Business Entities · Partnerships

Disposition of partner's interest

Two things make the sale of a partnership interest different from the sale of a share. The first is that the interest is an entity-level wrapper around assets whose character the Code refuses to let the wrapper disguise — hence IRC § 751. The second is that the seller’s basis includes their share of partnership debt, so the amount they are treated as receiving includes the relief of that debt. Both effects push in the same direction: the taxable amount is larger, and more of it is ordinary, than the cash figure suggests.

The rule

The default. on a sale or exchange of an interest in a partnership, gain or loss is recognised to the transferor partner and is treated as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in IRC § 751 on unrealised receivables and inventory items (IRC § 741)^TY2026

The exception. the money or fair market value of property received by a transferor partner in exchange for all or part of the interest, to the extent attributable to unrealised receivables or inventory items of the partnership, is considered an amount realised from the sale or exchange of property other than a capital asset (IRC § 751(a))^TY2026

Which assets are hot. unrealised receivables include, to the extent not previously includible in income under the partnership method of accounting, any rights to payment for goods delivered or to be delivered where the proceeds would be treated as from the sale of a non-capital asset, and for services rendered or to be rendered. For IRC §§ 731, 732 and 741 the term also reaches mining property, DISC stock, IRC § 1245 property, certain foreign corporation stock, IRC § 1250 property and other recapture items (IRC § 751(c))^TY2026

inventory items means property of the kind described in IRC § 1221(a)(1); any other partnership property that on sale would be property other than a capital asset and other than IRC § 1231 property; and any other property held by the partnership which, if held by the selling or distributee partner, would be of either of those kinds (IRC § 751(d))^TY2026

And the test that no longer applies here. IRC § 751(a) applies to inventory items whatever their appreciation. Pub. L. 107-147 § 417(12) struck the words "which have appreciated substantially in value" from IRC § 741 in 2002, and the substantial appreciation test now survives only in IRC § 751(b)(1)(A)(ii) for certain distributions^TY2026

Liabilities are part of the price. an increase in a partner share of partnership liabilities, or in the partner individual liabilities by reason of assuming partnership liabilities, is treated as a contribution of money by that partner to the partnership; a decrease in either is treated as a distribution of money to the partner (IRC § 752(a), (b))^TY2026

The buyer’s basis. the basis of a partnership interest acquired other than by contribution is determined under part II of subchapter O, beginning at IRC § 1011 — so a purchased interest takes a cost basis under IRC § 1012(a) and an inherited one takes its basis under IRC § 1014 (IRC § 742)^TY2026

But the partnership’s basis does not move. the basis of partnership property is not adjusted on a transfer of an interest by sale or exchange or on the death of a partner unless an IRC § 754 election is in effect or the partnership has a substantial built-in loss immediately after the transfer (IRC § 743(a))^TY2026

Unless it is elected. where a partnership files the election, the basis of partnership property is adjusted on a distribution of property in the manner provided by IRC § 734 and on a transfer of a partnership interest in the manner provided by IRC § 743; the election applies to all distributions and all transfers during the taxable year in which it is filed and to all later years (IRC § 754)^TY2026

Or the loss is large enough. $250,000 — a partnership has a substantial built-in loss on a transfer if its adjusted basis in partnership property exceeds the fair market value of that property by more than that amount, or if the transferee partner would be allocated a loss of more than that amount were the assets sold for cash at fair market value immediately after the transfer (IRC § 743(d)(1))^TY2026

What the adjustment does. where IRC § 754 is elected or a substantial built-in loss exists, the partnership increases the adjusted basis of its property by the excess of the transferee basis in the interest over their proportionate share of the adjusted basis of partnership property, or decreases it by the excess the other way (IRC § 743(b))^TY2026

Reporting. where there is an exchange described in IRC § 751(a) of an interest in a partnership during a calendar year, the partnership must make a return for that year giving the names and addresses of the transferee and transferor, and must furnish a written statement to each of them (IRC § 6050K(a), (b))^TY2026

Current figures

How it works in practice

Compute the amount realised before anything else, because the commonest error is to use the cash. The buyer takes over the seller’s share of partnership liabilities, so the seller’s share is relieved — a deemed distribution of money under IRC § 752(b) — and it forms part of the amount realised. A partner selling for cash while carrying a share of partnership debt always realises more than they receive. The seller’s basis also includes that debt, so the two effects partly cancel; but they cancel exactly only where the debt share and the basis attributable to it are the same figure, which is not generally so.

Then split the amount realised. IRC § 741 says the whole gain is capital except as otherwise provided in IRC § 751, and IRC § 751(a) treats so much of the amount received as is attributable to unrealized receivables and inventory items as realised from the sale of a non-capital asset. In practice: compute the ordinary income the seller would have taken had the partnership sold its hot assets at fair value, report that as ordinary, and treat the rest as capital. The capital portion is the residual, and it can be a capital loss even where there is an overall gain.

The scope of “hot” is much wider than it sounds. Unrealized receivables catch the accounts receivable of a cash-basis partnership, but the second sentence of the definition also reaches recapture items (IRC § 751(c)) — IRC § 1245 property, IRC § 1250 property, mining property and others — to the extent of the recapture. A partnership owning depreciated equipment has hot assets whether or not it has a single receivable. Inventory items are wider still, catching anything that would not be a capital asset or IRC § 1231 property in the partnership’s hands.

One trap here is a piece of law that changed in 2002 and is still commonly mis-stated. IRC § 741 once referred to inventory items “which have appreciated substantially in value”, and the substantial appreciation test therefore gated IRC § 751(a). Pub. L. 107-147 struck those words. On a sale of an interest, inventory is hot regardless of how much it has appreciated. The substantial appreciation test survives only in IRC § 751(b)(1)(A)(ii), which governs certain distributions — a genuinely different provision. Any source applying a substantial appreciation screen to a sale is applying pre-2002 law.

On the buyer’s side, two bases now diverge. The buyer takes a cost basis in the interest under IRC §§ 742 and 1012. The partnership’s basis in its assets does not change at all — IRC § 743(a) says so expressly — so the buyer inherits a share of inside basis that may be far below what they paid. Without relief, the buyer would be allocated gain on appreciation they bought and paid for.

The relief is the IRC § 754 election, which switches on IRC § 743(b) and adjusts the partnership’s inside basis, but only with respect to the transferee. Two features matter. It is made by the partnership, not the buyer, so a buyer’s protection depends on the partnership’s cooperation. And it is not revocable at will: it applies to all distributions and all transfers in the year filed and in every subsequent year, which is why partnerships hesitate — a downward adjustment on a later transfer is mandatory once the election is in place.

IRC § 743(d) supplies a mandatory downward adjustment even without an election, where the partnership has a substantial built-in loss. The threshold is tested two ways, either on the partnership’s aggregate basis against value or on the loss the transferee would be allocated on a hypothetical sale — the second test being the one added to stop a partnership avoiding the rule by holding offsetting positions.

Scenarios

How this has changed

Two amendments define the current shape of this topic.

The first is the 2002 removal of the substantial appreciation test from IRC § 741. Before it, inventory items were hot on a sale only if they had appreciated substantially in value, and practitioners screened for that before applying IRC § 751(a). Pub. L. 107-147 § 417(12) struck the words, and inventory is now hot on a sale whatever its appreciation. The test was not repealed — it remains in IRC § 751(b)(1)(A)(ii) for distributions — so a source describing it is describing something real, just not something that applies to a sale. That partial survival is what makes the error durable.

The second is the mandatory basis adjustment for a substantial built-in loss, which converted IRC § 743 from a purely elective regime into one with a compulsory branch. Before it, a partnership could decline to elect under IRC § 754 and leave a buyer’s inside basis untouched in both directions; now the downward adjustment is imposed where the loss exceeds the threshold, and the second limb of IRC § 743(d)(1) — testing the loss the transferee would be allocated — was added because the aggregate test alone could be defeated by offsetting positions.

Neither the IRC § 754 election mechanics nor the IRC § 741 default has otherwise moved.

Exam focus

Almost every question begins with the amount realised, and almost every distractor is the cash figure. Add the relieved share of liabilities first, then subtract outside basis — which itself includes that share, so the arithmetic is not a wash unless the question says so.

The second shape gives a partnership with receivables or inventory and asks for the character of the gain. Compute the seller’s share of the ordinary income embedded in the hot assets, report that as ordinary, and treat the balance as capital. Where the question offers “all capital gain” it is almost always testing IRC § 751(a).

For the buyer’s side, the question is usually whether inside basis changes. It does not, unless IRC § 754 is elected or the partnership has a substantial built-in loss — and where a question describes a buyer being taxed on pre-purchase appreciation, the missing element is the election.

Check yourself

1. A partner’s adjusted basis in her interest is $80,000, including a $30,000 share of partnership liabilities. She sells the interest for $70,000 cash, and the buyer assumes her share of the debt. What is her gain or loss?

Answer: a $20,000 gain. The amount realised is $70,000 of cash plus the $30,000 of relieved liabilities, treated as a distribution of money under IRC § 752(b), so $100,000 against an $80,000 basis. Under IRC § 741 the gain is capital except so far as IRC § 751(a) applies.

2. A partnership holds inventory that has appreciated by 8 percent since acquisition. A partner sells his interest. Does IRC § 751(a) apply to the inventory?

Answer: yes. Since Pub. L. 107-147 struck the words “which have appreciated substantially in value” from IRC § 741 in 2002, inventory items are within IRC § 751(a) on a sale whatever their appreciation. The substantial appreciation test applies only to certain distributions under IRC § 751(b)(1)(A)(ii).

3. A partner sells her interest for $500,000. Her outside basis is $470,000, and her share of the ordinary income that would arise if the partnership sold its unrealized receivables at value is $180,000. What does she report?

Answer: $180,000 of ordinary income and a $150,000 capital loss. IRC § 751(a) treats the amount attributable to the receivables as realised from the sale of a non-capital asset. The capital computation is then the residual $320,000 of amount realised against the $470,000 basis. An overall $30,000 economic gain produces a large ordinary income and a large capital loss.

4. A buyer pays $600,000 for an interest whose share of partnership inside basis is $150,000. The partnership has no IRC § 754 election and no substantial built-in loss. What happens to the partnership’s basis in its assets?

Answer: nothing. IRC § 743(a) provides that the basis of partnership property is not adjusted as the result of a transfer of an interest unless an IRC § 754 election is in effect or the partnership has a substantial built-in loss immediately after the transfer. The buyer’s outside basis is $600,000 under IRC §§ 742 and 1012, but her share of inside basis remains $150,000.

5. A partnership’s adjusted basis in its property exceeds the fair market value of that property by $400,000. A partner sells his interest. Is a basis adjustment required?

Answer: yes. Under IRC § 743(d)(1)(A) the partnership has a substantial built-in loss where its adjusted basis in partnership property exceeds the fair market value of that property by more than the statutory threshold, and IRC § 743(a) makes the adjustment mandatory in that case even though no IRC § 754 election has been made. The adjustment is downward as to the transferee.