Disposition of Partner's Interest The following discussions explain the treatment of gain or lossfrom the disposition of an interest in a partnership. Abandoned or worthless partnership interest.A loss incurred from the abandonment or worthlessness of apartnership interest is an ordinary loss only if both of the followingtests are met. The transaction is not a sale or exchange. The partner has not received an actual or deemeddistribution from the partnership. If the partner receives even a de minimis actual or deemeddistribution, the entire loss is a capital loss. Sale, Exchange,or Other Transfer The sale or exchange of a partner's interest in a partnershipusually results in capital gain or loss. However, see Paymentsfor Unrealized Receivables and Inventory Items, later, forcertain exceptions. Gain or loss is the difference between the amountrealized and the adjusted basis of the partner's interest in thepartnership. If the selling partner is relieved of any partnershipliabilities, that partner must include the liability relief as part ofthe amount realized for his or her interest. Example 1.Fred became a limited partner in the ABC Partnership bycontributing $10,000 in cash on the formation of the partnership. Theadjusted basis of his partnership interest at the end of the currentyear is $20,000, which includes his $15,000 share of partnershipliabilities. The partnership has no unrealized receivables orinventory items. Fred sells his interest in the partnership for$10,000 in cash. He had been paid his share of the partnership incomefor the tax year. Fred realizes $25,000 from the sale of his partnership interest($10,000 cash payment + $15,000 liability relief). He reports$5,000 ($25,000 realized - $20,000 basis) as a capital gain. Example 2.The facts are the same as Example 1, except that Fred withdrawsfrom the partnership when the adjusted basis of his interest in thepartnership is zero. He is considered to have received a distributionof $15,000, his relief of liability. He reports a capital gain of$15,000. Partnership election to adjust basis of partnership property.Generally, a partnership's basis in its assets is not affected by atransfer of an interest in the partnership, whether by sale orexchange or because of the death of a partner. However, thepartnership can elect to make an optional adjustment to basis in theyear of transfer. See Adjusting the Basis of PartnershipProperty, later, for information on making the election. Exchange of partnership interests.An exchange of partnership interests generally does not qualify asa nontaxable exchange of like-kind property. This applies regardlessof whether they are general or limited partnership interests orinterests in the same or different partnerships. However, undercertain circumstances, such an exchange may be treated as a tax-freecontribution of property to a partnership. See Contribution ofProperty, earlier. An interest in a partnership that has a valid election in effectunder section 761(a) of the Internal Revenue Code to be excluded fromthe partnership rules of the Code is treated as an interest in each ofthe partnership assets and not as a partnership interest. SeeExclusion From Partnership Rules, earlier. Installment reporting for sale of partnership interest.A partner who sells a partnership interest at a gain may be able toreport the sale on the installment method. For requirements and otherinformation on an installment sale, see Publication 537,Installment Sales. The gain from the installment sale is treated as part capital gainand part ordinary income if the partnership's assets includedunrealized receivables or inventory items. See Payments forUnrealized Receivables and Inventory Items, later. An allocation must be made to ensure that the income is correctlyreported. The gain allocated to unrealized receivables and inventoryitems is generally ordinary income and must be reported in the year ofsale. The gain allocated to the other assets is capital gain and canbe reported under the installment method. Liquidation at Partner's Retirement or Death Payments made by the partnership to a retiring partner or successorin interest of a deceased partner in return for the partner's entireinterest in the partnership may have to be allocated between paymentsin liquidation of the partner's interest in partnership property andother payments. For income tax purposes, a retiring partner or successor ininterest of a deceased partner is treated as a partner until his orher interest in the partnership has been completely liquidated. Payments made in liquidation of the interest of a retiring ordeceased partner in exchange for his or her interest in partnershipproperty are considered a distribution, not a distributive share orguaranteed payment that could give rise to a deduction (or itsequivalent) for the partnership. For information on the treatment ofgain or loss on the distribution by the retiring partner or deceasedpartner's successor in interest, see Partner's Gain or Lossunder Partnership Distributions, earlier. Unrealized receivables and goodwill.Payments made for the retiring or deceased partner's share of thepartnership's unrealized receivables or goodwill are not treated asmade in exchange for partnership property if both of the followingtests are met. Capital is not a material income-producing factor for thepartnership. (Whether capital is a material income-producing factor isexplained in the discussion under Family Partnership nearthe beginning of this publication.) The retiring or deceased partner was a general partner inthe partnership. However, this rule does not apply to payments for goodwill tothe extent that the partnership agreement provides for a reasonablepayment to a retiring partner for goodwill. Caution: Payments for unrealized receivables or goodwill are not treated asmade in exchange for partnership property under any circumstance ifthe partner retired or died before January 5, 1993 (or retired on orafter that date if a written contract to buy the partner's interest inthe partnership was binding on January 4, 1993, and at all timesthereafter). Unrealized receivables are defined later under Payments forUnrealized Receivables and Inventory Items. However, for thispurpose, they do not include the items listed in that discussion underOther items treated as unrealized receivables. Partners' valuation.Generally, the partners' valuation of a partner's interest inpartnership property in an arm's-length agreement will be treated ascorrect. If the valuation reflects only the partner's net interest inthe property (total assets less liabilities), it must be adjusted sothat both the value of and the basis for the partner's interestinclude the partner's share of partnership liabilities. Gain or loss on distribution.Upon the receipt of the distribution, the retiring partner orsuccessor in interest of a deceased partner will recognize gain onlyto the extent that any money (and marketable securities treated asmoney) distributed is more than the partner's adjusted basis in thepartnership. The partner will recognize a loss only if thedistribution is in money, unrealized receivables, and inventory items.No loss is recognized if any other property is received. Other payments.Payments made by the partnership to a retiring partner or successorin interest of a deceased partner that are not made inexchange for an interest in partnership property are treated asdistributive shares of partnership income or guaranteed payments. Thisrule applies regardless of the time over which the payments are to bemade. It applies to payments made for the partner's share ofunrealized receivables and goodwill not treated as a distribution. If the amount is based on partnership income, the payment istaxable as a distributive share of partnership income. The paymentretains the same character when reported by the recipient that itwould have had if reported by the partnership. For more information,see Partner's Distributive Share, earlier. If the amount is not based on partnership income, it is treated asa guaranteed payment. The recipient reports guaranteed payments asordinary income. For additional information on guaranteed payments,see five star hotel in ChaniaTransactions Between Partnership and Partners, earlier. These payments are included in income by the recipient for his orher tax year that includes the end of the partnership tax year forwhich the payments are a distributive share or in which thepartnership is entitled to deduct them as guaranteed payments. Former partners who continue to make guaranteed periodic paymentsto satisfy the partnership's liability to a retired partner after thepartnership is terminated can deduct the payments as a businessexpense in the year paid. Payments for Unrealized Receivables and Inventory Items If a partner receives money or property in exchange for any part ofa partnership interest, the amount due to his or her share of thepartnership's unrealized receivables or inventory items results inordinary income or loss. This amount is treated as if it were receivedfor the sale or exchange of property that is not a capital asset. This treatment applies to the unrealized receivables part ofpayments to a retiring partner or successor in interest of a deceasedpartner only if that part is not treated as paid in exchange forpartnership property. See Liquidation at Partner's Retirement orDeath, earlier. Caution: For a sale or exchange of a partnership interest before August 6,1997, inventory must be substantially appreciated before it generatesordinary income (rather than capital gain). This also applies to anysale or exchange under a written contract that is in effect on June 8,1997, and at all times thereafter before the sale or exchange. For thedefinition of "substantially appreciated," see Certaindistributions treated as a sale or exchange underPartnership Distributions, earlier. Unrealized receivables.Unrealized receivables include any rights to payment not alreadyincluded in income for the following items. Goods delivered or to be delivered to the extent the paymentwould be treated as received for property other than a capitalasset. Services rendered or to be rendered. These rights must have arisen under a contract or agreement thatexisted at the time of sale or distribution, even though thepartnership may not be able to enforce payment until a later date. Forexample, unrealized receivables include accounts receivable of a cashmethod partnership and rights to payment for work or goods begun butincomplete at the time of the sale or distribution of the partner'sshare. The basis for any unrealized receivables includes all costs orexpenses for the receivables that were paid or accrued but notpreviously taken into account under the partnership's method ofaccounting. Other items treated as unrealized receivables.Unrealized receivables include potential gain that would beordinary income if the following partnership property were sold at itsfair market value on the date of the payment. Mining property for which exploration expenses werededucted. Stock in a Domestic International Sales Corporation(DISC). Certain farm land for which expenses for soil and waterconservation or land clearing were deducted. Franchises, trademarks, or trade names. Oil, gas, or geothermal property for which intangibledrilling and development costs were deducted. Stock of certain controlled foreign corporations. Market discount bonds and short-term obligations. Property subject to recapture of depreciation under sections1245 and 1250 of the Internal Revenue Code. Depreciation recapture isdiscussed in chapter 3 of Publication 544. Determining value.Generally, the sales price of unrealized receivables, or theirvalue if received in a distribution treated as a sale or exchange, isdetermined by any arm's-length agreement between the buyer and theseller (or between the partnership and the partner receiving thedistribution). If no agreement exists, the price or value must be determined bytaking into account both the estimated cost to complete performance ofthe contract or agreement and the time between the sale ordistribution and the time of payment. Example.You are a partner in ABC Partnership. The adjusted basis of yourpartnership interest at the end of the current year is zero. Yourshare of potential ordinary income from partnership depreciableproperty is $5,000. The partnership has no other unrealizedreceivables or inventory items. You sell your interest in thepartnership for $10,000 in cash and you report the entire amount as again since your adjusted basis in the partnership is zero. You reportas ordinary income your $5,000 share of potential ordinary income fromthe partnership's depreciable property. The remaining $5,000 gain is acapital gain. Inventory items.Inventory items are not just stock-in-trade of the partnership.They also include the following property. Property that would properly be included in thepartnership's inventory if on hand at the end of the tax year or thatis held primarily for sale to customers in the normal course ofbusiness. Property that, if sold or exchanged by the partnership,would not be a capital asset or section 1231 property (real ordepreciable business property held more than one year). For example,accounts receivable acquired for services or from the sale ofinventory and unrealized receivables are inventory items. Property held by the partnership that would be consideredinventory if held by the partner selling the partnership interest orreceiving the distribution. Notification of partnership.If a partner exchanges a partnership interest attributable tounrealized receivables or inventory for money or property, he or shemust notify the partnership in writing. This must be done within 30days of the transaction or, if earlier, by January 15 of the calendaryear following the calendar year of the exchange. A partner may besubject to a $50 penalty for each failure to notify the partnershipabout such a transaction, unless the failure was due to reasonablecause and not willful neglect. Information return required of partnership.When a partnership is notified of an exchange of partnershipinterests involving unrealized receivables or inventory items, thepartnership must file Form 8308, Report of a Sale orExchange of Certain Partnership Interests. Form 8308 is filedwith Form 1065 for the tax year that includes the last day of thecalendar year in which the exchange took place. If notified of anexchange after filing Form 1065, the partnership must file Form 8308separately, within 30 days of the notification. On Form 8308, the partnership states the date of the exchange andthe names, addresses, and taxpayer identification numbers of thepartnership filing the return and the transferee and transferor in theexchange. The partnership must also provide a copy of Form 8308 (or awritten statement with the same information) to each transferee andtransferor by the later of January 31 following the end of thecalendar year or 30 days after it receives notice of the exchange. The partnership may be subject to a penalty of up to $50 for eachfailure to timely file Form 8308 and a $50 penalty for each failure tofurnish a copy of Form 8308 to a transferor or transferee, unless thefailure is due to reasonable cause and not willful neglect. If thefailure is intentional, a higher penalty may be imposed. See the forminstructions for details. Statement required of partner.If a partner sells or exchanges any part of an interest in apartnership having unrealized receivables or inventory, he or she mustfile a statement with his or her tax return for the year in which thesale or exchange occurs. The statement must contain the followinginformation. The date of the sale or exchange, the partner's adjustedbasis for the partnership interest, and the part of the basis thatrepresents the unrealized receivables or inventory items. The money and fair market value of any other property thepartner received or will receive for the interest in the partnership,and the part for the unrealized receivables or inventory items. The statement described earlier in Special adjustmentto basis of property received under Partner's Basis forDistributed Property, if the partner computes the basis for theunrealized receivables or inventory items under that provision. If the partnership used the optional basis adjustment, thecomputation described later under Adjusting the Basis ofPartnership Property and a list of the partnership properties towhich the adjustment has been allocated. Partner's disposition of distributed unrealized receivablesor inventory items.In general, any gain or loss on a sale or exchange of unrealizedreceivables or inventory items a partner receives in a distribution isan ordinary gain or loss. For this purpose, inventory items do notinclude real or depreciable business property, even if they are notheld more than 1 year. Example.Mike, a distributee partner, received his share of accountsreceivable when his law firm dissolved. The partnership used the cashmethod of accounting, so the receivables had a basis of zero to Mike.If the receivables are later collected, or if Mike sells them, theamount received will be ordinary income. Exception for inventory items held more than 5 years.If a distributee partner sells inventory items held for more than 5years after the distribution, the type of gain or loss depends on howthey are being used on the date sold. The gain or loss is capital gainor loss if the property is a capital asset in the partner's hands atthe time sold. Example.Ann receives, through dissolution, inventory that has a basis of$19,000. Within 5 years, she sells the inventory for $24,000. The$5,000 gain is taxed as ordinary income. If she had held the inventoryfor more than 5 years, her gain would have been capital gain, providedthe inventory was a capital asset in her hands at the time of sale. Substituted basis property.If a distributee partner disposes of unrealized receivables orinventory items in a nonrecognition transaction, ordinary gain or losstreatment applies to a later disposition of any substituted basisproperty resulting from the transaction.