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Sale of partnership interests with open-service or construction contracts.

Under Sec. 741, generally, the gain or loss resulting from the sale or exchange of a partnership interest is capital. The one exception to this general rule is Sec. 751(a), which states that the amount of consideration received by a partner in exchange for his partnership interest--attributable to unrealized receivables or inventory items--is considered as an amount received from the sale or exchange of property other than a capital asset. For this reason, the sale of partnership interests versus the sale of partnership assets can result in similar (if not identical) tax consequences. The Sec. 751 rules have been part of the Code for almost 50 years, and over the last few years have seen relatively few changes. However, under Regs. Sec. 1.751-1 (c) (3), transactions occurring after Dec. 14, 1999 may result in substantially different tax treatment between the sale of a partnership interest and the sale of the partnership's assets.

Service and Construction Contracts as Unrealized Receivables under Sec. 751(c)

Unrealized receivables are defined by Sec. 751(c) and Regs. Sec. 1.751-1 (c) (1) (ii), in pertinent part, as any rights (contractual or otherwise) to payment for:

1. Goods delivered, or to be delivered (to the extent that such payment would be treated as received for property other than a capital asset) or

2. Services rendered, or to be rendered, to the extent that income arising from such rights to payment was not previously includible in income under the partnership's accounting method.

Such rights must have arisen under contracts or agreements in existence at the time of the sale or exchange of a partnership interest, although the partnership may not be able to enforce payment until a later time. For example, the term includes rights to payment for work or goods begun but incomplete at the time of the sale or distribution. Based on this definition, any fees or revenues to be collected subsequent to the sale or exchange of service or construction contracts (entered into before the sale or exchange) are considered unrealized receivables.

Effects of Sec. 751(c)

In an applicable asset sale as defined in Sec. 1060, the allocation of the sales price agreed to by the buyer and seller is generally binding on them (although not the IRS) under Regs. Sec. 1.1060-1 (c)(4). Therefore, if the assets of a partnership were sold, the seller might avoid additional ordinary income recognition by agreeing with the buyer to allocate to open-service and construction contracts a portion of the sales price equal to the income already recognized under the contracts. This method would result in an allocation of the sales price equal to the seller's basis in any open-service or construction contract, yielding no gain or loss on the sale. This would seem like a reasonable conclusion, especially as:

* The performance and profitability of the open contracts subsequent to the sale are reflective of the buyer's performance and

* Sec. 197 intangibles amortizable over 15 years include customer-based intangibles that consist of any value resulting from the future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers.

However, the allocation of the sales price on the sale of a partnership interest attributable to unrealized receivables is governed by Sec. 751, not by Sec. 1060. For transactions prior to Dec. 15, 1999, under Regs. Sec. 1.751-1(c)(3), in determining the amount of the sales price attributable to unrealized receivables, any arm's-length agreement between the buyer and seller would generally establish the value.

For transactions occurring after Dec. 14, 1999, Regs. Sec. 1.751-1 (c)(3) provides that in determining the amount of the sales price attributable to unrealized receivables, full account shall be taken not only of the estimated cost of completing performance of the contract or agreement, but also the time between the sale and the payment. Thus, the amount of the sales price attributable to open-service and construction contracts would appear to be the discounted value of revenue expected to be received on the contracts by the buyer subsequent to the sale. This amount would be offset by the discounted value of estimated costs and administrative expenses expected to be incurred by the buyer and allocable to the contract. The difference between these two amounts would be the ordinary income generated by Sec. 751 (a).

Regs. Sec. 1.751-1(c)(3) does have judicial support. For example, in Woolsey, 326 F2d 287 (5th Cir. 1963), the taxpayers were partners in a partnership that entered into a 25-year contract to manage a mutual life insurance company and the partners sold their partnerhsip interests. The Fifth Circuit held that the management contract was an unrealized receivable. The results of this case are typical when there is a binding contract not terminable at the will of the party for whom the partnership is performing the services. When there has been no binding contract and the party for whom the services are being performed terminates the contract at will, the contracts have not been considered unrealized receivables, Note: While case law has distinguished between contracts that are terminable versus those that are not, Regs. Sec. 1.751-1(c)(3) does not recognize such a distinction.

Avoiding Sec. 751(c)

Generally, a partnership can avoid Sec. 751 easily, by selling assets directly. However, when dealing with partnerships whose income is generated from long-term contracts, prospective buyers would want to purchase partnership interests to avoid assigning and potentially renegotiating or losing existing contracts.

If a partnership must sell interests, it should consider the legislative history of Sec. 751, which was enacted to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests. Additionally, Sec. 751 (c) prevents the use of a partnership as a device for obtaining capital gain treatment on fees or other rights to income. Thus, to the extent taxpayers can demonstrate that the sale of a contract would be treated as a sale or exchange of property within the meaning of Sec. 1221 or 1231, they may be able to argue against the reasonableness of the allocations required under the regulations.

An alternative would have the partners contribute their partnership interests to an S corporation. Such a transaction is governed by Rev. Rul. 84-111, Situation 3, and is considered to be the incorporation of a partnership. While the tax consequences of incorporating a partnership are outside the scope of this discussion, importantly, this alternative may be more feasible if the entity is a limited liability company (LLC) taxed as a partnership, as most states allow the formation of single-member LLCs (SMLLCs). By a state allowing an SMLLC, the legal entity remains in existence, although it will terminate for tax purposes. Thus, any concerns about the assignment of service or construction contracts would likely be avoided. In contrast to LLCs, partnerships under state laws typically dissolve or liquidate if there is only one partner. Because the legal entity dissolves or liquidates for both legal and tax purposes, the contracts may need to be assigned. If dealing with a partnership, advisers may want to inquire as to whether it can convert to an LLC without assignment of the contracts, and then proceed with the incorporation of the LLC. Once the LLC has been incorporated, its membership units can be sold. The tax result is a deemed sale of S assets and allocation of the sale price is governed by Sec. 1060.

Additionally, advisers must address potential issues under Secs. 341 and 735 in incorporating a partnership or LLC. While these sections may not appear to be an issue, the statutory outline and definitions contained within may lead to unexpected issues.

Frank J. O'Connell, Jr., CPA, J.D.
Crowe Chizek
Oak Brook, IL
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Author:O'Connell, Frank J., Jr.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Sep 1, 2001
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