III. A Partnership Interest Sale Is Treated in Part As If It Were a Sale of Interests in the Partnership’s Assets and, Thus, Some Gain on Such a Sale May Be Ordinary, Rather than Capital, in Character
Deferring a partner’s gain or loss on a contributed asset requires preserving not only the amount, but also the tax character, of that gain or loss. When a partner contributes a capital asset or section 1231 asset to her partnership in exchange for part (but not all) of her partnership interest, the split-holding-period rules help to preserve the long-term character of any built-in long-term capital gain or loss on the contributed asset. Creating a separate holding period for the part of the interest that the partner received in exchange for the capital or section 1231 asset allows the partner’s holding period for the contributed asset to tack to her holding period for that part of her partnership interest. This, in turn, helps to ensure that the partner ultimately recognizes her deferred gain or loss on the contributed asset as long-term capital gain or loss if she sell her partnership interest before the partnership sells the contributed asset—even if the partner sells her interest within one year.
The split-holding-period rules affect how much of a partner’s capital gain or loss on the sale of her partnership interest is long-term, and how much is short-term. Yet, to grasp the rules’ myriad details, one must understand that not all gain or loss on the disposition of a partnership interest is always capital gain or loss. Depending on the character of the partnership’s assets, a portion of the partner’s recognized gain or loss on a sale or exchange of her interest may be ordinary instead. To account for that, the split-holding-period rules contain specific provisions for the treatment of contributed ordinary assets. And those particular provisions give rise to much of the rules’ complexity.
Hence, to decipher the split-holding-period rules, we must first review the rules for determining the extent to which recognized gain or loss on a taxable sale or exchange of a partnership interest is ordinary in character.
A. Subchapter K Adopts Elements of Both the Entity Approach and the Aggregate Approach to Partnership Taxation
There are two alternative approaches to taxing business organizations and their equity-owners—the entity approach and the aggregate approach. The entity approach treats a business organization as entirely separate and distinct from its owners. Under the entity approach, the organization’s tax attributes—i.e., its taxable income, gains, losses, deductions, credits, etc.— remain attributes of the entity itself, and the organization pays entity-level taxes. The clearest example of the entity approach is the federal income tax treatment of C corporations.
The aggregate approach, in contrast, treats a business organization not as a separate entity, but rather as merely an aggregation of the organization’s individual owners. Under the aggregate approach, the income, gains, losses, deductions, and credits attributable to the business are tax attributes of the business’s owners, because there is no recognized “entity” to which those tax attributes could otherwise belong. Accordingly, under the aggregate approach, a business organization is not subject to any entity-level tax. Instead, each of the business’s owners includes her respective share of the income or loss attributable to the business in the calculation of her own taxable income or tax loss. The purest example of the aggregate approach is the federal income tax treatment of a sole proprietorship.
The federal income tax treatment of partnerships is a hybrid of the aggregate approach and the entity approach. A partnership is treated as an aggregation of its partners in the most essential respect: A partnership does not pay an entity-level federal income tax. Instead, the partnership’s tax attributes pass through to its individual partners. Each partner takes account of her distributive share of the partnership’s taxable income or loss for a given partnership taxable year when calculating her own taxable income or tax loss for her corresponding taxable year.
At the same time, a partnership is treated as an entity to a limited but important extent: A partnership is viewed as a separate accounting entity for purposes of determining both the amount and the character of the partnership’s income, losses, deductions, etc. to be passed through to the partners. This is necessary to facilitate calculation of the partners’ respective shares of the partnership’s income and deductions for a given year. Those calculations would be unworkably complex if each partner had to report her share of partnership-related tax items on the basis of her own accounting method, her own method of depreciation, and so forth.
Therefore, even though partnerships do not pay an entity-level federal income tax, subchapter K treats a partnership as an entity in some important ways. For instance, a partnership must adopt its own method of tax accounting and its own taxable year. To calculate its taxable income, a partnership must make other entity-level elections, such as choosing an applicable tax depreciation method for its depreciable assets. A partnership has its own tax basis in its assets. And the tax character of any passed-through income or loss that the partnership derives from those assets—including the character of any gain or loss that the partnership recognizes if it disposes of the assets—is generally determined at the partnership level.
B. The Treatment of a Partnership Interest Sale, in Particular, Reflects a Combination of the Entity and Aggregate Approaches
Consistent with its approach to partnership taxation generally, subchapter K adopts a hybrid approach to the treatment of a partner’s sale of her partnership interest. The general rule in section 741 is that a partner’s recognized gain or loss on a sale or exchange of her partnership interest “shall be considered as gain or loss from the sale or exchange of a capital asset.” This follows the entity approach, under which the transaction is treated as the disposition of an interest in the partnership itself, rather than as a disposition of a portion of the partnership’s assets.
There are some significant exceptions and caveats to the general rule, however. First and foremost, section 751(a) treats a partner’s gain or loss on the sale of her partnership interest as ordinary in character to the extent that the gain or loss is attributable to the partnership’s ordinary assets. This prevents the partner from converting ordinary gain (on her share of the partnership’s ordinary assets) to long-term capital gain when she sells her interest. Similarly, a Treasury Regulation taxes a partner’s long-term capital gain on the sale of her partnership interest at special rates if such gain is attributable to the partnership’s collectibles or unrecaptured section 1250 gain.
These exceptions and caveats treat the sale of a partnership interest more like a sale of the partner’s proportionate share of each of the partnership’s assets. This moves the taxation of partnership-interest dispositions far closer to the aggregate approach. A sale or exchange of a partnership interest is not taxed in most cases exactly as if it were a sale or exchange of a corresponding share of the partnership’s assets, but the tax treatment generally is quite similar.
C. Section 751(a) Treats Gain or Loss on a Partnership Interest Sale as Ordinary Gain or Loss to the Extent That Such Gain or Loss Is Attributable to the Partnership’s Unrealized Receivables or Inventory Items
The second sentence of section 741 states that a partner’s recognized “gain or loss [on the sale or exchange of her partnership interest] shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items). Section 751(a), in turn, provides that a partner’s amount realized on a sale or exchange of “all or a part of [her] interest in the partnership attributable to (1) unrealized receivables of the partnership, or (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.” In other words, to the extent of a selling partner’s deemed interest in her partnership’s “unrealized receivables” or “inventory items” (as defined in section 751), a corresponding portion of the partner’s gain or loss on the sale of her partnership interest will be treated as ordinary, rather than capital, gain or loss.
The underlying premise of section 751(a) is that a portion of a partner’s gain or loss on the sale of her partnership interest arises from, or corresponds to, her distributive share of the gain or loss inherent in the partnership’s unrealized receivables and inventory items. Section 751(a) treats that portion of a partner’s gain or loss on her partnership-interest sale as ordinary gain or loss because the partnership’s unrealized receivables and inventory are ordinary assets.
1. Unrealized Receivables Under Section 751(c)
Section 751(c)’s definition of “unrealized receivables” encompasses a considerably broader group of assets than the terms might initially suggest. The definition includes a partnership’s unrealized rights to receive payment for either “goods delivered, or to be delivered,” or “services rendered, or to be rendered[,]” in each case “to the extent not previously includible in income under the [partnership’s] method of accounting[.]” This, of course, comports with what the phrase “unrealized receivable” generally connotes. Yet the section 751(c) definition also includes any inherent gain on a partnership’s capital asset or section 1231 asset that would be “recaptured” as ordinary income if the partnership were to sell the asset for fair market value and recognize the gain. This includes, most significantly, section 1245 recapture income that is inherent is a partnership’s depreciable personalty assets.
2. An Example of Section 1245 Recapture Income as a Section 751(c) Unrealized Receivable
Here is an example of how section 751(c) characterizes section 1245 recapture income inherent in a partnership’s depreciable section 1231 asset or capital asset:
Example 5: The JKL partnership is a calendar year partnership. In July 2019, Janice acquired from the partnership a 30-percent interest in the partnership’s capital, profits, and losses, in exchange for a cash contribution to the partnership. In April 2020, the partnership purchased (and placed into service) office furniture for use in its business headquarters, at a cost of $100,000. Assume that the partnership did not place any other depreciable assets into service during 2020. Between 2020 and 2023, the partnership took $68,760 of depreciation for tax on the office furniture. As of January 1, 2024, the partnership’s adjusted basis in the furniture was $31,240. Assume that the furniture’s fair market value on January 1, 2024 was $62,000.
As of January 1, 2024, there was $30,670 of tax gain inherent in the JKL partnership’s office furniture—even though the fair market value of the furniture declined by $38,000 since the partnership purchased it. The $30,670 of tax gain is due to reductions in the partnership’s basis, pursuant to section 1016(a), that correspond to the partnership’s depreciation deductions on the furniture. The partnership’s $68,760 of depreciation deductions reflect a statutory presumption that the fair market value of the furniture declined by $68,760, due to wear and tear, as the partnership used the furniture in its business during the period from April 2020 through December 2023. In fact, however, the value of the furniture declined by “only” $38,000 during that period. This means that the partnership took $30,760 more in depreciation deductions than the furniture’s actual decline in value warranted.
Because the depreciation deductions exceeded the partnership’s related business expense, Treasury needs to “recapture” the excess deduction amount to prevent the partners from receiving (or keeping) an unfounded tax break. The section 1016 reductions in the partnership’s basis in the office furniture ensure that Treasury will recover the amount of the excess depreciation deductions when and if the partnership disposes of the furniture in a taxable transaction. The partnership’s tax gain on the disposition will be greater—or its tax loss will be lower—by an amount equal to the “excess” portion of the depreciation deductions, because of the basis reductions.
Depreciation deductions are ordinary deductions; they reduce a taxpayer’s ordinary taxable income. Therefore, to recapture all of the federal income tax that the partners avoided because of the partnership’s excess depreciation deductions, any partnership gain on a disposition of the furniture that results from the section 1016 basis reductions must be treated as ordinary income—even though the furniture is a section 1231 asset. Accordingly, section 1245 provides for that ordinary-income treatment.
When a taxpayer disposes of section 1245 property in a taxable transaction, section 1245(a) characterizes as ordinary income the gain on the disposition that stems from the reduction in the taxpayer’s adjusted basis in the property corresponding to the tax depreciation that the taxpayer took on the property. For instance, in Example 5, assume that the partnership had sold its office furniture for fair market value on January 1, 2024. In that case, the partnership’s $30,760 of recognized gain would have resulted solely from the section 1016 reductions in partnership’s adjusted basis in the furniture. Therefore, under section 1245(a), that gain would have been ordinary income, rather than section 1231 gain, for the partnership.
By extension, to determine the ordinary gain on a sale of a JKL partnership interest, section 751 divides the value of the partnership’s office furniture into two assets. Section 751(c) reclassifies as an “unrealized receivable”—i.e., an ordinary asset—the portion of the furniture’s inherent gain that would be section 1245 recapture income in a taxable disposition for fair market value. The remainder of the furniture’s value continues to be a section 1231 asset. As of January 1, 2024, the JKL partnership would thus be deemed under section 751(c) to have held (i) an unrealized receivable with a fair market value of $30,670 (and a basis of $0) and (ii) office furniture with a fair market value (and an adjusted basis) of $31,240.
If the partnership had sold the office furniture on January 1, 2024, then $9,201 (or 30 percent) of its $30,670 in gain would have been allocated to partner Janice. Because the partnership’s gain would have been recaptured as ordinary income under section 1245(a), that partnership would have been allocated $9,201 of ordinary income to Janice in such case. Under subchapter K’s quasi-aggregate approach, a sale by partner Janice of her interest in the JKL partnership is treated similarly to a hypothetical sale of Janice’s interest in each of the partnership’s assets. Hence, because Janice would have had to report $9,201 of ordinary income if the partnership had sold the office furniture on January 1, 2024, she would have recognized $9,201 of ordinary gain pursuant to section 751(a) if she had sold her partnership interest on that date.
3. Inventory Items Under Section 751(d)
Section 751(d)’s definition of “inventory items” is also far broader than the term initially suggests. The definition includes, of course, stock in trade held primarily for sale to customers—i.e., the assets that section 1221(a)(1) carves out from the definition of a “capital asset.” But it also includes any other noncash asset that is neither a capital asset nor a section 1231 asset—i.e., any ordinary asset—in the partnership’s hands. Moreover, the definition includes any partnership asset that would be inventory or as another type of ordinary asset if it were in the selling partner’s hands.
Technically, section 751(d) subsumes all the assets within section 751(c) except for the recapture items. More to the point, section 751(c) “unrealized receivables” and section 751(d) “inventory items” collectively include all partnership assets that are ordinary in the partnership’s hands or that would be ordinary in the selling partner’s hands. Under section 751(a), therefore, a selling partner’s gain or loss on her partnership interest is ordinary to the extent attributable to her interest in any partnership ordinary asset.
D. The Treasury Regulations Provide Rules for Determining the Exact Portion of the Gain or Loss on a Partnership Interest Sale That Section 751(a) Treats as Ordinary in Character
Regulation section 1.751-1(a)(2) sets forth a three-step process for calculating the amount (if any) of a partner’s ordinary gain on a sale of her partnership interest: First, determine the total amount of gain (or loss) that the seller recognizes when she sells her partnership interest. Second, imagine that the partnership sold all of its assets for fair market value immediately before the partner sold her partnership interest. In this hypothetical sale, calculate how much of the gain or loss on the partnership’s section 751 assets would be allocated to the partner who is selling her partnership interest. Third, subtract (A) the selling partner’s distributive share of gain on the hypothetical sale of the partnership’s section 751 assets from (B) the selling partner’s total gain on the sale of her partnership interest. This is the amount of the gain on the sale of the partnership interest that is capital gain. The remainder of the gain on the sale of the partnership interest is ordinary gain.
Let us review an example:
Example 6: The MNO partnership is a calendar year partnership that operates a retail appliance store. In April 2006, Mary acquired from the partnership a 40-percent interest in the partnership’s capital, profits, and losses, in exchange for a cash contribution to the partnership. On January 1, 2024, the MNO partnership owned the following assets: (i) appliances which the partnership held in inventory for sale to customers, and which it had purchased from a wholesaler in November 2023 for $175,000; (ii) the building in which the store was located, which the partnership had purchased for $300,000 and placed in service in March 2012; (iii) the parcel of land which the building sits, which the partnership purchased in March 2012 for $100,000; and (iv) the partnership’s self-created goodwill for its business. Between 2012 and 2023, the partnership took $90,711 of depreciation for tax on the store building. Assume that, on January 1, 2024, the aggregate fair market value of the appliances was $225,000, the store building’s fair market value was $600,000, the land’s fair market value was $200,000, and the fair market value of the partnership’s goodwill was $150,000. Also assume that, as of January 1, 2024, the partnership had no liabilities. On January 1, 2024, Mary sold her interest in the MNO partnership to Ken for $470,000. Assume that, at the time of that sale, Mary’s outside basis in her partnership interest was $200,000.
Mary recognizes $270,000 of gain on the sale of her partnership interest. How much of that gain is ordinary, and how much is capital in character?
Following Regulation section 1.751-1(a)(2), we hypothesize that the MNO partnership sells all of its assets for fair market value on January 1, 2024, immediately before Mary sells her partnership interest. In that hypothetical sale, the partnership would recognize $50,000 of gain on the appliances, $390,711 of gain on the store building, $100,000 of gain on the land, and $150,000 of gain on the goodwill. The partnership would allocate 40 percent of each of those items of gain to Mary (who would still be a partner at the moment of the sale). We then determine, in particular, that Mary’s distributive share of gain on the hypothetical sale of the partnership’s section 751 assets—the appliances—would be $20,000.
Next, we subtract the $20,000 of gain attributable to the partnership’s section 751 assets from the $270,000 total of Mary’s gain on the sale of her partnership interest. The difference, $250,000, is the capital portion of Mary’s gain on the sale of her interest. The remaining $20,000 of Mary’s gain is ordinary.
E. A “Look-Through” Rule in the Treasury Regulations Is Further in Keeping With a More Aggregate Approach to the Treatment of a Partnership Interest Sale
In general, long-term capital gain on a partnership interest sale is taxed at 0 percent, 15 percent, or 20 percent, depending on the selling partner’s filing status and her overall taxable income for the year in question. A “look-through rule” in Regulation section 1.1(h)-1, however, requires the selling partner to determine whether any part of her capital gain under section 741 is attributable to the partnership’s collectibles or unrecaptured section 1250 gain. While most long-term capital gains are in the 0/15/20-percent category, long-term capital gains on “collectibles” are taxed at 28 percent, and unrecaptured section 1250 gain is taxed at 25 percent. The look-through rule provides that, if part of the long-term capital gain on a sale of a partnership interest is attributable to the partnership’s collectibles or to unrecaptured section 1250 gain inherent in the partnership’s depreciable real estate, such gain will be taxed at the appropriate 28-percent or 25-percent rate.
Regulation section 1.1(h)-1 provides that a partner’s “look-through capital gain” on a sale or exchange of her partnership interest includes the portion (if any) of her long-term capital gain on the sale or exchange that constitutes either “collectibles gain” or “section 1250 capital gain.” For purposes of this rule, the partner’s “collectibles gain” on the sale of her partnership interest equals the amount of gain that the partnership would allocate to her if the partnership sold all of its collectibles for fair market value immediately before she sold her interest. Similarly, the partner’s “section 1250 capital gain” on the sale of her partnership interest equals the amount of unrecaptured section 1250 gain that the partnership would allocate to her if the partnership sold all of its section 1250 property for fair market value immediately before she sold her interest.
A partner’s “collectibles gain” on a sale or exchange of her partnership interest is treated as if it were long-term capital gain on a sale or exchange of collectibles. It is thus taxed at the 28-percent collectibles rate. Similarly, a partner’s “section 1250 capital gain” on a sale or exchange of her partnership interest is treated as if it were unrecaptured section 1250 gain on a sale or exchange of section 1250 property. It is thus taxed at the 25-percent rate for unrecaptured section 1250 gain. Regulation § 1.1(h)-1 defines as “residual long-term capital gain or loss” any long-term capital gain or loss on a sale or exchange of a partnership interest that is neither collectibles gain nor section 1250 capital gain. Residual long-term capital gain is taxed at the standard 0-percent, 15-percent, or 20-percent long-term capital gain rates for individual taxpayers.
In Example 6, $90,711 of the gain inherent in the partnership’s building would be unrecaptured section 1250 gain. If the partnership were to have sold the building on January 1, 2024, immediately before Mary sold her partnership interest, Mary would have received an allocation of $36,284 of unrecaptured section 1250 gain (in addition to an allocation of $120,000 of 0/15/20-percent long-term capital gain). Thus, the Regulation section 1.1(h)-1 look-through rule provides that $36,284 of Mary’s long-term capital gain on the sale of her partnership interest is section 1250 capital gain and is taxed at 25 percent. The remaining $213,716 of her long-term capital gain on the sale is residual long-term capital gain and is taxed at either 15 percent or 20 percent, depending on Mary’s filing status and her overall taxable income for 2024. Like section 751(a), Regulation section 1.1(h)-1 ostensibly prevents a partner from converting gain in a higher-rate category to gain in a lower-rate category by selling her partnership interest before the partnership sells its assets.
Section 751(a) and the Regulation section 1.1(h)-1 look-through rule move the taxation of gain on a sale of a partnership from a pure entity approach—as initially reflected in section 741’s general rule—to something far closer to an aggregate approach. Subchapter K does not treat a sale of a partnership interest in precisely the same way as a sale of the selling partner’s proportionate “slices” of the partnership’s assets; there are a few significant differences. But the tax consequences generally are very similar—for both the seller and the purchaser of the partnership interest.
As we shall see, these provisions—and sections 751(a), (b), and (c), in particular—figured prominently in the crafting of the split-holding-period Regulations.
IV. The Split-Holding-Period Rules in Regulation Section 1.1223-3 Convert Capital Gain or Loss from Short-Term to Long-Term for Partners Who Hold Their Partnership Interests for One Year or Less
A. The Split-Holding-Period Rules Apply When a Partner Contributes a Capital Asset or a Section 1231 Asset in Exchange for Part of Her Partnership Interest, as Well as When a Partner Acquires Portions of Her Partnership Interest at Different Times
The split-holding-period rules for partnership interests are established in Regulation section 1.1223-3. Treasury issued the Regulation in accordance with a specific grant of authority under the Taxpayer Relief Act of 1997 (the 1997 Act). Among many other reforms, the 1997 Act significantly reduced individual taxpayers’ rates for long-term gains on most capital assets; it also established special long-term capital gain rates for collectibles and unrecaptured section 1250 gain. In conjunction with setting these new rates, section 311(a) of the 1997 Act added what is now section 1(h)(9) of the Code, which permits Treasury to “prescribe such regulations as are appropriate . . . to apply [the act’s new long-term capital gains rates] in the case of sales and exchanges by pass-thru entities . . . and [sales and exchanges] of interests in such entities.”
Pursuant to that grant of authority, in August 1999, Treasury proposed Regulation section 1.1223-3. At the same time, Treasury also proposed the Regulation section 1.1(h)-1 “look-through rule” for taxing a partner’s collectibles gain or section 1250 capital gain on a sale of her partnership interest. After receiving a number of comments on the Proposed Regulations, Treasury revised them significantly and published the final Regulations in October 2000.
The impetus for dividing the holding periods for certain partnership interests is the “the long-established principle that a partner has a single basis in a partnership interest.” A partner has a unitary tax basis in her entire partnership interest, even if she purchased portions of the interest at different times or if she acquired respective portions of the interest in exchange for different assets.
Suppose, for example, that a partner acquired a 15-percent capital interest in her partnership in March 2023 in exchange for a cash contribution to the partnership, and then acquired an additional 15-percent capital interest in the partnership in January 2024 in exchange for another cash contribution. The partner would not have a distinct basis in the half of her interest that she acquired in 2023 and a separate basis in the half of her interest that she acquired in 2024. Rather, she would have a single basis in her 30-percent partnership interest.
Similarly, imagine a partner who acquired, in March 2023, a 30-percent capital interest in a partnership in exchange for a contribution to the partnership of cash and a parcel of land. This partner would not have a distinct basis in the portion of the interest that she received in exchange for the cash and a separate basis in the portion of the interest that she received in exchange for the land. Instead, once again, she would have an undivided basis in the entire 30-percent partnership interest.
A partner’s unitary basis in her partnership interest poses a challenge if the partner acquired portions of her interest at different times and the partner recognizes capital gain on a taxable disposition of her interest within one year of the date of her most recent acquisition. For instance, in the example from the second preceding paragraph, assume that the partner sells her entire 30-percent partnership interest in August 2024 and recognizes $100,000 of capital gain on the sale. Her $50,000 of gain on the half of the interest that she purchased in March 2023 should be treated as long-term capital gain; however, her $50,000 of gain on the half of the interest that she purchased in January 2024 should be treated as short-term capital gain. Given that the partner does not have a separate basis in each half of her partnership interest, there needs to be some other mechanism for splitting the long-term and short-term portions of her capital gain.
Similarly, a partner’s unitary basis in her partnership interest creates challenges in applying section 1223(1)’s tacking rule when the partner (i) contributes both cash or an ordinary asset, on one hand, and a capital or section 1231 asset, on the other, in exchange for her partnership interest, and then (ii) sells her partnership interest within one year of having acquired it. Section 1223(1) applies in such a case because, under section 722, the initial basis that the partner takes in her partnership interest is determined in part by her adjusted basis in the capital or section 1231 asset she delivers in the exchange. Pursuant to section 1223(1), the partner’s holding period for the capital or section 1231 asset that she contributed should tack to her holding period for the portion of her partnership interest for which she received an initial basis equal to her adjusted basis in the contributed capital or section 1231 asset. Because the partner does not take a separate basis in that portion of her partnership interest, however, there has to be another mechanism for calculating the part of her interest to which her holding period for the contributed capital or section 1231 asset tacks.
In these scenarios, Regulation section 1.1223-3 provides the needed mechanism by ascribing separate holding periods to respective portions of a partnership interest, notwithstanding the partner’s undivided basis in the interest.
B. A Partner Has Different Holding Periods in Different Portions of Her Partnership Interest If She Acquired Those Portions at Different Times
Regulation section 1.1223-3(a)(1) provides that a partner has a divided holding period for her partnership interest if she “acquired portions of [her] interest at different times[.]” The appropriate division of the partner’s holding period is generally clear in such cases. In short, the partner has separate holding periods for portions of the interest that she acquires at different times. The respective size of each portion of the interest is determined by dividing (i) the partner’s total percentage interest in the partnership by (ii) the percentage interest in the partnership that the partner received by acquiring the portion in question. Then, the standard holding-period rules apply to each portion.
Below is an example:
Example 7: Patricia and Quentin formed the PQ partnership (a calendar year partnership) on February 1, 2022. On that date, Patricia contributed $100,000 in cash to the partnership in exchange for a 20-percent interest in the partnership’s capital, profits, and losses, and Quentin contributed $400,000 in cash in exchange for an 80-percent interest in the partnership’s capital, profits, and losses. On February 2, 2022, PQ purchased a number of assets for use in its business, at an aggregate cost of $500,000. Between February 1, 2022 and December 31, 2022, the PQ partnership “broke even;” its gross income equaled its deductible expenses. Assume that, as of January 1, 2023, the aggregate fair market value of PQ’s assets was $558,000. On that date, Patricia contributed an additional $62,000 in cash to the partnership in an exchange for an additional 10-percent partnership interest. Immediately thereafter, Patricia had a 30-percent interest (and Quentin had a 70-percent interest) in the PQ partnership’s capital, profits, and losses. On January 2, 2023, the partnership purchased additional assets for use in its business, at an aggregate cost of $62,000. Between January 1, 2023 and October 31, 2023, PQ again broke even. Assume that, as of November 1, 2023, the aggregate fair market value of PQ’s assets was $660,000; on that date, PQ’s aggregate inside basis in its assets was $562,000. Also assume that (i) as of November 1, 2023, the partnership had no liabilities, and (ii) at all times relevant hereto, all of PQ’s assets were non-depreciable capital or section 1231 assets. On November 1, 2023, Patricia sold her entire interest to Beverly for $198,000. Immediately prior to the sale, Patricia’s outside basis in her partnership interest was $162,000.
Patricia recognizes $36,000 of capital gain on the sale of her partnership interest. Of that amount, how much is long-term capital gain, and how much is short-term capital gain?
For purposes of the holding-period rules, Patricia’s partnership interest is divided into two portions—the portion that she received in the February 1, 2022 transaction, and the portion that she received in the January 1, 2023 transaction. The February 1, 2022 portion comprises two-thirds of her interest, and the January 1, 2023 portion comprises one-third of her interest. Thus, Patricia’s holding period for two-thirds of her partnership interest begins on February 2, 2022, and, under the general rule for capital assets, her holding period for one-third of her interest begins on January 2, 2023. As a result, $24,000 (i.e., two-thirds) of her capital gain is long-term. The remaining $12,000 (or one-third) is short-term.
C. The Split-Holding-Period Rules Facilitate the Tacking of a Partner’s Holding Period for a Contributed Capital Asset or Section 1231 Asset to Her Holding Period for a Portion of Her Partnership Interest
The split-holding-period rules become more complex when a partner contributes—at the same time, in one transaction—two or more assets with different tax characters in exchange for her partnership interest. Regulation section 1.1223-3(a)(2) provides that a partner has a divided holding period for her partnership interest, even though she “acquired [her entire interest] at [one] time,” if (i) the partner acquired her interest in exchange for a contribution of two or more assets to the partnership, and (ii) the contribution of those assets would “result[] in different holding periods [because of] section 1223[.]” Under this rule, the partner may have different holding periods in different portions of her interest if at least one of the assets that she contributed is a capital asset or section 1231 asset and at least one of the assets that she contributed is not a capital or section 1231 asset.
1. The General Rule for Dividing a Partner’s Holding Period for Her Partnership Interest When She Contributes a Capital Asset or Section 1231 Asset in Exchange for Part of Her Interest
Regulation section 1.1223-3(b)(1) sets forth the general formula for dividing a partnership interest into portions with different holding periods. Under that formula, each portion of a partner’s partnership interest is a percentage of the interest, expressed as a fraction. The numerator of the fraction is “the fair market value of the portion of the partnership interest received in the transaction to which the holding period relates[.]” The denominator of the fraction is “the fair market value of the entire partnership interest.” For both the numerator and the denominator, fair market value is “determined immediately after the transaction” in which the partner acquired the portion of the interest in question.
The key to applying this formula is to identify “the portion of the partnership interest received in the transaction to which the holding period relates[,]” for the numerator of the fraction. This is easy when a partner receives portions of her partnership interest at different times. In such a case, she has a different holding period for each portion. Hence, any portion received at a given time in exchange for the contribution of an asset to the partnership at such time is a “portion of the partnership interest received in [a] transaction to which the holding period [for such portion] relates[.]”
In contrast, when a partner receives her entire partnership interest at one time in exchange for a contribution to the partnership of both cash and at least one capital asset or section 1231 asset, “the portion of the partnership interest received in the transaction to which the holding period relates” refers, as applicable, to (i) the portion of her interest that the partner received in exchange for the cash or (ii) the portion that she received in exchange for a particular capital or section 1231 asset. By operation of section 1223(1), the partner has a different holding period for a portion of her partnership intertest she gets in exchange for a contributed capital or section 1231 asset than she has for a portion she gets in exchange for contributed cash. Accordingly, in such a case, the partner is deemed to receive a distinct portion of her interest in exchange for each capital asset or section 1231 asset that she contributes to the partnership in the transaction, and she is deemed to receive a distinct portion in exchange for the cash that she contributes.
Assume for instance that, in a single transaction in exchange for her partnership interest, a partner contributes (i) a section 1231 asset that she had held for two years, (ii) a capital asset that she had held for six months, and (iii) some cash. In that instance, for holding-period purposes, the partner’s interest would consist of three portions—a portion she is deemed to have received in exchange for the capital asset, a portion she is deemed to have received in exchange for the section 1231 asset, and a portion she is deemed to have received in exchange for the cash.
Typically, for the numerator of the fraction in Regulation section 1.1223-3(b)(1), the fair market value of any given portion of a partnership interest equals the fair market value (at the time of the transaction) of the particular asset that the partner contributed to the partnership in exchange for such portion. This follows from the presumption that, in an arm’s-length exchange, the value of the property transferred will equal the value of the property received. By parity of reasoning, in the denominator of the fraction, the value of the partner’s entire partnership interest generally equals the aggregate fair market value (at the time of the transaction) of all assets that the partner contributed to the partnership in exchange for her interest.
Therefore, when a partner contributes both capital or section 1231 assets and cash—in the same transaction—in exchange for her partnership interest, the percentage portion of the interest that the partner receives in exchange for any particular capital or section 1231 asset generally equals (i) the fair market value of such capital or section 1231 asset at the time of the contribution divided by (ii) the sum of (A) the cash and (B) the fair market value, at the time of the contribution, of all of the capital assets and section 1231 assets that the partner contributes in exchange for her entire interest.
Once a partnership interest is split into percentage portions under Regulation section 1.1223-3(b)(1), the normal rules apply for determining the partner’s holding period for each such portion. Thus, if a partner contributes cash to her partnership in exchange for a given portion of her partnership interest, then the standard rule for determining an owner’s holding period for a capital asset applies. Under that rule, the partner’s holding period for such portion of her interest begins on the day after she acquires such portion and ends on the day when she disposes of her interest.
By contrast, if a partner contributes a capital asset or a section 1231 asset to her partnership in exchange for a given portion of her partnership interest, then the tacking rule under section 1223(1) applies. In other words, the partner’s holding period for the contributed capital or section 1231 asset tacks (is added) to the holding period that the partner would otherwise have in the portion of the interest she receives in exchange. When these rules result in a partner having a split of (i) holding periods of more than one year in a certain percentage of her partnership interest and (ii) holding periods of one year or less in the remainder of her interest, any capital gain that the partner recognizes on a taxable sale or exchange of the interest is split between long-term capital gain and short-term capital gain in the same proportion.
For instance, if a partner contributes both a non-depreciable capital asset with a fair market value of $60 and of $40 of cash in exchange for her partnership interest, the partnership interest will presumably be valued at $100 immediately after the exchange. The partner thus will be deemed to have received 60/100 (or 60 percent) of her partnership interest in exchange for her contribution of the capital asset, and she will be deemed to have received 40/100 (or 40 percent) of her partnership interest in exchange for her contribution of the cash. Under section 1223(1), the partner’s holding period for the contributed capital asset tacks to her holding period for 60 percent of her partnership interest. The partner’s holding period for the remaining 40 percent of her interest begins on the day after the exchange. Assume that the partner held the capital asset for two years before contributing it to the partnership. Also assume that the partner sells her entire partnership interest one week after acquiring it. In that case, the partner will be deemed to have held 60 percent of her interest for two years and one week, and to have held 40 percent of her interest for one week. As a result, 60 percent of any capital gain that the partner recognizes on the sale will be long-term capital gain, and the remaining 40 percent will be short-term capital gain.
2. A Detailed Example of How the General Rule Applies When a Partner Contributes Cash and a Capital Asset in Exchange for Her Partnership Interest
Below is a more comprehensive example, to illustrate how Regulation section 1.1223-3(b)(1)’s split-holding-period rule intersects with section 751(a), section 704(c), and Regulation section 1.1(h) in determining the total amount and tax character of a partner’s gain on the sale of her partnership interest:
Example 8: Roberta and Sam formed the RS partnership (a calendar year partnership) on January 2, 2023, for the purpose of owning and operating a designer clothing store. On January 2, 2023, Roberta contributed $200,000 in cash and a parcel of land to the partnership in exchange for a 50-percent interest in the partnership’s capital, profits, and losses. Roberta purchased the land on May 7, 2021, for $270,000 and held it for investment; on January 2, 2023, the fair market value of the land was $300,000. Also on January 2, 2023, Sam contributed a building with a fair market value of $500,000 to the partnership in exchange for a 50-percent interest in the partnership’s capital, profits, and losses. Sam purchased the building for $450,000 on December 1, 2020, and used it as a retail store in a prior business of his. Immediately before his contribution to the partnership, Sam’s adjusted basis in the building was $426,442. On January 4, 2023, the RS partnership purchased various items of clothing to hold in inventory for customers, at an aggregate cost of $200,000. The partnership then began to conduct business, using the building as a store and the land as a parking lot. Between January 4, 2023 and November 29, 2023, RS sold 50 percent of its inventory to customers for an aggregate price of $160,000, and it recognized an aggregate gain of $60,000 on those sales. Between January 1, 2023 and December 1, 2023, RS paid $47,714 of deductible expenses. For 2023, RS took a $10,478 depreciation deduction on the building. On November 30, RS purchased additional clothing items to replenish its inventory, at an aggregate cost of $112,286. On December 1, 2023, Roberta sold her entire interest in the RS partnership to Francine for $650,000. RS allocated to Roberta $6,143 of its 2023 non-separately-computed net income and $6,143 of its 2023 separately-stated depreciation deduction on the building. Immediately prior to the sale of her partnership interest, Roberta’s outside basis was $470,000. Assume that, on December 1, 2023, the RS partnership held the following assets: (i) the building, which then had a fair market value of $600,000; (ii) the land, which then had a fair market value of $300,000; (iii) items of clothing in inventory, which then had an aggregate fair market value of $300,000; and (iv) goodwill that the partnership had created for its business, which then had a fair market value of $100,000. Also assume that, as of such date, the partnership had no liabilities. On December 1, 2023, the partnership’s inside bases in its assets were: $415,964 adjusted basis in the building; $270,000 basis in the land; $212,286 aggregate basis in the inventory; and $0 basis in the self-created goodwill.
Roberta realizes and recognizes $180,000 of gain on the sale of her partnership interest. Much of that gain is capital, but the portion that is attributable to the partnership’s inventory is ordinary under section 751(a).
To calculate the ordinary portion of Roberta’s gain, we follow the process set forth in Regulation section 1.751-1(a)(2) and imagine that the partnership had sold all of its assets for fair market value immediately before Roberta’s sale of her interest. In that hypothetical transaction, the partnership would have recognized $87,714 of gain on the sale of the inventory. The partnership would have allocated 50 percent—or $43,857—of that gain to Roberta, who still would have been a 50-percent partner at such time. Thus, $43,857 of Roberta’s gain on the sale of her partnership interest is attributable to the inventory, and is ordinary gain. The remaining $136,143 of Roberta’s gain on the sale of her interest is capital gain.
The next question is, how much of Roberta’s $136,143 of capital gain is short-term, and how much is long-term? This is where the split-holding-period rules come into play. Under Regulation section 1.1223-3(a)(2), Roberta has a divided holding period for her partnership interest because she contributed both a capital asset (the land, which was then worth $300,000) and $200,000 of cash in exchange for her interest. Under Regulation section 1.1223-3(b)(1), Roberta’s partnership interest has two parts: (i) the portion she received in exchange for the land, and (ii) the portion she received in exchange for the cash. The fair market value of Roberta’s partnership interest, on the date she acquired it, presumably equaled the $500,000 aggregate fair market value of the assets she contributed in exchange for her interest. It follows that Roberta received 300,000/500,000 (or 60 percent) of the interest’s value in exchange for her contribution of the land and received 200,000/500,000 (or 40 percent) of the interest’s value is exchange for her contribution of the cash. Therefore, the “land portion” constitutes 60 percent of Roberta’s interest, and the “cash portion” constitutes 40 percent of her interest.
Roberta’s actual holding period for her partnership interest began on the day after she acquired the interest. Under section 1223(1), however, the holding period that Roberta had for her contributed land tacks to her holding period for the 60-percent portion of her interest that she received in exchange. In contrast, nothing tacks to Roberta’s holding period for the 40-percent portion of her interest that she received in exchange for the cash. By operation of these rules, Roberta is deemed to have held 60 percent of her interest for longer than one year at the time of her sale, while she held the other 40 percent for less than one year before the sale. As a result, 60 percent (or $81,686) of Roberta’s capital gain is long-term capital gain, and 40 percent (or $54,457) of her capital gain is short-term capital gain.
The building is a section 1231 asset in the partnership’s hands, and part of the gain inherent in the building is unrecaptured section 1250 gain because it stems from basis reductions corresponding to straight-line-depreciation deductions on the asset. A portion of Roberta’s long-term capital gain on the sale of her partnership intertest is attributable to that inherent unrecaptured section 1250 gain. Pursuant to Regulation section 1.1(h)-1, this portion of Roberta’s gain is section 1250 capital gain and is taxed at the special 25-percent rate for unrecaptured section 1250 gain. The remainder of Roberta’s long-term capital gain is “residual” and is taxed at a rate of 0 percent, 15 percent, or 25 percent, as applicable.
To calculate the amount of Roberta’s section 1250 capital gain, we return to the partnership’s hypothetical sale of its assets immediately prior to Roberta’s sale of her interest. In such a sale, Roberta would receive a $30,000 allocation of section 1231 gain on the land, a $50,000 allocation of capital gain on the goodwill, and a $56,143 allocation of section 1231 gain on the building. Of the allocated gain on the building, $6,143 would be unrecaptured section 1250 gain. Thus, under Regulation section 1.1(h)-1, $6,143 of Roberta’s long-term capital gain is section 1250 capital gain, and $75,543 is residual long-term capital gain.
In sum, Roberta recognizes $180,000 of gain on the sale of her partnership interest. Of that amount, $43,857 is ordinary gain; $54,457 is short-term capital gain; $6,143 is section 1250 capital gain, and $75,543 is residual long-term capital gain. The ordinary gain and the short-term capital gain are taxed at Roberta’s federal income tax rate(s) for ordinary income. The section 1250 capital gain is taxed at 25 percent. The residual long-term capital gain is taxed at 15 percent or 20 percent, depending on Roberta’s overall taxable income for the year.
3. The Split-Holding-Period Rules Disregard a Partner’s Contribution of Section 751 Assets
If a partner contributes both a section 751 asset and either a capital asset or a section 1231 asset in exchange for her partnership interest, Proposed Regulation section 1.1223-3(b) would have counted the contribution of the section 751 asset in calculating the divided holding period for the partner’s interest. Under the Proposed Regulation, the partner would have been deemed to receive a portion of her partnership interest in exchange for her contribution of the section 751 asset. In turn, the value of the “section-751-asset portion” of the interest would have been included in determining the percentage of the interest that the partner was deemed to receive in exchange for her contribution of the capital or section 1231 asset.
Consider this example:
Example 9: In exchange for a 50-percent interest in the capital, profits, and losses of the TU partnership, Tabitha contributed to her partnership (i) a non-depreciable capital asset with a fair market value of $60 (which she had purchased two years earlier for $60) and (ii) section 751(d) inventory items with an aggregate fair market value of $40 (which she had purchased for an aggregate price of $40). At the same time, in exchange for the other 50-percent interest in the partnership, Umberto contributed a non-depreciable section 1231 asset with a fair market value of $100 (which he had purchased two years earlier for $100). Tabitha sold her partnership interest six months after acquiring it, for $115. Assume that the TU partnership had no liabilities and “broke even”—i.e., incurred no net taxable income or tax loss—during its first six months. Also assume that, immediately prior to Tabitha’s sale of her interest, the capital asset was worth $80, the inventory was worth $50, and the section 1231 asset was worth $100.
In Example 9, Tabitha recognizes $15 of gain on the sale of her partnership interest. Of that gain, $5 is ordinary under section 751(a), and $10 is capital under section 741. Under Proposed Regulation section 1.1223-3(b), Tabitha’s partnership interest would have been split into two parts. Sixty percent of her interest would have been deemed to be received in exchange for the capital asset, and 40 percent would have been deemed to be received in exchange for the section 751(d) inventory. Tabitha’s two-year holding period for the capital asset would have tacked to her six-month holding period for 60 percent of her partnership interest. Accordingly, 60 percent (or $6) of Tabitha’s capital gain would have been long-term, and 40 percent (or $4) would have been short-term.
During the review-and-comment period for Proposed Regulation section 1.1223-3, Treasury received objections to the manner in which contributions of section 751 assets would affect the division of a partner’s short-term vs. long-term capital gain. Commentators argued that, “if a partner has a short-term holding period in a partnership interest on account of the contribution of [section 751 assets],” the combination of section 751(a) and “the proposed regulations [would] cause the section 751 assets to be counted twice” if the partner sold her interest “within 12 months of the contribution[.]” Under section 751(a), the contributed section 751 assets would be counted first “to treat part of the [partner’s recognized gain on the sale of her partnership interest] as ordinary income. Then, under Proposed Regulation section 1.1223-3(b), the contributed section 751 assets would be counted “again in determining the selling partner’s short-term capital gain.” The commentators contended that counting the contribution of section 751 assets the second time would result in understating the percentage of a partnership interest to which the partner’s holding period for a contributed capital or section 1231 asset should tack.
Treasury made a number of revisions to Proposed Regulation section 1.1223-3(b) in the final Regulations. Among other changes, the general rule in the Proposed Regulation became Regulation section 1.1223-3(b)(1) in the final Regulation. And, in response to the comments regarding how the Proposed Regulation treated contributions of section 751 assets, Treasury added Regulation section 1.1223-3(b)(4).
Paragraph (b)(4) of the Regulation applies when (i) a partner receives a portion of her partnership interest in exchange for her contribution to the partnership of a section 751 asset and (ii) the partner disposes of her partnership interest in a taxable sale or exchange within one year after having acquired it. The rule provides that, when determining a split in the partner’s holding period for her partnership interest under Regulation section 1.1223-3(b)(1), the partner’s contribution of a section 751 asset “shall be disregarded” if the partner recognizes gain or loss “on account of” that section 751 asset within one year after acquiring her interest. For purposes of this rule, a partner recognizes gain or loss “on account of” a contributed section 751 asset if either (i) the partnership sells the asset and allocates gain or loss on the sale to the partner or (ii) the partner sells her interest and, pursuant to section 751(a), recognizes ordinary gain or loss attributable to the asset.
Disregarding the contribution of a section 751 asset under Regulation section 1.1223-3(b)(4) means ignoring the portion of the partnership interest that the partner received in exchange for the contributed section 751 asset, when applying the Regulation section 1.1223-3(b)(1) formula to determine the percentage of the partner’s interest to which her holding period for a contributed capital or section 1231 asset should tack. It requires pretending that (i) the partner contributed only the capital assets, section 1231 assets, and/or cash that she actually contributed to the partnership and (ii) the partner received only the portion(s) of her partnership interest that she actually received in exchange for such capital assets, section 1231 assets, and/or cash.
Consider, for instance, the difference that Regulation section 1.1223-3(b)(4) makes in Example 9: Pursuant to Regulation section 1.1223-3(b)(4), partner Tabitha is deemed to have contributed only her $60 non-depreciable capital asset to the TU partnership, and she is deemed to have received only a partnership interest worth $60 in return. In turn, under Regulation section 1.1223-3(b)(1), Tabitha is deemed to have received 60/60 (or 100 percent) of her partnership interest in exchange for her contribution of the capital asset. Thus, under section 12231(1), Tabitha’s two-year holding period for the capital asset tacks to her six-month holding period for 100 percent of her partnership interest.
When Tabitha sells her partnership interest for $115, she still recognizes $15 of gain. And $5 of that gain is still ordinary gain under section 751(a). Disregarding the contributed section 751(d) inventory is solely for purposes of applying Regulation section 1.1223-3(b)(1). Section 751 assets are not disregarded when determining the actual amount of a selling partner’s gain or loss, nor are they disregarded when determining the portion of any such gain or loss that is ordinary under section 751(a).
At the same time, $10 of Tabitha’s gain is still capital gain under section 741. This is where Regulation section 1.1223-3(b)(4)—and its effect on Regulation section 1.1223-3(b)(1)—makes a difference. Because Tabitha’s holding period for the capital asset tacks to her holding period for her entire partnership interest, all $10 of her capital gain is long-term. (Compare this to the $6 long-term/$4 short-term split that would have resulted under the Proposed Regulation.)
By operation of Regulation section 1.1223-3(b)(4), there is no division in a partner’s holding period for her partnership interest when she contributes a section 751 asset and one non-section-751 asset in exchange for her interest. As illustrated in Example 9, if the non-section-751 asset is a capital asset or a section 1231 asset, then the partner’s holding period for such asset tacks to her holding period for her entire partnership interest. Conversely, if the non-section-751 asset is cash, there is no tacking to the partner’s holding period for any portion of her interest.
But what if a partner contributes a section 751 asset and multiple non-section-751 assets in exchange for her partnership interest? For instance, what if a partner contributes (i) a section 751 asset, (ii) a capital or section 1231 asset, and (iii) cash? In such a case, there is a split in the partner’s holding period for her interest. Regulation section 1.1223-3(b)(4), however, affects the proportion of the split.
As a case in point, consider the following variation on Example 9:
Example 10: Same facts as in Example 9 except that, in exchange for her partnership interest, Tabitha contributes to the TU partnership (i) a non-depreciable capital asset with a fair market value of $60 (which she had purchased two years earlier for $60), (ii) section 751(d) inventory items with an aggregate fair market value of $20 (which she had purchased for an aggregate price of $20), and (iii) $20 of cash. On the following day, the partnership uses the contributed cash to purchase additional section 751(d) inventory items with an aggregate fair market value of $20.
In this version of the example, pursuant to Regulation section 1.1223-3(b)(4), Tabitha is deemed to have contributed her $60 non-depreciable capital asset and $20 of cash to the TU partnership, and she is deemed to have received a partnership interest with a fair market value of $80 in return. Under Regulation section 1.1223-3(b)(1), Tabitha is deemed to have received 60/80 (or 75 percent) of her partnership interest in exchange for her contribution of the capital asset, and she is deemed to have received 20/80 (or 25 percent) of her interest in exchange for her contribution of the cash. Tabitha’s two-year holding period for the capital asset tacks to her six-month holding period for 75 percent of her partnership interest, pursuant to section 1223(1).
Tabitha sells her partnership interest, six months after acquiring it, for $115—just as in Example 9. Once again, she recognizes $15 of gain on the sale; $5 of the gain is ordinary under section 751(a), and $10 of the gain is capital under section 741. In Example 10, however, because of the 75/25 split in Tabitha’s holding period for the partnership interest, $7.50 of her capital gain is long-term, and $2.50 is short-term capital again.
The theory underlying Regulation section 1.1223-3(b)(4) seems to be that, if a partner receives a portion of her partnership interest in exchange for contributing section 751 assets to her partnership, then such portion of her interest is not a capital asset. In other words, the apparent hypothesis is that a partnership interest—or a portion thereof—is a capital asset only if the partner receives it in exchange for a contribution of non-section-751 property. If that were true, it might make sense for the split-holding-period rules to account only for contributions of non-section-751 property—to determine a division of the contributing partner’s holding period only for the “capital-asset portion” of her interest. After all, the distinction between short-term and long-term holding periods is relevant only to gain or loss that is recognized on a taxable disposition of a capital asset.
Yet, in actuality, such a notion is plainly inconsistent with relevant Code provisions. No exception or carve-out in section 1221 indicates that a partnership interest is a non-capital asset to the extent that the partner received it in exchange for a contribution of section 751 assets. Nor does section 751(a) mandate ordinary-gain treatment for a percentage of gain on the sale of a partnership interest equal to the percentage of the interest that the partner had received in exchange for contributing section 751 assets. Instead, as “interpreted” under Regulation section 1.751-1(a)(2), section 751(a) requires ordinary-gain treatment of the portion of the selling partner’s gain equal to the gain that the partnership would have allocated to the partner if it had sold all of its section 751(a) assets immediately before the partner sold her partnership interest.
In many cases, the percentage of a selling partner’s gain that is ordinary under section 751(a) is quite different from the percentage of the partnership interest that the partner received in exchange for her contribution of section 751 assets. In Example 9, for instance, partner Tabitha received 40 percent of her partnership interest in return for her contribution of section 751(d) inventory. In contrast, only one-third (or approximately 33.3 percent) of her gain was ordinary under section 751(a).
The following variation on Example 8 provides an even starker comparison:
Example 11: Same facts as in Example 8, except that, instead of contributing $200,000 of cash, Roberta contributed items of clothing that she had purchased at an aggregate cost of $200,000 and had held in inventory in a prior retail business of hers. On January 2, 2023 (the contribution date), the aggregate fair market value of the contributed inventory items was $200,000. Because of this contribution, the partnership did not make the January 4, 2023 purchase of inventory that was referenced in Example 8. (All subsequent sales and purchases of inventory by the partnership are the same as in Example 8, however.)
Roberta recognizes $180,000 of gain on the sale of her partnership interest, just as she did in Example 8. And, just like in Example 8, $43,857 of that amount is ordinary gain, while the remaining $136,143 is capital gain. The difference is whether any portion of the capital gain is short-term.
In Example 11, by application of Regulation section 1.1223-3(b)(4), Roberta is deemed to have contributed only the $300,000 land to the partnership, and she is presumed to have received in return a partnership interest worth $300,000. By extension, Roberta is deemed to have received 300,000/300,000 (or 100 percent) of her partnership interest in exchange for her contribution of the land, pursuant to Regulation section 1.1223-3(b)(1). In turn, under section 12231(1), Roberta’s holding period for the land tacks to her holding period for 100 percent of her partnership interest. As a result, Roberta’s entire $136,143 of capital gain in Example 11 is long-term. This is in sharp contrast to Example 8, in which 60 percent of Roberta’s capital gain is long-term and 40 percent is short-term. Even more strikingly, Roberta received 40 percent of her partnership interest in exchange for contributing section 751 assets in Example 11, whereas only approximately 24 percent of the gain on the sale of her interest is ordinary under section 751(a).
Perhaps commentators were rightly concerned about overweighting contributed section 751 assets in the formula that determines the long-term/short-term split in a partner’s capital gain on the sale of her partnership interest. A more appropriate response, however, would have been to disregard the contributed section 751 assets to the extent—and only to the extent—of the partner’s ordinary gain under section 751(a). Unfortunately, that is not how Regulation section 1.1223-3(b)(4) actually works.
For instance, in Example 11, approximately 24 percent of Roberta’s gain on the sale of her partnership interest is ordinary gain, and approximately 76 percent of such gain is capital gain. Roberta had received 40 percent of her partnership interest in exchange for her contribution of section 751 assets. Hence, 40 percent of Roberta’s gain on the sale of her interest derives from her contribution of the section 751 assets—even though not all of that 40 percent is attributable to inherent gain in the section 751 assets themselves. The 40 percent of her gain that Roberta received because she contributed the section 751 assets includes, of course, the 24 percent that is attributable to the section 751 assets and is ordinary under section 751(a). But that 40 percent also includes an additional 16 percent of Roberta’s gain on the sale of her interest, which is capital gain. With this in mind, it may make sense to disregard 24/40 of the contributed section 751 assets when applying Regulation section 1.1223-3(b)(1) to calculate Roberta’s divided holding period for her partnership interest. Nevertheless, 16/40 of the section 751 assets should still be included in the denominator of the Regulation section 1.1223-3(b)(1) fraction—because Roberta contributed 16/40 of those assets in return for a portion of her interest that generated capital gain.
As shown above, Regulation section 1.1223-3(b)(4) actually produces a very different result. In Example 11, Regulation section 1.1223-3(b)(4) disregards 40 percent of the partner’s contribution of assets, even though only about 24 percent of the partner’s gain on the sale of her partnership interest is ordinary. Similarly, in Example 9, Regulation section 1.1223-3(b)(4) disregards 40 percent of the partner’s contribution of assets, even though only about 33 percent of the partner’s gain on the sale of her partnership interest is ordinary. In each of those examples, Regulation section 1.1223-3(b)(4) causes an underweighting of the selling partner’s contributed section 751 assets—and thereby increases the over-weighting of the partner’s contributed capital asset or section 1231 asset—in the Regulation section 1.1223-3(b)(1) formula for dividing the partner’s partnership interest into holding-period percentages. In turn, the partner’s holding period for her contributed capital or section 1231 asset tacks to her holding period for a greater percentage of her partnership interest than Regulation section 1.1223-3(b)(1) would otherwise provide. As a result, a more inordinate share of the partner’s capital gain on the sale of her partnership interest is treated as long-term, rather than short-term.
As discussed below, Regulation section 1.1223-3(b)(1) often provides a tax windfall to short-term holders of partnership interests. It does so by extending the benefit of preferential long-term rates to capital gain on a short-term sale of a partnership interest beyond any gain that is attributable to a selling partner’s contributed capital or section 1231 asset. The above-described flaw in Regulation section 1.1223-3(b)(4) exacerbates this tax windfall by further increasing the portion of a selling partner’s gain that is subject to preferential long-term capital gain rates—without any technical or policy-based justification.
To see the arbitrary results that Regulation section 1.1223-3(b)(4) can produce—and how easily the Regulation can be manipulated—one need only compare the respective outcomes in Examples 8 and 11. The only difference in the two fact-patterns is that: (i) in Example 8, partner Roberta contributed cash, which the partnership immediately used to purchase inventory; and (ii) in Example 11, Roberta purchased the inventory and contributed it to the partnership directly. By virtue of Regulation section 1.1223-3(b)(4), one non-substantive change in Roberta’s manner of funding the partnership’s inventory converted 40 percent of Roberta’s capital gain on the sale of her partnership interest from short-term to long-term. The resulting tax benefit to Roberta in Example 11 (via the preferential long-term rates) is difficult to rationalize.
4. Section 1245 Recapture Income Inherent in a Contributed Capital Asset or Section 1231 Asset Is Treated as a Disregarded Section 751 Asset Under the Split-Holding-Period Rules
a. The Rule in Regulation Section 1.1223-3(e). Imagine the following: On July 1, 2021, a farmer named Victoria purchased for $200,000 a combine harvester for harvesting grain and placed it in service in her farming business. On July 1, 2023, Victoria contributed the combine to a farming partnership in exchange for an interest in the partnership. On the contribution date, the combine’s fair market value was $165,000, and Victoria’s adjusted basis in the combine was $120,000. Prior to the contribution, Victoria took a total of $80,000 in depreciation deductions on the combine.
In this scenario, Victoria is deemed to have contributed two assets to her partnership—notwithstanding that she actually contributed only the combine. At the time of the contribution, the combine had $45,000 of built-in gain for tax, even though it was then worth $35,000 less than when Victoria purchased it. The built-in tax gain was due entirely to the reductions in Victoria’s basis that resulted from her depreciation deductions on the combine. Therefore, the $45,000 of built-in gain was inherent section 1245 recapture income.
As discussed above, section 751(c) classifies section 1245 recapture income inherent in a partnership’s capital asset or section 1231 asset as an unrealized receivable of the partnership that is separate from such capital assent or section 1231 asset. Accordingly, for purposes of Regulation section 1.1223-3(b)(1)’s split-holding-period formula, Regulation section 1.1223-3(e) treats section 1245 recapture income inherent in a contributed capital asset or section 1231 asset as a separately-contributed section 751 asset. In the present scenario, $45,000 of the combine’s $165,000 fair market value on the contribution date was attributable to inherent section 1245 recapture income. Therefore, for purposes of Regulation section 1.1223-3(e), partner Victoria contributed a section 751 asset with a fair market value of $45,000, as well as a section 1231 asset with a fair market value of $120,000.
The treatment of built-in section 1245 recapture income as a section 751 asset under Regulation section 1.1223-3 should come as no surprise, given section 751(c)’s classification of inherent section 1245 recapture income as an unrealized receivable. Nonetheless, the Regulations’ approach to section 1245 recapture has seemingly caused confusion since the Regulations were first proposed, and the rule in Regulation section 1.1223-3(e) eludes some commentators and practitioners even to this day.
In Proposed Regulation section 1.1223-3, Treasury included an “Example 2,” in which a partner contributed $50,000 of cash and an item of business-use equipment with a fair market value of $100,000 in exchange for a partnership interest with a fair market value of $150,000. In the example, $20,000 of the equipment’s value was attributable to section 1245 recapture income inherent in the equipment. Thus, the partner was deemed to have contributed three assets to the partnership: $50,000 of cash, a $20,000 ordinary asset, and an $80,000 section 1231 asset. (The ordinary asset was a section 751(c) unrealized receivable; however, contributed section 751 assets would not have been disregarded under the Proposed Regulation.) Applying the formula in Proposed Regulation section 1.1223-3(b), the example concluded that the partner’s holding period for the contributed equipment tacked to the partner’s holding period for 80,000/150,000 (or 53.33 percent) of the partnership interest.
Perhaps Example 2 in Proposed Regulation section 1.1223-3(e) might have been more illuminating if it had included an express reminder that section 1245 recapture income inherent in a partnership asset is considered a separate asset—a partnership unrealized receivable—under section 751(c). Apart from that, though, the example was clear. Nonetheless, “[s]ome commentators” on the Proposed Regulations “raised questions on the position taken in this example.” In response, Treasury reiterated that “it is appropriate to characterize all properties and potential gain treated as unrealized receivables under section 751(c) and the regulations thereunder as separate assets that are not capital assets or [section 1231 assets].” At the same time, Treasury apparently concluded that Example 2 did not adequately communicate this approach or explain the rationale for its result. “Accordingly,” in the final Regulations, Treasury eliminated the example and, in its stead, added “a specific rule . . . to provide for such a result.”
The rule for inherent section 1245 recapture income (and other section 751(c) unrealized receivables) appears in final Regulation section 1.1223-3(e). The Regulation states plainly that, “[f]or purposes of [Regulation section 1.1223-3], properties and potential gain treated as unrealized receivables under section 751(c) shall be treated as separate assets that are not capital assets or [section 1231 assets].” This echoes Treasury’s explanation of the rule it had intended to advance in Example 2 under Proposed Regulation section 1.1223-3(e). In introducing the final rule, however, Treasury made sure to clarify that the treatment of inherent section 1245 recapture income as a separately-contributed unrealized receivable is subject to the “disregard-of-section-751-assets” rule in final Regulation section 1.1223-3(b)(4). In other words, as with any other section 751 asset, a contribution of inherent section 1245 recapture income is to be disregarded “in computing the holding period of a partnership interest where the interest is sold within one year after contribution.”
Building on the scenario above, here is a fuller example of how Regulation section 1.1223-3(e) applies:
Example 12: Walter and Victoria formed the WV partnership (a calendar year partnership) on July 1, 2023, for the purpose of owning and operating a farming business. On July 1, 2023, Victoria contributed a combine harvester and $55,000 in cash to the partnership in exchange for a 50-percent interest in the partnership’s capital, profits, and losses. Victoria had purchased the combine on July 1, 2021, for $200,000 and had used it in a prior farming business of hers. On July 1, 2023, the fair market value of the combine was $165,000, and Victoria’s adjusted basis in the combine was $120,000. Prior to the contribution, Victoria had taken $80,000 of depreciation deductions on the combine. Also on July 1, 2023, Walter contributed $220,000 in cash to the partnership in exchange for a 50-percent interest in the partnership’s capital, profits, and losses. On July 2, 2023, the WV partnership purchased a large parcel of farmland for $275,000. The partnership then began to conduct its farming business, using the land to grow grain and using the combine to harvest the grain. For 2023, the partnership took a $20,000 depreciation deduction on the combine. During the period from July 1, 2023 to December 31, 2023, the partnership received $65,000 of gross income from its farming operations and paid $65,000 of deductible expenses. On January 1, 2024, Victoria sold her entire interest in the WV partnership to Kathy for $262,000. Immediately prior to the sale, Victoria’s outside basis in her partnership interest was $168,750. Assume that, on January 1, 2024, the WV partnership held the following assets: (i) the combine, which then had a fair market value of $155,000; and (ii) the land, which then had a fair market value of $369,000. Also assume that, as of that date, the partnership had no liabilities. On January 1, 2024, the partnership’s inside bases in its assets were: $100,000 adjusted basis in the combine, and $275,000 basis in the land.
Victoria recognizes $93,250 of gain on the sale of her partnership interest. To determine the tax character of the gain, the first step is to determine how much is ordinary.
At the time of Victoria’s sale, $55,000 of gain is inherent in the combine. The inherent gain is due entirely to basis reductions that resulted from depreciation deductions on the combine. If the partnership were to sell the combine for fair market value, the $55,000 of recognized gain would thus be section 1245 recapture income. Under section 751(c), the $55,000 of section 1245 recapture income inherent in the combine is deemed to be an unrealized receivable that is separate from the combine itself. A portion of Victoria’s gain on the sale of her partnership interest is attributable to the inherent gain in such unrealized receivable. Pursuant to section 751(a), that portion of Victoria’s gain is ordinary.
To calculate the amount of Roberta’s ordinary gain, we hypothesize that the partnership sold all of its assets for fair market value immediately before Victoria’s sale of her interest, as Regulation section 1.751-1(a)(2) directs. In such a transaction, the partnership would have recognized $55,000 of gain on the combine. Because the gain would have been section 1245 recapture income, section 751(c) would treat the hypothetical combine sale as (i) a sale of an unrealized receivable with a fair market value of $55,000 and an adjusted basis of $0 and (ii) a sale of a combine with a fair market value of $100,000 and an adjusted basis of $100,000. The partnership would have allocated $50,000 of its $55,000 in gain on the unrealized receivable to Victoria (who would still have been a partner). Thus, $50,000 of Victoria’s gain on the sale of her partnership interest is attributable to the unrealized receivable, and that portion of her gain is ordinary. The remaining $43,250 of Victoria’s gain on the sale of her interest is capital gain.
Even though Victoria did not hold her partnership interest for more than one year before selling it, part of her $43,250 of capital gain will be long-term capital gain. This is because her two-year holding period for the combine tacks to her holding period for a portion of her interest.
To determine the percentage of Victoria’s interest to which her holding period for the combine tacks, we look to the split-holding-period rules—starting with Regulation section 1.1223-3(e). Under Regulation section 1.1223-3(e), Victoria is deemed to have contributed a $45,000 unrealized receivable and a $120,000 combine, as well as $55,000 in cash, in exchange for a partnership interest then worth $220,000. Pursuant to Regulation section 1.1223-3(b)(4), however, the contribution of the unrealized receivable (a section 751(c) asset) is disregarded. Thus, for purposes of Regulation section 1.1223-3(b)(1), Victoria is deemed to have contributed only a $120,000 combine and $55,000 in cash, in exchange for a partnership interest worth $175,000. Under Regulation section 1.1223-3(b)(1), Victoria is deemed to have received 120,000/175,000 (or approximately 69 percent) of her interest in exchange for the combine and to have received 55,000/175,000 (or approximately 31 percent) of her interest in exchange for the cash.
Accordingly, pursuant to section 1223(1), Victoria’s two-year holding period for the combine tacks to her six-month holding period for 69 percent of her interest. In other words, Victoria is deemed to have held 69 percent of her partnership interest for two years and six months, while she held the other 31 percent for six months. As a result, 69 percent (or $29,843) of her $43,250 capital gain on the sale of her interest is long-term, and the remaining 31 percent (or $13,407) is short-term.
So, to recap: On the sale of her partnership interest, Victoria recognizes $50,000 of ordinary gain, $13,407 of short-term capital gain, and $29,843 of long-term capital gain.
b. The Confusion That Regulation Section 1.1223-3(e) Has Caused. Despite the relatively plain language of Regulation section 1.1223-3(e), some commentators and practitioners seem to be either unmindful of it or confused by it. Even in an otherwise outstanding instructional text on partnership tax, for instance, the authors ignore Regulation section 1.1223-3(e) and fail to separate a depreciable section 1231 asset from the asset’s inherent section 1245 recapture income, in an example that is intended to illustrate the split-holding-period rules.
Perhaps more curiously, another commentator opines that the ambit of Regulation section 1.1223-3(e) “is not completely clear”—and that taxpayers may choose whether to follow it—because the examples in Regulation section 1.1223-3 “do not specifically address the contribution of recapture property.” This view is misguided for a couple for reasons.
First, the commentator neglects to take proper account of Regulation section 1.1223-3(e)’s administrative history. It is of course true that final Regulation section 1.1223-3 does not include an example in which an asset’s inherent recapture income is treated as separate from the asset in which it inheres. Yet, as noted above, this is precisely because Treasury decided to replace such an example (from the Proposed Regulation) with an express provision stating that such recapture income constitutes a separate section 751(c) asset for purposes of the split-holding-period rules. Given that history, it is unreasonable to interpret the absence of a specific example the final Regulation as any sort of indication that Regulation section 1.1223-3(e) lacks meaning or effect.
Second, the commentator appears to base his approach on a nonexistent “rule” of regulatory interpretation that would be risky to follow. It is wrong to conjecture that taxpayers may ignore any given provision within a Treasury Regulation simply because the Regulation’s examples do not include a specific illustration of that provision. For instance, the Regulation section 1.1223-3(f) examples also omit to include any fact-pattern in which a partner acquires portions of her partnership interest at different times. Are we to conclude, on the basis of that omission, that Regulation section 1.1223-3(a)(1) is ineffective surplusage and that such a partner would not have a divided holding period for her interest? Of course not.
