Breaking Up is So Hard to Do, The Drama Continues (Part 2 of 3)

December 28, 2011
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The Drama Continues…Queue the Red Tape!

The first blog installment discussed the difficulties in establishing an exit strategy for a business entity, and a few problems that occur when transferring interests from an entity to a specific partner. The general rule is that gain is not recognized when property is distributed to a partner by a partnership, except where cash distributed exceeds a partner’s tax basis.  This is why a partnership is so popular; however, in taxation, popularity is usually followed by more restrictions.

The rules are designed to tax three situations.  Let’s say, for example, that property contributed by “partner A” is distributed “to partner B” within 7 years of the date of contribution. The built-in-gain (mentioned previously) to Partner A calculated at the time of contribution will usually be taxed.  This prevents partnerships from being used to disguise what is, in reality, a sale. Another restriction in this case would be that the property (other than money) that has appreciated will be distributed to a partner that contributed  appreciated property within the previous seven years to the entity.

Even more importantly comes a point that in negotiations, partner A must be aware of the potential for gain recognition in such a circumstance and protect himself. §737 changes the traditional non-recognition rule under these circumstances by causing partner A to recognize the lesser of the built-in-gain or the excess of the Fair Market Value of the property he receives over his basis.

The third situation is to tax distributions of marketable securities as money.  An exception to  an exception is for investment partnerships.

The final installment will discuss some strategies for avoiding gain recognition when distributing assets, and some unexpected results from that become apparent investment partnerships.

For more on this series, check out part one and three:

*Part 2 – “Complications of Exit Consequences”

*Part 3 – Strategies for avoiding gain recognition when distributing assets