February 21, 2018
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. This article explains 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 Rule
When 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” Rule
There’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 37% (down from 39.6% in 2018). 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?
- Unrealized partnership receivables (zero-basis receivables if your firm uses the cash method of accounting, as most law firms do).
- Appreciated inventory items (usually not an issue with law firms).
- Appreciated tangible or intangible assets (fair market value in excess of tax basis) that the firm owns and that have ordinary income recapture potential because of previous depreciation or amortization write-offs. For example, this could include depreciable office equipment and furnishings and amortizable purchased goodwill).
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.