 capital loss limit, he will recognize $2,000 more taxable income on the sale of his partnership interest than he realized in economic income.
Example 6: * M owns a one-third interest in KLM Partnership,
a cash-basis partnership. In 2002, he sells his partnership
interest for $10,000; his basis was $15,000, including a
$10,000 share of partnership liabilities. M held his KLM
interest for two years and made no capital contributions
since acquiring the interest. In addition to selling his
partnership interest in 2002, M has $50,000 of ordinary income
from other sources and a $3,000 short-term capital loss.

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $3,000 $ 3,000
Collectibles 1,000 4,000
Intangibles (goodwill) 0 32,000
Unrealized receivables 0 21,000
Totals $4,000 $60,000

Capital-gain netting process

Short-term:
Short-term gain $ 0
Short-term loss (3,000)
Net short-term loss $(3,000) **

Long-term:
Collectibles gain $ 1,000
Residual capital loss (3,000)
Net long-term loss $(2,000) **

 M's tax consequences

Total gain realized $5,000
Sec. 751 ordinary income 7,000
Pre-lookthrough capital loss (2,000)
Collectibles gain (28%) 1,000
Residual long-term capital loss (3,000)
Maximum economic income $5,000
 that should be recognized

M's Form 1040 summary

Items unrelated to sale of partnership interest:
Ordinary income from other sources $50,000
Short-term capital loss (3,000)

Items related to sale of partnership interest:
Sec. 751 ordinary income 7,000
Collectibles gain (offset) 0
Residual long-term capital loss (limited) 0
Ordinary income currently taxed from
 M's sale of his partnership interest $ 7,000

* Adapted from Regs. Sec. 1.1.(h)-1(f),
Example 1.

** Net short-term loss is taken first; net long-term loss
is limited and carried forward.


Under the regulations, M first recognizes his one-third share of ordinary income from the deemed sale of unrealized receivables under Sec. 751. The pre-lookthrough gain or loss equals his $5,000 realized gain, reduced by $7,000 of Sec. 751 ordinary income. Thus, he has a $2,000 pre-lookthrough capital loss, further reduced by his $1,000 share of collectibles gain, resulting in a $3,000 residual long-term capital loss. Both the $1,000 collectibles gain and the $3,000 residual long-term capital loss flow to Schedule D, along with the $3,000 short-term capital loss from M's other investments. The capital-loss-limit ordering rules call for the short-term loss to be recognized first. The collectibles gain is netted against the $3,000 residual long-term capital loss; the remaining $2,000 long-term loss is carried forward. Thus, in Example 6, neither the collectibles gain nor the residual long-term capital loss has a current-year marginal effect on M's taxable income.

M will report on his return items unrelated to the sale of his partnership interest, consisting of $50,000 of ordinary income and $3,000 of short-term capital loss. M will currently report $7,000 of ordinary income from the sale of his partnership interest, even though he realized only $5,000 of gain on the transaction. The remaining $2,000 residual long-term capital loss carried forward due to the capital loss limit may be deducted against ordinary income up to a $3,000 limit in a future year. This example points out the importance of planning for the sale of a partnership interest under the new regulations.

If M is specially allocated the collectibles (see Example 7 below), (6) the rules still operate to produce the maximum amount of ordinary income to M--the entire $7,000 gain is characterized as ordinary. If M has additional ordinary or short-term capital-gain income and a current-year net short-term capital loss of at least $3,000 (as in Example 6), the residual $3,000 long-term capital loss would have to be carried forward for future use. M's economic income is $7,000, but he would be taxed currently on $10,000 of taxable income from the sale of his partnership interest--$7,000 of ordinary income plus $3,000 of collectibles gain taxed at 28%.
Example 7: The facts are the same as in Example 6, except that
M has no other income or loss items. In addition, the KLM
Partnership agreement calls for a special allocation to M of
100% of the collectibles gain. M sells his partnership interest
for $12,000, resulting in a $7,000 realized gain.

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $3,000 $ 3,000
Collectibles 1,000 4,000
Intangibles (goodwill) 0 32,000
Unrealized receivables 0 21,000
Totals $4,000 $60,000

 M's tax consequences

Total gain realized $7,000
Sec. 751 ordinary income 7,000
Pre-lookthrough capital loss (0)
Collectibles (special allocation) 3,000
Residual long-term capital loss (3,000)
Total ordinary income recognized * $7,000

* Assumes these are M's only income and loss items.


What if the partnership's deemed sale of collectibles results in a loss, rather than a gain? (See Example 8 below.)
Example 8: The facts are the same as in Example 6; except that
M has no other income or loss items and KLM Partnership has a
$3,000 unrealized collectibles loss.

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $3,000 $ 3,000
Collectibles 4,000 1,000
Intangibles (goodwill) 0 32,000
Unrealized receivables 0 21,000
Totals $7,000 $57,000

 M's tax consequences

Total gain realized $5,000
Sec. 751 ordinary income 7,000
Pre-lookthrough capital loss (2,000)
Collectibles loss (ignored) (0)
Residual long-term capital loss (2,000)
Total ordinary income recognized * $5,000

* Assumes these are M's only income and loss items.


M still reports the maximum ordinary income on the sale of his partnership interest. The net collectibles loss is not recognized, because none of the gain from the sale of the partnership interest is attributable to unrealized appreciation in the value of partnership collectibles. Unrealized losses are ignored by the lookthrough provisions. Assuming the items in Example 8 are M's only income and loss items, the long-term capital loss computed under the lookthrough procedure offsets the ordinary income from Sec. 751 hot assets, so that the net result is $5,000 ordinary income. If the residual long-term capital loss were limited and carried forward due to the presence of other income and loss items on the return, M could again recognize up to $7,000 of taxable ordinary income on the partnership interest sale, producing only $5,000 of economic gain.

What if KLM owns Sec. 1250 property depreciated under the MACKS straight-line method? (See Example 9 at right.)
Example 9: M owns a one-third interest in KLM Partnership,
a cash-basis partnership. In 2002, he sells his partnership
interest for $60,000; his basis was $55,000, including a
$10,000 share of partnership liabilities. M held his
partnership interest for two years and made no capital
contributions since acquiring it.

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $ 3,000 $ 3,000
Collectibles 1,000 4,000
Other capital assets 8,000 5,000
Sec. 1250 property * 150,000 177,000
Unrealized receivables 0 21,000
Totals $162,000 $210,000

 M's tax consequences

Total gain realized $15,000
Sec. 751 ordinary income 7,000
Pre-lookthrough capital gain 8,000
Collectibles gain (28%) 1,000
Unrecaptured Sec. 1250 gain 9,000
Residual long-term capital loss (2,000)

Total ordinary income recognized ** $7,000

* MACRS straight-line property on which at least
$9,000 of depreciation has been taken.

** Assumes these are M's only income and loss items.


M has an amount realized of $70,000 (including his relief of liabilities) and a $55,000 basis, giving him a $15,000 realized gain on the sale of his partnership interest. His holding period is 100% long-term. He will report $7,000 of ordinary income from Sec. 751 hot assets, reducing his pre-lookthrough long-term gain to $8,000. His share of the collectibles ($1,000) and unrecaptured Sec. 1250 gain ($9,000) combine to create a $2,000 residual long-term capital loss. Assuming these are M'S only income and loss items, M will report $7,000 of ordinary income on Schedule E. The $2,000 residual capital loss may be used first to offset the 28% gain, reducing it to zero, and then to reduce the 25% gain to $8,000. M will report $7,000 of ordinary income and $8,000 of 25% gain on the sale of his partnership interest.

Short-term Partnership Interests

Although the sale or exchange of any portion of an interest deemed to have a short-term holding period is not subject to the lookthrough provisions, sales of short-term interests can still result in income recharacterization. Under Regs. Sec. 1.751-1(a)(2) (effective Dec. 15, 1999), a hypothetical sale of partnership assets is used to determine the ordinary income realized under Sec. 751 by a partner selling or exchanging a partnership interest. To determine the amount of Sec. 751 ordinary income, the partnership is deemed to sell all of its property for FMV (taking into account Sec. 7701 (g)) in a fully taxable transaction for cash immediately prior to the partner's transfer of his partnership interest. The selling partner realizes ordinary income or loss equal to the income or loss from Sec. 751 property (including any remedial allocations under Reg. 1.704-3(d)) allocable to the partner under the hypothetical sale. The selling partner's capital gain or loss is the total gain or loss realized on the sale of the transferred interest, less the partner's ordinary income or loss, determined as calculated above. (See Example 10 below.)
Example 10: The facts are the same as in Example 9, except that
M's holding period at the time of the sale of his partnership
interest is 100% short-term. The lookthrough provisions do not
apply; gain recharacterization on the sale of M's partnership
interest is governed by Regs. Sec. 1.751-1(a)(3).

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $ 3,000 $ 3,000
Collectibles 1,000 4,000
Other capital assets 8,000 5,000
Sec. 1250 property * 150,000 177,000
Unrealized receivables 0 21,000
Totals $162,000 $210,000

 M's tax consequences

Total gain realized $15,000
Sec. 751 ordinary income 7,000
Short-term capital gain 8,000
Total ordinary income recognized ** $15,000

* MACRS straight-line property on which at least
$9,000 of depreciation has been taken.

** Assumes these are M's only income and loss items.


To determine the Sec. 751 ordinary income in Example 10, Regs. Sec. 1.1(h)-1(f), Example 5, provides for a hypothetical transaction under which the partnership is deemed to make a fully taxable cash sale at FMV of all of the partnership's assets immediately after the transfer of the partnership interest. In Example 10, the deemed sale would produce $21,000 of ordinary income, one-third of which would be allocated to M. The remainder of M's $15,000 gain would be short-term capital gain. The lookthrough provisions do not apply to the sale or exchange of short-term partnership interests, thus preventing the conversion of M's short-term capital gain into long-term capital gain.

Regs. Sec. 1.1223-3 provides rules on allocating a divided holding period for a partnership interest; these rules generally provide that a holding period will be divided if a partner acquires portions of an interest at different times or acquires an interest in a single transaction giving rise to different holding periods under Sec. 1223. The question arises as to how the above rules will apply if a portion of the partnership interest being sold has a short-term holding period to the partner. (See Example 11 below.)
Example 11: The facts are the same as in Example 9, except
that nine months ago, M contributed cash to KLM Partnership
equal to the value of his partnership interest at that time.
Thus, M's holding period at the time of the sale of his KLM
interest is divided into 50% short-term and 50% long-term.

 Balance sheet on date of sale
 of M's interest

Assets AB FMV

Cash $ 3,000 $ 3,000
Collectibles 1,000 4,000
Other capital assets 8,000 5,000
Sec. 1250 property * 150,000 177,000
Unrealized receivables 0 21,000
Totals $162,000 $210,000

Capital-gain netting process

Short-term:
Short-term gain $4,000
Short-term loss (0)

Net short-term gain $4,000

Long-term:
Collectibles gain 500
Unrecaptured Sec. 1250 gain 4,500
Residual capital loss (1,000) ****

Net long-term gain $4,000

 M's tax consequences

 Short-term Long-term
Characterization interest interest

Sec. 751 ordinary income $3,500 $3,500
Short-term/pre-lookthrough capital gain $4,000 $4,000
Collectibles gain (28%) 500 **
Unrecaptured Sec. 1250 gain 4,500 **
Residual long-term capital loss (1,000)
Total ordinary income recognized *** $7,500 $3,500

M's Form 1040 summary

Items related to sale of partnership interest:

Ordinary income:

Sec. 751 ordinary income (short-term interest) $ 3,500
Sec. 751 ordinary income (long-term interest) 3,500
Net short-term capital gain 4,000
 Total ordinary income $11,000

Net capital gain:

Net long-term gain (25%) $4,000
 Total net capital gain $ 4,000
Total income recognized $15,000

* MACRS straight-line property on which at least $9,000 of
depreciation has been taken.

** Limited to the portion allocable to the percent of the
interest held long-term.

*** Assumes these are M's only income and loss items.

**** The loss is netted first against 28% gain, then against 25% gain.


Regs. Sec. 1.1223-3 calls for M's ownership interest to be divided into 50% long-term and 50% short-term holding periods. This begins by allocating 50% of M's $15,000 gain ($7,500) to the short-term portion and 50% ($7,500) to the long-term portion. The lookback provisions apply only to the long-term portion. The short-term portion is governed by Kegs. Sec. 1.751-1(a)(3), as illustrated in Example 10 above. As to the short-term portion, the allocable Sec. 751 income (50%) resulting from the partnership asset deemed sale is $3,500. The remainder of the $7,500 gain allocated to the short-term portion ($4,000) is short-term capital gain. The Sec. 751 ordinary income allocated to the long-term portion is $3,500, leaving a $4,000 pre-lookthrough capital gain. Under the Sec. 1(h) regulations, the lookthrough gain cannot exceed the percentage of the interest that is long-term. Fifty percent of the collectibles gain ($500) and the unrecaptured Sec. 1250 gain ($4,500) are allocated to the long-term portion; the $1,000 residual long-term capital loss is applied first against the 28% (collectibles) gain and then against the 25% (unrecaptured Sec. 1250) gain. Assuming M has no other income or loss items, he will report a total of $11,000 of ordinary income, $7,000 of Sec. 751 ordinary income, $4,000 of short-term capital gain and $4,000 of capital gain taxed at 25%. The ordinary component of the gain is again maximized.

Planning Opportunities

S Corporations

S corporations can avoid lookthrough collectibles gain by avoiding corporate ownership of collectibles. In addition, the Regs. Sec. 1.1223-3 holding-period rules apply only to partnerships. Each separate stock purchase by an S shareholder takes on a new holding period. (However, capital contributions without additional ownership do not result in a new holding period for S shareholders.)

Sales of Passthrough Interests in Redemptions

Practitioners should ensure that a liquidation or redemption of a partnership interest is not recast as a sale and purchase. Taxpayers have three reasons to prefer redemptions over sales to third parties. First, recent changes in the tax law make distributions under Sec. 751(b) (as to the distribution of money or property in exchange for a partner's interest) more attractive than the treatment of a sale or exchange of the interest under Sec. 751 (a). Second, a redeeming partnership may still elect under Sec. 754 to adjust the basis of its undistributed assets; the remaining partners may benefit from such an election. Third, redemption may result in less ordinary-income recognition than a sale or exchange under the Sec. 1(h) regulations.

Prior to the TRA '97, Sec. 751(a) required a partner to recognize as ordinary income received in a sale or exchange of a partnership interest attributable to unrealized receivables or substantially appreciated inventory. The TRA '97 eliminated the "substantially appreciated" exception. (7) This requirement was designed as a de minimis exception, so that Sec. 751's complexities could be avoided if inventory appreciation was small. Now, property merely has to satisfy the definition of inventory to be treated as Sec. 751 property. Thus, the change broadened the ordinary-income potential on the sale or exchange of a partnership interest.

However, Sec. 751(b) distributions retain the rule that inventory must be substantially appreciated to be a hot asset. Ordinary income will be triggered in a distribution only if there is a disproportionate distribution (e.g., the partner receives cash rather than his proportionate share of inventory) of unrealized receivables or substantially appreciated inventory. Regs. Sec. 1.1(h)-1 pertains only to sales or exchanges of partnership interests, not to redemptions; thus, redemptions may result in less ordinary-income recognition, especially if the partnership is an accrual-basis taxpayer. This may lead a partner wishing to sell his interest to a third party to construct a redemption of the partnership interest, followed by the subsequent issuance of an identical partnership interest to the "buyer" in exchange for cash or property.

Further, Letter Ruling (TAM) 8836001 (8) stated that, in the case of a distribution of partnership property to a partner in liquidation of his partnership interest, the partnership may elect under Sec. 754 to adjust the basis of undistributed partnership property via Sec. 734.

This can be beneficial to the remaining partners. A realized gain by a redeeming partner on the receipt of cash in liquidation of his partnership interest represents his share of appreciation in the assets the partnership retains. If the partnership's basis is not adjusted as a result of the redemption, when the partnership later sells the assets, the gain attributable to the redeeming partner share will be taxed a second time. This second reporting of gain (by the remaining partners) will be corrected later, because the partners' adjusted base in their partnership interests are increased by the gain recognized. That increase will result in a reduced gain on the ultimate sale of their partnership interests. However, a timing difference, which may be prolonged, will exist without a Sec. 734(b) adjustment. (9) For all of the above reasons, redemptions of partnership interests have become relatively more attractive for tax purposes than sales or exchanges.

However, practitioners need to be cautious in constructing redemptions, to minimize risk for their clients that the transaction will be recast as a sale. A redemption in liquidation of a partner's interest' followed by a sale to a third party may not be respected by the IRS. FSA 200024001 (10) addressed the disposition of a partnership interest. The Service looked to the "elements of artificiality" of the transaction and ruled that a redemption of a partnership interest of one party, followed by a sale of an interest to another, was properly characterized as a direct transfer of the partnership interest (i.e., a sale or exchange).

Installment Reporting

A partner or S shareholder who sell an interest at a gain may be able to report the sale on the installment method. (11) The gain allocable to unrealized receivables and inventory items is generally ordinary income and must be reported in the year of sale. The gain allocable to the other assets is capital gain and can be reported under the installment method. Although Regs. Sec. 1.1(h)-1 does not mention installment sales or Sec. 453, the sale of a partnership interest on the installment method allows a taxpayer to time the recognition of future capital gains triggered by the installment payments with capital losses from the sale of other assets. When a sale of an interest will result in short-term capital gains, planning for ordinary deductions may be beneficial.

Suspended PALs

The passive loss limit is lifted when a taxpayer disposes of his entire interest in a passive activity in a fully taxable transaction. Suspended passive activity losses (PALs) attributable to the activity and losses recognized on the disposition may be deducted from active and portfolio income. Limited partners and passive S shareholders can use suspended PALs in excess of passive income in the year of disposition of the interest to offset the ordinary-income component recognized under Sec. 751 and other short- and long-term gains.

Reporting and Compliance Issues

Regs. Sec. 1.1(h)-1(e) adopts reporting rules for sales or exchanges of passthrough interests similar to those that apply to partners and partnerships under Sec. 751(a). As part of the Tax Reform Act of 1984, Congress addressed the problem of noncompliance with the Sec. 751 requirements. The solution is Sec. 6050K, which imposes reporting requirements on transfers of partnership interests. In theory, these partnership reporting requirements enable the IRS to effectively police exchanges of partnership interests involving unrealized receivables and inventory under Sec. 751.

To ensure that ordinary income is being reported in these situations, a partnership must file an information return on Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, with the IRS for exchanges of partnership interests that involve partnership unrealized receivables or inventory. The return covers the calendar year of the exchange and must include the name and address of each transferor and transferee. Other information must be supplied to the extent required by the Sec. 6050K(a) regulations.

Sec. 6050K(c)(1) requires that any transferor of a partnership interest give prompt notice of the transfer to the partnership; Sec. 6050K(c)(2) delays the partnership's required filing date until after it is "notified of such exchange" Thus, the burden of triggering the reporting process falls on the transferor. In the case of an extension of these rules to the lookthrough regulations, this burden will be on the selling partner or S shareholder.

In addition to the information return submitted to the IRS, the partnership must furnish a statement to the seller and buyer showing the partnership's name and the information sent to the IRS. These statements must also include the name, address and telephone number of a partnership information contact. The telephone number provides access to someone with relevant information and resources to resolve any questions.

Even though Sec. 6050K's clear intent is to force compliance with Sec. 751(a), neither Sec. 6050K, Form 8308 or its instructions nor Regs. Sec. 1.6050K-1 require a partnership to notify a partner of the information necessary to calculate his ordinary income under Sec. 751(a). The partner is merely informed of the requirement to treat a portion of gain or loss from the sale of his partnership interest as ordinary.

Nonetheless, a partner selling or exchanging any part of his interest in a partnership with any Sec. 751 property at the time of sale or exchange (and now, any short-term, collectibles or unrecaptured Sec. 1250 lookthrough gain), must submit with his return for the tax year in which the sale or exchange occurs, a statement setting forth the date of the sale or exchange and the appropriate amount of any gain or loss (as outlined in Regs. Sec. 1.1 (h)-1).

The Sec. 751 rules are complex and frequently overlooked (or ignored) by both practitioners and revenue agents. (12) Nonetheless, the rules potentially apply very broadly. Virtually any partner who transfers his partnership interest is likely to be subject to Sec. 751(a) if the partnership owns depreciable property or uses the cash method. The IRS should either require partnerships to provide accurate information as to each and every sale, or provide partnerships with reasonable estimation (or de minimis) procedures for sales of interests below a certain threshold, so that taxpayers and their advisers can reasonably comply with the new Sec. 1(h) rules.

Conclusion

The Sec. 1(h) final regulations will make compliance, planning and advising more difficult for practitioners. Treasury or the IRS should provide for specific information reporting that will allow taxpayers and tax advisers to adequately comply with the regulations. Alternatively, the IRS should provide a procedure that would allow partnerships to reasonably estimate amounts of hot assets, collectibles gain and unrecaptured Sec. 1250 gain for reporting to taxpayers on a timely basis.

The regulations' operating rules generally provide for maximum ordinary-income recognition on the sale of a partnership interest. Depending on a taxpayer's other income and loss items, the taxable income currently recognized on the sale of a passthrough interest can exceed the economic gain realized.

S shareholders can avoid application of the rules to sales of S interests by avoiding collectibles as corporate assets. However, the related holding-period regulations under Sec. 1223, adopted at the same time, will affect partnerships and LLCs and interact with the regulations analyzed in this article. Given the increasing popularity of LLCs over corporate forms, the new Sec. 1(h) regulations merit study by practitioners and the development of reasonable information-reporting guidelines by Treasury and the IRS.
Example 2: S sells the following capital assets in 2002:

 Holding
Asset period AB FMV

Collectibles 3 years 1,000 $3,000
Sec. 1250 property,
 (original cost,
 $80,000) 8 years 50,000 100,000
Other property 9 months 55,000 20,000
Totals $106,000 $123,000

 Capital
Asset Gain gain rate

Collectibles 2,000 28%
Sec. 1250 property, 25%
 (original cost, 30,000
 $80,000) 20,000 20%
Other property (35,000) Allocate
Totals $17,000

Because there are no short-term gains against which to net the
short-term loss, the $35,000 short-term loss is used first to offset
the $2,000 28% gain, reducing it to zero. The $33,000 remaining
short-term loss reduces the $30,000 25% gain to zero. The remaining
$3,000 short-term loss offsets the $20,000 20% gain.

S will report $17,000 of 20% gain on her return. The allocation rules
are written to provide maximum taxpayer benefit.


EXECUTIVE SUMMARY

* Regs. Sec. 1.1(h)-1 applies to the sale or exchange of partnership interests, S stock and trust interests held for more than one year.

* A partner's lookthrough capital gain is the sum of his collectibles gain and Sec. 1250 capital gain; an S shareholder's or trust beneficiary's lookthrough capital gain is only his share of collectibles gain.

* The transactions described in the regulations have tangibly different results for partnerships and S corporations.

(1) TD 8902 (9/20/00). TD 8902 also adopts final Regs. Sec. 1.1223-3, which explains the division of a partnership interest holding period. The final regulations, effective Sept. 21, 2000, adopt with some modifications the proposed regulations (REG-106527-98, 8/9/99).

(2) The Internal Revenue Service Restructuring and Reform Act of 1998, Section 6005 (d), authorized regulations to apply the capital gain provisions to sales and exchanges of interests in passthrough entities.

(3) Under Sec. 1 (h)(2)(B) and (h)(9), the 20% capital gain rate has been lowered to 18%, provided property has been held for more than five years and the taxpayer's holding period begins after 2000. The 10% capital gain rate under Sec. 1 (h)(2)(A) has been lowered to eight percent, provided the property is held for more than five years when sold. These provisions apply to all gains other than "collectibles gain" (as defined in Sec. 1(h)(6)), unrecaptured Sec. 1250 gains and Sec. 1202 gains.

(4) See Examples 10 and 11 and the accompanying text, infra.

(5) While the regulations apply to transfers of trust interests, that discussion is beyond the scope of this article. In summary, transfers of trust interests may trigger collectibles gain and residual long-term capital gain or loss.

(6) It is assumed that the special allocation has substantial economic effect.

(7) The change was effective for sales or exchanges of partnership interests after Aug. 5, 1997, unless there was a binding contract before June 8, 1997.

(8) IRS Letter Ruling (TAM) 8836001 (5/13/88).

(9) See Manolakes, Partnerships and LLCs: Tax Practice and Analysis (CCH, Inc., 2000), at [paragraph] 1902.10.

(10) FSA 200024001 (2/8/00).

(11) See IRS Pub. 537, Installment Sales.

(12) See Manolakes, note 9 supra, at [paragraph] 1206.

Janet W. Tillinger, Ph.D., CPA Professor, Department of Accounting & Business Law Texas A&M University--Corpus Christi Corpus Christi, TX
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Author:Tillinger, Janet W.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 2002
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