Partnership interest & 754 when outside basis is less

I am in the same place as Jeff. Perhaps this will help. A’s transfer of his entire interest in the partnership in exchange for assets (i.e., a share in each asset of the target LLC) is a partnership redemption or liquidating distribution. Generally no gain is expected upon such distribution under section 731.

Your analysis eludes me in several respects.

Same

Your approach here is kind of a break-down approach starting with the single-member LLC’s balance sheet. I’d take more of a build-up approach.

Also, agreed. I'd encourage OP to take this advice and see where this gets you before going any further. This approach will also help suss out the 704(c) dynamic.

Your analysis eludes me in several respects.

First, there’s this, with talk about “at what was FMV” and “I anticipate a gain”:

Everything happened simultaneously. A took his assets of the existing partnership out, and will receive a K-1 for this distribution at what was FMV of this at the time. The preparer has given me A's basis (and I can corroborate through 1040s) prior to exit. I anticipate a gain if it plays out this way.

Worded poorly when I said took his assets out. What was communicated to me, by the tax preparer of the existing partnership (Partnership Entity), is that the equity A had in the Partnership is to be exchanged in the sale treated as a distribution. At closing, this amount, which was valued in the agreement, is applied toward the purchase price of the SM LLC. The preparer indicated the basis is X, the amount valued and used in consideration at closing (shown as a distribution on the K-1) is Y, Y is bigger than X, so we will report this as a gain in the K-1 footnotes as a distribution in excess of capital.

Next there’s this:

Then, A contributes that to the entity (previous SMLLC) at closing, and B contributes cash.

It sounded to me like A was redeemed out and he got an interest in (or assets of) the single-member LLC owned by existing partnership. Then B paid cash to existing partnership for the remaining interest in the single-member LLC that was previously owned by the existing partnership. Did existing partnership get any cash from B? I’m guessing it did, such that when you say “B contributes cash” that cash is on top of the cash B gave to existing partnership. But maybe I’m wrong. Maybe you’re saying 100% of the single member LLC was distributed to A from existing partnership and then the only cash B parted with was contributed to New Partnership. I’m skeptical of this route, but you keep adding to the facts.

At closing, the purchase price is stated. Net working capital adjusted down a bit to leave a balance due to the existing partnership (Partnership Entity) . A's distribution number noted above was applied to the purchase price, and the remaining balance due owed was paid to the existing partnership (Partnership Entity) in cash by B. B's only cash outlay was at closing and payable to the existing partnership (Partnership Entity).

You’re approach here is odd:

For argument's sake, if there's not, I plan to write down the assets inside of the entity to their outside basis, similar to if the agreement was simply an asset sale with allocations done.

You’re approach here is kind of a break-down approach starting with the single-member LLC’s balance sheet. I’d take more of a build-up approach. That is, if we do have a redemption of A from existing partnership, that will be revealed on the K1 A receives. With assistance from the 1065 preparer, including any 751 issues, you will be able to determine the basis of the assets received by A. Those then get contributed to Newco (along with a 704c issued as noted by Captain). And then if B really did purchase a portion of assets from existing partnership, those will be booked up at FMV (i.e., the amount B paid for them). Those then get contributed to New Partnership. Now we have the initial tax basis Balance Sheet for New Partnership. And then you should be able to reconcile that Bal Sheet to the existing Bal Sheet you were given. The reconciling items are obvious: (1) differences between basis of assets in A’s hands after redemption vs inside basis and (2) differences in basis of what B purchased from existing partnership and contributed to New Partnership vs inside basis of those assets.

With the equity exchange triggering gain,

I do not understand why you keep saying this (unless there is some aspect of Subchapter K that causes you to say this). Unlicensed mentions a Distribution in Post #12 (before facts were clear – but now it seems there was a distribution). You yourself say it will be shown as a distribution on A’s K1. And you can also see the first paragraph of Post #17.

In short, I see a redemption of A and a contribution of those assets to New Partnership by A. Then I see a purchase of assets by B from existing partnership with B then contributing those assets to New Partnership. So, like others, I see no 754 opportunity. However, if this was papered up, for example, with the redemption happening first, now the single-member LLC really is a multi-member LLC after the redemption. And it could be that existing partnership is saying that B immediately purchased an interest in that multi-member LLC from existing partnership, which could give rise to a 754 election. But that would be on the existing partnership’s 1065.

I'm saying it is triggering gain simply because that is how I was told we would receive A's final K-1, with a distribution in excess of capital account using the value assigned to his equity as a payment at closing of the purchase of the Single Member LLC. Therefore, A's basis is this amount. I am not saying this is 100% correct, but it is how they intend to issue A the K-1. Simply put -- his capital account was $700k, they're value his interest in the existing partnership (Partnership Entity) at $1,000,000, they are going show him realizing a $300,000 capital gain and now his basis is $1,000,000. The $1,000,000 was applied to the purchase price at closing of the SMLLC, B brought $1,000,000 of cash to the table. Round figures but you get the idea. No cash ever made it's way into the newly formed partnership (former Single Member LLC) as it was all paid to the prior entity.

Build-up approach makes sense, I only started backwards due to being delivered a balance sheet from the seller's accounting team saying to start with this as they are assuming it. I challenged this, which is where this all started.

I know B's basis, it is simple. His cash. I need to dig into A's true basis and then use that to start the balance sheet. The seller's approach was that A's true basis is the FMV used to exchange his equity.

I oversimplified the explanation at the start as to try to not confuse things without thinking through all of the issues.

Even if the K-1 showing a $1M distribution, based on fair market value, was correct (it is not), the resulting -300K does not mean 300K of capital gain to A.

You are fundamentally not understanding partnership distribution rules. Please review below. Happy to answer any questions you might have after reading.

https://www.thetaxadviser.com/issues/20 ... erest.html

Curious, what exactly is your role in this transaction? Who is your client?

I believe the seller (and seller’s CPA) are intending to treat the FMV distribution as an actual cash sale by A, who then immediately used the cash to buy his % in the single member LLC. This fact pattern didn’t happen (he did not receive cash) but they may be taking the position it was papered as such. I understand the basics of partnership basis and rules of distribution but am not very technical in it as I do not practice in that space very often.

I was not implying it was the correct treatment in my previous post, I am simply communicating that is the direct statement that was passed on to me when I inquired on the reporting of the final K-1.

It’s a long story, but A involved me after the fact on all of this to help try and sort some things out. He’s a friend and related to a large client of mine. Early on, I advised him to hire a tax attorney to help his negotiation and understanding of the transaction as this wasn’t something I am an expert on. You can tell they didn’t happen. Can lead a horse to water…

Let’s see the K-1. Please post with identifying information redacted.

I don't have it, as it won't be issued until the Spring. This happened a couple months ago. See below for direct language from the seller and seller's accounting team. * are what I redacted. This is verbatim -- not my language.

The equity that *A* holds in **parent entity** is held through *A's entity mentioned above*. It had $689,450 in its capital account on 12/31/23. The equity was valued such that *A's entity mentioned above* will not receive any pro rata share of 2024 income or losses. There will also not be a short-year tax return. The return will be filed as normal next year at which time *A's entity mentioned above* will receive a K1 that shows the amount of the equity exchanged in the sale treated as a distribution. The equity in the transaction is valued at $1,014,023. This distribution will put his capital account in a negative position of $324,573. I do not know his situation on loss-carryforwards so this may be offset if he has some, but otherwise would be treated as a LTCG if the entity took the prior year losses.

The deal is structured as an entity acquisition. The entity that they are purchasing is *SMLLC*. *SMLLC* is a 100% disregarded entity of the seller of the transaction, *Previous Partnership (Parent Entity)*. Since *SMLLC* is a 100% disregarded entity of *Previous Partnership (Parent Entity)* there will not be a short-year tax return filed. *Previous Partnership (Parent Entity)* will have all of the income/losses associated with *SMLLC* through 8/31/24. As of 9/1/24 *SMLLC* will no longer be a disregarded entity. We are delivering a GL with the sale that includes a starting entries for the Balance Sheet. All income and expenses starting on 9/1/24 will be the reporting responsibility of *SMLLC*.

I don't have it, as it won't be issued until the Spring. This happened a couple months ago. See below for direct language from the seller and seller's accounting team. * are what I redacted. This is verbatim -- not my language.

The equity that *A* holds in **parent entity** is held through *A's entity mentioned above*. It had $689,450 in its capital account on 12/31/23. The equity was valued such that *A's entity mentioned above* will not receive any pro rata share of 2024 income or losses. There will also not be a short-year tax return. The return will be filed as normal next year at which time *A's entity mentioned above* will receive a K1 that shows the amount of the equity exchanged in the sale treated as a distribution. The equity in the transaction is valued at $1,014,023. This distribution will put his capital account in a negative position of $324,573. I do not know his situation on loss-carryforwards so this may be offset if he has some, but otherwise would be treated as a LTCG if the entity took the prior year losses.

The deal is structured as an entity acquisition. The entity that they are purchasing is *SMLLC*. *SMLLC* is a 100% disregarded entity of the seller of the transaction, *Previous Partnership (Parent Entity)*. Since *SMLLC* is a 100% disregarded entity of *Previous Partnership (Parent Entity)* there will not be a short-year tax return filed. *Previous Partnership (Parent Entity)* will have all of the income/losses associated with *SMLLC* through 8/31/24. As of 9/1/24 *SMLLC* will no longer be a disregarded entity. We are delivering a GL with the sale that includes a starting entries for the Balance Sheet. All income and expenses starting on 9/1/24 will be the reporting responsibility of *SMLLC*.

They are wrong.

Hard to understand. But I wonder if there are some fictions going on here. Specifically, A is deemed to receive a cash distribution of $1,014, 023. At this point, there is no movement of the single-member LLC’s equity interest or its assets. The single-member LLC is still sitting inside of existing partnership (EP), along with its assets. EP makes this journal entry: Debit Cash Distributions $1,014,023, credit Suspense for the same amount. Then, A is deemed to take that deemed cash, turn around, and pay it over to EP, as purchase consideration, for a portion of the single-member LLC interest. EP makes this journal entry: Debit Suspense $1,014,023, credit Sales Proceeds for the same amount. The two Suspense amounts wash each other out. And then B contributes his cash to EP in exchange for the remainder of the single-member LLC interest.

Is this what is going on? If you don’t know the answer, that is the first question I’d ask. We are all scratching our heads since A already indirectly owns some portion of the single-member LLC. If the above is correct, A is effectively purchasing something, in a taxable transaction, that he already owns.

Accounting firm also said this:

*A's entity mentioned above* will receive a K1 that shows the amount of the equity exchanged in the sale treated as a distribution.

What kind of distribution – a cash distribution?

They also said this:

The deal is structured as an entity acquisition.

I would submit that an “entity acquisition” could be accomplished in the way we are saying: A redemption distribution of a portion of the single-member LLC interest to A with the remainder being purchased for cash by B. In other words, “entity acquisition” doesn’t necessarily mean “fully taxable purchase.”

I am also curious about these things:

1. A’s representation surrounding this transaction; and
2. If the accounting firm is saying what I posted in the first paragraph above (about the fictions), could the agreement be interpreted to create a redemption? The fact is, what you quoted did not come from the agreement.

I'd suspect that they are likely structuring it this way so they can get the step up cleanly and completely on their end for 734(b) purposes. Doesn't make it correct, but that's a likely explanation.
I like Jeff's description that A is deemed to be purchasing something he already owns. I agree.

No such thing as a deemed cash distribution by a partnership to a partner followed by a deemed purchase of partnership assets by the partner using that cash. After all, an actual cash distribution followed by an actual cash purchase would be disregarded and recharacterized as a distribution of the assets under the circular cash doctrine.

I'd suspect that they are likely structuring it this way so they can get the step up cleanly and completely on their end for 734(b) purposes.

Not sure. While existing partnership (EP) might get a step-up for $324,573, won’t EP also be receiving deemed sales consideration from A as a result?

I think the simplest explanation is that the partnership’s accounting team, or the particular accountant who has been communicating with the OP, does not understand partnership liquidating distribution rules. They think a distribution of SMLLC equity should be shown as a distribution at fair market value for tax basis capital account purposes, which is not true, and that such distribution would result in gain recognition to the distributee partner, which is also not true (usually).

Edit: Note that A and the partnership may recognize gain under section 751(b).

No such thing as a deemed cash distribution by a partnership to a partner followed by a deemed purchase of partnership assets by the partner using that cash.

I understand the sentiment. I’m just trying to figure out what’s going on here and this is all that I can come up with. But I most certainly think such deeming is possible, but only based on an agreement. We haven’t seen the agreement. So we don’t know what the parties agreed to. And we don’t know if what the accounting firm is doing is entirely consistent with that agreement. I am not even sure that A had legal representation in this transaction. If he did, I’d like to know what that attorney has to say about this transaction and the manner in which existing partnership intends to carry it out.

Here’s an example: We have a partnership. I have a capital account of $50k. I want to leave. Everyone agrees I am owed $50k. But I also want the Company car, that is worth $50k and has a $0 basis. We could very easily agree that instead of the partnership distributing $50k to me, and then me returning that $50k to the partnership as purchase consideration for the car, we would just book things up as if those two steps actually happened…in accordance with our agreement that the Company car will be PURCHASED by me. Or, we could paper the transaction up as a distribution of the car to me.

So, I think it’s very possible for there to be deeming, but only if consistent with the agreement, so as to short-cut the exchanging of funds back and forth. So, I am seriously wondering if (1) such deeming is what is going on here and (2) it is accordance with the agreement. I do not think this language in Post #27 answers these questions:

The deal is structured as an entity acquisition.

…despite the next sentence in Post #27 saying, “The entity that they are PURCHASING is SMLLC…”

And this is not said very well in Post #25:

I believe the seller (and seller’s CPA) are intending to treat the FMV distribution as an actual cash sale by A, who then immediately used the cash to buy his % in the single member LLC.

I think you want to say that they intend to treat the FMV amount as a deemed cash distribution to A.

I'd suspect that they are likely structuring it this way so they can get the step up cleanly and completely on their end for 734(b) purposes.

Not sure. While existing partnership (EP) might get a step-up for $324,573, won’t EP also be receiving deemed sales consideration from A as a result?

I'm reaching a bit with that statement, but that desire on their end is likely still rooted in a fundamental misunderstanding of how this is supposed to be treated.

I think the simplest explanation is that the partnership’s accounting team, or the particular accountant who has been communicating with the OP, does not understand partnership liquidating distribution rules. They think a distribution of SMLLC equity should be shown as a distribution at fair market value for tax basis capital account purposes, which is not true, and that such distribution would result in gain recognition to the distributee partner, which is also not true (usually).

There is a very high probability this is accurate, especially the “particular accountant” part. And I hear you on the 751 issue. I’ve been keeping that issue to the side and pretending it doesn’t exist for simplicity’s sake.

I'm reaching a bit with that statement, but that desire on their end is likely still rooted in a fundamental misunderstanding of how this is supposed to be treated.

That could very well be.

I think we’re all on the same page here: None of us trusts that the intended approach is accurate and is the exclusive way to handle the transaction as per the agreement. But we haven’t seen the agreement. And we don’t know what A’s legal counsel has to say about the intended approach. It could be that the agreement is entirely in our favor and the accountant is flat out wrong. Or, it could be that the agreement is ambiguous. There is no reason this matter cannot be fleshed out in the very near future, with both parties having a full understanding of the other party’s position. Once it gets that far, and if things cannot be favorably resolved, then a decision will have to be made as to (1) going with the intended approach or (2) going with Inconsistent Treatment. But the potential application of 751(b) will have to be quantified since that plays into the decision-making.

No such thing as a deemed cash distribution by a partnership to a partner followed by a deemed purchase of partnership assets by the partner using that cash.

I understand the sentiment. I’m just trying to figure out what’s going on here and this is all that I can come up with. But I most certainly think such deeming is possible, but only based on an agreement. We haven’t seen the agreement. So we don’t know what the parties agreed to. And we don’t know if what the accounting firm is doing is entirely consistent with that agreement. I am not even sure that A had legal representation in this transaction. If he did, I’d like to know what that attorney has to say about this transaction and the manner in which existing partnership intends to carry it out.

Here’s an example: We have a partnership. I have a capital account of $50k. I want to leave. Everyone agrees I am owed $50k. But I also want the Company car, that is worth $50k and has a $0 basis. We could very easily agree that instead of the partnership distributing $50k to me, and then me returning that $50k to the partnership as purchase consideration for the car, we would just book things up as if those two steps actually happened…in accordance with our agreement that the Company car will be PURCHASED by me. Or, we could paper the transaction up as a distribution of the car to me.

So, I think it’s very possible for there to be deeming, but only if consistent with the agreement, so as to short-cut the exchanging of funds back and forth.

I agree that as a general matter parties can agree to “deem” transactions or create fictional transactions. For example, in lieu of a transfer money up a chain of entities, hitting the bank account of each entity, the lower-tier entity can directly transfer funds to the parent and deem each entity to have made distributions to the entity immediately above, and so forth. Or two parties that owe money to each other for unrelated reasons can set off those obligations and deem each to have paid in cash her respective obligation.

What I really meant was that in this context, due to the circular flow of funds, a fictional cash distribution and fictional cash purchase should not be respected as such for federal income tax purposes.

For the same reason, I do not think your example would generally work. The partnership’s deemed cash distribution to a partner, followed by such partner’s purchase of a car owned by the partnership, should generally not be respected. For federal income tax purposes, the partnership should be treated as distributing the car to the partner. See Rev. Rul. 78-397: Rev. Rul. 83-142.

Now not all circular cash flows would be disregarded. To go back to your example, if the partnership made a pro rata cash distribution to all of its partners but one partner wanted a particular asset, I think the partnership could directly transfer the asset to the partner in lieu of a distribution of cash followed by a purchase of the asset. The direct transfer likely is treated as a cash distribution followed by a purchase because the partner is entitled to receive cash distribution in his capacity as a partner, just as all of the other partners are, and separately, he is purchasing the asset from the partnership.

What I really meant was that in this context, due to the circular flow of funds, a fictional cash distribution and fictional cash purchase should not be respected as such for federal income tax purposes.

Not sure why the context matters if the context includes an agreement that the partner is purchasing the car from the partnership. If the partnership says to the partner, “Please pay $50k to the partnership for the car,” and then the partner says, “The partnership owes me my $50k capital balance, since we all agreed that’s what I’d get if I left. I’m leaving and I want the car. Just keep that $50k that the partnership owes me as my purchase price for the car.”

All evidence indicates a purchase of the car from the partnership, not a distribution of the car to the partner.

No different than if the partnership didn’t even own a car, but went out and bought one to appease the departing partner – and then distributed that car to the partner. That would be treated as a cash distribution, not a property distribution. And to tie it all up, the partner would be treated as having bought the car from the partnership with the deemed cash distribution.

What I really meant was that in this context, due to the circular flow of funds, a fictional cash distribution and fictional cash purchase should not be respected as such for federal income tax purposes.

Not sure why the context matters if the context includes an agreement that the partner is purchasing the car from the partnership. If the partnership says to the partner, “Please pay $50k to the partnership for the car,” and then the partner says, “The partnership owes me my $50k capital balance, since we all agreed that’s what I’d get if I left. I’m leaving and I want the car. Just keep that $50k that the partnership owes me as my purchase price for the car.”

All evidence indicates a purchase of the car from the partnership, not a distribution of the car to the partner.

No different than if the partnership didn’t even own a car, but went out and bought one to appease the departing partner – and then distributed that car to the partner. That would be treated as a cash distribution, not a property distribution. And to tie it all up, the partner would be treated as having bought the car from the partnership with the deemed cash distribution.

Sorry, I will provide a detailed response later, but just to understand what you mean…

Suppose here the MIPA just said the partnership was selling its interest in LLC to A and B, the consideration from each being $X. The partnership and A also enter into a redemption agreement under which the partnership purchases A’s partnership interest for $X. And lastly, there is some documentation that says that given the partnership owes $X to A and A owes $X to the partnership, the parties agree to offset those amounts.

Is your view that the above arrangement will/should/more likely than not be treated as a liquidating cash distribution by the partnership and a sale of the LLC assets by the partnership for federal income tax purposes?

Is your view that the above arrangement will/should/more likely than not be treated as a liquidating cash distribution by the partnership and a sale of the LLC assets by the partnership for federal income tax purposes?

In the instant case, if they wrote up the acquisition as a purchase by 2 parties, that’s likely why the accounting firm is saying we’re dealing with a cash distribution. And I get why they’re saying that. But I haven’t seen the agreement.

It’s one of those situations where you can’t have it both ways. It can’t be a distribution of the asset and also a purchase of it (ignoring Partner B).