Earlier this month the IRS issued, in tandem, two sets of new proposed regulations addressing certain issues involving the sales or exchanges of interests in partnerships, S corporations and trusts. The first set of regulations was issued under Code Sec. 1(h) (the "1(h) Proposed Regulations") and addresses the treatment of the sale of an interest in a flow-through entity where the entity holds section 1250 capital gain property (basically, depreciable real property, to the extent of depreciation taken that would not be recaptured as ordinary income) or collectibles (i.e., property, such as art work, coins, etc., defined in Code Sec. 408(m), that, if sold directly, would be taxed at 28%). The second set of proposed regulations was issued under Code Sec. 1223 (the "1223 Proposed Regulations") and addresses the holding period of a partnership interest where the partnership interest is "acquired" at various times. This month's Partner's Perspective will discuss these new Proposed Regulations.
What has been a controversial issue since the passage of the 1997 Tax Act (and as deemed clarified by Congress in a footnote in the 1998 Tax Act), has been put to bed by the 1(h) Proposed Regulations. The issue is the tax treatment of a sale of a partnership interest where the partnership owns property containing section 1250 capital gain property. After the 1997 Tax Act, many tax professionals suggested that perhaps the gain from a sale of a partnership interest in a partnership owning such property would only be taxed at 20%, i.e., there would be no "look-through."
Let's look at a simple example of the "look-through" rule contained in the 1(h) Proposed Regulations. Assume Russell owns a 40% membership interest in Office Building LLC. The sole asset of the LLC is a building (the land is ground leased) that had been acquired for $2,000,000, and has a present tax basis of $1,200,000 and a fair market value of $3,500,000. Russell sells his 40% membership interest (with a basis of $480,000) for $1,400,000 (40% of $3,500,000), recognizing gain of $920,000. During the five-year period prior to the sale, Russell has recognized Code Sec. 1231 losses from the sale of non-LLC assets.
Pursuant to Prop. Reg. §1.1(h)(b)(3)(ii), Russell has "section 1250 capital gain" in an amount equal to what he would have been allocated had the LLC sold all its section 1250 capital gain property in a fully taxable transaction:
- Original cost
- $2,000,000
- Basis
- 1,200,000
- Section 1250 capital gain
- 800,000
- x .40
- Russell's allocable share
- $320,000
Russell's remaining $600,000 gain is residual long-term capital gain and is taxed at the 20% long-term capital gain rate. Note that the 1(h) Proposed Regulations make clear that there is no look-through rule for Code Sec. 1231 gain, meaning that Russell is not subject to the five-year Code Sec. 1231 loss recapture rule to which he would have been subject had the LLC sold the 1250 capital gain property. Prop. Reg. §1.1(h)-1(b)(3)(iii). It is also worth noting that in the case of sales of interests in trusts or S corporations, the "look-through" rule only applies to collectibles and not to section 1250 capital gain property.
One should also note that the look-through rule is applied in a manner that will cause the selling partner, S corporation shareholder or trust beneficiary to recognize his appropriate share of look-through gain, even if the overall gain on the sale of the interest in the entity is less. (This concept is the same as applies to the recognition of a partner's share of Code Sec. 751 "hot asset" gain upon a sale or exchange of a partnership interest.) For example, if a partnership's assets consist solely of an appreciated collectible and an equally offsetting depreciated capital asset, the selling partner will recognize his share of the collectible gain and recognize an equal amount of capital loss from the sale of his partnership interest.
Fifteen years ago, the IRS set forth its position that a partner has a unified basis in his partnership interest. Rev. Rul. 84-53 1984-1 CB 159. According to the IRS, however, this position has created confusion as to how one measures the holding period of a partnership interest when all or a portion of the interest is sold. The 1223 Proposed Regulations are designed to put an end to the confusion.
It probably comes as no surprise that the IRS takes the position that, if a partnership interest is acquired at different times (or if a partnership interest is acquired in a single transaction that gives rise to different holding periods under Code Sec. 1223), and then is sold, the holding period for the interest is to be divided. The division is based on a fraction that is equal to the value of the portion of the partnership interest received in the transaction to which the holding period relates (determined immediately after acquisition) over the value of the entire partnership interest.
Assume Ashley and Zachary form the AZ LLC as equal members. Ashley contributes land for development with a basis of $150,000 and a value of $500,000, and Zachary contributes cash of $500,000. Two years later, on September 1, 1999, after all the cash has been expended and the property is virtually completed and has been appraised at $1,800,000, Ashley and Zachary each contribute an additional $100,000 to complete tenant improvements. Two months later, as the property is about to be placed in service, Ashley sells her membership interest for $1,000,000 (i.e., there has been no increase in value of the property from the date of the capital infusion to the date of the sale of the membership interest).
One would think that this transaction should be easy to analyze--Ashley has a basis in her membership interest of $250,000 ($150,000 basis for the contributed property plus her additional $100,000 cash contribution) and she sold her interest for $1,000,000, ergo she has a long-term capital gain of $750,000. Not so fast!
Let's take a look at how this simple transaction is treated under the 1223 Proposed Regulations. Ashley's holding period is divided into two parts--one part is equal to the portion of her membership interest in existence as of the date of her additional cash capital contribution and the other part is represented by the additional cash contribution. These parts are divided by valuing her membership interest at the time of the additional cash contribution, to wit--
- Ashley's share of value at time of additional
capital contribution (50% x $1,800,000) - $900,000
- 90%
- Cash contribution
- $100,000
- 10%
Accordingly, when Ashley sells her membership interest she is regarded as having a long-term holding period for 90% of her membership interest and a short-term holding period for 10% of her membership interest, yielding $75,000 of short-term capital gain. This is the result even though there was no increase in the value of the property after the date of the additional cash contribution. Prop. Reg. §1.1223-3(e), Ex. 4. In essence, Ashley's additional capital contributions served to convert a portion of her long-term capital gain to short-term capital gain when her partnership interest was sold shortly after making her additional capital contribution.
Note what would have happened if Ashley and Zachary had some foresight and each lent $100,000 to the LLC rather than made a capital contribution. The purchaser of Ashley's interest would have paid her $100,000 to acquire the loan due her from the LLC, a non-gain generating transaction. The purchaser would then have paid Ashley $900,000 for her membership interest, generating the same $750,000 of gain as described above--
.- Sale proceeds
- $900,000
- Basis
- 150,000
- Gain of sale
- $750,000
However, all the gain would be long-term. And from Ashley and Zachary's standpoint, whether the "capital" was loaned or contributed generally would have no significance.
Note, the 1223 Proposed Regulations also provide that a partner's holding period in a partnership interest is not affected by distributions from a partnership. Prop. Reg. §1.1223-3(d). As a result, it would appear that Ashley and Zachary cannot correct the holding period problem by withdrawing the capital contribution and converting it to a loan.
One should also note that Examples 4 and 5 of the 1223 Proposed Regulations seem to inadvertently ignore the principles of Code Sec. 704(c). It is this author's understanding that these examples will be appropriately modified or recast when the 1223 Proposed Regulations become final.
At this time it is unknown if the 1223 Proposed Regulations will be adopted in their present form. In the meantime, if it is anticipated that holding period may become relevant, it is critical to take care in the manner in which the LLC is capitalized.