What Are The Tax Consequences On Sale Or Exchange of A Partnership Interest?

Overview

Partnerships are a common entity form for farming operations.  This is particularly true when the farming operation participates in federal farm programs.  A general partnership is the entity form for a farming operation that can result in the maximization of federal farm program payments.  But, tax issues can get complex when a partner sells or exchanges a partnership interest.  In addition, the 20 percent deduction for non-C corporate businesses may also come into play.

The tax issues surrounding the sale or exchange of a partnership interest – that’s the topic of today’s post.

General Rule

When a partner sells or exchange a partnership interest to anyone other than the partnership itself, the partner generally recognizes a capital gain or loss on the sale. I.R.C. §741.  That’s a good tax result for capital gain because of the favorable tax rates that apply to capital gain income, but not a good tax result if a loss is involved because of the limited ability to deduct capital losses (e.g., they offset capital gain plus $3,000 of other income for the year).  When a partner sells his interest in the partnership to the partnership in liquidation of the partner’s interest, the liquidating partner generally does not recognize gain (except to the extent money is received that exceeds the partner’s basis in the partnership interest or the partner is relieved of indebtedness).  The liquidating partner receives a basis in the distributed property equal to what his basis had been in the partnership interest. 

Exception

The general rule that a partner’s sale or exchange of his partnership interest triggers capital gain doesn’t apply to the extent the gain realized on the transaction is attributable to “hot assets.”  “Hot assets” (as defined under I.R.C. §751) are unrealized receivables or inventory items of the partnership.  In essence, “hot assets” are ordinary income producing assets that have not already been recognized as income, but eventually would have been recognized by the partnership and allocated to the partner in the ordinary course of partnership business and taxed at ordinary income rates.  The partner’s sale or exchange of their interest merely accelerates the recognition of the income (such as with depreciation recapture).  Thus, the income on the transaction is recharacterized from capital to ordinary. I.R.C. §751(a).  The rationale for the recharacterization is that if the partnership were to sell such “hot assets,” ordinary income or loss would be recognized on the sale.  Thus, when a partner sells or exchanges a partnership interest, the partner should recognize ordinary income on the portion of the income from the sale of the partnership interest that is attributable to the “hot assets.”  If this recharacterization rule didn’t apply, a partner would be able to transform what would have been ordinary income into capital gain by selling or exchanging their partnership interest. 

Similarly, when a partnership distributes property to a partner in exchange for the partner’s interest in the “hot assets” of the partnership, the transaction may be treated as sale or exchange of the hot assets between the partner and the partnership that generates ordinary income. It is possible, and perhaps frequent, for a partner involved in farming to recognize ordinary income and a capital loss, even though the partner had an overall gain on the sale. The ordinary income is taxed immediately, but the capital loss is limited as described above.

Types of “Hot Assets”

Unrealized receivables. There are three categories of unrealized receivables: (1) goods; (2) services; and (3) recapture items. I.R.C §751(c) defines the term “unrealized receivables” as including, “to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2) services rendered, or to be rendered.”  In addition, the term “unrealized receivables” includes not only receivables, but also depreciation recapture.  See, e.g., Treas. Reg. §§1.751-1(c)(4)(iii) and (v). 

In the farming context, the “goods” terminology contained in the definition of “unrealized receivables” would include property used in the trade or business of farming that is subject to depreciation or amortization as defined by I.R.C. §1245.  Included in the definition of I.R.C. §1245 property is personal property (I.R.C. §1245(a)(3)(A)) such as farm equipment and machinery.  Also included in this definition are horses, cattle, hogs, sheep, goats, and mink and other furbearing animals, irrespective of the use to which they are put or the purpose for which they are held.  Treas. Reg §1.1245-3(a)(4).  The definition also includes certain real property that has an adjusted basis reflective of accelerated depreciation adjustments.  I.R.C. §1245(a)(3)(C).  That would include such assets as farm fences and farm field drainage tile.  It also includes grain bins and silos by virtue of a definitional provision including a facility that is used for the bulk storage of fungible commodities.  I.R.C. §1245(a)(3)(B)(iii).  In addition, the definition includes single purpose agricultural or horticultural structures as defined in I.R.C. §168(i)(13).  I.R.C. §1245(a)(3)(D).

The “goods” terminology also includes real property defined by I.R.C. §1250 that has been depreciated to the extent that accelerated depreciation incurred to the date of sale is in excess of straight-line depreciation.  Farm property that falls in the category of I.R.C. §1250 property includes barns, storage sheds and work sheds. If these properties are sold after the end of their recovery period, there is no ordinary income. Also, included in this definition is farmland on which soil and water conservation expenses have been recaptured.  I.R.C. §751(c); IRC §1252(a).

The “unrealized receivables” definition also includes rights (contractual or otherwise) to payment for goods delivered or to be delivered to the extent that the payment would be treated as received for property other than a capital asset, or services rendered or to be rendered to the extent that the income from such rights to payment was not previously included in income under the partnership’s method of accounting.  The rights must have arisen under contracts or agreements that were in existence at the time of the sale or distribution, although the partnership may not be able to enforce payment until a later time.  Treas. Reg. §1.751-1(c)(1).  Thus, in the ag realm, the definition includes the present value of ordinary income attributable to deferred payment contracts for grain and livestock, installment notes for assets sold under the installment method, cash rent lease income, and ag commodity production contracts. 

Inventory.  The other category of “hot assets,” inventory items, includes stock in trade or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the tax year, and property the taxpayer holds primarily for sale to customers in the ordinary course of business.  I.R.C. §751(d) referencing I.R.C. §1221(a)(1).  Whether a taxpayer holds property as a capital asset or for use in the ordinary course of business is a dependent on the facts.  See, e.g. United States v. Winthrop, 417 F.2d 905 (9th Cir. 1969).  For many farm partnerships, inventory items that constitute “hot assets” might include harvested crops, livestock that are being fed-out, poultry, tools and supplies, repair parts, as well as crop inputs (e.g., seed, feed and fertilizer) not yet applied to the land.  On the other hand, an unharvested crop is not included in the definition of “inventory” if the unharvested crop is on land that the taxpayer uses in the trade or business that has been held for more than a year, if the land and the crop are sold or exchanged (or are the subject of an involuntary conversion) at the same time and to the same person.  I.R.C. §1231(b)(4). 

Inventory also includes any other property that, if sold by the partnership, would neither be considered a capital asset nor I.R.C. §1231 property.  I.R.C. §751(d)(2).  I.R.C. §1231 property is real or depreciable business property held for over a year (two years for some livestock).  Thus, for a farm partnership, included in the definition of “inventory” by virtue of not being I.R.C. §1231 property would be  single purpose agricultural or horticultural structures, grain bins, or farm buildings held for one year or less from the date of acquisition (I.R.C. §1231(b)(1); personal property (other than livestock) held for one year or less from the date of acquisition (Id.); cows and horses held for less than 24 months from the date of acquisition (I.R.C. §1231(b)(3)(A)); and other livestock (regardless of age, but not including poultry) held by the taxpayer for less than 12 months from the date of acquisition (I.R.C. §1231(b)(3)(B)).

Qualified Business Income Deduction

The Tax Cuts and Jobs Act (TCJA) creates new I.R.C. §199A effective for tax years beginning after 2017 and before 2026.  The provision creates an up to 20 percent deduction from taxable income for qualified business income (QBI) of a business other than a C corporation.  To be QBI, only ordinary income is eligible.  Income taxed as capital gain is not.  If gain on the sale or exchange of a partnership interest involves “hot assets,” the gain is taxed as ordinary income.  Is it, therefore, QBI-eligible? 

Under Prop. Treas. Reg. §1.199A-3, any gain that is attributable to a partnership’s hot assets is considered attributed to the partnership’s trade or business and may constitute QBI in the hands of the partner.  Thus, if I.R.C. §751(a) or (b) applies on the sale or exchange of a partnership interest, the gain or loss attributable to the partnership assets that gave rise to ordinary income is QBI.  Given the potentially high amount of “hot assets” that a farm partnership might contain (particularly when depreciation recapture is considered), the QBI deduction could play an important role in minimizing the tax bite on sale or exchange of a partnership interest.

Conclusion

When a partnership interest is sold or exchanged, the resulting tax issues have to be sorted out.  An understanding of what qualifies as a “hot asset” helps in properly sorting out the tax consequences.  In addition, the new QBI deduction can help soften the tax blow.