Several years ago, Amy, Bob, and Carol formed a partnership that operates a marina in Florida.

Carol is ready to retire. Three options are being considered:

Option 1: Sell the business      and distribute part of the proceeds to each partner.

Option 2: Borrow money to      pay for Carol’s interest in the business.

Option 3: Ask Carol to find      an outside buyer for her interest in the business.

Pick one of these options and describe the tax consequences for the partnership and the partners for the option selected. If Carol should die before the plan is executed, how would this option be affected?
 

When responding to your peers’ posts, explain whether you agree or disagree with the other student’s recommendation. The reason you agree or disagree can be tax or non-tax related.
 

Provide an opinion about the tax consequences and related issues of your peer’s proposal.

#1- Option 2: Borrow money to pay for Carol’s interest in the business.

In this choice the marina business will not show any gains or losses. “Only the partner and the purchaser of the interest
are affected.” (Anderson, Hulse, & Rupert, 2023) There may be basis adjustments that will need review once Amy and Bob buy out Carol’s interest in the business. Although, if there is a Section 751 the business would be able to to recognize a gain or a loss on the buyout. Section 751 assets consist of inventory and unrealized receivables. These are items that can bring in ordinary income when the sale of property happens. An unrealized receivable consists of accounts receivable accounts. When Carol sales her interest in the business there will only be a recognized gain if the cash distributed is more than her “basis in partnership interest before distribution.” (Anderson, Hulse, & Rupert, 2023)

Carol will recognize a loss on unrealized receivables and/or inventory distributed if the “partnerships distributes money, inventory, and receivables with basis less than partner’s basis in partnership interest before distribution and partnership distributes no other property.” (Anderson, Hulse, & Rupert, 2023) If there is any other property distributed Carol’s basis will be equal to her basis in the property interest.  This happens before any distributions have been reduced by any money or carryover in the inventory or receivables. There is no gain or loss recognized.  Although, Carol may recognize a precontribution gain under Sec. 737 “if a precontribution net gain remains and the FMV of the property distributed exceeds the adjusted basis of the partnership interest immediately before the property distribution (but after any money distribution).” (Anderson, Hulse, & Rupert, 2023) 

“Sec. 754 provides an election to adjust the inside bases of partnership assets pursuant to Sec. 743(b) upon the transfer of a partnership interest caused by a partner’s death. ” (Ellentuck, 2015) If Carol were to die before the liquidation of her interest in the company happened her successor in interest would receive the interest in the partnership.  Amy and Bob could then buyout Carol’s interest in the partnership or the interest could be sold to outsiders. If Amy and Bob were to buy out the interest then “payments made for the property interest are taxed under the liquidating distribution rules.” (Anderson, Hulse & Rupert, 2023) If any payments are made to Carol’s successor-in-interest that are more than Carol’s share of property there will be a different tax result for both the partnership and the successor-in-interest. 

#2-Based on my research into the tax code and regulations, I would recommend Option 1 – selling the business and distributing the proceeds – as the best approach for Carol’s retirement.

Under IRC Section 741, the sale or exchange of a partnership interest is generally treated as the sale of a capital asset, resulting in capital gain or loss for the partner selling their interest. The selling partner’s outside tax basis in their partnership interest determines the gain or loss.

In Carol’s case, selling her full partnership interest in exchange for a distribution of proceeds would trigger recognition of capital gain or loss based on the difference between her outside basis and the distribution amount (Treas. Reg. 1.741-1(a)). This capital gain treatment offers more favorable tax rates than ordinary income.

The partnership itself would also recognize gain or loss on selling its underlying assets (IRC Section 1001). This would pass through as ordinary business income to Amy, Bob and Carol under IRC Section 702.

If Carol passes away before the sale, the same tax treatment would apply but her heirs would receive the distribution and recognize the capital gain in place of Carol (IRC Section 742). Her outside basis would carry over to her heirs.

In conclusion, Option 1 allows both Carol and the partnership to realize tax results from the liquidation event. The capital gain treatment for Carol is advantageous. I believe this option makes the most sense from a tax planning perspective.