It is commonly known that sales of partnerships can give rise to ordinary income (subject to a current maximum tax rate of 39.6%) and long-term capital gain (subject to a current maximum tax rate of 20%). This is true regardless of whether the transaction consists of the partnership’s sale of its assets or the partners’ sale of their ownership interests in the partnership. Tax professionals can assist their clients in maximizing the long-term capital gain recognized from a sale of a partnership by negotiating an allocation of more of the sales proceeds to long-term capital gain assets and less of the sales proceeds to “hot assets,” such as inventory, accounts receivables, and depreciation recapture.
It is less commonly known, however, that tax professionals can also assist their clients in maximizing their ability to defer the recognition of taxable gain from a partnership sale through the installment sale method of tax reporting. This is done by allocating each payment of sales proceeds among the various assets of the partnership.
This article first summarizes the principles relating to the strategy of maximizing long-term capital gain treatment from a partnership sale. Next, this article builds on those principles by discussing the strategy of maximizing the ability to qualify for installment sale reporting of gain from the sale. These concepts are discussed in the context of a partner’s sale of ownership interests in the partnership, although the same concepts may be applied to the partnership’s sale of its assets.
Maximizing Long-Term Capital Gain Treatment
A partner’s gain from the sale of a partnership interest is generally eligible for taxation under the beneficial long-term capital gain tax rate. See I.R.C. § 741. If the gain, however, is attributable to the partner’s allocable share of the partnership’s “hot assets,” that gain must be taxed under the higher marginal tax rates applying to ordinary income. See I.R.C. § 751(a).
For this purpose, “hot assets” consist of the partnership’s inventory and unrealized receivables. See id. Unrealized receivables consist of several different items listed explicitly in I.R.C. § 751(c). Principally, unrealized receivables consist of: (i) any rights (contractual or otherwise) to payment for goods delivered, or to be delivered, or services rendered, or to be rendered (to the extent the income from those rights has not already been reported as income for tax purposes); and (ii) the amount of depreciation recapture income that would be required to be recognized under I.R.C. § 1245 if the partnership’s assets subject to depreciation recapture were sold for fair market value at the time of the partner’s sale of the partnership interest. See I.R.C. § 751(c).
The amount of ordinary income that must be recognized upon a partner’s sale of a partnership interest is determined through hypothetical sale of partnership assts. See Treas. Reg. § 1.751-1(a). This hypothetical sale assumes that all of the partnership’s assets were sold in a fully taxable transaction for cash in an amount equal to their fair market value immediately prior to the partner’s sale of the partnership interest. See id. The partner’s allocable share of ordinary income that would be recognized in connection with the hypothetical sale of partnership assets serves as the amount of ordinary income that must be recognized by the partner from the sale of the partnership interest. See id. The amount of gain from the partnership interest sale that is eligible for taxation under the beneficial long-term capital gain tax rate equals the excess of: (i) the partner’s total gain from the sale of the partnership interest; over (ii) the amount of ordinary income that is required to be reported pursuant to the aforementioned hypothetical partnership asset sale analysis. See id.
The selling partner can benefit by negotiating an agreed allocation of purchase price among the partnership’s assets. Specifically, the selling partner can optimize the federal income tax consequences of the partnership interest sale by negotiating a lower allocation of purchase price to the “hot assets” that would give rise to ordinary income (subject to the current maximum tax rate of 39.6%) and higher allocation to capital assets, such as goodwill, which could give rise to long-term capital gain (subject to the current maximum tax rate of 20%).
Purchase price allocations are not binding on the IRS. The seller and buyer, however, have adverse interests in allocating the purchase price over the assets of the acquired partnership. A buyer of a partnership that has an I.R.C. § 754 election in place will generally want to allocate more of the purchase price to “hot assets,” such as inventory or equipment that would give rise to depreciation recapture, so that an I.R.C. § 743 adjustment may be made to increase the buyer’s share of inside basis in those assets and give rise to increased tax deductions recovering that basis in the years following the buyer’s purchase of the partnership interest. Because the buyer and seller typically have contrary tax motivations in allocating the purchase price, their agreed allocations often serve as persuasive evidence of the fair market value of the hot assets at the time of the partnership interest transfer.
Maximizing Installment Sale Method Reporting
Partnership interests are often sold for a combination of proceeds payable upon closing and the buyer’s commitment to make additional payments in the future. This creates the risk that the seller may be required to recognize taxable gain in the year in which the sale closes based on the amount of the total sales proceeds, notwithstanding that a significant portion of those proceeds may not be received until later years. This risk is generally addressed by the installment sale method of reporting, which basically provides that a ratable portion of the taxable gain from a sale is recognized in each taxable year based on the portion of the total purchase price that was received by the seller during each of those years. See I.R.C. § 453.
Certain assets, however, are ineligible for installment sale method reporting. For example, depreciation recapture income is not eligible to be deferred under the installment sale method and must be reported in the year of sale. See I.R.C. § 453(i)(1). This is required even when the depreciation recapture income is recognized in connection with a selling partner’s allocable share of the recapture income under I.R.C. § 751. See I.R.C. § 453(i)(2).
In addition, the IRS has ruled that a partner cannot report gain from the sale of a partnership interest pursuant to the installment sale method to the extent that gain is attributable to that partner’s allocable share of the partnership’s inventory. See Rev. Rul. 89-108, 1989-2 C.B. 100 (under the law existing at the time of Rev. Rul. 89-108, I.R.C. § 751(a) only applied to “substantially appreciated” inventory but has since been amended to apply to any inventory regardless of whether it is substantially appreciated). Furthermore, the Fifth Circuit Court of Appeals has ruled that a partner selling a partnership interest is ineligible to report under the installment sale method to the extent the sales proceeds were attributable to the partner’s allocable share of the partnership’s accounts receivables for services that were already rendered. See Mingo v. Comm’r, 773 F.3d 629 (5th Cir. 2014), aff’g, T.C. Memo 2013-149.
Thus, a partner selling an interest in a partnership is required to recognize in the year of sale the gain that is attributable to that partner’s allocable share of the partnership’s inventory, accounts receivable and depreciation recapture income, regardless of the deferred timing of payment of the sales proceeds. As a result, it may be in the selling partner’s best interest to ensure that the sales proceeds paid upon closing are allocated to the selling partner’s interest in the inventory, accounts receivable, and depreciation recapture, since that income must be reported in the year of sale in any event. By allocating the closing proceeds to those assets that are ineligible for the installment sale method, the deferred payments are allocated to those assets that are eligible for installment sale reporting, thus enabling the selling partner to maximize the deferral of gain recognition from the sale of the partnership interest. (It is important to keep in mind, however, that the interest charge under I.R.C. § 453A will generally apply to a partner who: (i) sells his/her partnership interest in exchange for an installment obligation in excess of $150,000; and (ii) holds installment obligations that arose during and remain outstanding at the end of the tax year with a face amount exceeding $5 million.)
An allocation of payments among the selling partner’s allocable share of partnership assets isn’t binding on the IRS. In addition, the seller and buyer are not necessarily adverse regarding the manner in which the payments are allocated among the partnership’s assets for tax purposes. Thus, there is no guaranty that agreed allocations will be upheld in the event of IRS challenge.
Even though payment allocations do not guaranty favorable tax treatment, clients are in a better position to support their maximum potential eligibility for installment sale reporting if those allocations are set forth in an agreement with the buyer. Without an agreement, it appears that each payment received for a partnership interest may be allocated among the partnership assets in proportion to their relative fair market value. See Veenkant v. Comm’r, 416 F.2d 93 (6th Cir. 1969); Rev. Rul. 68-13, 1968-1 C.B. 195. As a result, the absence of any agreement regarding the manner in which the sales payments are allocated may subject a selling partner to increased gain recognition in the year of sale and reduced deferral available under the installment sale method.
If anyone has any questions regarding the allocation of sales proceeds or payments among a selling partner’s allocable share of partnership assets, or any other strategies that may assist clients who are planning to purchase or sell business, please feel free to contact Stephen Beck at 214-749-2401 or firstname.lastname@example.org.