Eli Wolford, a U.S. citizen and our client, plans to sell his interest in Wolford General Partnership (WGP) to Kevin Dole on June 30, 2015. The aforementioned interest constitutes 60% of partnership profits and losses, with the remaining interest allocated between Ethan Wolford (20%) and Nora Latham (20%). Eli Wolford requires to determine the amount and character of taxable gain generated by the sale of interest, as well as possible adverse tax consequences of the proposed sale and Kevin Dole becoming a partner.
Gain and Loss Analysis
We recommend that Eli Wolford sell 60% of the total partnership interest, which represents the total share of the interest he owns. Kevin Dole does not have any previous interest in WGP; therefore, he should be treated as the third party. Thus, this is the case of the sale of the entire interest to the third party under the IRC §741, which states that “gain or loss should be recognized to the transferor partner” and that it should be considered as “gain or loss from the sale or exchange of a capital asset”. According to the IRC §741, an exception could be applied if the sale is a hot asset.
In the case under consideration, the gain or loss from the partnership sale will be calculated as the difference between the total amount received and the adjusted tax basis. In such a transaction business essay writing service the total amount received includes the amount received in cash, the full market value of the property received, and the assumed or relived seller liabilities. The latter include formal liabilities and deemed liabilities, i.e. the share of partnership liabilities. In the case under discussion, the adjusted tax basis includes the share of partnership liabilities, allocated income or loss through the date, and capital account balance. The allocation of partnership liabilities will be also required for the consideration of the amount received, which includes partnership recourse and nonrecourse liabilities that either hold or do not hold borrowers personally liable.
According to the client’s brief, the total amount received will include the agreed sum of cash received, the sum of ten annual principal payments, and interest payments on the note secured by the partnership interest. Thus, the total amount received equals $500,000 plus the accrued interest due in ten annual payments since January 1, 2016. According to the projected balance sheet provided by the client, there is a list of assets held by the WGF. Consequently, the sale of the partnership interest under discussion is subject to the application of the hot assets rule because the list of assets includes assets that are unrealized receivables and inventory items.
Gains and losses will be further estimated according to the following procedure. First, we will calculate the total gain/loss in case the hot assets exception is not applied. Second, the gain/loss associated with the assets specified by §751 will be determined using the FMV and the tax basis provided. Third, a re-characterization procedure will be applied by subtracting the deemed sale gain/loss from the total gain loss to obtain the capital gain/loss.
According to the client’s brief, the total gain/loss is calculated as follows: Total = $500,000 - $650,000 = -150,000$. The gain/loss on the deemed sale is estimated as the difference between the FMV and the inventory tax basis as follows: Deemed Sale = $575,000 - $462,000 = $133,000. Thus, the sale of the partnership interest will result in the loss of $283,000, which could be mediated by the accrued interest payments effective on January 1, 2016. Consequently, the current structure of the agreement will lead to the significant losses incurred by WGF because of the hot assets rule in effect. Thus, Eli Wolford is advised to reconsider the approach used for the establishment of the current agreement through the consideration of additional tax consequences presented in the following chapter.
Other Tax Consequences
According to the client’s brief, the partnership has an IRS §754 election in effect, which states that the basis of partnership property could be adjusted if there is a substantial built-in loss in effect immediately after the transfer. Thus, the adjusted basis could be increased “by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis” (Pub. L. 98-369, 1984). The proportionate share could be determined by the interest in partnership capital only in case it is applied to the transferee partner. Thus, Eli Wolford should consider the adjustment possibility if he wants to proceed with the existent form of the agreement.
The next recommendation should be primarily viewed taking into consideration the presence of two other partners, namely Ethan Wolford and Nora Latham, and the amount of their partnership interest. Since Eli Wolford owns 60% of the partnership interest, while the other two partners cumulatively own 40% of the partnership interest, the sale of her partnership interest will result into a technical partnership termination. A technical termination occurs when the sale of 50% of the total partnership interest within a 12-month period is officially confirmed, leading to the closure of the current tax year and the opening of the new tax year on the next calendar day (Blikshteyn, 2012). Specifically, it leads to the deemed transfer of assets and liabilities from the old partnership to the new one, defining property as newly acquired. Such a new partnership is subject to the property depreciation and is eligible for an additional 50% depreciation in the new tax year.
A technical termination of the partnership means a technical termination of the tax return. Thus, it is strongly advised to zero out the ending balance sheet. The K-1 schedules of the old partners should also indicate zero ending capitals and should be marked as final ones. These activities are advised considering the fact that after the establishment of the new partnership, the partnership can decide on possible changes in inventory methods, accounting methods, and tax year end. Moreover, the partnership can decide whether the previously irrevocable elections under the IRS §754 should be enforced. Consequently, the formation of the new partnership might have a negative impact on the accrued gains that Eli Wolford is entitled to receive since January 1, 2016 because the partnership interest of the old agreement will not be secured by the new agreement, possibly leading to even greater losses than previously estimated.
Moreover, a technical partnership termination could lead to specific changes in the allocation of the partnership income to the transferor, a change in the tax year of the partnership, and a change in the overall accounting method. According to the client’s brief, the current method used to allocate the partnership income to the transferor is an interim closing method that assumes the closing of accounting books from the beginning of the tax year to the date of transfer, hence determining the transferor’s share. However, it is possible to use a proration method that will allocate a prorate share of the amount that will be estimated based on the entire year. However, the proration method should be reflected in the partnership agreement. Consequently, if Kevin Dole were already informed on the method used through official documents, the change could not be enforced.
Besides, Kevin Dole can solely change the tax year of the partnership as the future owner of the majority of interest. In such a case, Ethan Wolford and Nora Latham will be required to follow the decision of Kevin Dole and adjust their taxpayer approach accordingly. Finally, the accounting method could be changed from the accrual method to the cash method. However, such an approach could have a negative impact on liabilities and capital accounts.
Conclusions and Recommendations
The analysis of the tax issues associated with the sale of the partnership interest by Eli Wolford to Kevin Dole revealed several structural weaknesses that may result in a loss if the current proposal is accepted without any amendments. Primarily, these weaknesses stem from the facts that the selling of the bigger part of interest will result in the technical termination of the partnership and that the partnership has IRS §751 assets listed under its projected balance sheet. The aforementioned structural weaknesses allow the transferee to significantly change the accounting method, the tax year definition, and the additional arrangements associated with irrevocable elections, which means that partnership guarantees will not cover the initial agreement between Wolford and Dole. Thus, Eli Wolford is advised to reconsider his approach to the selling of the partnership interest taking into consideration the following recommendations.
Considering that other partners have a certain level of trust in Kevin Dole as a future managing partner, Eli Wolford can conduct his sale of partnership interest in the course of two periods. During the first period, Eli Wolford is advised to sell 30% of his partnership interest to Dole, t
