Rev. Rul. 57-318

Advice has been requested as to the proper method of determining gain upon the sale of a partner's interest in a partnership where such partner's capital account shows a deficit which, in accordance with the terms of the sale, is forgiven.

The taxpayer was a member of a partnership. At the close of the partnership taxable year ended December 31, 1954, after taking into consideration his pro rata share of the partnership profits and losses and withdrawals of capital, his capital account showed a deficit. On January 1, 1955, the taxpayer sold his partnership interest to his partner and, in consideration therefor, received cash and was relieved of his liability for repayment of his deficit. The partnership carried no inventory items or unrealized receivables to which section 751(a) of the Internal Revenue Code of 1954 might apply.

Under section 741 of the Code, in the case of a sale or exchange of an interest in a partnership, gain or loss will be recognized to the transferor partner and such gain or loss will 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 which have appreciated substantially in value).

Section 705(a) of the Code provides, as far as is pertinent, that the adjusted basis of a partner's interest in a partnership shall, except as provided in subsection (b) thereof, be the basis of such interest determined under section 722 of the Code (relating to contributions to a partnership) or section 742 of the Code (relating to transfers of partnership interests), increased by the sum of his distributive share for the taxable year and prior taxable years of taxable income of the partnership as determined under section 703(a) of the Code, and decreased (but not below zero) by distributions by the partnership, as provided in section 733 of the Code, and by the sum of his distributive share of losses of the partnership and expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to a capital account. Section 1.705-1 of the Income Tax Regulations is to the same effect. In addition, subparagraph (a)(4) thereof contains a reference to section 752 of the Code and section 1.752-1 of the regulations regarding the effect of liabilities in determining the amount of contributions made by a partner to a partnership or the amount of distributions made by a partnership to a partner. Under such sections, any increase in a partner's share of the liabilities of a partnership is considered as a contribution of money by such partner to the partnership and any decrease in a partner's share of the liabilities of the partnership is considered as a distribution of money to the partner by the partnership.

Section 731(a) of the Code provides, in part, that in the case of a distribution by a partnership to a partner, `gain shall not be recognized to such partner except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution.' However, a withdrawal of capital from a partnership under an obligation to repay the amount of such withdrawal does not constitute a distribution subject to section 731 of the Code but is a loan governed by section 707(a) of the Code. To the extent that such an obligation is cancelled, the obligor partner is considered to have received a distribution of money or property at the time of the cancellation. See section 1.731-1(c)(2) of the Income Tax Regulations.

For the purpose of computing gain on the sale of the taxpayer's partnership interest, the basis of such interest cannot be less than zero. Any gain or loss recognized under section 731(a) of the Code is considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner, that is, capital gain or loss. For example: A , a partner in the partnership AB , has a deficit of $1,000 in his capital account. He sells his interest to his partner for $5,000 in cash and, in accordance with the sales agreement, is relieved of his liability to repay the deficit of $1,000. The selling price of his interest is $5,000 and his basis is zero. Thus, he would realize a gain of $5,000 on the transaction, and the gain, to the extent it is not considered under section 751 of the Code as an amount realized from the sale or exchange of property other than a capital asset, would constitute a long-term or short-term capital gain depending upon the length of time the partnership interest was held by him. The deficit of $1,000 would, upon cancellation of the obligation to repay, be treated under section 731(a) of the Code as a distribution to A of an amount which would be taxable as capital gain.

Accordingly, in the instant circumstances, the cash received by the seller for his partnership interest will be considered as gain from the sale of a capital asset, there being no partnership property of the kind described in section 751(a), and the amount of the cancelled deficit will be considered as a distribution to the seller which will also be treated as capital gain.