Reporting publicly traded partnership Sec. 751 ordinary income and other challenges

Editor: Valrie Chambers, CPA, Ph.D.

Properly reporting information from Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for publicly traded partnerships (PTPs) is a difficult task. The task is particularly challenging in the year of sale. Most clients purchase their investment in a PTP through their stockbroker or other financial adviser. Just like other partnerships, the basis of the investment in the PTP is adjusted each year by income, deductions, and distributions. The brokers do not normally see the annual Schedules K-1 and do not have the information to adjust the cost basis in the client’s account records. When the investment is sold, the Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, that reports the sale shows the original cost. So the cumulative basis adjustments must be made to properly report the gain or loss. Fortunately, most PTP Schedules K-1 include additional schedules with the necessary information.

Many PTP sales disclosure schedules include an ordinary income component. The ordinary income is Sec. 751, or “hot asset,” ordinary income, which is discussed in more detail in Milo, “The Tax Cost of Hot Assets Upon the Disposition of a Partnership Interest,” The Tax Adviser (August 2010). Sec. 751 refers to the ordinary gain from the sale of unrealized receivables and substantially appreciated inventory. There seems to be a common misconception that ordinary income is recognized only to the extent of gain, much like a depreciation recapture in an asset sale. This is not correct. Ordinary gain is fully recognized whether there is an overall gain or loss on the sale.

As with any investment, there may be short-term and long-term capital gain components to the sale. In the following example, it is assumed that the two 500-unit acquisitions are long-term and the remaining 113 units are short-term, the original cost was $111,300, and the sales price is $44,520. The table “Sales Disclosure Statement Provided by PTP” shows the sales disclosure statement provided by the PTP with Schedule K-1. Ordinary gain is reported on Form 4797, Sales of Business Property. The table “Gain and Loss on the Transaction” shows how this transaction would be reported.

This results in a potentially taxing situation if the partner is limited to a $3,000 net capital loss, yet has to realize the ordinary income in full. The components to the sale calculation come from at least two source documents provided by the client, Form 1099-B and Schedule K-1. The calculation can be quite tedious if there are many unit purchases or reinvestments of distributions. A standard PTP sale reporting worksheet to facilitate the calculation of gains and losses that may make these calculations more efficient is available here.

Regs. Sec. 1.751-1(a)(3) also requires a disclosure statement to be included with the partnership’s and with each partner’s tax return in the year of sale. In the footnotes to the Schedule K-1, the PTP will disclose the existence of Sec. 751 income to the partner and a recommended disclosure statement for the partner to use. Most tax preparation software does not have a standard disclosure statement template. Here is an example of a proper disclosure statement:

The taxpayer has reported ordinary income upon the disposition of units in [name], LP, as provided by the Partnership. The amount was determined in accordance with ­Internal Revenue Code Section 751. ­Detailed information is available from the Partnership upon request.

Another often overlooked challenge in reporting PTP losses is the prohibition on claiming losses upon disposition under Sec. 469(k)(3) if the taxpayer owns any interest in the same PTP through another entity. For example, it is not uncommon to see the same PTP owned by each spouse under separate PTP Schedules K-1. If one spouse sells his or her investment at a loss, the selling spouse cannot recognize any losses until the other spouse disposes of his or her investment in a fully taxable transaction or recognizes a gain. Even more insidious is the embedded PTP ownership within a master limited partnership that owns multiple PTPs. Ownership of a master PTP that holds an interest in the same individually owned PTP that is sold will also cause loss recognition to be suspended until a gain is recognized in a fully taxable transaction or the master PTP is sold.

Final comment about PTP reporting

When a new client brings in a copy of a prior-year tax return, check for PTP ownership. If the tax return does not contain PTP loss carryforward information, be sure to obtain it from the prior CPA for both regular and alternative minimum tax purposes for each PTP. Since PTP activity is not reported on Form 8582, Passive Activity Loss Limitations, the PTP loss carryforward information is often missing from the client’s copy of the tax return. It is quite time-consuming to reconstruct loss carryover information from a prior-year Schedule K-1. The only saving grace is that losses are limited on a PTP-by-PTP basis, which eases some of the calculation if the loss carryover information cannot be obtained from the client or the prior accountant.

When estimating billing fees, a CPA should keep in mind that accounting for PTPs is time-consuming. Due to the additional professional time required, clients’ tax preparation fees may increase by 200%-300% when they acquire investments in PTPs. Clients might appreciate a frank discussion of the overall investment merits compared with the cost of accounting for these types of time-consuming investments, especially when the dollar amount of the investment is minimal.