Legal Definitions - collapsible partnership

A collapsible partnership refers to a business partnership that holds assets which, if sold by the partnership, would generate ordinary income (like profits from sales or services). The term "collapsible" comes from a historical tax strategy where partners would try to "collapse" or dissolve the partnership, or sell their ownership interests, *before* the partnership itself realized this ordinary income. The goal was to convert what would have been ordinary income (taxed at higher rates) into capital gains (historically taxed at lower rates) for the partners.

Tax laws, particularly in the United States, have specific rules designed to prevent this type of tax avoidance. These rules often recharacterize the gain from selling a partnership interest as ordinary income rather than capital gain if the partnership is deemed "collapsible" under the tax code, thereby eliminating the intended tax benefit.

• Example 1: Real Estate Development
  Imagine a partnership formed by three developers to purchase land, build several houses, and then sell them. The houses, once built, represent inventory for the partnership. If the partnership were to sell the houses, the profits would be ordinary income. Before the houses are sold, however, the partners decide to sell their individual ownership interests in the partnership to a new investor. Their intention might be to have the gain from selling their partnership interests treated as lower-taxed capital gains, rather than waiting for the partnership to sell the houses and distribute ordinary income. This scenario could be scrutinized as a collapsible partnership because the partners are attempting to convert future ordinary income from the sale of inventory into capital gains by selling their partnership interests prematurely.
• Example 2: Film Production Company
  Consider a partnership of filmmakers that produces a movie. The movie itself, once completed, is an asset that will generate significant revenue through distribution, licensing, and ticket sales, all of which would typically be ordinary income for the partnership. Before the movie is released and starts generating this revenue, the partners decide to sell their shares in the partnership to a large film studio. They hope that the profit from selling their partnership interests will be treated as capital gains. This situation aligns with the concept of a collapsible partnership because the partners are selling their interests in an entity whose primary asset (the film) is poised to generate substantial ordinary income, and they are doing so before that income is realized by the partnership itself.
• Example 3: Software Development Startup
  A partnership of software engineers develops a groundbreaking new application. The partnership plans to license this software to various companies, generating substantial recurring revenue, which would be ordinary income. Before any licensing agreements are finalized or significant revenue is generated, a large tech company offers to buy out the individual partners' stakes in the partnership. The partners might be tempted to sell their interests, hoping to classify their profits as capital gains, rather than waiting for the partnership to license the software and distribute ordinary income. This scenario illustrates a collapsible partnership because the partnership holds a valuable asset (the software) that is designed to produce ordinary income, and the partners are selling their interests before that income stream fully materializes within the partnership.