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).
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.