Gain on Sale of a Partnership Interest: Capital, Ordinary, or Both?
One reasonably might expect her sale of a partnership interest to generate only capital gain; after all, a partnership interest is a capital asset. While it is certainly true that overall gain from the sale of a partnership interest is determined by reference to the difference between sale proceeds and the partner’s outside basis, rules under Subchapter K require “look-through” analysis of the character of the partnership’s assets on the date of sale to properly allocate the seller’s overall gain or loss between “buckets” of ordinary income and capital gain.
So, how must a seller determine the character of gain or loss from the sale of a partnership interest? The first step is to identify ordinary income-producing properties held by the partnership on the date of the sale of the partnership interest. Next, the seller must determine her share of gain from a hypothetical sale of those ordinary income-producing properties. Finally, the selling partner subtracts her share of gain upon a hypothetical sale of ordinary income-producing properties from the seller’s overall gain; the difference is the amount of gain or loss which retains capital gain character.
Stated succinctly, this article highlights a significant, yet often over-looked, federal income tax consideration for the seller of a partnership interest:
All gain (or loss) realized on the sale of a partnership interest in an operating business is not likely entirely capital in character. What is more likely, is that some, all, or more than all of the gain, is properly characterized as ordinary.
Important implications flow from cognizance that sale of a partnership interest may produce ordinary income and heightened current tax costs. For example, when negotiating terms of installment payments for a partnership interest, the seller may consider that installment gain treatment is generally not available for gains from ordinary income items such as the sale of inventory, certain accounts receivable, recapture items, and securities traded on an established exchange. A seller also may wish to defray current tax costs by considering that the buyer will want a step-up in basis in underlying assets represented by her acquired partnership interest; the buyer may be willing to pay a premium to obtain the selling partner’s consent to a partnership-level election, a necessity to the buyer’s inside basis step-up. Finally, a seller may consider that although, in form, she sells a partnership interest, the hypothetical gain or loss calculation on partnership-level assets may drive the need for, and cost of, a fair value appraisal of underlying partnership assets.
In summary, federal tax rules require the seller of a partnership interest to determine the ordinary and capital character of gain or loss upon sale. The ultimate character of the seller’s gain is determined by analyzing the character of underlying partnership assets, as represented by the seller’s partnership interest. By gaining a solid understanding of ordinary and capital characters of gain or loss in advance of a proposed partnership interest transaction, an informed seller is better-equipped to quantify the tax costs associated with a proposed transaction. A seller, informed in advance of tax consequences of the proposed transaction, is also better positioned to negotiate payment terms, negotiate terms of consent to potential partnership-level elections, and ultimately to maximize her partnership interest offering price.