“Hot Assets” and the Sale or Exchange of Partnership Interests

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Jason B. Freeman

Jason B. Freeman

Managing Member

214.984.3410
jason@freemanlaw.com

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine , a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

Hot Assets Explained

When a partner enters into a sale or exchange of their partnership interest, there are often lurking tax surprises—such as unexpected phantom income triggers.  Sales of partnership interests are notoriously fraught with potential tax traps for the unwary.  It is, in fact, even possible to trigger more tax on a sale than one receives in exchange for the interest in the partnership.

​One of the more common lurking issues involves triggering income from so-called “hot assets,” often in the form of “unrealized receivables” held by the partnership.  The scope of “unrealized receivables” is deceptively wide, and can include partnership attributes such as depreciation recapture, mining property, and a host of other items.

Moreover, to add insult to injury, the Code provides that “recapture income” is not eligible for installment method reporting. Thus, where a partnership interest is sold in exchange for payments over time, part of all of the transaction may not qualify for installment method reporting, requiring that the income related to the “recapture income” be reported immediately (i.e., as phantom income if the reporting of the income does not match the actual receipt of the payments).

The Rule of a Sale or Exchange

Treasury Regulation Section 1.751-1(a)(1) provides the general rule that in the case of a sale or exchange:

To the extent that money or property received by a partner in exchange for all or part of his partnership interest is attributable to his share of the value of partnership unrealized receivables or substantially appreciated inventory items, the money or fair market value of the property received shall be considered as an amount realized from the sale or exchange of property other than a capital asset. The remainder of the total amount realized on the sale or exchange of the partnership interest is realized from the sale or exchange of a capital asset under section 741.

In other words, where the sale or exchange of a partnership interest is subject to this rule, it gives rise to ordinary income (at the taxpayer’s marginal tax rate), rather than capital gain (which is subject to lower tax rates).  The phrase “unrealized receivables,” as used in the regulation cited above, is defined elsewhere in the Code and is subject to certain exceptions and modifications under Treasury Regulations.  Note that the Treasury Regulations also require any partner selling or exchanging any part of an interest in a partnership that has any “unrealized receivables” to submit certain statements to the IRS with his or her tax return or be subject to reporting penalties.

Triggering phantom income through unexpected “hot assets” is just one of many potential tax traps in play when a partner enters into a sale or exchange of their partnership interest.  Partners may be able to guard against such tax surprises or to structure a transaction in a manner that avoids them altogether.  Partners who are contemplating selling their partnership interests should consult with a tax attorney to ensure an optimal transaction structure.

 

Business Tax Planning Lawyer

Need assistance in managing the business planning processes? Freeman Law advises clients with corporate and other entity formations and reorganizations. Restructuring entities—through conversions, mergers, and liquidations—can involve particularly complex tax and regulatory considerations. Freeman Law provides experienced tax and business counsel, helping our clients achieve their organizational goals in a tax-efficient manner. Schedule a consultation or call (214) 984-3410 to discuss your corporate structuring or business and tax planning concerns.

 

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