In Episode 25 of How Tax Works, Matt Foreman discusses the tax implications of dividing partnerships, redeeming partners, and dealing with partnership debt. 

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 25th episode of How Tax Works. I’m Matt Forman. In this episode I will discuss partnership divisions, which are literally dividing a partnership that groups of a partnership or otherwise. In case you weren’t sure, How Tax Works is meant for informational entertainment purposes only. This may be attorney advertising and it is not legal device. Please hire your own attorn. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices we all make before we get started.

Matthew Foreman [00:00:43]:
Administrative new episodes 2 weeks Next episode is going to talk about acquisitive reorganizations under 368 and C as of the Internal Revenue Code, as well as section 351. If you have any questions, comments, constructive criticisms, you can email me my FRB email address which you can find via your favorite search engine. Upcoming speaking agents, webinars, etc. Are on the How Tax Works page and the FRB websites. Now let’s. Let’s divide it up. Let’s talk about partnership divisions. There are a lot of things I can cover.

Matthew Foreman [00:01:13]:
This could be a good hour and a half without an issue. I’m going to issue spot amiss a little more and go into less detail. I really don’t want. I definitely don’t want. I really don’t need another three parter like. Like the QSBs. They were just. I tried to do that in an episode and it just.

Matthew Foreman [00:01:29]:
I just knew it wouldn’t work. So let’s do this one a little more high level. The devil’s in the details though. Very much so. High level. We’re assuming it was a partnership before and a partnership after. So we’re not doing 99 revenue rolling 995 or 99. Six which deal with, you know, partnership disregarded entity.

Matthew Foreman [00:01:47]:
Partnership. Partnership disregarded entity. No, no. Partnership before, partnership after. Same owners. We’re not changing out owners, et cetera, et cetera. Simplifying a little bit. I’m ignoring state issues.

Matthew Foreman [00:01:57]:
I’m assuming states follow subchapter K and I’m assuming states allow us to do what we’re telling them to do. States are aggressively quirky in this regard and they follow weird things. So highly recommend it. And finally, finally, I am not talking about cross border issues. There are no foreign partners. There is no foreign operations. There is nothing. This is US only subchachor K does not need more complexity city, I promise you.

Matthew Foreman [00:02:24]:
And bringing in anything relating to cross border zero stars do Not. Do not recommend. Okay. Do not recommend at all. So let’s. Let’s get into it. Let’s get into some partnership division stuff. Quick preview idea of this.

Matthew Foreman [00:02:38]:
The general premise of this is that neither the partnership nor the partner recognize any gain or any loss on the distribution of cash or property. Okay. The gain or loss is recognized upon distribution when deferral is impractical or the deferral would result in the change of character. Capital. Ordinary. Ordinary capital. Whatever you want it to be. Right.

Matthew Foreman [00:03:03]:
Non recognition is generally under 731A and B. Both gains and losses generally marketable securities and cash are generally viewed as taxable. 731C the basis in the distributed property. I’m going to go through some real technical stuff real quick, but I think it’s important. Basis in distributed property 732 in a current distribution, current versus liquidating. Liquidating means that the one partnership disappears. You’re just kind of pulling out, likely pulling out assets. Whereas a current distribution for a partnership division usually is when you bring, you know, the.

Matthew Foreman [00:03:33]:
The old part, the historic partnership still exists and the new part, the new partnership is also pulled out of it. Maybe a continuation. Not going to talk that much about the concept of continuation of partnerships. It just sort of gets too quirky. Don’t want to do it. Oh, I’m also not going to really talk about EIN issues. We’re all just going to assume that the continuing partnership retains its ein. That may not be the case.

Matthew Foreman [00:03:52]:
You can actually have a partnership get pulled out. Take the EIN and the old one gets a new one. We’re not going to talk about that. Wait dots out of it. So current distribution. Generally non recognition. Carryover basis unless insufficient outside basis. I’ll get into that.

Matthew Foreman [00:04:06]:
And the liquidating distribution. Again, generally non recognition. And you allocate old outside basis among the all the properties held for continuing basis in the partnership. That’s 733. It only applies to current distributions. And it’s the partner’s basis in the partnership itself. The outside basis. I think that’s really important.

Matthew Foreman [00:04:24]:
There’s generally no adjustment to the basis the property. No outside basis. Excuse me, their inside basis. The no adjustment to the basis of the partnership’s basis in its own property due to distribution. There may be under certain circumstances some income recognized. You can do a seven for some before election and that’ll help. There are characterization rules under section 755 which are similar to 724 rules. All right.

Matthew Foreman [00:04:49]:
So current distribution is defined as a partner’s interest in a partnership continues after the distribution. Possibly, but not necessarily to reduce share. Right? So if you pull stuff out pro rata, no one’s share actually decreases. You’re just taking out assets. So if you distribute it, you know something, partnerships worth 100 distribute $10 worth of an asset deal with the basis issues. I’ll get into those. But everyone still owns the same because they’re getting it pro rata. A liquidating distribution is when a partner or multiple partners interest in a partnership terminates as a result of liquidating distribution.

Matthew Foreman [00:05:21]:
Pretty common, right? You have two, you have say of three partners, third, a third, a third. There’s three piece of property each worth $30. You distribute one of the piece of property to one of the partners in liquidation of their interest. It is a liquidating distribution. It does not mean the partnership liquidates. It means the partner’s interest in the partnership liquidates. Right? If there’s a disparity between inside basis and outside basis, have an opportunity for a 754election to make a 754election for a 734B adjustment. And let’s talk about capital accounts to all the sub K mavens out there.

Matthew Foreman [00:05:57]:
Let’s. Let’s get ready because capital account’s really important. The 1.7041 B2 Roman at 4.4if my. My scribbled hand notes are correct. So partnership distributes property to partner. The partnership recognizes gain or loss inherent to the distributed property. For book, not tax purposes. No tax recognition.

Matthew Foreman [00:06:15]:
Remember, subchapter K is only tax. Doesn’t really care about book that much. Just sort of says, well, that’s what book does. That’s cute. Don’t care. So the steps, you’re going to adjust your partner’s capital accounts to reflect the way the partners share in the inherent book gain or loss in distributed property. And then the balance of the distributed capital account is reduced by the net fair market value of distributed property. Right? So you’re gonna adjust, then you’re gonna drop based on what you distributed.

Matthew Foreman [00:06:38]:
Pretty easy. Character and holding, period. Distributed property to character after distribution. So, so think about it, right? The after distribution. So let’s say it’s capital, right? After distribution, the partner who received the property sells it. Its capital stays. Okay, that’s, that’s the idea, you know, it’s gonna retain some of the exceptions. Inventory items are ordinary unrealized receivables, right? Inventory items are by default, by rule.

Matthew Foreman [00:07:03]:
They remain ordinary income for five years. So even if they’re inventory to the partnership but not the partner. That’d be too easy a way. Distribute. Distribute to the partner. Pay no tax and sell capital gains. You gotta wait five long years. Unrealized receivables are always.

Matthew Foreman [00:07:17]:
Always ordinary income items. So hot assets because become problematic. Holding period. Great holding period. Tax pretty straightforward there. The basis of the partnerships under distributed property unaffected. However if there is a. You know there may be a substantial basis reduction under 754.

Matthew Foreman [00:07:36]:
Not going to go into that a lot. Right. Recognition of gain or loss. So this is. This is a pretty important point here I want to make. All right. So the recognition of gain or loss generally non recognition for the partner and. And the partnership cash distribution.

Matthew Foreman [00:07:50]:
Well obviously that’s different. That’s not what we’re looking for. Right. Cash distribution. That’s just a distribution. It distributes. You know. The distribution reduces the outside basis by the value of the cash.

Matthew Foreman [00:08:01]:
Right. And preserving gain or loss in the partnership interest. 733 if there’s a property distribution the distributee’s outside basis is allocated among property received and the partner’s continuing interest in the partnership. So Right. Based on fair market value. So you’re going to have that. 732. 733 a pre distribution gain or loss in the distribute’s partnership interest is preserved in the property received or distributed partnership interest.

Matthew Foreman [00:08:28]:
So basically you get a carryover. The basis fair market value just gets pushed out. And if there’s gain or loss inherent to the partnership’s interest you get that really interesting when deferral is impractical or change the character of the gain or loss. You have to recognize gain or loss is treated as if it is the came from a sale or exchange of the partnership interest. 731 A2 741 recognition of gain. Just gain. Right. We must recognize gain if the distribution of money is in excess of your outside basis.

Matthew Foreman [00:08:57]:
Right. Not. Not property Right. Reduction of partner share or partnership liabilities is treated as a distribution in cash because it’s 752B. So I think that’s really important marketable security. So what happens sometimes this is sort of a hidden issue. Right. You distribute some property.

Matthew Foreman [00:09:13]:
It decreases their ownership in it. And what happens is their share of partnership debt decreases as a result. When you distribute the property and decrease the basis they may actually because they’re now responsible for it may actually push their basis down. So they may have to recognize gain. That’s the idea. Marketable securities are viewed as cash. If distributed it becomes problematic. Recognition of loss.

Matthew Foreman [00:09:37]:
You again recognize Loss only on a liquidating distribution losses. So loss is recognized only if 732A2 liquidating distribution consists of cash, unrealized realized receivables or inventory. That’s 1 and 2. The distribute’s outside basis exceeds the sum of money distributed plus the partnership’s inside basis to the property. So so basically you know if when you’re liquidating, if you distribute property and you have extra basis at the end, that’s going to be it. A partner recognizes a capital loss because you can’t adjust cash as basis. And you cannot adjust basis and ordinary income assets because it’ll turn a capital loss into an ordinary loss basis of distributed property. This is a real, real.

Matthew Foreman [00:10:21]:
I think it’s straightforward. There’s quirks to it, right? For a current distribution, the distributed basis and property received in a current distribution cannot exceed the distribute’s outside basis. Less the cash received, less the liability relief in the same transaction. 731A2 if the partner is subject to 731A2 limitation decrease the basis in the distributed property. Outside basis is now zero. Multiple properties received. There’s rules for allocating between the properties under 732C. I think that’s pretty straightforward.

Matthew Foreman [00:10:52]:
But the steps are interesting. So step one, basis allocated to cash or reduction in liabilities. Reduction in liabilities is viewed as cash. Two, the basis allocated to other distributed property equal to the partnerships inside basis, the transferor basis. And three, the basis is allocated the partner’s continuing interest in the partnership. So continuing interest is the most likely to be zero. Whatever you distribute is more likely to have basis. You can play around with that a little bit.

Matthew Foreman [00:11:18]:
Kind of how you want to do stuff, right? What you want to sell. Pretty pretty taxpayer friendly liquidating distribution. So they begin with the distributees outside basis. That’s step one. Step two, reduce the distributee’s outside basis by the sum of cash distributed and liability relief. And that’ll get your what’s called the partners reduced outside basis or rob. We don’t like rob, but actually we do because basis is a good thing to have. Step three, does the distributee receive some of cash and liability relief? Does that exceed their outside basis? If yes, then you recognize gain not at the excess you received.

Matthew Foreman [00:11:54]:
If not, go to the next step. Step four, you have to allocate the rob the partner’s reduced outside basis. 732C talked about that. First you allocate to 751 property unrealized receivables inventory commonly referred to as hot assets. And then Next you go to step five. Is there any other property? Right. These are gonna be your capital assets. Do you distribute a house? Right.

Matthew Foreman [00:12:16]:
That kind of stuff. If no, then distributed partner recognize a capital loss because there’s no assets left. If yes, then you’re going to recognize a capital loss on the amount of remaining outside basis. If no, there’s no other property, it’s all cash. Then you know, if the sum of inside basis exceeds fair market value, then you’re going to allocate the rob the reduced outside basis to properties with unrealized gains. And you’re going to allocate the remainder of the reduced outside basis based on fair market value. If the sum of the inside basis does not exceed fair market value, so equals or less, you’re going to allocate the reduced outside basis to properties with unrealized losses and allocate the remainder of the reduced outside basis based on the adjusted basis. You’ll notice the remainder of the allocations are actually based on different factors dependent on something else kind of interesting.

Matthew Foreman [00:13:03]:
All right. Special rule 732D then. Then we’re going to go to a break. I think we’ll need one after this. If a partner acquired their interest by a transfer such as a purchase or death from a partner during the two years prior to the distribution, then the partner may elect to treat as if there had been a 754election in place at the time of transfer. 2. No matter when the distribution occurs, even if the purchasing partner makes no 732d election, the regulations make 732 mandatory under certain circumstances. 1.7322d4.

Matthew Foreman [00:13:40]:
The reason is to prevent the shifting of basis from non depreciable to non depreciable assets. There used to be a rule with partnership divisions where if, you know, you do certain things under 708 partnership terminations, technical terminations over 708 rules. Inarguably, the best thing that, that, that TCJ did, the best thing every tax professional is going to tell you, the best thing they did was get rid of technical terminations under 708. They were stupid, they were annoying and they ran into stuff. All right, let’s go to some music. I’ll be back in a moment. So let’s talk about 7:52. Okay.

Matthew Foreman [00:14:24]:
What is 752? Premise of 752 is if a partnership has basis, has debt, that the partners get an increase in their basis in the partnership under section 752. Really, really, really important. Right? Full basis credit for purchases made using borrowed funds inside basis and outside basis. The changes in the partner share of partnership liabilities are treated as contributions or distributions from the partnership. The partner’s share of partnership liabilities are included in their outside basis. That’s 722 partner cannot deduct partnership losses in excess of their outside basis. Duh. Capital accounts can go below zero.

Matthew Foreman [00:15:03]:
Outside basis cannot.704d and if a partner receives a partnership distribution that exceeds their outside basis, you have gains 731.81 so what happens if a partner has allocated a loss that would push the outside basis below zero? The loss is suspended. Suspended. It cannot use outside basis. Cannot, cannot, cannot go below zero. You can make a contribution, right? And then distribute later. You could. The partner could assume liabilities then quote unquote, unassume them later. That’s pretty common.

Matthew Foreman [00:15:31]:
And I think that’s really important. So what is a liability is a really important question because you know I use the word debt the word the code uses in the regs 7521 it says liability liabilities are either obligations that when incurred and there’s three things they can be they either increase or decrease basis direct directly such as a purchase money mortgage or indirectly such as a second mortgage unsecured loan, an obligation. The second one is that give rise to a deduction so accrued but unpaid expenses or accrued method partnership unpaid liabilities for cash method partnership. That’s revolt8877 where the third one is give rise. You know and any obligation that gives ride to an expenditure under 705 a 2 cap B. So generally, you know expenses that cannot be deducted or capitalized syndication fees. Common example. And then this, you know another example was 7521 liability certain liabilities that don’t actually constitute indebtedness.

Matthew Foreman [00:16:28]:
That’s helpful. Right? So for example a partnership’s short sale of securities created a partnership liability but are not actually considered indebtedness as short sale even though it’s kind of of indebtedness. Rev 9526 talks about that recourse liabilities are shared among partners in the same way the partners share the economic risk of loss. It’s at 1.7522 a and non recourse liabilities are shared in manner that’s consistent with non recourse deductions. Right. So recourse goes to the partner who’s economically at risk. Non recourse. Well that’s.

Matthew Foreman [00:17:01]:
That’s however you do non recourse deductions generally the partner’s interest in the partnership. However, that’s determined. There’s also a 7527 regulation. And these are partnership obligations that are not governed by the general rules. And this is, you know, examples are amounts by which a752.1 obligation exceeds the amount taken into account of the general rules. Contingent obligations such as environmental tort, pension, et cetera. And they’re generally not reflected in basis, but they reduce the fair market value of the property to which they relate. You know, a liability can be a loan.

Matthew Foreman [00:17:31]:
Like a partner can make a loan to a partnership, but look at the loan if it’s legitimate, right? Oh, I’m loaning $100 million to it. Oh, I get all this basis. Great. Like that, you know, do they really have the assets? Is that possible? Is it on, you know, market terms, et cetera. And I think that that’s really kind of an important note. I have a lot of stuff about sharing recourse liabilities that I’m, I’m looking at the time. I think I’m going to skip them. How you deal with recourse liabilities is really important.

Matthew Foreman [00:17:59]:
It’s basically who has the economic risk of loss. Maybe not helpful, but I’m cool with that. All right. Importantly, the thing is for 752 basis, it adjusts at the end of the year. So it’ll fluctuate, fluctuate. You can net in out. You know, if what happens is sometimes they, a loan gets paid off, then about a week, two weeks later you get the loan back to do something else or just, you know, you have a week period between when you kind of finalize terms. That’s fine.

Matthew Foreman [00:18:22]:
You’re, you’re doing it at the end of the year. A recourse liability can, you can create recourse liability by have a partner indemnify the partnership or the partner indemnify another partner. You could remove a recourse liability, make it non recourse by having one of the partners indemnify another one. Having, you know, someone, an unrelated third party, you can pay for an indemnification. You know, banks will do it for money, right? They’re a bank. They’ll, they’ll loan you the money. They’ll loan you the indemnification, basically. But the key is you must be able to actually be recourse.

Matthew Foreman [00:18:51]:
You need assets, you know, oh, don’t worry, I’ll pay. But having, you know, three fairly obvious that you’re never gonna pay. That’s, that’s that’s suboptimal. That’s problematic. All right, let’s get some more music in and then we’re gonna come back for a little more on some recourse stuff and then, then bring it on home. All right, so now we’re going back some, some recourse stuff. So really important. I know I said this in the last one, but.

Matthew Foreman [00:19:20]:
1.752-dash2b6 assume that all parties will live up to the obligations without regard to net worth, et cetera. You know, that’s true. But like, if it’s really facially false, you know, you, you, you’re like, all right, well this other LLC that I owe that has no assets, that’s going to do it. And you’re like, well, no, you know, if you’re like, well, does this person really have the $5 million for the guarantee? Maybe. But the truth is, if you had a recourse load on your own house, like, do you really have the money to pay that after the house? Maybe not, right? So it depends, right? A guarantor does not need to honor an obligation until the primary obligor, the partnership defaults. A partner’s guarantee can make a non recourse liability, right? Make it recourse for that partner. That’s really important. So I think that that’s really important.

Matthew Foreman [00:20:07]:
I’ve seen once, for example, a recourse mortgage, a partner, partner A indemnifies partner B for the loss in excess of their capital contribution. So, you know, that part of it becomes, you know, basically, oh, no, no, no, this way do this and you do that to get extra basis. And I think that’s really important. And the rule is if, you know, if you’re following a constructive liquidation, a partner or a related person is responsible for paying a partnership liability, either A directly to the creditor or B via contribution. That partner bears the economic risk of a loss for the liability and shares in the liability to that extent. Right? 1.7522 b6. So I think it’s really, really, really, really important. This is the whole idea of a recourse mortgage, but also kind of the idea of substantial economic effects sort of build in.

Matthew Foreman [00:20:56]:
Is it real? You know, do you actually have to pay it if something comes to it? And I think that’s really important. Want to kind of finish this up? Let’s talk about sharing of non recourse. I didn’t do the sharing of recourse. Want to give a couple quick points on sharing of non recourse? Right. Non recourse Liability is a partnership liability for which no partner or any related person bears the economic risk of loss. If you pledge property to secure it, it becomes recourse, right? Because it’s recourse, you have an economic risk of loss for it. So that’s really important. This is, this is one of the things, if you ever read a partnership operating agreement, they’re going to talk about partnership minimum gain, 704c minimum gain, excess non recourse liabilities, recourse, you know, non recourse this and that, you know, non recourse deductions, things like that.

Matthew Foreman [00:21:40]:
Basically, there is a mechanism. I’m not going to go into the mechanics of it, but I promise you I can. But I would put you to sleep in two minutes on if you have basically driven your capital account below zero, but you still have outside basis because of non recourse debt, how the income gets reallocated back. The idea is that what they want to do, if you got a non recourse deduction, deduction is permitted because you have outside basis because of non recourse liabilities. Basically you have to reverse it back, right? You have to reverse. You took the deductions. Now you can take the income in the same way. So if you have a partner, for example, you know, not responsible for any debt or ran out of outside basis faster than everyone else, right.

Matthew Foreman [00:22:20]:
That person may not get the income quite as quickly. So really important to think about. And that’s. That’s it. That’s the whole thing. I want to talk about the biggest issue that I really didn’t talk. I talked about a little. But I want to, I want to put this up in conclusion.

Matthew Foreman [00:22:36]:
Is the biggest issue in partnership divisions is the movement of debt, okay. And increases and decreases in debt. And people are like, oh, it’s partnership division, it’s tax free. And what happens sometimes, especially when you’re dividing partnership between two, you know, two groups of partners or one partner’s leaving or whatever they may be leaving with an asset that on a net basis is the correct value, right? 100, say it’s $100 of three partners, a third, third, a third. There’s $100 of assets and $10 of debt. The properties are 30, 30 and 40, right. If they leave with that 30. Right.

Matthew Foreman [00:23:10]:
They’re getting their proper economic amount. Right? 30 of a total net value, 90. Great, fine. But they’re also, in addition to the 30, they’re also getting debt relief for a third of the 10. So you sort of have this issue where you have this debt that also goes. And that’s considered. That’s like cash. So that can mess with the basis.

Matthew Foreman [00:23:27]:
It can create a realization recognition event. And that’s something you really need to watch out for. Debt is the hidden problem with it. All right, well, that was the 25th episode of How Tax Works. I hope you learned something. Be back in two weeks. 26 episode. 26 episodes.

Matthew Foreman [00:23:42]:
Which means that the 27th, the one immediately thereafter, is going to be the next year, which is kind of crazy to do. And in the 26th episode, I’m going to be talking about acquisitive reorganizations. And now for some music. Hope you enjoyed it.