It is a little known secret that IRS Large Business & International (“LB&I”) issues “Practice Units” from time to time. Often, these Practice Units are worth a read because they “are developed through internal collaboration and serve as both job aids and training materials . . . [to IRS examiners] on tax issues.” A list of former Practice Units can be found here.
Recently, on March 12, 2021, IRS LB&I issued a 50-page Practice Unit on the “Sale of a Partnership Interest.” This Insight discusses that Practice Unit.
Subchapter K of the Internal Revenue Code (“Code”) houses the partnership tax rules. Under these complex rules, a partnership is generally not a taxable entity—rather, the items from the partnership flow through and are reported by the partners on their respective income tax returns. In this manner, a partnership is not treated as a separate entity but instead is treated more as an aggregate of its partners. For federal tax purposes, this is known as the “aggregate theory” of partnership taxation.
But, in many cases, subchapter K treats the partnership as a separate entity. In these instances, federal tax law refers to such treatment as the “entity theory” of partnership taxation. The competing interests of aggregate versus entity theories are ubiquitous in subchapter K of the Code.
For example, these competing interests can be seen when a partner sells his or her interest in a partnership. Generally, the selling partner treats the gain or loss on the sale of a partnership interest as the sale of a capital asset. See Sec. 741. However, if the partnership holds certain assets, the aggregate theory trumps the entity theory and requires the partner to characterize part of the gain or loss as subject to varying rates (e.g., ordinary income). See Sec. 751.
The Five IRS Identified Issues in the Sale of a Partnership Interest
The IRS identifies at least five potential audit issues with respect to the sale of a partnership interest. These include:
- Did an ownership change occur where one partner sold an interest in the partnership to a new or existing partner?
- Did the partner who sold an interest in the partnership properly report the gain or loss?
- Did the selling partner consider whether the partnership has any Section 751 assets and treat any of the gain or loss on the sale of the partnership interest as ordinary income?
- Did the selling partner consider whether the partnership has any Section 1250 assets and treat any of the gain or loss on the sale of the partnership interest as being subject to tax at the unrecaptured Section 1250 gain tax rate?
- Did the partnership have a Section 754 election in place? If so, did the partnership correctly compute the Section 743(b) adjustment?
Factual Audit Development
The Practice Unit identifies various parts of the partnership return (Form 1065) that the IRS examiner should review to determine whether the sale of a partnership interest has occurred. For example, the IRS examiner is instructed to review the Schedules K-1 issued to the partners to determine whether the partnership issued any Schedules K-1 marked “final” or whether capital accounts have been reduced to zero. In addition, IRS examiners are advised that they can determine whether an ownership change has occurred through a careful review of the Form 1065’s Schedule M-2. Finally, IRS examiners are instructed to look for a filed Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, with the Form 1065.
Issue One: Did an Ownership Change Occur?
The first issue in the Practice Unit focuses on identifying whether an ownership change has occurred at the partner level. The Practice Unit correctly notes that a partner may dispose of a partnership interest in various manners, such as through sale, exchange, gift, death, or abandonment. The Practice Unit focuses solely on identifying sales of partnership interests.
To assist IRS examiners in determining whether an ownership change has occurred, IRS examiners are instructed to ask three questions: (1) Did the benefits and burdens of ownership transfer to the buyer; (2) Which partner has the right to present and/or future partnership profits under the partnership agreement; and (3) Assuming that there was a clearly-established partnership, what was the intent of the parties involved in the transaction at issue?
In addition, IRS examiners are told that they should review the potential selling partner’s tax return to determine whether the seller reported the sale transaction. For example, a partner generally reports the sale of a partnership interest on Schedule D, Form 8949, and/or Form 4797. The Practice Unit cautions IRS examiners that if the seller’s return is silent regarding any potential sales transaction, “it doesn’t necessarily mean there was no sale. Seller’s non-inclusion could point to a fraudulent intent and/or tax evasion motive.”
If a sale has been identified by the IRS examiner, the examiner is advised to also look to whether it was a related party sale (which can result in disallowance of any loss) and whether the partnership properly allocated its income/loss between the buyer/seller in the year of the sale.
Issue Two: Did the Partner Properly Report the Gain or Loss?
The second issue in the Practice Unit is whether the selling partner properly reported the gain or loss from the sale of the partnership interest on his or her return. For these purposes, the Practice Unit notes that the gain or loss from the sale of a partnership interest is generally the difference between the sales proceeds received and the partner’s tax basis in the interest at the time of the sale. Moreover, for purposes of determining the sales proceeds (or the amount realized), the IRS examiner is instructed to look for the amount of cash and property received, plus the amount by which the partner’s share of partnership liabilities decreased.
The Practice Unit also cautions the examiner that, depending on the identity of the partner, there may be additional filing requirements watch for—i.e., if the selling partner is a foreign partner, the foreign partner may have filing and withholding requirements under the Code.
If a sale of a partnership interest has been identified, the Practice Unit notifies the IRS examiner that he or she should request copies of the following documents during the examination: (1) the partnership agreement; (2) the sales agreement; (3) the selling partner’s outside basis computation; and (4) the selling partner’s tax return to determine how the sale was reported.
Issue Three: Did the Selling Partner Properly Consider Section 751 in the Sale?
Under Section 751(a), if a partnership holds certain property (referred to as “hot assets”) at the time of the sale, the partner is required to recognize gain or loss from its share of those assets. Generally, this gain is treated as ordinary income and not capital gain. Hot assets include unrealized receivables and inventory items as defined in Section 751. And Section 751 can act as a trap for the unwary because the statutory definition of the term “unrealized receivables” and “inventory items” is broader in scope than what taxpayers generally consider as falling within the scope of those terms.
To determine whether a taxpayer properly reported the sale under Section 751, the Practice Unit advises IRS examiners to look for a required statement on the selling partner’s return. This statement must include the following: (1) the date of the sale; (2) the amount of the gain/loss attributable to Section 751 property; and (3) the amount of the gain/loss attributable to capital gain/loss from the sale of the partnership interest. Treas. Reg. § 1.751-1(a)(3). After studying the statement, the IRS examiner is further instructed to look at the partnership’s Form 8308 to determine if there are any discrepancies between the seller’s tax treatment and the partnership’s reported tax treatment vis-à-vis the sale. If the partnership and/or partner have failed to attach the required Form and/or statement, the IRS examiner is told to request such information.
Finally, the IRS examiner is directed to review Schedule L of the Form 1065. Schedule L has, among other items, the following: depreciable assets (Lines 9(a) and (b)); intangible assets (Lines 12(a) and (b)); accounts receivable (Lines 2(a) and (b)); and inventory (Line 3). If the Section 751 assets have been consistently reported on the partner and partnership return, the IRS examiner is instructed to determine whether the reported fair market values of the Section 751 assets are proper and whether the partnership and/or partner used an appraiser to determine those values. If the IRS examiner determines the Section 751 assets’ fair market values may have been underreported, he or she is instructed to consider requesting an IRS valuation expert.
Issue Four: Did the Selling Partner Properly Consider Section 1250 in the Sale?
Although the sale of an asset may be capital gain, not all capital gain rates are the same. For example, the look-through rule of Treas. Reg. § 1.1(h)-1 indicates that certain types of capital gains are taxed at rates higher than the normal long-term capital gain rates.
Unrecaptured Section 1250 gain is taxed higher than normal capital gains rates (25% versus reduced rates for other capital gains). For these purposes, unrecaptured Section 1250 gain is the amount of depreciation taken on property but limited to actual gain on the sale. If a partner has Section 1250 gain, he or she generally must provide additional information to the IRS regarding the sale on a tax return.
The Practice Unit notifies IRS examiners that a partnership holding a building generally spins off unrecaptured Section 1250 gain if the sale of a partnership interest occurs. Similar to Issue Three above, the Practice Unit identifies parts of the partnership’s Form 1065 that will help determine whether the partner reported all necessary Section 1250 gain and, if so, whether such valuations were reasonable.
Issue Five: Did the Partnership Correctly Compute the Section 743(b) Adjustment Related to the Selling Partners’ Recognition of Gain or Loss on the Sale?
Generally, no adjustment is made to the partnership’s inside basis of assets when a sale of a partnership interest occurs. However, Congress recognized early that when a partner sells his or her partnership interest, the buyer will generally pay for any unrealized gains and losses related to the partnership’s property—i.e., the buyer will pay fair market values. As a result, discrepancies often occur between a buyer’s outside basis in the partnership and the partnership’s inside bases in its assets. To remedy this discrepancy, Congress enacted Section 754 and Section 743(b).
A partnership makes a Section 754 election by attaching a proper statement of the election to its Form 1065. Once the election is made, it applies to the year of the election and all subsequent years unless permission to revoke it is secured from the IRS. If the election has been properly made, adjustments under Section 743(b) are required.
To determine whether Section 743(b) applies and has been applied correctly, the Practice Unit advises IRS examiners to:
- Verify the partnership has a valid Section 754 election that has not been revoked.
- Determine if the year under examination is the year of the sale transaction or a subsequent year.
- Review the Section 743(b) optional basis statement attached to the partnership return.
- Determine whether the amount of the Section 743(b) optional basis adjustment is correct.
- Verify the partnership’s allocation of the Section 743(b) adjustment to the partnership’s assets makes sense.
As the Practice Unit above on sales of partnership interests shows, IRS examiners are instructed specifically on what issues they should look for in addition to what documents they should request with respect to any given tax examination. Accordingly, Practice Units make great tools for tax practitioners who are representing clients before the IRS regarding those issues already identified in a particular Practice Unit. The Practice Unit on sales of partnership interests provides a readily-usable tool to taxpayers who sold partnership interests and who are subject to IRS examination.
Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3000 to discuss our tax representation services.