Sample Answers to Question 2
Partnership Tax
Spring 2004

Exam No. 4793

Dora: selling partner

Under § 741, any gain or loss on the sale of a partnership interest is treated as capital to the extent that § 751 does not apply. Section characterizes the amounts received which are attributable to “hot assets” as ordinary income. Section property includes unrealized receivables and inventory.

In this case, Dora sells her interest for $36K. Additionally, she is relieved of $9K of partnership debt for a total amount of $45K. Her outside basis is $38K, so she realizes a 7K gain. The character of this gain is based on her share of the partnerships hot assets. The only hot asset in this partnership is the accounts receivable. If liquidated at FMV, Dora’s share would be $5K. Therefore, on the sale of her interest, Dora recognizes $5K of ordinary gain and $2K of capital gain.

Pete: buying partner

No gain or loss will be recognized by a transferee partner on the sale or exchange of a partnership interest. The basis of a transferee partner’s interest is a cost basis under § 742. This generally results in a basis discrepancy because under § 743(a), absent a § 754 election, the basis of partnership property is not adjusted as the result in a transfer of interest.

In this case, if no § 754 election is in place, Pete’s outside basis will be $36K, his cost, plus his share of the partnership liabilities, 9K, for a total of 45K. His inside basis in the partnership will be the same as Dora’s, $38K, provided no § 754 election is in place.

If the partnership previously made a § 754 election, under § 743(b), Pete will increase his inside basis to the property by the excess of his outside basis over his inside basis, or $7K. This adjustment would be allocated according to the regulations under § 755, which require the adjustment first be allocated between capital assets and non-capital assets according to the gain or loss which would be recognized in a hypothetical transaction where all the partnership interests were liquidated for their FMV. Under the hypothetical liquidation, Pete would have a $2K loss on the stock, a $4K gain on the real estate, and a $5K gain on the accounts. Allocating between classes, first $5K of the personal inside basis would go on the accounts, then 2K would go on the capital assets: $4K on the real estate and negative $2K on the stock, for a total of $7K.

Emma, Fiona and the partnership

The sale of Dora’s interest has no tax consequences to Emma and Fiona or the partnership. The § 754 election does not affect the inside or outside basis of the other partners or the interests of the partnership but is merely used for accounting purposes to prevent the buying partner from taking a loss which was already accounted for. If no election is in place, the inside and outside bases of the partnership and partners will not match up.

Exam No. 4646

Dora – will be assumed to have sold her third of all of the properties for 45 (cash received + liability discharged; 36 + 9). She will have an aggregate gain of 45 – 38 (OB) = 7 gain. The trick is to figure out what the nature of this gain is. She will get 5 ordinary gain from the disposition of her 751 hot Account Receivable. The partnership has 0 basis so that is what she gets when disposing of her third. She will further receive a net capital gain of 2 on the sale of her third of the capital properties 4 capital gain from the RE (1/3 of (72-60)) netted against the 2 capital loss on her portion of the stock (1/3 of (18-24)). The 7 gain is comprised of 5 ordinary and 2 capital gain.

A 754 election does not change the effects of this sale on Dora

Pete – Under 742 takes a cost basis in the partnership interest which includes his share of the liabilities. 36 (cost) + 9 (liability assumed) = 45 OB. The IB of the properties is not written up or down to reflect the cost paid by Pete under the default rule 743a. However, if the partnership agrees to a 754 election Pete’s share of the assets will be written up or down for his benefit. In this case A/R would have an AB of 5; the stock would be written down 2 to 22; and the RE would be written up 4. In this way if the any of the assets are disposed of immediately after his entry into the EFP, P will not have to pay any tax on the appreciated gain or get any of the losses.

Emma & Fiona - if there is no 754 election (and they are the ones to chose to make one) there is no impact on them other than the inside outside basis mismatch caused by the Pete’s purchase of the partnership interest and that they spread gains and losses meant only for E and F to P, this is good for them because there are more gains than losses to spread to P. P in effect gets to help pay their portion of the tax. If they do make the election then they are stuck with 754. Under this election they will not be able to spread the gains or losses built into the assets prior to Pete’s entry to P because P will have his own basis as to each of the assets.