Posted on May 16, 2016 Show
Sooner or later, one of your law firm partners will probably sell his or her partnership interest to an incoming partner. At that point, there will be important tax consequences for the exiting partner. Read about the applicable federal income tax rules in a nutshell. The same rules apply if your firm operates as an LLC that is treated as a partnership for federal tax purposes. The General RuleWhen law firm partners or LLC members sell out, they generally have either a capital gain or loss under Section 741 of the Internal Revenue Code. It’s easy enough to calculate that gain or loss as long as the firm maintains accurate tax-basis capital accounts, which measure partners’ equity in the firm. Typically, law firms use tax-basis accounting to calculate capital accounts, but other methods such as GAAP-basis accounting are also common. The gain or loss from a sale equals the difference between sale proceeds received by the exiting partner and the dollar amount of a partner’s tax-basis capital account as of the sale date. In general, there are no tax consequences for the firm itself or the other existing partners, and there is no immediate tax impact for the incoming partner. Let’s look at an example to illustrate the consequences for the partner who is leaving. Say Partner A sells his interest to incoming partner B for $100,000 cash. Assume partner A’s tax-basis capital account is $15,000 as of the sale date. Therefore, Partner A has an $85,000 capital gain ($100,000 minus $15,000). Partner B’s initial tax-basis capital account equals the $100,000 purchase price. That seems simple enough. But unfortunately, this procedure doesn’t always work. For instance, if a firm doesn’t maintain accurate tax-basis capital accounts, an exiting partner will have to do some work to figure out the tax basis of his or her partnership interest in order to properly calculate the taxable gain or loss. Ordinary Income Can Be Triggered by the Unfavorable “Hot Assets” RuleThere’s another complication: Certain assets can trigger ordinary income from the sale and change the tax consequences for the exiting partner. If the partnership owns “hot assets,” a selling partner must pretend that his or her share of those assets were sold to the incoming partner for fair market value. In that case, the exiting partner may have deemed taxable gains that must be treated as ordinary income and taxed at the partner’s regular federal rate, which can be as high as 39.6 percent (up from 35 percent in 2012). In other words, all or part of what initially appears to be a low-taxed capital gain becomes high-taxed ordinary income. So what are considered “hot assets” for a partnership or LLC?
Let’s look at another example. Say that exiting Partner A still sells his interest for $100,000. But this time, he has a share in the partnership’s zero-basis client receivables and so he must recognize $40,000 of ordinary income under the hot assets rule. Therefore, in this case, Partner A’s low taxed capital gain is reduced to $45,000 ($85,000 gain minus the $40,000 transformed into ordinary income by the hot assets rule). When the transaction is complete, Partner A must recognize $40,000 of high-taxed ordinary income from selling his or her partnership interest. As in our previous example, Partner B’s initial tax-basis capital account still equals the $100,000 purchase price. Observation: The unfavorable hot assets rule is unique to partnerships and firms operating as LLCs, which are treated as partnerships for federal tax purposes. There is no similar rule that converts capital gain into ordinary income when selling shares in a law firm that is operated as a C or S corporation. The hot assets rule usually comes into play when a partner who is leaving sells to an incoming partner. As a result, the tax outcome for the exiting partner might be more complicated than it first appears. Contact your tax adviser for more information about the consequences of selling law firm interests.  LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA,
CVA Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters. What are hot assets?Hot Assets are business assets that if sold have the potential to create ordinary income. This is important to keep in mind because the partner is probably not aware these rules even exist.
What is the partnerships basis in the assets following the sale?The inside basis is the partnership's tax basis in the individual assets. The outside basis is the tax basis of each individual partner's interest in the partnership. When a partner contributes property to the partnership, the partnership's basis in the contributed property = its fair market value ( FMV ).
Which of the following assets would not be classified as hot assets?Hot assets include all assets except for cash, capital assets, and §1231 assets.
What is the recognized gain or loss from the sale of partnership interest?The sale of a partnership interest is generally treated as the sale of a capital asset. As a result, the sale of a partnership interest will generally generate capital gain or loss for the difference between the amount realized on the sale and the partner's adjusted basis in the partnership interest.
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