Category: Partnerships & LLCs; Sales
& Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer is an LLC. I will refer to the members as Messrs. A, B, and C. As I understand it from our telephone conversation, A bought out the interests of B and C for a total cash price of $275,000 in March, 1996. Prior to the buy-out, Messrs. B and C had equal ownership shares representing in the aggregate 30% of the profits and 36.44% of the capital of Taxpayer. A owned the balance of the interests. From the context of your memorandum and our conversations, I gather that Taxpayer does not have a valid Section 754 election in effect at this moment. Please correct me if this is wrong. As you point out, Taxpayer is taxed as a partnership. For federal tax purposes, whether a partnership continues or is terminated by a given event is determined by principles of federal tax law. This determination is entirely independent of whether the partnership or LLC survives under local law. You have told me that Taxpayer survives the buy-out of B and C under state law, but as I have said, the local law determination does not affect whether Taxpayer survives for federal tax purposes. For federal tax purposes, the buy-out terminates the partnership. Under Internal Revenue Code Section 708(b)(1)(A), a partnership terminates if no part of any business of the partnership continues to be carried on by any of its partners in a partnership. It is well settled that a one-man partnership is not a partnership for tax purposes, and the old partnership is terminated at the moment the sole remaining partner buys out his other partners. Regs. Section 1.708-1(b)(1)(i). Mechanically speaking, Taxpayer is deemed liquidated for tax purposes as of the date in March, 1996 when Mr. A bought out B and C. Taxpayer is required to file a final tax return 3-1/2 months after the end of March, i.e., by July 15, 1996. As I understand it, no return or extension was filed by that deadline. It seems to me that Mr. A will be treated for tax purposes as having operated Taxpayer as a sole proprietorship between the buy-out of his partners and the subsequent sale of the assets in mid-1996. The appropriate question at this point would seem to be the following. -What is the basis of the assets Mr. A receives on the termination of Taxpayer? -What, if anything, can Mr. A and/or Taxpayer do to affect how the basis of the various assets is determined? In general, assets distributed in liquidation of a partnership take on the basis of the partner's interest in the partnership prior to the liquidation. Mr. A received assets in liquidation of his pre-existing interest in Taxpayer, and he received assets in liquidation of the interests he bought from B and C. I have no way of knowing the basis of Mr. A's interest prior to the buy-out, but obviously the basis of the interests he bought from B and C is $275,000. The issue is how to allocate Mr. A's aggregate basis ($275,000 plus whatever he had in the first instance) as between the assets received in liquidation. It seems to me that 30% of Taxpayer's assets (this is the aggregate capital interest formerly held by B and C) will take on a basis of $275,000. The remaining 70% will take on basis equal to A's basis in his partnership interest prior to the buy-out. The general rule is set forth at Section 732(c). Basis is first allocated to cash and unrealized receivables to the extent of the partnership's basis in these items. Any remaining basis is allocated among the other properties is proportion to their adjusted basis to the partnership. In your memorandum, you stated that Taxpayer's only assets are inventory of $14,000 and fixed assets of $88,000. I disagree with your assertion. I think we must consider the rights under the operating lease as well even though these rights have no basis. Since rights are being sold within a short time after the buy-out, I think it is difficult to ignore them for our purposes. In broad strokes, I think the net effect of the general basis allocation rule is as follows. The basis of A's pre-existing interest in Taxpayer will be allocated among 70% of Taxpayer's assets. Assuming that outside basis equals inside basis, this simply means that 70% of Taxpayer's assets will have carryover basis in the hands of Mr. A. Note that this a big assumption I am making. We should discuss this issue. $275,000 will be allocated among the remaining 30% of Taxpayer's assets. Under the general rule, all the step-up in basis will be allocated to the fixed assets. Apparently, this is what the taxpayer wants because it effectively creates an artificial Section 1231 loss (potentially ordinary) on sale of the equipment and shifts the gain to the operating lease which is a capital asset. There is an election under Section 732(d) which would allow Mr. A to allocate the basis of the 30% of Taxpayer's assets distributed in the termination based on the relative differences between fair market value and inside basis. This election would have the effect of allocating most of the step-up to the operating agreement and thereby avoiding the artificial shift between Section 1231 loss and capital gain on the subsequent disposition of the assets. Of course, Mr. A would not voluntarily make this election. Unfortunately, the last sentence of Section 732(d) provides
that a taxpayer can be required to apply the rules of Section
732(d) in certain instances. Reg. Section 1.732-1(d)(4)(i) requires
application of the principle of Section 732(d) if at the time
of his acquisition of the transferred interest-- The taxpayer in this case clearly meets the first and third tests. Does he meet the second test? In order to meet the second test, the general allocation rule must result in shifting basis from non-depreciable assets to depreciable assets relative to the Section 732(d) allocation methodology. As discussed above, I think the general allocation methodology has the effect of allocating a great deal of the step-up to the fixed assets which are of course depreciable and away from the operating lease which is non-depreciable. I believe the mandatory allocation rule applies in this case. I think the next step is to prepare the final partnership tax return for Taxpayer. Once that is done, it will be much easier to proceed with the calculations necessary for basis allocation and determination tax effects of the subsequent sale of Taxpayer's assets by Mr. A. Please call me when you have had the opportunity to digest this memo. |
