8938 / How is a sale of partnership interests taxed?

Editor’s Note: Under the 2017 tax reform legislation, the technical termination rule was repealed. Therefore, a partnership will be treated as though it is continuing even if more than 50 percent of the total capital and profits interest of the partnership are sold or exchanged. This provision applies for tax years beginning after 2017.¹

As a practical matter, limited partnership interests are often not freely transferable because there is a lack of a market for the interests. However, in the event that an interest is sold, gain recognized by a limited partner on the sale of an interest is taxed as a long-term capital gain (see Q 8606). Any portion of that gain that is attributable to a limited partner’s share of the partnership’s IRC Section 751 “unrealized receivables” and “substantially appreciated inventory” items is subject to treatment as ordinary income.

In addition to any requirements in the partnership agreement that must be met upon the transfer of an interest, the IRC requires the transferor-partner to promptly notify the partnership of a transfer of a unit that occurs at a time when the partnership holds unrealized receivables or inventory items that have substantially appreciated in value. A penalty is imposed for a failure to make this notification, unless the failure is due to reasonable cause and not to willful neglect. Once the partnership has been notified, it is required to inform the buyer, the seller and the IRS of the names, addresses and taxpayer identification numbers of the parties to the transfer.

Upon the sale or exchange of, or certain distributions with respect to a partnership unit, the partnership will be treated as owning its proportionate share of the property owned by any other partnership in which it is a partner. Therefore, if gain is realized upon the sale or exchange of, or certain distributions with respect to, a unit, a portion of the gain may be treated as ordinary income rather than capital gain to the extent it is attributable to unrealized receivables and substantially appreciated inventory held, not only by the partnership, but also by any partnership in which the partnership holds an interest.

If it is found that a limited partner holds an interest primarily for sale to customers in the ordinary course of business, rather than for investment purposes, all gain recognized by that partner upon sale is taxable as ordinary income under the theory that the units are actually inventory held for sale in the ordinary course of business.

The amount of gain recognized by a limited partner on the sale of partnership units is equal to the excess of: (a) the amount realized on the sale of a unit, over (b) the adjusted tax basis of the interest. The amount realized includes cash, the fair market value of other property received on the sale and the partners’ share of any qualifying nonrecourse liability of the partnership. Because nonrecourse liabilities must generally be taken into account, it is possible for a partner to be subject to a tax liability that exceeds the actual proceeds received upon the sale of a partnership interest. This is frequently referred to as “phantom income.”

The partnership agreement may permit the general partner to make a special election under IRC Section 754 to adjust the basis of partnership property when there is a transfer of a unit or a distribution of partnership assets that takes into account the basis in the partnership unit. If the value of the partnership property has increased, this election would result in the transferee partner having an increased basis in the allocable share of partnership assets and, therefore, the partner would receive more favorable tax treatment (greater cost recovery) if the partnership filed the Section 754 election. A general partner may choose not to make this election, however, because of the complexities and added expenses of the tax accounting required. In some cases, this may adversely affect the marketability of partnership interests and the price that a prospective purchaser would be willing to pay for a partnership unit. However, when a partner dies, a Section 754 election allows for a step up in basis for the partner’s interest in the partnership’s assets. This can be a valuable tax benefit for estates which own interests in partnerships.

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Planning Point: In the event a partner in a partnership were to die, the partnership agreement should be examined to determine if a Section 754 election is authorized or required. Next, the general partner should be contacted to determine if an election is already in effect. Once an election is in effect under Section 754, it remains in effect for future years and can only be revoked with the consent of the IRS.²

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