My friend, Tony Mailhot, is a CPA who knows more about taxes than anyone else I know. I asked him for his take on a recent question Mike asked me about capital gains.
What I liked about Tony's answer is that it goes a bit deeper than just how it looks on paper and explains how a negative basis can come about, and what it means for cash proceeds vs gain when the partnership interest is sold.
When I passed along this question to him here is what he said. And he meant it when he said: 'Have fun with this.'
Linda,
You are correct, it is difficult to tell the cash impact of amounts reported on the K-1. In a typical operating business where the owners have all been owners from the start and their ownership percentages have all remained steady, the K-1 is more reliable than where ownership changes have occurred. Here is what I look for.
The capital account could represent FMV, if the partnership is accounting on a FMV basis. However, FMV accounting is pretty unusual. A significant negative capital account balance is usually an indication the partnership has been spending more cash than its revenue. The operating cash to fund the excess expenses had to come from either loans made to the partnership or partner capital calls.
Disproportionate capital calls can lead to the noncontributing partners reporting a negative capital account. Most partners are not willing to pay a capital call unless all the other partners must also contribute the extra capital, so I don't consider this a likely cause.
My first assumption is that negative capital accounts are the result of working capital borrowing by the partnership to fund cash losing operations. You may remember from way back in your tax days that a partner's basis in his or her interest is the sum of the capital account and the share of partnership debt. It follows then that the sale price of a partnership interest is the sum of cash or other compensation plus the selling partner's share of partnership debt.
In addition to the taxpayer's form 1040 with all attachments and the related schedule K-1, I would ask for a copy of the contract or agreement related to the sale of the partnership interest and a copy of the accountant's computation of the sale price and basis as reported on the tax return. With these two documents, I think I could determine the cash flow impact of the deal and I could get a sense of whether the income tax impact was properly estimated.
If I have a partner with a capital account balance of -$309,000, I will look at the partnership debt disclosure on the K-1 form. The partner's share of the partnership debt will probably be at least $309,000, if not more, indicating that the partnership spent the partner's capital as well as a bunch of borrowed money.
The negative capital account also is a strong indicator that the partner has probably deducted losses totaling $309,000, maybe more. If he sells his partnership interest for $95,000 cash or notes he will have received a total of $404,000 for his partnership interest, $95,000 cash plus $309,000 of debt relief. Since the negative capital account appears to have used up all of his basis with deductible losses, he will have no basis left to offset the sale proceeds. The result is a $404,000 gain with $60,000 potential capital gain.
Sounds unusual, but from an economic standpoint, it is fair. The partner doesn't have to pay back $309,000 of debt, for which he got beneficial tax deductions, plus he got $95,000 in cash. That adds up to a $404,000 increase in wealth.
Factors that might affect the partner's taxable gain or loss I would be interested in knowing as a preparer as they affect the income tax cost of the transaction.
Suspended losses
Even though the partner may be allocated his or her share of the partnership debt, it may not be the right kind of debt to allow him to actually deduct the losses.
Most nonrecourse debt does not support deductible losses. Even though these types of losses are not deductible, they still reduce the partner's basis as far as the partnership is concerned.
The losses are held in suspense on the partner's tax return until the loan becomes recourse or the partnership has some other event that creates basis. The sale of a partnership interest will release the suspended losses so they can be deducted on the partner's tax return.
Passive Activity Suspended Losses
Similar to suspended losses, passive activity losses are not deductible unless the partner meets certain requirements. The partnership continues to report the allocated losses as though they are deductible, reducing the partner's capital account accordingly. Suspended losses become deductible when the partnership interest is sold.
Book/Tax Difference
The partnership may not be reporting the partners' tax basis in the capital section. Often, the partnership reports book accounting balance in the capital section, not the tax basis. The partnership K-1 form is supposed to disclose the accounting basis for the capital account information. Tax basis may have to be reconstructed.
Outside Basis
The partnership usually doesn't keep track of basis adjustments which happen outside of the partnership accounting function. For example, a partnership interest may be purchased from one of the other partners.
The payment for the interest is a private party transaction and never is reported to the partnership. The partnership has no reason to adjust the capital accounts and it has no requirement to keep track of basis.
Ordinary Income from Hot Assets
The sale of a partnership interest doesn't always end up with capital gains tax, sometimes the more expensive ordinary income rates apply.
If a partnership owns certain types of ordinary income property such as inventory or high depreciated equipment and furnishings, the IRS requires a special computation for a departing partner. They are called "Hot Assets" because they trigger the worst kind of income for the seller, ordinary income.
Inventory and depreciation recapture are two ordinary income items. The tax code requires that a selling partner account for the ordinary income portion of his partnership interest and report it accordingly. This prevents a partner from converting ordinary income to capital gain income. The more valuable the hot assets, the greater the tax cost related to a sale.
Best Regards,
- Tony
More on partnerships
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