8111 / What are the tax consequences of a charitable contribution of a partnership interest?

If the partnership interest includes a liability (mortgage, etc.), the amount of the liability is treated as an amount realized on the disposition of the partnership interest.² Thus, the contribution is subject to the bargain sale rules, and the transfer will be treated, in part at least, as a sale (see Q 8075).³ (If the partner’s share of partnership liabilities exceeds the fair market value of his partnership interest, he may have taxable income, but no deduction under the bargain sale rules.) In Goodman v. United States,⁴ the taxpayer contributed her partnership interest to charity, subject to her share of partnership debt. The district court held that the taxpayer recognized gain on the transfer equal to the excess of the amount realized over that portion of the adjusted basis of the partnership interest (at the time of the transfer) allocable to the sale under IRC Section 1011(b).⁵

In order to determine the taxable income and the amount of charitable deduction under the bargain sale rules, the following steps must be taken:

1. Determine the taxable gain on the sale portion. Under the bargain sale rules, part of the donor’s basis is allocated to the portion sold. The basis allocated to the sold portion is the amount of basis that bears the same ratio to his entire basis as the amount realized bears to the market value of the property. Presumably, the sold portion includes the same proportionate part of his share of unrealized receivables and substantially appreciated inventory as it does basis.

Example. Mr. Jones owns a 10 percent interest in a partnership that he has held for three years. The fair market value of his interest is $100,000 and his adjusted basis is $50,000. His share of a mortgage on partnership property is $40,000, and his share of “unrealized receivables” (potential depreciation recapture on the mortgaged property) is $5,000 in which the partnership’s basis is zero. He donates his entire interest to charity. He is deemed to have received $40,000, his share of partnership liabilities, on the transfer. In effect there are two transactions–a sale for $40,000 and a contribution of $60,000.

Of Mr. Jones’ $50,000 basis in his partnership interest, $20,000 is allocated to the sale portion: $40,000 (amount realized)/$100,000 (fair market value) × $50,000 (total adjusted basis). The fair market value of the sold portion is $40,000 (amount realized). Mr. Jones must recognize a gain of $20,000 ($40,000 realized less $20,000 adjusted basis allocated to the sold portion). Of that gain, $2,000 is allocable to unrealized receivables ($5,000 unrealized receivables × $40,000/$100,000). Because the partnership has no basis in the unrealized receivables, the entire $2,000 would be ordinary income. Mr. Jones must report a taxable long-term capital gain of $18,000 and a taxable ordinary gain of $2,000.

2. Determine the charitable contribution deduction. As a general rule, the fair market value of the portion given to charity is deductible except to the extent the property would have generated ordinary income if sold. Consequently, the allowable deduction for the gift portion must be reduced to the extent the portion of the partnership interest given to the charity would produce ordinary income if sold.

Example. The fair market value of Mr. Jones’ gift to charity is $60,000. Because 60 percent of the partnership interest was given to the charity ($60,000/$100,000), 60 percent of Mr. Jones’ share of partnership “unrealized receivables,” or $3,000 ($5,000 × 60% = $3,000), is considered included in the gift. The balance of the gift would be long-term capital gain on sale. Because $3,000 would be ordinary income on a sale, Mr. Jones’ contribution is reduced by $3,000, and his charitable contribution deduction is $57,000.

Other special rules may apply under certain circumstances, for example, if the partnership owns property subject to tax credit recapture, if it has made installment sales, or (as might occur in the case of an oil and gas partnership) if it is receiving income in the form of “production payments.” See also Q 8076 with regard to prepaid interest.

Further, the IRS may examine the transaction in which a donation takes place and may disallow the charitable deduction based upon the doctrine of substance over form. In one case, a partner claimed a deduction for his donation of a partnership interest to a charitable organization. The IRS examined the transaction and found that the charity had received no membership rights in the transaction and was given only a promissory note from the partner claiming the deduction. The partner retained the right to determine when interest payments would be made on the note. The IRS found that, in substance, the partner had never transferred the interest to the charitable organization and, as such, denied the deduction.⁶