U.S. Income Series
Partnerships
	 Portfolio 718-1st: Dispositions of Partnership Interests;...
Dispositions of Partnership Interests; Termination of a Partnership
by Kevin N. Kemp, Esq. 
Citibank, N.A.
New York, New York

Special Consultant to Tax Management
PORTFOLIO DESCRIPTION
Tax Management Portfolio, Dispositions of Partnership Interests; Termination of a Partnership, No. 718, addresses the tax consequences arising from dispositions of partnership interests and those arising from structural changes to a partnership. It also analyzes the circumstances giving rise to, and the consequences resulting from, the termination of a partnership.
Parts I and II of the Portfolio address the tax consequences to all parties (the transferor partner, the transferee, and the partnership) arising from dispositions of partnership interests. Part III compares the tax consequences resulting from dispositions of partnership interests and other transactions which have similar economic consequences. Part IV of the Portfolio analyzes the tax consequences of incorporating a partnership. Finally, Parts V and VI analyze the circumstances that result in a partnership termination and the federal income tax consequences that may arise from the termination.
This Portfolio may be cited as Kemp, 718 T.M., Dispositions of Partnership Interests; Termination of a Partnership.
Kevin N. Kemp, B.A., University of Utah (1976); J.D., Georgetown University Law Center (1979); LL.M. in Taxation, New York University (1983); member, Colorado Bar and New York State Bar.

DETAILED ANALYSIS
I. Introduction
This portfolio discusses the tax consequences arising from dispositions of partnership interests and from structural changes to a partnership. Dispositions of partnership interests are partner level transactions generally not involving the partnership as an entity. Structural changes to a partnership, on the other hand, such as divisions, mergers and consolidations, are transactions occurring at the partnership entity level. Some dispositions of partnership interests and some structural changes to a partnership result in a termination of the partnership. This portfolio addresses both terminating and non-terminating transactions. It also analyzes the tax consequences that arise if a partnership, in fact, terminates for tax purposes.
Parts II and III discuss the tax consequences to the transferor, transferee, and the partnership upon a disposition of a partnership interest. Tax-free, as well as taxable, dispositions are discussed. A disposition that constitutes a "sale or exchange," within the meaning of §708,1 of a partnership interest that represents, by itself or when aggregated with other sales or exchanges occurring within a 12-month period, 50% or more of partnership capital and profits will cause a termination of the partnership. However, Parts II and III only address the tax consequences arising from the disposition. The tax consequences that may result if the partnership also terminates are discussed in Parts V and VI of the portfolio.
1Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended, and the regulations thereunder.
Part IV of the portfolio discusses the tax consequences arising from incorporating a partnership. Although incorporating a partnership will result in its termination for tax purposes, only the tax consequences arising from the incorporation are addressed in Part IV.
The final two parts of this portfolio analyze the events causing, and the tax consequences resulting from, the termination of a partnership. Three separate circumstances, which may or may not coincide with a dissolution of the partnership under state law, may cause the termination of a partnership for federal income tax purposes. §708 specifies those three events. The only tax consequence specifically referred to in the Code that arises from a termination is that the taxable year of the partnership closes. However, the regulations issued under §708 provide generally that all partners' interests are treated as liquidated for tax purposes. If the business is continued in the partnership form, notwithstanding the termination, or if further actions remain to be taken after the termination but prior to formal dissolution under state law (such as winding up firm affairs), the regulations also call for a constructive formation of a "new" partnership upon the termination. Some of the tax consequences resulting from this constructive liquidation followed by a reconstitution of a new partnership are uncertain.
II. Dispositions of Partnership Interests
A. Overview of Tax Consequences
As a general rule, subchapter K of the Code, which sets out the rules governing taxation of partnerships and their members, adopts an entity approach to partnership taxation. Under subchapter K, a partnership is generally treated as an entity separate and distinct from its partners for tax purposes. The entity approach to partnership taxation is somewhat comparable to the entity approach to corporate taxation. A corporation is treated as an entity separate from its shareholders for tax purposes. Under this entity approach, the general rule is that a partner who disposes of his interest in a partnership is treated as if he disposed of a single asset rather than his pro rata share of all of the underlying assets of the partnership. Like most general rules found in federal income tax law, however, there is a significant exception to this rule.
A partner that disposes of his interest in a partnership in a taxable transaction generally recognizes gain or loss measured by the difference between the amount realized and his adjusted basis in the interest immediately before the disposition.2 This gain or loss is generally capital in nature.3 Whether the gain or loss on the disposition is short- or long-term capital gain or loss depends on how long the partner has held his interest prior to the disposition under the tax rules applicable to dispositions of capital assets generally.4
2§741; Regs. §1.741-1(a).
3§741.
4A partner's holding period for his interest in a partnership is determined under §1223, the provision for determining the holding period generally. See IV, B, below, for a discussion of partnership interests with a divided holding period.
Note: Special reporting requirements apply where a 10% partner transfers an interest in the partnership and, in connection with the transfer, the partner or a related person enters into an employment contract, covenant not to compete, royalty agreement, lease agreement or any other agreement with the transferee. §1060(e) requires that the partner and the transferee must, at the time prescribed by the Secretary of the Treasury, furnish such information as the Secretary may require.
The exception, referred to above, to the general rule that a partnership is treated as an entity for purposes of determining the tax consequences of a taxable disposition of an interest in the partnership is found in §751. If, at the time of a partner's taxable disposition of his partnership interest, the partnership owns assets described in §751, the entity theory of partnership taxation breaks down. In that case, the partner is taxed as though he sold his proportionate share of the partnership's §751 assets to the purchasing party.5 The portion of the purchase price received for the partner's share of partnership §751 assets is taxed as ordinary income or loss.6 The remaining gain or loss on the disposition is taxed as capital gain or loss.7
5Regs. §1.751-1(a).
6§751(a).
7Regs. §1.751-1(a)(1).
The person who acquires a partner's partnership interest from a partner is also, generally speaking, treated as though he acquires an interest in an entity rather than an interest in each of the assets of the partnership. A transferee obtains a unitary basis in the acquired interest equal to the consideration given for the interest,8 and his holding period for the interest generally begins at the time of his acquisition.9 Since a partnership is generally treated as an entity, the disposition of a partnership interest generally has no effect on the partnership, just as the disposition of a share of corporate stock has no tax effect on the corporation.
8§§742, 1012.
9No specific provision is contained in subchapter K relating to a partner's holding period for a partnership interest. Therefore, the general holding period rules of §1223 apply.
The entity approach to partnership taxation may also break down with respect to a transferee partner and the partnership if the partnership has a §754 election in effect or if the partnership has a substantial built-in loss immediately after the transfer. In the absence of the election or a substantial built-in loss, the adjusted basis of partnership assets is not affected by a disposition of a partnership interest. However, if a §754 election is in effect, or the partnership has a substantial built-in loss immediately after the transfer, the transferee partner's share of the partnership's basis in its assets is adjusted at the time of the disposition to reflect fair market values.10
10§743(b), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §833(b)(2), effective for transfers after Oct. 22, 2004. A partnership has a substantial built-in loss if its adjusted basis in the partnership property exceeds the property's fair market value by more than $250,000. §743(d), as added by the 2004 AJCA, §833(b)(3).
Dispositions of assets that are tax-free, generally, are also tax-free if the asset involved happens to be a partnership interest. One significant exception is an exchange described in §1031. An exchange of a partnership interest for an interest in another partnership cannot qualify for §1031 benefits. With the exception of §1031 exchanges, the tax consequences to the transferor and the transferee in a tax-free disposition of a partnership interest are the same as would be the case in tax-free dispositions generally. The transferor has no gain or loss to be recognized in connection with the disposition, and the transferee generally takes the transferor's basis and holding period for the transferred partnership interest.
Whether a disposition of a partnership interest is taxable or tax-free, a tax consequence of concern is the treatment of partnership income or loss in the year of disposition. A partnership is treated as a "pass-through" entity for tax purposes. That is, although a partnership is treated as an entity that is distinct from its partners, it is not itself subject to taxation. Rather, each partner must include on his own tax return his proportionate share of partnership income or loss. If a partner disposes of his partnership interest, partnership income or loss for the year of disposition must be apportioned between the transferor and the transferee. The apportionment is generally made by closing the partnership's books as of the day of the transfer and calculating the transferor's share of partnership income or loss through that date. However, the parties may elect an alternative method in which partnership income or loss is apportioned between the transferor and transferee based on the portion of the year each holds the interest.11
11Regs. §1.706-1(c)(2).
B. Taxable Dispositions
1.	Types of Taxable Dispositions
Generally speaking, the same types of dispositions of assets that are taxable under general tax principles are also taxable if the disposition is of a partnership interest. Thus, for example, a sale, exchange, forfeiture or abandonment of a partnership interest is a taxable event resulting in gain or loss recognition to the transferor.
a.	Sales
A sale of a partnership interest is a taxable disposition in which gain or loss must be recognized by the seller.12 It is normally a simple matter to determine whether a sale of a partnership interest has taken place. The purchaser buys the partnership interest from the seller for cash, a check, some other form of legal tender, the purchaser's note, or a combination of two or more of the foregoing. In some instances, however, the courts have concluded that a transaction that does not, on its face, appear to be a sale will nevertheless be treated as a sale.
12§741.
 In Crenshaw v. U.S.,13 for example, an elaborate set of interrelated transactions was entered into in order to avoid sale treatment with the resulting recognition of gain. The taxpayer was a partner in a partnership that owned an apartment building. The partnership liquidated the taxpayer's partnership interest by distributing an undivided interest in the building in exchange for her interest as a partner. The in-kind distribution resulted in no gain or loss recognition by the taxpayer14 or the partnership.15 After the distribution, the taxpayer exchanged her undivided interest in the apartment building for a shopping center that was owned by the estate of the taxpayer's deceased husband. In form, the exchange of the taxpayer's interest in the apartment building for the shopping center was a tax-free exchange under §1031.
13450 F.2d 472 (5th Cir. 1971), rev'g and rem'g 315 F. Supp. 814 (D. Ga. 1970), cert. denied, 408 U.S. 923(1972).
14Pursuant to §731(a)(1), a partner receiving only property other than money in partial or complete liquidation of his partnership interest does not recognize gain except, according to §731(d) (pre-1994 Uruguay Round Agreements Act §731(c)), to the extent provided in §751. If the partnership has no §751 assets, a distributee partner recognizes gain only to the extend that money distributed in liquidation of his partnership interest exceeds the partner's adjusted basis in the interest immediately before the distribution. For this purpose, §731(c) generally treats marketable securities as money. In addition, pursuant to §752, the distributee partner's relief from partnership liabilities is considered to be a distribution of money.
Pursuant to §731(a)(2), loss is recognized by a partner in connection with a distribution only if it is in complete liquidation of his partnership interest and he receives no property other than money (which, for this purpose, does not include marketable securities), inventory, and unrealized receivables in connection with the liquidation.
15§731(b).
The estate's basis in the shopping center was equal to the date of death fair market value under the step-up mechanism of §1014.15.1 Consequently, the estate's basis in the undivided interest in the apartment building received from the taxpayer in the §1031 exchange was equal to the value of the shopping center, which was also presumably equal to the value of the interest in the apartment building.16 The estate then sold its interest in the building for $200,000 to a corporation whose sole shareholders were the remaining two partners in the partnership that owned the remaining undivided interest in the building from which the taxpayer had withdrawn. Since the estate's basis in the building was equal to its $200,000 value, it had no gain or loss on the sale to the corporation. The corporation then contributed its newly-acquired interest in the apartment building to the same partnership that had previously distributed the interest to the taxpayer upon her withdrawal. When the dust settled, the taxpayer owned the shopping center previously held by her deceased husband's estate, the estate had $200,000 in cash, and the taxpayer's former partners owned all of the apartment building through the partnership from which the taxpayer had withdrawn. All of those steps occurred without payment of taxes by anyone.
15.1Cf. §1022, as added by the 2001 Tax Relief Act, P.L. 107-16, §542. Under §1022, not all property acquired from a decedent dying after Dec. 31, 2009, will be eligible for a step-up in basis. See 560 T.M., Income Tax Basis: Overview and Conceptual Aspects, for further discussion.
16§1031(d).
The IRS predictably objected and claimed that the substance of the transaction was a purchase of the taxpayer's partnership interest by the remaining partners for $200,000 in cash followed by the taxpayer's purchase of the shopping center from the estate for the same amount. The court agreed with the IRS and concluded that the taxpayer was subject to tax on the transaction. The substance over form doctrine, which pervades federal income tax law generally, was therefore relied upon to recharacterize a series of tax-free transactions into a taxable sale of a partnership interest.
Another method by which a partner may obtain the economic equivalent of a sale of all or a portion of his partnership interest without suffering the tax consequences (if the form is respected) is in connection with a liquidation of all or a portion of his interest followed (or preceded) by a capital contribution to the partnership. Economically, the two steps (liquidation of one partner's interest coupled with a capital contribution by another partner) is the same as a sale of the interest to the contributing partner. Yet, if the form is respected, the tax consequences may differ greatly.
Example: Partner A has a 20% interest in partnership R. The interest has a current value of $200,000 and a basis to A of $100,000. A would like to reduce his interest to 10% and would like to receive $100,000 to compensate him for the reduction. If R distributes $100,000 to A in partial liquidation of A's partnership interest, A will have no gain to recognize under §731(a); his basis in his R interest will merely be reduced to zero.17 If, however, A sells 1/2 of his R interest to B for $100,000, A will be required to recognize $50,000 of gain.18
B's purchase of A's interest could be structured as a contribution by B of $100,000 in capital to R for a 10% interest in the firm followed or preceded by a distribution of $100,000 to A in liquidation of 1/2 of his interest. If this contribution/liquidation structure is respected for tax purposes, A and B will be in the same position economically as they would have been had B purchased 1/2 of A's interest. The tax consequences are quite different, because in the contribution/liquidation structure, A will not be subject to current taxation.19
17§733.
18§741.
19The consequences to B will also vary (though less drastically than for A) depending on whether B's acquisition of a 10% interest in R is structured as a purchase of 1/2 of A's interest or as a capital contribution by B followed or preceded by a distribution by R in partial liquidation of A's interest. If the purchase structure is followed, B will "inherit" a portion of A's capital account. Assume that in the example in the text A's capital account prior to the purchase is $100,000. If B purchases 1/2 of A's interest, B's capital account will generally be $50,000 and A will retain a $50,000 capital account. If B acquires his interest by making a $100,000 capital contribution to R, on the other hand, his initial capital account will equal the full $100,000 paid for the interest. In addition, if B purchases the interest from A and a §754 election applies to the purchase, the basis of R's assets will be stepped-up for the benefit of B, pursuant to §§743(b) and 755, allowing greater depreciation deductions for B's benefit. If B acquires his interest by making a $100,000 capital contribution to R, however, no step-up in basis of R assets is available even if a §754 election is in effect.
Regs. §1.731-1(c)(3) foresees this easy method of avoiding taxable gain on a sale of a partnership interest and places taxpayers on notice that the form of a contribution/liquidation transaction may be recharacterized as a direct sale between the parties. That regulation provides that §731 may not apply to a distribution from a partnership to a partner if, within a short period before or after the distribution, another party makes a contribution to the capital of the partnership.
Section 707(a)(2)(B) also recharacterizes a contribution/liquidation transaction as a sale of a partnership interest if, when taken together, the contribution/liquidation is "properly characterized" as a sale. Section 707(a)(2)(B) was enacted many years after promulgation of Regs. §1.731-1(c)(3).20 Although the statute provides that indirect, as well as direct, contributions to capital and distributions are subject to recharacterization if the two transactions are related while the regulation only refers to contributions and distributions, the statute does not appear to add much to the authority of the IRS to recharacterize a transaction in these circumstances.21
20Section 707(a)(2)(B) was added to the Code by the Tax Reform Act of 1984, P.L. 98-369. Regs. §1.731-1(c)(3) was adopted in 1956 by T.D. 6175.
21In addition, the regulation states that §731 "may" not apply to a distribution under the circumstances referred to while the statute provides that a contribution/liquidation "shall" be recharacterized as a sale between parties. However, this difference may also be a distinction without much meaning. Although on its face Regs. §1.731-1(c)(3) appears to be subjective, requiring the IRS to determine the circumstances under which a contribution/liquidation will be recharacterized as a sale, while the statute appears to be mandatory, requiring that a contribution/liquidation be treated as a sale by the taxpayers in the first instance, it is nevertheless left to IRS discretion to determine whether a contribution is "related" to a liquidation and whether the two transactions are "properly characterized" as a sale. Thus, the regulation and the statute essentially address the same perceived abuse in the same way. The only substantive change to IRS authority added by §707(a)(2)(B) was to give Congressional approval to IRS authority granted in Regs. §1.731-1(c)(3). Thus, any regulations promulgated under §707(a)(2)(B) (see Prop. Regs. §1.707-7, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04)) will be legislative, having the force of law, while Regs. §1.731-1(c)(3) is only interpretive, having less weight.
The Claims Court, in Jupiter Corp. v. U.S.,22 decided to respect the form of a liquidation of an existing partner's interest close to the same time that a new partner was admitted by making a capital contribution to the partnership. In that case, which was decided upon consideration of Regs. §1.731-1(c)(3) prior to the enactment of §707(a)(2)(B), limited partners were admitted to a partnership upon making a cash contribution and the sole general partner's interest was reduced through a cash distribution in partial liquidation of his interest. The court disagreed with the government's recharacterization of the transaction as a sale of part of the general partner's interest to the newly admitted limited partners for two primary reasons. First, the court reasoned that subchapter K grants taxpayers great latitude in structuring transactions in the partnership context. Second, the court emphasized that a direct sale between the general partner and the newly admitted limited partners would not carry out the parties' intent. The general partner wanted to retain sole managerial control of the partnership. The new limited partners required insulation from partnership liabilities and also required distribution and liquidation preferences over the general partner. A sale by the general partner of part of his interest could not have achieved these objectives. The Claims Court reached a similar conclusion in Communications Satellite Corp. v. U.S.23
222 Cl. Ct. 58 (1983).
23625 F.2d 997 (Ct. Cl. 1980).
Comment: Although Jupiter Corp. and Communications Satellite Corp. provide authority for respecting the form of a contribution/liquidation transaction, caution is suggested in this area, particularly in light of the perceived abuse sought to be corrected by Congress in enacting §707(a)(2)(B).24Jupiter Corp. and Communications Satellite Corp. had unique facts and may not be followed by other courts. A conservative practitioner should ensure that a contribution of capital is separated by a significant amount of time from a liquidation of an interest in order to have the form of the transaction respected. While the statute does not set forth a bright line test regarding the length of time that must elapse between the two transactions, the legislative history of §707(a)(2)(B) indicates that a three-year separation may be adequate.25 Of course, under the right set of facts, a much shorter period of time could be sufficient or a longer lapse of time could be inadequate.26 In addition to a lapse of time between a contribution and a liquidation, it may be sufficient if the parties establish that the intent of the parties could not have been carried out by a sale of an interest from the liquidated partner to the contributing partner. For example, if the contributor obtains different rights or liabilities under the partnership agreement by contributing property for his interest than he would have obtained had he purchased his interest from the liquidated partner, the separate transactions may be respected.27
24The legislative history of §707(a)(2)(B) cited Jupiter Corp. and Communications Satellite Corp. as examples of the types of transactions at which the legislation was aimed. S. Rep. No. 98-169, at 230 (1984).
25S. Rep. No. 98-169, at 231 (1984).
26If it could be established factually that a contribution of capital is unrelated to a distribution in liquidation of a partnership interest, the form of the two transactions should be respected despite the fact that the two transactions occur near the same time. For example, if shortly after a new partner is admitted to a partnership, an existing partner discovers that he has an immediate need for cash due to unforeseen circumstances and obtains a distribution in partial liquidation of his interest, the form of the two transactions should be respected.
27See Jupiter Corp. v. U.S., 2 Cl. Ct. 58 (1983). But see Colonnade Condominiums Inc. v. Comr., 91 T.C. 793, 820-21 (1988) (court rejected form of transaction and found that §741 sale existed where partner transferred portion of his partnership interest to three new partners in exchange for discharge of liabilities with no new capital transferred to partnership and no modifications of partnership assets and liabilities).
Final regulations under §707(a)(2) were promulgated in September 1992.28 These regulations set forth rules and safe harbors for determining when a transaction, which in form is structured as a contribution of property to a partnership followed or preceded by a related distribution to the contributing partner, is to be recharacterized as a sale of property from the contributing partner to the partnership. The regulations also contain rules and safe harbors for recharacterizing a distribution of property by a partnership to a partner followed or preceded by a related contribution from the distributee partner to the partnership as a sale from the partnership to the distributee. Rules for recharacterizing a liquidation of a partnership interest were not included in the 1992 regulations. However, in 2004 Treasury and the IRS proposed regulations on disguised sales of partnership interests.29
28Regs. §§1.707-0, 1.707-2 through 1.707-9, T.D. 8439, 57 Fed. Reg. 44974 (9/30/92). See also Prop. Regs. §§1.707-3(c)(2), -5(a)(8), -6(c), -7, -8, -9, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04) (proposing expanded disclosure requirements for disguised sale transactions and proposing rules for disguised sales of partnership interests). For a full discussion of the disguised sales regulations, see 711 T.M., Partnerships -- Formation and Contributions of Property or Services.
29Prop. Regs. §1.707-7, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04). See Notice 2001-64, 2001-41 I.R.B. 316 (soliciting comments on guidance concerning disguised sales of partnership interests).
In general, the regulations treat property contributions occurring two years or less before or after a cash distribution as being presumptively a taxable sale of the property rather than a tax-free capital contribution under §721. Contributions occurring more than two years before or after a distribution are presumed to be unrelated transactions and the form is therefore presumptively respected. In both cases, however, the presumption may be rebutted by facts and circumstances indicating that a contribution and distribution are unrelated (or related), regardless of the time elapsing between the two transactions.30
30Facts and circumstances that tend to prove that a contribution of property is related to a distribution are listed in Regs. §1.707-3(b)(2). Although the rules do not so specify, the absence of one or more of the listed facts and circumstances presumably tends to prove that a contribution and distribution are unrelated. Proposed regulations would require disclosure of transactions occurring within seven, not two, years of each other, in order to make it more likely that taxpayers will undertake the facts and circumstances test and to make this test easier for the IRS to administer, and would expand the types of transactions that must be disclosed. See Prop. Regs. §1.707-3(c)(2), -5(a)(8), -6(c), -8(c), REG-149519-03, 69 Fed. Reg. 68838 (11/26/04).
Treasury and the IRS adopted a similar approach in the case of disguised sales of partnership interests. Under proposed regulations, a liquidation of a partner's interest occurring within two years of a capital contribution would be presumed to be a sale of the liquidated partner's partnership interest to the contributing partner, and a liquidation and capital contribution occurring more than two years apart would be presumed to be unrelated and, therefore, the form of the separate transfers would be respected. In both cases, the proposed regulations would provide that the presumption is rebuttable.30.1
30.1Prop. Regs. §1.707-7, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04). Prop. Regs. §1.707-7(b)(2) would contain a list of facts and circumstances tending to prove that transfers should be treated as a sale. See also Prop. Regs. §1.707-3(c)(2), -5(a)(8), -6(c), -8(c) (proposed regulations requiring disclosure of transactions undertaken within seven years of each other and expanding types of transactions that must be disclosed).
b.	Abandonment, Forfeiture, or Worthlessness
The abandonment or forfeiture of an asset is a taxable disposition resulting in a loss equal to the owner's basis at the time of abandonment or forfeiture. Although an asset becoming worthless is not technically a disposition, a loss when the asset becomes worthless is generally deductible if the other conditions for deduction are met (e.g., the asset is not a personal use asset).31
31See Regs. §1.165-2(a) (loss upon "sudden termination of the usefulness" of nondepreciable assets).
If an asset is not encumbered with liabilities, a loss realized from its abandonment or forfeiture, or from its becoming worthless, is an ordinary loss even if the asset was a capital asset in the taxpayer's hands. This result follows because an abandonment, forfeiture, or worthlessness of an asset is not considered a sale or exchange unless the taxpayer was relieved of liabilities in connection with the abandonment, forfeiture, or worthlessness.32
32See, e.g., Rev. Rul. 57-503, 1957-2 C.B. 139. Under §1211, a capital loss does not occur unless the taxpayer engages in the "sale or exchange" of a capital asset.
This result also occurs in the case of abandonment, forfeiture, or worthlessness of a partnership interest. In the absence of partnership liabilities, non-subchapter K Code provisions and case law generally apply, and a partnership interest's abandonment, forfeiture, or worthlessness results in ordinary loss equal to the partner's basis in the interest at the time of the loss event.33 The courts came to this conclusion under the 1939 Code, prior to the adoption of subchapter K,34 and two cases decided under the 1954 Code indicate the same result after the adoption of subchapter K.
33A limited partner is not entitled to include recourse debt of a partnership in his basis in many circumstances. If the limited partner is not required to contribute additional capital to the partnership under the terms of the partnership agreement and does not personally guarantee or otherwise become liable for partnership recourse debt, he is not entitled to include any of the partnership debt in his basis. See Regs. §1.752-1(d). Therefore, a limited partner that is not entitled to a share of partnership recourse liabilities realizes an ordinary loss upon the abandonment, forfeiture, or worthlessness of his partnership interest.
34 In both Gannon v. Comr., 16 T.C. 1134 (1951), acq., 1951-2 C.B. 2, and Hutcheson v. Comr., 17 T.C. 14 (1951), the Tax Court held that partners withdrawing from a law firm were entitled to an ordinary losses in connection with the withdrawals where they received nothing in consideration for their interests in the firm.
Note: Some have argued that §1234A may require capital loss treatment for the abandonment of a partnership interest, regardless of whether encumbered by liabilities. This reading ignores the legislative intent behind §1234A, which was to attack certain financial straddles. Indeed, the IRS has stated that a loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss if the transaction is not a sale or exchange and if the partner has not received an actual or deemed distribution from the partnership.35
35IRS Publication 541, "Partnerships."
In Echols v. Comr.,36 the Fifth Circuit held that a partner was entitled to a loss upon his abandonment of a partnership interest. The court also emphasized that abandonment and worthlessness were two separate bases for claiming a §165 loss, and asserted that the IRS could not disallow a §165(a) deduction by a taxpayer who could demonstrate his subjective determination of worthlessness in a given year, coupled with a showing that in such year the asset in question was in fact essentially valueless. Thus, the court held in the alternative that the taxpayers in Echols were entitled to a loss deduction under §165(a) for their partnership interests on the basis of worthlessness. A petition by the IRS for a hearing on its alternative holding that worthlessness constitutes an independent ground for a loss deduction under §165 was denied.37
36935 F.2d 703 (5th Cir. 1991). But see LaRue v. Comr., 90 T.C. 465 (1988); Tapper v. Comr., T.C. Memo 1986-597 (court rejected argument that partnership interests had been abandoned; integrated sale of partnership assets and liquidation of partnership). Cf., Rodman v. Comr., 542 F.2d 845 (2d Cir. 1976), rev'g and rem'g T.C. Memo 1973-277; Stilwell v. Comr., 46 T.C. 247 (1966); Cooley v. Comr., T.C. Memo 1986-423. Note, however, that the court in Cooley stated that under "certain circumstances," ordinary loss upon an abandonment of a partnership interest would be appropriate.
37950 F.2d 209 (5th Cir. 1991). The court cited Rhodes v. Comr., 100 F.2d 966 (6th Cir. 1939), and Proesel v. Comr., 77 T.C. 992 (1981), for the proposition that, although an act of abandonment by the taxpayer may be one of several factors in the analysis of whether the taxpayer's subjective determination of an asset's worthlessness is sustainable, abandonment is not an indispensable requirement for a worthlessness deduction under §165. See also Tejon Ranch Co. v. Comr., T.C. Memo 1985-207 (although court allowed ordinary loss on worthlessness of partnership interest, fact that partnership had unsatisfied liabilities at time of worthlessness not considered by court); Zeeman v. U.S., 275 F. Supp. 235 (S.D.N.Y. 1967), aff'd in part and rem'd on other issues, 395 F.2d 861 (2d Cir. 1968). But see LaRue v. Comr., 90 T.C. 465 (1988) (Tax Court rejected the argument that partnership interest becoming worthless was separate from liability assumption by third party).
The Tax Court addressed the character of abandonment loss in Citron v. Comr.38 In Citron, the Tax Court concluded that a partner was entitled to an ordinary loss upon an abandonment of his partnership interest, and predicated this conclusion on the fact that the partnership had no liabilities. Thus, in the absence of partnership liabilities, any loss realized on an abandonment or forfeiture of a partnership interest would be characterized as an ordinary loss; no sale or exchange, which is required for capital loss treatment, occurred upon a forfeiture or abandonment, and nothing within subchapter K recharacterized the loss from ordinary to capital.
3897 T.C. 200 (1991).
The IRS subsequently ruled in Rev. Rul. 93-8039 that a loss incurred on the abandonment or worthlessness of a partnership interest was an ordinary loss if sale or exchange treatment did not apply. Under the ruling, sale or exchange treatment applied if a taxpayer was relieved of any liabilities by virtue of the abandonment or worthlessness of a partnership interest, in which case the loss would be treated as a capital loss. The IRS did not distinguish between the abandonment or worthlessness of a partnership interest in the ruling.
391993-2 C.B. 239, revoking Rev. Rul. 76-189, 1976-1 C.B. 181, and clarifying and superseding Rev. Rul. 70-355, 1970-2 C.B. 51. For full text of Rev. Rul. 93-80, see the Worksheets, below.
Observation: The IRS's conclusion in Rev. Rul. 93-80 is inconsistent with the logical implication of the holding in Echols that a taxpayer could take a worthlessness loss with respect to a partnership interest and remain a partner. Yet Echols is not cited or discussed in Rev. Rul. 93-80, and the IRS's conclusion is unsupported by any other authority. If there is no abandonment, there is no change in the legal relationship among the parties, and no relief from liabilities for the partner whose interest has become worthless. Nonetheless, the IRS apparently continued to argue, as it did in Echols, that abandonment and worthlessness are "simply two sides of the same coin."40
40950 F.2d at 211. See also "Ruling Examines Abandonment and Worthlessness of Partnership Interests," 34 Tax Mgmt. Memo 389 (1993); Diana, "Abandonment and Worthlessness of Partnership Interests After Echols and Citron," 33 Tax Mgmt. Memo 35 (1994).
If a partner has partnership liabilities that were taken into account in determining the basis for his partnership interest, the abandonment, forfeiture, or worthlessness is governed by subchapter K, and a loss from abandonment or forfeiture of the partner's interest is a capital loss because the Code treats such a transaction as a constructive sale or exchange. Under §752(a), a partner is deemed to have contributed cash to a partnership to the extent of any increase in his proportionate share of partnership liabilities or upon the assumption by the partner of partnership liabilities. A decrease in a partner's share of partnership liabilities or the assumption by the partnership of a partner's liabilities is treated as a distribution of cash from the partnership to the partner under §752(b). Consequently, if a partner withdraws from a partnership that has liabilities without receiving any consideration for the withdrawal, and his share of partnership liabilities is thereby reduced, a distribution of cash to the partner in consideration for his partnership interest is deemed to occur.41 A constructive sale or exchange of his partnership interest therefore occurs under §731; under §741, the loss on the constructive sale or exchange is characterized as a capital loss. This result follows even if a limited partner withdrew and the partner received no consideration in connection with the withdrawal because the partnership had nonrecourse liabilities at that time.42
41An interesting question is whether a constructive sale or exchange under §§752(b), 731, and 741 occurs where a partner withdraws from a partnership that has liabilities but the partner remains liable for the debts after the distribution. There does not appear to be a statutory basis for finding a sale or exchange in this context. See Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (no gain recognized by expelled partner attributable to recourse liability relief because expelled partner remained liable for partnership debt); Hirsch v. Comr., T.C. Memo 1984-52 (no gain recognized under §741 where taxpayer, who had deficit capital account balance in partnership when he assigned his interest in the partnership to another taxpayer, was not released from liabilities). However, the issue does not often arise because it is unlikely that a partner would withdraw from a partnership without receiving any consideration and, at the same time, agree to remain liable on the same portion of partnership debt for which he would otherwise be liable in the absence of the withdrawal.
42O'Brien v. Comr., 77 T.C. 113 (1981).
Example: Partner A in partnership ABC has an adjusted basis in his partnership interest of $10,000. ABC's only assets are securities with an adjusted basis of $30,000 and a current fair market value of $3,000. ABC has no liabilities. If A withdraws from the partnership and receives nothing in consideration for the liquidation of his partnership interest, A will recognize a $10,000 ordinary loss.
However, if ABC has $1,500 of liabilities, of which A's share is $500, A will be deemed to receive a cash distribution of $500 upon his withdrawal from the partnership. Therefore, under §§752(b), 731, and 741, A will recognize a $9,500 loss, which will be characterized as a capital loss in these circumstances. Because A is deemed to receive a cash distribution of $500, A's loss would be $9,500 rather than his $10,000 basis prior to the withdrawal ($10,000 basis - $500 deemed distribution).
As noted in the Observation above, and strictly from a technical point of view, the existence of partnership liabilities should not convert an ordinary loss to a capital loss if a partnership interest becomes worthless. If a partnership interest becomes worthless but the partner does not withdraw from the partnership, the partner's share of partnership liabilities remains the same before and after the worthlessness. Consequently, the subchapter K provisions that create a constructive sale or exchange (§§752(b), 731, and 741) are not operative and the worthlessness should give rise to an ordinary loss deduction.
If a partner can establish factually that his interest in a partnership is worthless because the partnership's assets are worthless and the partnership has no prospect of becoming profitable, it would seem that there is no sound basis to deny a worthlessness deduction even if the partnership has liabilities. If nonrecourse partnership liabilities are included in the partner's basis, a court would most likely not allow a partner to claim an ordinary, rather than a capital, loss deduction from the worthlessness.43 If a liability is nonrecourse, no person is personally liable to repay the indebtedness if the partnership fails to pay, and a creditor must look solely to the partnership assets to collect the debt in the event the partnership refuses or is unable to pay.44 If a partner claims that his interest in a partnership with nonrecourse liabilities is worthless, he is in essence claiming that it no longer makes economic sense for the partnership to pay its liabilities. If the partnership continues to pay its nonrecourse liabilities, the partnership is admitting that it still makes economic sense to pay the debts and avoid the creditors' foreclosing on partnership assets. A partner's claim of worthlessness if the partnership continues to pay its nonrecourse debts is therefore subject to attack. If, alternatively, a partner claims that his interest has become worthless and the partnership has discontinued payment on its nonrecourse debts, either: (1) the nonrecourse creditors of the partnership will commence foreclosure proceedings on the assets securing the nonrecourse debts; (2) the parties will negotiate for the creditors to take the assets in lieu of a foreclosure; or, (3) if the partnership has no assets with value, the debts will be forgiven. Foreclosure, a transfer of assets in lieu of foreclosure, or debt relief all result in sale or exchange treatment to the partners. A court would probably not look favorably on allowing a partner to claim an ordinary loss on worthlessness of his interest in this context. It would more likely view the partnership level foreclosure, transfer of assets, or debt relief in tandem with the worthlessness and conclude that a constructive sale or exchange occurred, resulting in a capital loss.
43See LaRue v. Comr., 90 T.C. 465 (1988).
44See Regs. §1.752-1(a)(2).
The same cannot, of course, be said if a partnership has recourse liabilities. It is not at all clear, at the time a partner may justifiably claim that his partnership interest is worthless, that recourse liabilities will be satisfied in some manner other than payment in full, such as by the creditor taking property in lieu of repayment or through outright debt relief. A recourse liability creditor may proceed against partners individually if the partnership is unable or unwilling to pay its debts. Thus, a partner who has included recourse debt in his basis may ultimately have to pay his proportionate share of the debt long after his partnership interest became worthless. A stronger argument can therefore be made that the worthlessness of a partnership interest (at least a general partner's interest) should result in an ordinary loss because no sale or exchange occurred if the partnership's only liabilities are recourse liabilities.45
45See In re Kreidle, 91-2 USTC ¶50,371 (Bankr. D. Col. 1991) (general partner was entitled to ordinary loss under §165 on worthlessness of his partnership interest because he remained liable for partnership debts; there was, therefore, no discharge of liabilities, no deemed distribution under §752, and no sale or exchange).
c.	Exchange of Partnership Interests
In the absence of statutory relief, an exchange of property for other property is a taxable disposition resulting in the recognition of gain or loss. Thus, for example, if partner B in partnership ABC transfers his partnership interest to E in exchange for a parcel of real estate owned by E, both B and E would recognize gain or loss on the transaction.
An exchange of a partnership interest for an interest in another partnership is also a taxable disposition resulting in gain or loss recognition, even if the two partnerships are very similar in terms of types of assets and amounts of partnership liabilities. Section 1031, which provides for tax-free exchanges of property of a like kind, specifically does not apply to an exchange of partnership interests.46 Before the specific exclusion from §1031 treatment for partnership interests was added to the Code in 1984,47 the courts and the IRS disagreed as to whether §1031 applied to partnership interest exchanges.48 The 1984 legislation resolved this dispute between taxpayers and the IRS in favor of the IRS.49
46§1031(a)(2)(D).
47Section 1031 was amended by §77(a) of the Tax Reform Act of 1984, P.L. 98-369, to exclude the exchange of partnership interests from like-kind exchange treatment.
48Prior to the amendment to §1031 by the Tax Reform Act of 1984, the courts generally concluded that an exchange of a general partnership interest for an interest in another general partnership or an exchange of a limited partnership interest for a limited partnership interest qualified for tax-free treatment under §1031. Long v. Comr., 77 T.C. 1045(1981); Gulfstream Land & Development Corp. v. Comr., 71 T.C. 587 (1979); Meyer Est. v. Comr., 58 T.C. 311 (1972), aff'd per curiam, 503 F.2d 556 (9th Cir. 1974). The IRS ruled in 1978, however, that partnership interests did not qualify for §1031 exchange benefits. Rev. Rul. 78-135, 1978-1 C.B. 256.
49The legislative history of the 1984 legislation provides that the exclusion from §1031treatment does not apply to exchanges of partnership interests in the same partnership. S. Rep. No. 169, 98th Cong., 2d Sess. (1984). The IRS reached the same conclusion using a different section of the Code in concluding that exchanges of partnership interests in the same partnership are tax-free. Rev. Rul. 84-52, 1984-1 C.B. 157.
d.	Corporate Distributions of Partnership Interests
(1)	Post-1987 Law
A corporation that distributes appreciated property to its shareholders as a dividend, in redemption of shareholder stock or in complete liquidation of the corporation generally is required to recognize the gain inherent in the appreciated assets.50 Loss may not be recognized by a corporation in connection with a nonliquidating distribution of depreciated property.51 Loss may, however, generally be recognized by a liquidating corporation.52 These relatively straight-forward rules were enacted as part of the Tax Reform Act of 198653 and are known generically as the repeal of the "General Utilities" doctrine.54
50Section 311 applies to nonliquidating distributions and §336 applies to liquidating distributions. There are exceptions to the general rules. In the case of nonliquidating distributions, no gain or loss is recognized by a corporation upon the distribution of its own stock or debt obligations. §311(a). Exceptions to recognition upon liquidation of a corporation are in connection with the liquidation of an 80% controlled subsidiary (with the inevitable exceptions to the exception) (§337), liquidations occurring as part of a tax-free reorganization (§§336(c) and 361) and various loss recognition denial rules (§336(d)).
51§311(b).
52§336(a).
53P.L. 99-514 ("the 1986 TRA").
54See General Utilities and Operating Co. v. Helvering, 296 U.S. 200 (1935), rev'g 74 F.2d 972(4th Cir. 1935).
Consequently, a corporation that distributes an appreciated partnership interest to one or more shareholders must recognize gain in connection with the distribution, whether the distribution is a dividend, in redemption of some or all of a shareholder's stock, or in complete liquidation of the corporation.55 A corporation that distributes a depreciated partnership interest as a dividend or in redemption of stock may not recognize loss on the distribution, but a liquidating distribution of the partnership interest will entitle the corporation to recognize loss. The shareholder/recipient of the partnership interest will be taxed under the normal subchapter C rules that apply to corporate distributions generally (§§301, 302, and 331).
55Note that the IRS has issued proposed regulations (57 Fed. Reg. 59324) that implement Notice 89-37, 1989-1 C.B. 679 and that address a corporate partner's use of a partnership structure as a means of circumventing the repeal of the General Utilities doctrine. The proposed regulations provide that §311(b), requiring gain recognition by a corporation in connection with a distribution of appreciated property, takes precedence over nonrecognition of gain under §731. Consequently, under the distribution rule a distribution of a corporate partner's own stock, or the stock of an affiliate, by a partnership will generally be characterized as a redemption of the stock with the corporate partner's partnership interest, potentially resulting in gain recognition. In addition, the redeeming partner is treated as contributing the redeemed stock back to the partnership for all purposes. Under the deemed distribution rule, a partner recognizes gain at the time of, and to the extent that, any transaction (or series of transactions) has the economic effect of a partner exchanging its interest in appreciated property for an interest in its stock that is owned or acquired by the partnership. The proposed regulations also apply to transactions involving stock of an affiliate of the partner or other equity interests in the partner or affiliate, including options, warrants, and similar interests. Finally, the proposed regulations, under a de minimis rule, do not apply to a partner for a taxable year if the partner has never owned more than 5% of the partnership, and as of the close of the taxable year and while the partner is a partner, the partnership has not held in the aggregate the lesser of $250,000 of the stock of the partner, or 2% of the value of any class of stock of the partner. The regulations are proposed to apply to any transaction or distribution occurring after March 9, 1989.
The IRS issued an advanced notice (Notice 93-2, 1993-3 I.R.B. 11) limiting the applicability of the proposed regulations (57 Fed. Reg. 59324) to transactions in which affiliation exists immediately before the deemed redemption or distribution.
Various judicial and legislative changes occurred in this area before the adoption of the Tax Reform Act of 1986. These changes are summarized below for those readers with an interest in tax law history.
(2)	Prior Law
Before the repeal of the General Utilities doctrine in 1986, the general rule under pre-1986 TRA §311 was that a corporation did not recognize gain or loss upon a liquidating or nonliquidating distribution to its shareholders. There were, of course, the inevitable exceptions to the general rule. In the case of nonliquidating distributions, the major statutory exception applied in the case of distributions in redemption of a shareholder's stock. Gain (but not loss) was recognized by the corporate distributor upon distributions of property in redemption of the distributee's stock except for redemptions of stock of noncorporate shareholders who owned 10% or more of the corporation's stock and held their shares for five or more years. Other limited exceptions to gain recognition on redemptions applied. Additional statutory exceptions to the general nonrecognition rule that applied to in-kind dividend distributions included distributions of installment obligations, distributions of LIFO inventory, distributions of property encumbered with liabilities in excess of basis and distributions of property with inherent depreciation recapture under §§1245 and 1250.
Pre-1986 TRA §336 applied to insulate a corporation from gain or loss recognition upon a complete liquidation of the corporation. Exceptions for distributions of LIFO inventory, installment obligations, and depreciation recapture property also applied. In addition, certain judicially created exemptions to nonrecognition evolved over the years to require gain recognition in connection with both liquidating and nonliquidating distributions. These court-created exceptions included the assignment of income doctrine,56 the tax benefit rule,57 and the Court Holding Company58 doctrine.
56See, e.g., J. Ungar, Inc. v. Comr., 244 F.2d 90 (2d Cir.1957).
57See Hillsboro Nat'l Bank v. Comr., 460 U.S. 370 (1983).
58Comr. v. Court Holding Company, 324 U.S. 331 (1945), rev'g 143 F.2d 823(5th Cir. 1944), rev'g and rem'g 2 T.C. 531 (1943), nonacq., 1969-2 C.B. XXVI. Under this doctrine, a corporation that distributes an asset in anticipation of a sale of the asset by the shareholder/distributee is required to recognize gain.
Except in the case of an in-kind distribution in redemption of corporate stock, which did not depend on the character of the property for gain recognition, a distribution of a partnership interest would not trigger gain recognition to the corporate distributor because a partnership interest is not the type of property included in the foregoing exceptions to nonrecognition. It could therefore be assumed that a corporate distribution of a partnership interest (other than in connection with redemption distributions) would not trigger gain recognition even though the subject partnership held assets that were of the "tainted" variety. That was the state of the law until 1984, when two events occurred.59
59But see Rev. Rul. 77-321, 1977-2 C.B. 98 (obsoleted by Rev. Rul. 2003-99, 2003-34 I.R.B. 388), in which the IRS distinguished the transfer by a corporation of all of its assets to a partnership immediately before the corporation's liquidation under §333, prior to its repeal by the Tax Reform Act of 1986.
The first event was the Claims Court's decision in Holiday Village Shopping Center v. U.S.60 In that case, a corporation held an interest in a partnership which, in turn, owned real property subject to §1250 recapture. In what at least one commentator views as an ill-conceived decision,61 the court concluded that depreciation recapture was required when the corporation distributed the partnership interest in connection with its liquidation. Although §336, as then in effect, did not mandate gain recognition and §1250 did not apply to override §336 nonrecognition because the partnership interest was not depreciable real property subject to §1250 recapture, the court nevertheless concluded that recapture was required.62 The Claims Court reasoned that the statutory scheme created a loophole and felt obliged to close the loophole by creating a new exception to §336 nonrecognition.
605 Ct. Cl. 566 (1984), aff'd, 773 F.2d 276 (Fed. Cir.1985).
61See McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners at ¶15.07[2]. However, another prominent commentator does not view the Claims Court's decision as being without merit. Willis, Pennell & Postlewaite, Partnership Taxation at ¶121.06. In fact, the authors of the latter work apparently believe the Claims Court reached the right decision since that treatise states that the exception to nonrecognition "arguably" does not apply in the case of the distribution of an interest in a partnership holding tainted assets.
62Section 751 also did not apply technically, although not discussed by the court, because a distribution under §336 was not an otherwise taxable sale or exchange as required in order for §751(a) to apply.
The second event occurring in 1984, that changed the general rule of nonrecognition in connection with a corporate distribution of a partnership interest, was legislative in nature. §386 was added to the Code as part of the Tax Reform Act of 1984.63 The provision was short-lived, however, since it was repealed in 1988 as being unnecessary after the 1986 repeal of the General Utilities doctrine.64 It, therefore, applied to corporate distributions of partnership interests occurring after March 31, 1984, and before 1987.
63P.L. 98-369.
64Section 386 was repealed by the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647.
Section 386 took the Claims Court's Holiday Village Shopping Center decision one step further. The statute provided that, for purposes of determining the amount and character of gain to be recognized by a corporation in connection with its distribution under §311 or §336 of an interest in a partnership, the corporation would be treated as owning directly a share of the assets of the partnership.65 Consequently, any assets owned by a partnership that would create gain recognition and character taint under any of the exceptions to nonrecognition under §311 or §336, if owned and distributed directly by a corporation, would create gain recognition and character taint under those provisions when the corporation distributed the partnership interest to its shareholders.66
65A comparable rule was provided under §386 that applied to a corporate sale of a partnership interest in connection with a liquidation of the corporation pursuant to §337, before its repeal by the 1986 TRA.
66A special "look-through" rule also applied in the case of tiered partnerships. In the case of a corporation that acquired an interest in a partnership which, in turn, owned an interest in one or more other partnerships, the top-tier partnership was treated as owning a proportionate share of the assets owned by the lower-tier partnerships for purposes of §386.
Example: To illustrate the 1984 changes in the foregoing rules, assume that C corporation Realco owns two assets: (1) an apartment building, purchased for $500,000, with a current fair market value of $1,000,000 on which $250,000 of depreciation subject to §1250 recapture has been claimed, and (2) a $1,000,000 installment note that arose from Realco's sale two years ago of undeveloped real estate. The undeveloped land had a zero basis in Realco's hands at the time of sale and the installment note, upon which Realco was reporting gain under the §453 installment method, called for $100,000 per year principal payments for 10 years. Realco received and paid tax on $200,000 of installment payments.
If Realco liquidated under pre-1986 TRA §336, Realco would be required to recognize $250,000 of recapture gain relating to the apartment building, and the remaining $800,000 of gain relating to the installment note notwithstanding the general nonrecognition rules of pre-1986 TRA §336.
Assume, alternatively, that Realco's only asset is a 50% interest in partnership P that owns the apartment building and installment note mentioned above. If Realco liquidated prior to the 1984 judicial and legislative changes discussed above, Realco would have no gain recognition under §336. The 50% interest in P was not the type of property upon which gain was recognized under pre-1986 TRA §336. The same rule would have applied if Realco distributed its interest as a dividend to its shareholders. If, however, §386 applied to the distribution of Realco's interest in P, Realco would be required to recognize gain under §336 just as if Realco owned directly a 50% interest in P's assets. Thus, Realco would recognize $125,000 of depreciation recapture and $400,000 of gain relating to P's installment note.
e.	Distributions of Interests in Lower-Tier Partnerships Holding Long-Term Contracts
Partnership transactions involving long-term contracts66.1 are divided into "step-in-the-shoes transactions" and "constructive completion transactions." In a step-in-the-shoes transaction, the pre-transaction taxpayer's obligation to account for the contract terminates and is assumed by the post-transaction taxpayer.66.2 In a constructive completion transaction, however, the original taxpayer is treated as completing the contract on the date of the transaction.66.3
66.1A long-term contract is any contract for the manufacture, building, or construction of property if the contract is not completed within the taxable year in which the contract is entered into. §460(f)(1).
66.2Regs. §1.460-4(k)(3).
66.3Regs. §1.460-4(k)(2).
Transfers of interests in partnerships holding long-term contracts are generally step-in-shoes transactions (i.e., the transferee assumes the transferor's obligations to account for the contract). However, the constructive completion rules apply to the distribution by a partnership (upper-tier partnership) of an interest in a lower-tier partnership that holds a long-term contract either directly or through other partnerships.66.4
66.4Regs. §1.460-4(k)(2)(iv), as amended by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04), applicable to transactions after May 14, 2002. The constructive completion rules do not apply, however, to a partnership's §721 transfer of all of its assets and liabilities to another partnership, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership. Id.
f.	Other Categories of Taxable Dispositions
A general principle of federal income tax law is that income, in whatever form received, is subject to tax unless specifically exempted by the Code.67 The same rule applies in the case of a disposition of a partnership interest. That is, gain or loss is recognized upon a partner's disposition of his interest in the partnership unless the disposition is specifically exempted from recognition under the Code. The categories of nontaxable dispositions are discussed in II, B, below. Other types of dispositions will result in gain or loss recognition.
67See Regs. §1.61-1(a).
Example: B is a partner in partnership P. B's basis for his P interest is $1,000, and the interest has a current fair market value of $10,000. L is B's lawyer. B and L agree that, in consideration for L's representing B in certain litigation, B will transfer his entire partnership interest to L. B's transfer of the interest in P is a taxable disposition and results in $9,000 of taxable gain to B.
Example: Assume alternatively in the foregoing example that B transfers his interest in P to Oldco, an existing corporation that is owned by C. B receives a 20% interest in Oldco in consideration for the transfer of his P interest. Since the transfer does not, under these facts, qualify for nonrecognition under §351, the disposition is a taxable transaction resulting in $9,000 of gain to B.
2.	Tax Consequences to Transferor Partner
a.	Measure of Gain or Loss
(1)	In General
Upon a taxable disposition of a partnership interest, the gain or loss recognition by the transferor conforms to the rules applicable to taxable dispositions of assets in general.68 Thus, the transferor partner's gain or loss equals the difference between the consideration received for the transfer and the transferor's adjusted basis in the transferred interest.69 In the absence of partnership liabilities, this calculation is simple. The consideration received equals the amount of cash plus the fair market value of any other property received by the transferor in exchange for the transferred partnership interest.70 The adjusted basis of the transferor's partnership interest is determined under §705 and is discussed at II, B, 2, a, (3), below.
68§741.
69§1001(a).
70§1001(b).
While the computational aspects of determining gain or loss on a disposition of a partnership interest are fairly simple, it generally is not possible to determine the precise amount of the gain or loss on the day of the transfer. This is due to the rules applicable to determining basis. As discussed at II, B, 2, a, (3), below, calculating a partner's basis in his partnership interest requires a determination of his share of partnership income, gain, loss, and deduction. This requires calculating the transferor partner's share of those items for the year of the transfer. It would be the exception rather than the rule for a partner to be able to determine precisely his share of partnership income or loss as of the date of transfer. Consequently, calculating the precise amount of gain or loss on the transfer may need to be made many months after the transfer occurs, when the transferor partner's share of partnership income or loss through the date of transfer is known.
Note: As discussed in II, B, 1, e, above, an upper-tier partnership's distribution of an interest in a lower-tier partnership that holds a long-term contract is a "constructive completion transaction." Thus, the rules for measuring income and loss specific to constructive completion transactions apply to such a distribution.70.1
70.1Regs. §1.460-4(k)(2)(ii),  (iv)(A).
(2)	Effect of Partnership Liabilities
Under the Supreme Court's decision in Crane v. Comr.,71 if a purchaser assumes a seller's liabilities or if property is purchased subject to a liability, the amount of the liability is treated as an amount realized on the sale. §752(d) provides that, in the case of a sale or exchange of an interest in a partnership, liabilities of the partnership are to be treated in the same manner as liabilities in a nonpartnership context. Consequently, the amount realized by the transferor partner in connection with a sale or exchange of an interest in a partnership that has liabilities is increased by the partner's share of the partnership debt.
71331 U.S. 1 (1947), aff'g 153 F.2d 504(2d Cir. 1945), rev'g 3 T.C. 585 (1944), nonacq., 1945 C.B. 8. See also PLR 9622014, in which the IRS ruled that a general partner must include her share of partnership liabilities in the amount that she realized by assigning her partnership interest to another partner, even though the partnership's lender refused to cancel the partner's personal guaranty of a loan the creditor made to the partnership. Noting that the assignee partner agreed to indemnify the transferor for her share of the partnership's liabilities, the IRS reasoned that the former partner no longer bore any risk of economic loss on the loan.
The existence of partnership liabilities is essentially neutral in the context of a sale or exchange of a partnership interest. This is because, in order for a partnership liability to be included in the amount realized on a sale or exchange of an interest in the partnership, the liability must also have been included in the transferor's basis in the interest.72 Therefore, the partner's share of the liability appears on both sides of the ledger when calculating his gain or loss on a disposition of his partnership interest. The partner's amount realized is increased by the liability, but the partner's adjusted basis in the transferred interest has also been increased to the same extent.
72A partner's share of partnership liabilities is determined under Regs. §1.752-0. In general, under these regulations, a partner's share of partnership liabilities may vary depending on whether the liabilities are recourse or nonrecourse liabilities. If a partner does not include any partnership liability in his basis under these regulations (for example, a limited partner that is not obligated to contribute additional capital under the partnership agreement does not include any portion of partnership recourse debt in his basis), the partner will not be required to include any portion of the partnership debt in the amount realized upon a disposition of his partnership interest.
Example: Partner B in the ABC partnership has a 1/3 interest in the partnership and contributed $10,000 for his interest. The partnership has had no gain or loss for tax purposes and has made no distributions at the time B sells his interest to D for $20,000. At the time of the sale, B's basis in his partnership interest is equal to his capital contribution ($10,000) so that he recognizes a $10,000 gain ($20,000 amount realized minus $10,000 basis) on the sale.
Example: Assume additionally in the foregoing example that the partnership incurred $60,000 in liabilities, of which B's share was $20,000. Under §752(d) and Crane, B's amount realized on the sale to D for $20,000 in cash is $40,000 ($20,000 cash plus $20,000 of debt relief). However, rather than a $10,000 basis in his partnership interest, B's basis is $30,000 ($10,000 contribution plus $20,000 of liabilities). B would, therefore, still have a $10,000 gain on the sale to D since the debt increased B's basis to the same extent that it increased his amount realized.
The neutral aspect of partnership liabilities upon a disposition of a partnership interest is sometimes lost on a partner who sells a partnership interest when the partner's capital account is a negative figure.73 In that case, the partner's gain will be greater than the amount of cash or other property received in consideration for his partnership interest, excluding partnership debt.
73While a partner's capital account may be negative, under §704(d), his basis in his partnership interest may never be a negative figure. If a partner has a negative capital account, the partnership must have liabilities that were taken into account in determining the partner's adjusted basis.
Example: Partner B in partnership ABC originally contributed $10,000 for his interest, and his share of partnership liabilities is $20,000. The partnership has been in existence for five years and has incurred a taxable loss in each of those years, of which B's share has been $3,000 per year. Assuming that there have been no distributions from ABC, B's basis in his partnership interest is $15,000 ($10,000 initial contribution plus $20,000 of liabilities minus $15,000 aggregate losses), and his capital account is a negative $5,000. If B sells his interest to D for $10,000 in cash, A's gain will be $15,000, calculated as follows: Amount realized of $30,000 ($10,000 cash plus $20,000 in debt relief) minus adjusted basis of $15,000.
It is relatively well settled that, where a partnership has recourse or nonrecourse liabilities, a partner's amount realized includes his share of the partnership indebtedness regardless of the value of the assets of the partnership. That conclusion was not always clear. A controversy developed over whether partnership nonrecourse indebtedness secured by partnership property, with a value that was less than the outstanding balance of the debt, had to be fully included in the amount realized upon a disposition of an interest in the partnership. It was argued by taxpayers that the amount realized attributable to partnership nonrecourse debt was limited to the partner's share of the fair market value of the partnership property that secured the debt.74
74See Tufts v. Comr., 651 F.2d 1058 (5th Cir. 1981), rev'd, 461 U.S. 300 (1983).
This controversy is generally traced to footnote 37 of the Crane decision.75 That footnote indicated that, if an owner of property abandoned the property or transferred it subject to the nonrecourse indebtedness, the amount realized by the owner would be limited to the fair market value of the property. However, since the outstanding balance of the debt did not exceed the value of the property under the facts before the Court in Crane, the Supreme Court did not decide whether the amount realized was limited by the value of property secured by nonrecourse debt for purposes of its opinion. Footnote 37 was, therefore, nonbinding dicta.
75331 U.S. 1, fn. 37.
The Supreme Court finally resolved the controversy raised in footnote 37 nearly 40 years after the Crane decision in Comr. v. Tufts.76 In Tufts, a partnership owned an apartment complex subject to a nonrecourse debt that exceeded the value of the real property. All partners in the partnership joined in selling their partnership interests to a third party for a cash price equal to the selling expenses incurred by the partners. If the amount realized by the partners on the sale of their interests included the full principal amount of the nonrecourse mortgage secured by the apartment complex, the partners would be required to recognize a significant gain. If the amount realized attributable to the nonrecourse mortgage was limited to the value of the real estate, however, the partners had a small loss in the aggregate.
76461 U.S. 300 (1983).
The partners in Tufts argued that §752(c) limited the amount realized on the sale of their partnership interests to the value of the apartment complex. Section 752(c) provides that, for purposes of §752, "a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property." (Emphasis added.) The Supreme Court rejected the taxpayer's argument and concluded that a partner's share of the full principal amount of nonrecourse indebtedness of a partnership must be included in the partner's amount realized upon a disposition of his interest in the partnership regardless of the value of the property that secures the debt. Relying on the legislative history of §752(c), the Court concluded that the fair market value limitation of that provision applied only to transactions between a partner and the partnership (i.e., cash contributions and distributions under §752(a) and (b)) and did not apply to limit the amount realized on sales of partnership interests to third parties.77
77Section 7701(g), which was added to the Code by the Tax Reform Act of 1984, P.L. 98-369, codified the Supreme Court's holding in Tufts. That section provides that, for purposes of the income tax provisions of the Code, the fair market value of property shall be deemed to be not less than the outstanding balance of any nonrecourse indebtedness to which the property is subject in determining gain or loss with respect to the property.
(3)	Adjusted Basis of Transferor's Interest
After the amount realized has been determined, the second component in the computation of gain or loss realized on the sale or exchange of a partnership interest is the adjusted basis of the interest transferred. This determination is not particularly difficult in the case of a disposition of a partner's entire interest in the partnership. The computation, set out in §705, requires a determination of the transferor's original basis. The original basis is the amount of cash and the adjusted basis of other property contributed to the partnership in the case of an interest acquired by original issuance from the partnership.78 In the case of an interest acquired from an existing partner in a taxable acquisition, the partner's initial adjusted basis equals the cash and fair market value of other property given in exchange for the interest.79 If the partnership interest was acquired by gift, the donee's original basis is generally equal to the donor's basis at the time of the gift.80 A partner's original basis in a partnership interest acquired from a decedent is the fair market value of the interest on the date of the decedent's death (or on the alternate valuation date if so elected by the personal representative of the decedent's estate).81 A partner's initial adjusted basis for an interest acquired from an existing partner in other nontaxable acquisitions is generally equal to the transferor partner's basis prior to the transfer, as discussed at II, C, below.
78§722.
79§§742, 1012.
80§§742, 1015.
81§742; §1014 (for property acquired from a decedent dying before 2010). See also FSA 199935053 (adjusted basis for sale of inherited partnership interest is FMV increased by decedent's partnership liabilities measured as of the date of decedent's death plus adjustments for interim years in accordance with §705 and §752). Cf. §1022, as added by the 2001 Tax Relief Act, P.L. 107-16, §542, for property acquired from a decedent dying after 2009.
Various adjustments must be made to a partner's initial basis in the partnership interest in order to determine basis as of any particular date. The adjustments are made on a cumulative basis from the date the interest was originally acquired through the date for which the determination is made (for our purpose, the date of a disposition of the interest). The transferor's original basis is increased, pursuant to §705(a)(1), by: (1) the amount of cash and the adjusted basis of other property contributed to the capital of the partnership in addition to the partner's original capital contribution; (2) the partner's share of partnership taxable income and tax exempt income; (3) the partner's share of percentage depletion that exceeds the basis of partnership depletable property; and (4) any increase in the partner's share of partnership liabilities, as determined under §752(a) (which is treated as a cash contribution to the partnership). Under §705(a)(2), the transferor's basis must be decreased by: (1) the amount of cash and the adjusted basis of property distributed in kind to the partner;82 (2) the partner's share of partnership losses and non-capital expenditures that are not deductible for tax purposes; (3) the partner's share of depletion deductions with respect to partnership oil and gas property (to the extent the depletion deductions do not exceed the partnership's basis in the depletable property); and (4) any reduction in the partner's share of partnership liabilities as determined under §752(b) (which is treated as a cash distribution from the partnership to the partner). A partner may not, however, have a negative basis for his partnership interest. Negative adjustments may be made only to the extent that the partner's basis is thereby reduced to zero.83
82The reduction in a partner's basis in his partnership interest that arises from a distribution of property other than cash is generally equal to the partnership's adjusted basis in the property immediately before the distribution, under §732(a)(1). However, if the partnership's basis in the property exceeds the partner's basis in the partnership interest, the partner's basis in the interest is reduced to zero under §732(a)(2). In that case, rather than taking the partnership's basis in the asset distributed that would ordinarily be the case, the partner acquires a basis in the asset equal to his basis in the partnership interest immediately before the distribution, less any cash distributed in the same transaction.
83At first blush, the no negative basis rule of §705(a)(2) seems to be a glaring loophole in Subchapter K. However, as one might imagine, the integrity of the Code is upheld by other sections of the partnership provisions. Under §704(d), a partner may claim his share of partnership deductions on his individual tax return only to the extent of his basis in his partnership interest. In that connection, it should be noted that a partner makes percentage or cost depletion computations with respect to partnership oil and gas properties and claims the depletion deductions only on his individual return. The depletion deductions reduce the partner's basis in his partnership interest but only to the extent that the deductions do not exceed the partner's proportionate share of the adjusted basis of the depletable property under §613A(c)(7)(D). A partner is required to recognize taxable gain to the extent a partnership distribution of money (for purposes of this rule, §731(c) generally treats marketable securities as money) (including a deemed distribution arising from a reduction in the partner's share of partnership liabilities under §752(b)) exceeds the partner's basis in his partnership interest pursuant to §731(a)(1). Further, if property other than money is distributed to a partner, the general rule, that the partnership's basis in the property prior to the distribution becomes the partner's basis in the property, is modified if the partnership's adjusted basis in the property exceeds the partner's basis in his partnership interest. In that case, the partner is not required to recognize gain in connection with the in-kind distribution. However, the partner's basis for his interest is reduced to zero and his basis in the distributed property is limited to his basis in the partnership interest prior to the distribution. Thus, upon the partner's subsequent sale of the property distributed to him, a larger gain (or smaller loss) will be recognized than would have been the case had the partnership's basis in the property been the measure of his basis.
As mentioned above, a transferor partner's basis in his partnership interest must be determined as of the date of transfer. Since the adjustments to basis must include the transferor's share of partnership income or loss, his share of partnership income or loss must be determined as of the date of transfer. The manner in which a transferor partner's share of partnership income or loss is determined for the short period beginning with the first day of the taxable year of the disposition through the date of transfer is discussed at II, D, below. Thus, it is relatively rare that a transferor partner will be able to determine his exact basis on the day of the transfer. It will be some time later, perhaps as late as the completion of the partnership's tax return for the year that includes the disposition date, before the transferor's exact basis may finally be calculated.
The computation of a transferor partner's basis in a transferred partnership interest may be less straightforward if the transfer is of less than the transferor's entire interest. If the partnership has no liabilities which were taken into account in determining the transferor's basis under §752, a determination of the basis of a partial interest involves only one step in addition to the determination of basis generally as discussed above. After determining the transferor's basis in his entire interest, the basis in the portion transferred is determined by allocating a portion of the entire basis to the transferred interest based on the relative fair market values of the portion of the interest transferred and the portion of the interest retained.84
84Regs. §1.61-6(a); Rev. Rul. 84-53, 1984-1 C.B. 159.
Example: Partner A has a $10,000 adjusted basis in his interest in partnership ABC, and the fair market value of his interest is $30,000. If A sells a portion of his interest at fair market value for $15,000, A's basis in the transferred portion would be $5,000 ($10,000 basis for entire interest x [$15,000 value of transferred interest ÷ $30,000 value of entire interest]).
The rule for allocating basis between the interest transferred and the interest retained (based on relative fair market values) applies even if the transferor owns both a general partnership interest and a limited partnership interest. It also applies even though the transferor acquired his partnership interest in two or more transactions in which he paid different amounts for the acquired interests. This conclusion follows because, unlike shares of stock for which the owner has a discreet basis for each share, a partner's basis in a partnership interest is considered to be a single unified basis, regardless of the fact that the interest is comprised of general and limited partnership interests that were acquired at different times for different amounts.85
85Rev. Rul. 84-53, 1984-1 C.B. 159.
Example: Partner A is the sole general partner in limited partnership ABC and acquired his 1/3 general partner interest by contributing $10,000 to partnership capital in 1985. In 1989, A purchased B's 1/3 limited partner interest for $50,000. Assuming that ABC has distributed to the partners an amount equal to its total income each year and that it has no liabilities, A's basis in his entire interest, general and limited, after acquiring B's interest would be $60,000. In 1990, A sells 1/2 of the 1/3 limited partnership interest purchased from B to D (a 1/6 interest) for its fair market value of $30,000 when the value of A's entire partnership interest before the sale is $200,000. A's adjusted basis in the limited partnership interest sold to D is, therefore, $9,000 ($60,000 entire basis X [$30,000 value of transferred interest ÷ $200,000 value of A's entire interest]).
The calculation becomes more complicated if the transferor has general and limited partnership interests and the partnership has both recourse liabilities, that are generally taken into account in determining basis only by general partners under §752, and nonrecourse liabilities, that are generally taken into account by both general and limited partners. The rule continues to be that a partner has a single unitary basis for his interest in a partnership, even though the partnership has recourse and nonrecourse liabilities and the partner has both limited and general partnership interests.
However, the method of allocating basis between the transferred interest and retained interest based on relative values would not lead to the correct result in this situation, at least if the transferor does not transfer a proportionate share of limited and general partnership interests.
The method of allocating basis between transferred and retained interests where the partnership has liabilities is addressed by the IRS in Rev. Rul. 84-53.86 The method differs depending on whether the partner's share of partnership liabilities exceeds his adjusted basis for his entire interest. If his share of liabilities does not exceed his basis, the ruling directs the transferor to determine the basis of the transferred interest by first excluding his share of liabilities from basis. The basis remaining after excluding liabilities ("net basis") is then allocated between the interest transferred and the interest retained based on relative fair market values. The liabilities from which the transferor is considered to be relieved in connection with the transfer are then added to the net basis of the transferred interest to determine the transferor's total basis in the transferred interest.
86Id.
Example: B has a 10% interest in partnership Realco as a general partner (B is the sole general partner) and a 40% interest as a limited partner. Realco has $50,000 of recourse debt included in B's basis and no nonrecourse debt. B's basis for his entire 50% partnership interest is $60,000, including B's share of recourse debt. If B sells 1/2 of his limited partnership interest (representing a 20% interest in the partnership) for $40,000, B's basis in the transferred interest would be $4,000, determined as follows: (1) Adjusted basis of entire interest ($60,000), less share of Realco liabilities ($50,000), equals net basis of $10,000; (2) Allocate net basis to transferred interest based on relative fair market values ($10,000 net basis × [$40,000/$100,000] = $4,000); and (3) Add to $4,000 net basis the portion of partnership debt from which transferor is considered to be relieved in connection with transfer ($0).87 The basis for B's transferred interest is, therefore, $4,000.
87Since the Realco debt is assumed to be recourse, B is not considered to be relieved of any of the $50,000 debt included in his partnership interest basis in connection with the sale of a portion of his limited partnership interest. Regs. §1.752-2.
Example: Assume the same facts as in the preceding example except that, rather than selling a 20% limited partnership interest, B sells a portion of his general partnership interest representing a 5% share of the partnership for $10,000. In that case, B's basis in the transferred general partnership interest would be $26,000, determined as follows: (1) Net basis of entire interest as determined in step (1) in preceding example = $10,000; (2) Allocate net basis to transferred interest based on relative fair market values ($10,000 × [$10,000 ÷ $100,000] = $1,000); and (3) Add to $1,000 net basis the portion of partnership recourse liabilities from which B is considered to be relieved in connection with the transfer under §752(d) ([$50,000 recourse liabilities × 50% debt relief] + $1,000 net basis = $26,000).
According to Rev. Rul.84-53, the allocation of basis to the transferred interest is calculated under a different methodology if the transferor's share of partnership liabilities exceeds his entire adjusted basis (including his share of liabilities). In that case, the basis in the transferred interest bears the same relation to the partner's entire basis as the discharged portion of the partner's share of partnership liabilities bears to the transferor's entire share of partnership liabilities.
Example: Assume the same facts as in the preceding example, except that B's basis in his entire interest is $40,000 rather than $60,000. If B sells1/2 of his limited partnership interest (representing a 20% share of the partnership) for $40,000, his basis in the transferred interest would be zero, determined as follows: entire basis ($40,000) × (liability relief [$0] ÷ entire share of liabilities [$50,000]).
Example: Assume the same facts as in the preceding example, except that B sells a 5% general partnership interest for $10,000 rather than the limited partnership interest. In that case, the basis of the transferred interest would be $20,000, determined as follows: entire basis ($40,000) × (liability relief [$25,000] ÷ entire share of liabilities [$50,000]).
b.	Character of Gain or Loss
(1)	General Rule -- Capital Gain or Loss
A partner who disposes of all or a portion of his partnership interest is, except as provided in §751 and discussed at II, B, 2, b, (2), below, treated as disposing of a capital asset pursuant to §741. Thus, under the general rule, gain or loss arising from a disposition of a partnership interest is taxed as capital gain or loss.
Even in years in which the difference between ordinary income rates and long-term capital gain rates is small,88 the difference may still be relevant. For example, capital gains can be offset dollar-for-dollar by capital losses, while capital losses can only offset ordinary income in the hands of individuals to the extent of $3,000 of capital losses per year and cannot offset ordinary income in the hands of a corporation at all.89 In years in which the rate differential is greater, of course, the distinction between capital gain treatment and ordinary income treatment has even more vitality.90
88For tax years beginning after 1986 and before 1993, for instance, the maximum tax rate for capital gains and most levels of ordinary income was 28%. As a result, capital gains generally enjoyed a tax preference over ordinary income only when an individual would have paid tax at the highest ordinary income rates (topping out at 31%).
89§1211.
90The Revenue Reconciliation Act of 1993 increased the top marginal rate at which individuals' ordinary income was taxed to 39.6%. The 1997 Taxpayer Relief Act reduced the maximum capital gain rate to 20%. The top marginal income tax rate has since been reduced to 35%, and the maximum capital gain rate has been reduced to 15%. See §1(i), as amended by the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003, P.L. 108-27, §105; §1(h), as amended by P.L. 108-27, §301. See 507 T.M., Income Tax Liability: Concepts and Calculation, for further discussion of the individual income tax rate reductions, and 561 T.M., Capital Assets, for a complete discussion of the capital gains tax rates currently in effect.
[Footnote 91 reserved.]
A partner who disposes of a partnership interest may recognize both long-term and short-term capital gain or loss from the transaction, if the partner has a divided holding period for the interest. The IRS has set forth rules for determining divided holding periods of partnership interests in Regs. §1.1223-3. Under the regulations, the holding period of a partnership interest is divided when a partner acquires portions of an interest at different times or an interest is acquired in a single transaction that gives rise to different holding periods (for example, when the partner received the interest in exchange for two or more assets which themselves had different holding periods at the time of the contribution). A partner may also receive a divided holding period in a partnership interest as a result of making a cash contribution subsequent to acquiring the interest. If a partner sells or exchanges its entire partnership interest, any capital gain or loss recognized will be divided between long-term and short-term capital gain or loss in the same proportions as the holding period of the partnership interest. For a detailed discussion of the divided holding period rules for partnership interests, see 710 T.M., Partnerships; Overview, Conceptual Aspects and Formation.
(2)	Section 751
The general rule of §741, that treats the disposition of a partnership interest as a sale or exchange of a capital asset, treats a partnership as an entity separate and distinct from its partners. However, §751 is an exception to §741 and adopts the opposite approach. Section 741 provides that a sale or exchange of a partnership interest is treated as a disposition of a capital asset "except as otherwise provided in section 751." This seemingly innocuous exception is actually a broad exception from the general capital gain or loss rule and often provides much computational complexity. In the context of the disposition of a partnership interest, §751 treats the portion of the gain or loss realized on the disposition that is attributable to the selling partner's interest in partnership "unrealized receivables" (as defined in §751(c)) and "inventory items" (as defined in §751(d)) as ordinary income or loss. Unlike the general rule of §741, therefore, §751 treats a partnership as an aggregate of individual partners, with each partner owning a share of partnership §751 assets.
The schizophrenic treatment of the disposition of a partnership interest afforded by §§741 and 751 is necessary to plug a glaring loophole that would otherwise exist. The loophole that would be available, in the absence of §751, is a relatively simple method of converting ordinary income to capital gain.
Example: B is a dealer in real estate, and his sole source of income arises from purchasing and selling real estate. Under relevant case law,92 gains and losses from B's dealings in real estate are characterized as ordinary income or loss. It would be a simple matter for B to transfer some of his real estate holdings to a partnership and, after a suitable period adequate to avoid a recharacterization as a sale of the real estate, sell his interest in the partnership. In the absence of §751, B could thereby convert the ordinary income he would have realized upon the sale of the real property directly into capital gain from the sale of B's interest in the partnership. If B only occasionally tried this approach, the conversion would likely be successful in the absence of §751(a).93
92 E.g., Malat v. Riddell, 383 U.S. 569(1966), vac'g and rem'g per curiam 347 F.2d 23 (9th Cir. 1965), aff'g 64-1 USTC ¶9432 (D. Cal.1964).
93If B consistently sold interests in partnerships holding appreciated real estate, a court could presumably conclude that B is a dealer in partnership interests and thereby characterize B's gains as ordinary.
If a partnership has no unrealized receivables or inventory items ("§751 assets"), a partner's gain or loss from a disposition of an interest in the partnership is calculated as described in II, B, 2, b, (1), above. Section 741 treats that gain or loss as capital in nature. However, if the partnership has §751 assets, the calculation necessary to determine a partner's gain or loss from a disposition of an interest in the partnership is more complicated due to the mechanics of §751. In fact, although a partner may otherwise realize an overall loss on the disposition of a partnership interest, if the partnership possesses §751 assets, it is likely that the selling partner will be required to recognize ordinary income on the §751 portion of the disposition, which will correspondingly increase the capital loss on the portion of the transaction covered by §741. In addition, although it would be unusual because of the type of property included in the definition of §751 assets, it is theoretically possible for a partner to recognize an ordinary loss, under §751(a), upon a disposition of a partnership interest while the partner has an overall gain on the disposition.
A complete discussion of the intricacies of §751 is beyond the scope of this portfolio. For a detailed discussion of §751, see 720 T.M., Partnership Transactions -- Section 751 Property. The following is an overview of the application of §751 to the disposition of a partnership interest, but by no means should be viewed as a comprehensive description of the complexities of the provision.
If a partnership potentially has §751 assets, determining the character of the gain or loss to be recognized in connection with a taxable disposition of an interest in the partnership entails three steps. First, determine whether the partnership, in fact, owns §751 assets. Second, determine the portion of the gain from a hypothetical sale of these §751 assets that the partnership would allocate to the transferred interest. The transferor will recognize this amount as ordinary income, without regard to amount of overall gain or loss from transferring the interest. Third, calculate the transferor's net capital gain or loss by subtracting the partner's ordinary income determined in step two from the overall gain or loss that the partner realizes from the transfer.
In determining whether the partnership owns §751 assets, two broad categories are included. The first category is "unrealized receivables," defined in §751(c). Within the category of unrealized receivables are three subcategories of property: (1) rights to payments for goods delivered or to be delivered (to the extent not previously included in the partnership's income); (2) rights to payments for services rendered or to be rendered (to the extent not previously included in the partnership's income); and (3) the amount of ordinary income that the partnership would be required to include in income under most (if not all) of the various recapture provisions of the Code (such as §§1245 and 1250) if the partnership were to sell all of its assets.
The second category is "inventory items." These are defined as:94 
(1) property of the partnership of the kind described in §1221(a)(1), 
(2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in §1231, and
(3) any other property held by the partnership which, if held by the selling or distributee partner, would be considered property of the type described in paragraph (1) or (2).
94§751(d), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §413(c)(11). Prior to amendment by the 2004 AJCA, §751(d) inventory items also included any other property of the partnership that, if sold or exchanged by the partnership, would result in a gain taxable under former §1246(a) (relating to gain on foreign investment company stock). As the 2004 AJCA, §413(a), repealed §1246, this provision was removed from §751(d), effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end.
The inclusion of "inventory items" as §751 assets was introduced in the Taxpayer Relief Act of 1997 (1997 TRA).95 Pre-1997 TRA §751(d) required that inventory be substantially appreciated in value in order to be treated as a §751 asset upon the sale and exchange of a partnership interest. The change conforms the treatment of inventory to the treatment of unrealized receivables under these rules.
95P.L. 105-34, §1062(b)(2). The amendments to §751 are generally effective for sales, exchanges, and distributions after August 5, 1997. However, the new provisions do not apply to any sale or exchange pursuant to a written binding contract in effect on June 8, 1997, and at all times thereafter before such sale or exchange.
If the partnership owns §751 assets at the time of a partner's disposition of a partnership interest, the second step is to determine the portion of the amount realized by the seller attributable to §751 assets. The regulations use a hypothetical sale approach, under which the income or loss attributable to §751 property in a sale or exchange of a partnership interest is the amount of income or loss that would have been allocated to the partner from §751 property (to the extent attributable to the partnership interest sold or exchanged) if the partnership had sold all of its property in a fully taxable transaction for fair market value immediately prior to the partner's transfer of the partnership interest. The selling partner will recognize this amount as ordinary income. If, in unusual circumstances, the §751 assets have fallen in value below their basis to the partnership, the partner will recognize an ordinary loss. In either case, the selling partner recognizes the ordinary gain or loss from the step without regard to the partner's overall gain or loss from the transfer of the partnership interest.96
96Regs. §1.751-1(a)(2), T.D. 8847, 64 Fed. Reg. 69903 (12/15/99). The current "hypothetical-asset-sale" regulation is effective for transfers of partnership interests after Dec. 14, 1999. For earlier transfers, the former regulations generally respected the buyer's and seller's arm's length allocation of a portion of the sales price to §751 property. The IRS might nonetheless challenge such an allocation if the parties had no real adverse interest in the valuation of the §751 property (if, for example, the buyer would not receive an increased basis in these assets because the partnership had no §754 election in effect) or if the buyer and seller were related parties. The former regulations gave little guidance in allocating the sales price when the parties themselves did not specify the value of the §751 property in the sales agreement. The usual approach was to base the allocation on the fair market value of the selling partner's share of each of the partnership assets. See former Regs. §§1.751-1(a)(2) and 1.751-1(c)(3).
The third step is to determine the amount of the selling partner's capital gain or loss. Substract the amount of ordinary gain determined in step two, above, from the selling partner's overall gain or loss from the transfer of the partnership interest and report the result as capital gain or loss. If the partner received an ordinary loss from the hypothetical sale in step two, add this amount to (or, literally, subtract a negative amount from) the overall gain or loss to determine the capital gain or loss from the transfer.97
97Regs. §1.751-1(a)(2).
[Footnotes 98 and 99 Reserved.]
Example: A and B are equal partners in partnership P, which uses cash method accounting and which has the following balance sheet:
                                                   Assets               
                                             Adjusted        Fair Market
                                                Basis              Value
  Cash                                        $ 3,000            $ 3,000
  Loans Receivable                             10,000             10,000
  Capital Assets                                7,000              5,000
  Unrealized Receivables                            0             14,000
  Total                                        20,000             32,000

                                     Liabilities and Capital            
                                             Adjusted        Fair Market
                                            Per Books              Value
  Liabilities                                 $ 2,000             $2,000
  Capital:                                                              
   A                                            9,000             15,000
   B                                            9,000             15,000
  Total                                        20,000             32,000

None of P's assets is §704(c) property and the partnership's capital assets are nondepreciable.
B transfers B's interest in P to T for $15,000. The total amount which B realizes is $16,000 ($15,000 cash plus B's share of partnership liabilities that T assumes). B's undivided half-interest in the partnership property includes a half-interest in P's unrealized receivables. B's basis for the partnership interest was $10,000 ($9,000, plus $1,000, B's share of the partnership liabilities). If §751 did not apply, B would recognize $6,000 of capital from the sale of the interest. Because P has unrealized receivables, however, §751 does apply to the sale and B must calculate gain by reference to a hypothetical sale of P's assets.
If P sold all of its §751 property in a fully taxable transaction immediately before the transfer of B's partnership interest, P would have allocated $7,000 of ordinary income to B from the sale of P's unrealized receivables. Therefore, B must recognize $7,000 of the gain from the sale of the partnership interest as ordinary income. The difference between the amount of capital gain or loss that B would realize in the absence of §751 ($6,000) and the amount of ordinary income or loss realized ($7,000) is B's capital gain or loss on the sale of his partnership interest. Thus, B will recognize a $1,000 capital loss.
A selling partner's share of the total value of §751 assets (and other partnership assets) is generally equal to his proportionate partnership interest. Thus, if a selling partner has the same interest in partnership profits, losses, and capital, his proportionate share of the value of each of the partnership's assets should equal that percentage interest. However, many partnership agreements are more complicated, such as those providing that a partner has a different percentage interest in profits, losses or capital, or that a partner's interest in these items may fluctuate from year to year, or even within a year. Determining a partner's interest in partnership assets when he has a different percentage share of profits, losses, and capital is less straightforward than if his share of each of these items is static. In the case of different percentage shares, a partner's interest in any particular §751 asset probably varies depending on whether the asset has appreciated or depreciated in value. A portion of the existing depreciated tax book value of each asset is probably allocated to the partner based on his relative interest in partnership capital. If the asset has appreciated in value, the partner's share of appreciation should probably be determined based on his profit sharing percentage. If it has depreciated in value, the depreciation in value should probably be allocated based on loss sharing ratios. Under Regs. §1.1245-1(e)(2)(i), recapture gain would be allocated to those partners who originally benefitted from depreciation deductions attributable to the property during the life of the partnership, or even before the property was contributed to the partnership if it was depreciated before then. For an in-depth discussion of these regulations, see 712 T.M., Partnerships--Taxable Income; Allocation of Distributive Shares; Capital Accounts.
c.	Timing of Gain or Loss
Unless the installment sale rules of §453 (discussed below) apply, a partner's gain or loss realized upon a taxable disposition of all or a portion of his partnership interest must be included in taxable income for the partner's year in which he transfers the burdens and benefits of ownership of the interest to the transferee.100 Generally, that means that gain or loss will be recognized in the year the acquiring party is admitted to the partnership or when he is entitled to gain or loss allocations and distributions from the partnership.101
100 E.g., U.S. v. Winthrop, 417 F.2d 905 (5th Cir. 1969), rev'g 67-2 USTC ¶9651 (D. Fla. 1967).
101In the case of a limited partnership, a transferee often need not be formally admitted to the partnership in order to be entitled to partnership allocations of gains, losses, and distributions. Whether or not a transferee must be formally admitted in order to participate in the economic ups and downs of the partnership is generally governed by the partnership agreement. A transferee may, if the partnership agreement so provides, participate in the allocations and distributions the transferor was entitled to without being formally admitted as a partner. In that case, however, the transferee would not be entitled to the other rights of a partner, such as the right to participate in voting (to the limited extent that a limited partner is entitled to vote) or to demand to see the books and records of the partnership. A general partnership, on the other hand, requires that a partner be formally admitted to the partnership in order that he be entitled to a share of partnership profits, losses, and distributions.
The installment sale rules of §453 apply to a disposition of a partnership interest at a gain where: (1) at least one payment is to be received in the taxable year following the year of disposition; and (2) the seller does not elect out of reporting the gain on the installment method.102 The first requirement does not mandate that two separate installment payments be contemplated, but only that at least one payment be received in the year following the year in which the burdens and benefits of owning the partnership interest are transferred to the acquirer. For example, if the seller receives no payment in the year of sale, with a single payment of the entire purchase price being payable in the following year, the installment sale rules would apply. Electing not to report on the installment method is accomplished by recognizing the full amount of the gain realized on a timely filed tax return (including extensions) tax return for the year of sale.103
102§453.
103Temp. Regs. §15A.453-1(d)(3)(i).
While gain on an installment sale of a partnership interest must be reported on the installment method (unless an election not to report under that method is made), loss may not be reported on the installment method.104 Even though no payments are actually received in the year in which the sale occurs, all of the loss realized must be reported in the year of sale.
104Section 453(a) provides that the installment method applies to the "income" realized from an installment sale, prohibiting installment treatment in the case of a loss.
As mentioned in II, B, 2, b, (2), above, a selling partner may have an overall gain to be recognized in connection with a disposition of his partnership interest but, due to the interplay between §§741 and 751, he may have a gain on the §751 portion of the transaction and a capital loss, under §741, on the remainder. While it would be unusual, he could also have a loss on the §751 portion and a gain on the §741 portion. It is not clear whether installment reporting is available in these circumstances.
Section 453 envisions reporting gain on the installment method and prohibits installment reporting of loss. Should installment reporting apply only to the gain portion, to both the gain and the loss portion, or not at all when the selling partner reports both gain and loss from the disposition of his partnership interest? The technically correct answer appears to be that if a partner recognizes an overall gain, installment reporting should be available. If an overall loss is recognized, installment reporting should not be available. This follows because §751 merely applies to characterize the overall gain or loss on a disposition of a partnership interest as ordinary or capital. If the mechanics result in ordinary income under §751, while leaving a loss under §741, the fact remains that gain is recognized on the sale and installment reporting technically applies. On the other hand, it could also be argued that §453 itself applies to "income from an installment sale." If, for example, a partner has both ordinary income and capital loss on a sale of his interest, the statute could be interpreted as applying only to the income portion while any loss must be reported, in total, in the year of disposition. These are apparently unanswered questions.
If the installment method applies to a sale of a partnership interest, §453 generally requires that the gain realized be included in income in proportion to the percentage of total payments that are received in a given year. This percentage is determined by multiplying payments received during the year by the taxpayer's "gross profit ratio."105 The "gross profit ratio" is, in turn, equal to the ratio of the gain to be recognized to the "contract price."106 The "contract price" is equal to the seller's amount realized less debts assumed or taken subject to by the purchaser to the extent that the indebtedness does not exceed the seller's basis.107
105Temp. Regs. §15A.453-1(b)(2)(i).
106Id.
107Temp. Regs. §15A.453-1(b)(2)(iii).
Example: Partnership ABC has the following assets and liabilities: 
  ASSETS                                        BASIS    ADJUSTED VALUE 
  Cash                                         $3,000            $ 3,000
  Unimproved Land                               6,000             18,000
  Total                                        $9,000            $21,000
                                                                        
  LIABILITIES AND CAPITAL                                               
  Liabilities                                  $6,000            $ 6,000
  A                                             1,000              5,000
  B                                             1,000              5,000
  C                                             1,000              5,000
  Total                                        $9,000            $21,000

A sold his interest to D for a total cash price of $5,000, payable $1,000 down and $1,000 per year for each of the following four years. A's gross profit ratio is $4,000 (gain recognized) @73 $5,000 (contract price), or 80%. Thus, 80% of each installment payment represents gain to be recognized by A. He would, therefore, have taxable gain of $800 in the year of sale and in each of the following four years.
Although a partner is required to report gain from a disposition of his partnership interest on the installment method unless he elects out of installment reporting, the partner is required to include his share of partnership income in the year of the disposition if the partnership owns property subject to depreciation recapture under §1245 or §1250.108 This recapture recognition is required even if the selling partner receives no payments from the purchaser in the year of disposition.
108§453(i)(2). The exclusion of §751 assets from installment reporting only to the extent of a selling partner's share of potential partnership recapture income under §§1245 and 1250 lends support to the conclusion that installment reporting is available for other types of §751(a) income. See also Rev. Rul. 75-323, 1975-2 C.B. 346, ruling that installment reporting was available in the case of a sale of an interest in a partnership with depreciation recapture. This ruling was prior to the amendment of §453(i) to require current inclusion of §§1245 and 1250 recapture on installment sales.
The IRS has extended this denial of installment reporting to the portion of a partnership interest attributable to the partnership's "substantially appreciated inventory." 108.1 The IRS reasoned that §751 not only converts part of a selling partner's gain from capital gain to ordinary income but also requires treating the partner as the direct seller of the assets which give rise to ordinary income. Because §453(b)(2)(B) denies use of installment reporting for personal property that a taxpayer includes in its inventory, the IRS concluded that, under §751, the selling partner is the direct seller of the appreciated inventory that produces ordinary income and therefore cannot report this income on the installment method. Although §751 itself only requires the conversion of a portion of a selling partner's capital gain to ordinary income, the IRS cited the legislative reports from the enactment of §751 for authority that Congress intended the statute to give the transferor partner "the same tax consequences which would be accorded an individual entrepreneur." For sales of partnership interests after August 5, 1997, the selling partner must report ordinary income for the portion of gain attributable to any partnership inventory, not just "substantially appreciated inventory." 108.2 The reasoning of Rev. Rul. 89-108 should, therefore, deny installment reporting to any gain attributable to inventory.
108.1See Rev. Rul. 89-108, 1989-2 C.B. 100; former §751(a)(2).
108.2§751(a)(2).
d.	Holding Period of Partnership Interest
As mentioned above, a partner may recognize long-term or short-term capital gain or loss, or both, on the disposition of a partnership interest. Whether the capital gain or loss is long-term or short-term depends on the partner's holding period of the partnership interest.
Under the holding period rules applicable to assets (including partnership interests) in general,108.3 the holding period of a partner who acquired a partnership interest by purchase (or is deemed to have acquired it by purchase) is the period for which the partner has held the partnership interest. If the partner acquired the interest by purchasing it from an existing partner, for instance, the acquiring partner's holding period begins at the time of the purchase. If the partner received the partnership interest in return for services and the partner is deemed to have purchased the interest,108.4 the partner's holding period for the interest begins when the partner acquired the interest. Likewise, if a partner's contribution of cash to a partnership in exchange for an interest in the partnership is considered a purchase of the interest,108.5 the partner's holding period begins as of the date of the deemed purchase.
108.3See §1223.
108.4See §707(a)(2)(A).
108.5See §707(a)(2)(B).
A partner who contributes certain kinds of property described below to a partnership in exchange for a partnership interest, however, may be able to "tack" the partner's holding period for the contributed property onto the partner's holding period for the partnership interest. In other words, the partner's holding period of the partnership interest includes the period for which the partner held the property transferred to the partnership.108.6
108.6§1223(1). Similarly, the partnership continues the partner's holding period for the assets received. §1223(2); Regs. §§1.723-1, 1.1223-1(b).
The tacking rules apply to contributions to both newly formed and continuing partnerships.108.7 Therefore, it is possible for a partner in a newly formed partnership to be deemed to have held a partnership interest from a time before the partnership was created.
108.7See §1223(1),  (2).
A partner can only tack holding periods, however, with respect to the following types of property contributed:108.8
• a capital asset;108.9 or
• §1231 property (i.e., property used in a trade or business that has been held for more than one year), including recapture property, but not to the extent that the §1231 property is attributable to inventory or other ordinary income assets.
 In addition, tacking is only permitted if the partner's contribution of a capital asset or §1231 property was a nonrecognition transaction.108.10 Therefore, if the partner recognized gain on the contribution because the partnership is an investment company, the partner cannot tack holding periods.
108.8§1223(1).
108.9"Capital asset" is defined in §1221.
108.10§1223(1); Regs. §1.1223-1(a).
If a taxpayer who already owns an interest in a partnership makes a contribution of property, or a partner acquires a partnership interest by simultaneously contributing property subject to tacking and property not subject tacking, the partner has more than one holding period in the partner's partnership interest. Divided, or "split," holding periods in a partnership interest are discussed in II, G, 7, below.
C. Non-Taxable Dispositions
As mentioned previously, the same types of dispositions of assets generally resulting in gain or loss recognition also result in gain or loss recognition where the asset disposed of is a partnership interest. The same statement may also be made in the case of a non-taxable disposition. To the extent that a nonrecognition provision of the Code applies to a disposition generally, nonrecognition of gain or loss should also apply to a similar disposition of a partnership interest. An exception to this statement is nonrecognition under §1031which does not, by the terms of the statute, apply to exchanges of partnership interests. The only unique aspect of dealing with an interest in a partnership in the nonrecognition context relates to the amount of liabilities from which a partner is deemed to be relieved in connection with a disposition of a partnership interest. The liability relief could, in turn, result in gain recognition to the partner disposing of his interest notwithstanding the general rule deferring gain or loss recognition.
1.	Contribution to Controlled Corporation
A contribution of a partnership interest to a corporation in exchange for stock in the corporation is tax-free to the transferring partner under §351as long as the requirements of that provision of the Code are met.109 In order to qualify for §351 treatment, the transferring partner alone, or together with other contributors of the partnership interest to the corporation, must be in control of the corporation immediately after the contribution.110 Control means at least 80% of the voting power of the corporation and at least 80% of the total number of shares of all non-voting stock.111 Under §362, the corporation's basis in the partnership interest contributed to it under §351 is generally equal to the transferor partner's basis in the interest prior to the contribution.
109See Rev. Rul. 84-111, 1984-2 C.B. 88. Prior to the amendment of §351(a) by the Revenue Reconciliation Act of 1989, P.L. 101-239, a contribution of property to a controlled corporation in exchange for debt securities also qualified for nonrecognition under §351. §7203(a) of the 1989 Act deleted the words "or securities" from §351(a).
110Section 351(a). The recipient corporation also recognizes no gain or loss upon its receipt of a partnership interest in exchange for stock in the corporation under §1032.
111§368(c). A contribution of a partnership interest to a corporation without the transferor receiving stock or other property for the contribution should not result in gain or loss recognition to the corporation or the transferor under §118 (contributions to capital).
An exception to §351 nonrecognition applies if the amount of the contributing partner's share of partnership liabilities that the transferee corporation assumes exceeds the partner's basis in the partnership interest. In that event, gain on the exchange is required to be recognized by the transferor partner to the extent of the excess of debt assumption over basis.112 Section 752 and the arcane morass of regulations promulgated under §752 determine each partner's share of partnership liabilities. Those rules must be referred to in determining a partner's debt relief in the context of a transfer of a partnership interest in a nonrecognition transaction. A thorough discussion of those regulations is beyond the scope of this portfolio.
112§357(c). Under §357(d), a transferee is generally treated as assuming a recourse liability to the extent the transferee agrees to assume the liability and is expected to satisfy it, while a nonrecourse liability is generally treated as assumed only if the assets subject to the liability are transferred. However, the IRS is considering conforming the rules for assumptions of nonrecourse liabilities to the rules for assumptions of recourse liabilities. See REG-100818-01, 68 Fed. Reg. 23931 (5/6/03).
Section 357(b) may also require gain recognition in the transfer of a partnership interest otherwise qualifying for nonrecognition under §351. Section 357(b) applies if, "taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption was made," a principal purpose of the transferor partner in having the corporate transferee assume partnership liabilities was tax avoidance, or the assumption did not have a bona fide business purpose. If §357(b) applies, the full amount of the debt assumption is treated as boot, with the resulting gain recognition. In the blatant case in which a partnership liability is incurred shortly before a purported §351 contribution of a partnership interest, and the debt proceeds are distributed to the transferring partner before the exchange, the IRS is likely to assert that §357(b) requires gain recognition to the full extent of the transferor partner's share of partnership liabilities.
2.	Contribution to Another Partnership
A partner's contribution of a partnership interest to a second partnership in exchange for an interest in the second partnership qualifies for nonrecognition of gain under §721. The partner's basis in his interest in the recipient (upper-tier) partnership will generally be equal to his basis in the contributed (lower-tier) partnership interest prior to the transfer.113 The upper-tier partnership has no gain or loss recognition114 and its basis in its interest in the lower-tier partnership is equal to the contributor's basis in that interest prior to the contribution.115
113§722.
114§721(a).
115§723.
As one might expect, an exception to nonrecognition by the contributing partner may apply if his share of partnership liabilities associated with the contributed interest is excessive in relation to his basis in the contributed partnership interest. To the extent that the contributing partner is considered to receive a cash distribution from the recipient upper-tier partnership due to the contributor's being relieved of his share of debt of the lower-tier partnership, the partner has taxable gain, under §§752 and 741, arising from the contribution. Under §752(b), a decrease in a partner's share of partnership liabilities is considered to be a cash distribution from the partnership. §752(a) provides that an increase in a partner's share of partnership liabilities is considered to be a capital contribution from the partner to the partnership. Where a partner contributes an interest in a partnership with liabilities to an upper-tier partnership in return for an interest in the upper-tier partnership, an issue arises as to whether the contributing partner's debt relief on the contribution should be netted against his debt assumption related to his interest in the upper-tier partnership. Whether netting is available will determine whether and to what extent gain will be recognized by the contributing partner in connection with the contribution of the partnership interest.
Example: Partner B is a 20% partner in partnership ABC, and B's basis in his partnership interest, including his share of partnership liabilities, is $500. ABC has liabilities of $5,000, and, under the §752 regulations, B's share of ABC liabilities is 20%, or $1,000. B, therefore, has a negative capital account of $500. If B contributes his interest in ABC for a 50% interest in new partnership AD, which has no liabilities other than those associated with its interest in partnership ABC, whether B will recognize gain on the contribution depends on whether B's debt relief under §752(b) from his partnership liabilities in ABC is netted against his debt assumption in partnership AD under §752(a). If netting is not available, B will have $500 of taxable gain arising from the contribution ($1,000 cash deemed to be received under §752(b) less B's $500 basis in ABC). If netting is available, B would have no taxable gain on the contribution since the debt relief from ABC debt ($1,000) less the debt assumption arising from AD's share of ABC debt ($500) equals B's basis in ABC immediately before the contribution.
Although there does not appear to be a clear answer on whether netting of debt relief and debt assumption is possible in this context, the view of the IRS apparently is that netting is permissible.116 Assuming netting is permissible, a partner's basis in his interest in the recipient upper-tier partnership will be equal to his basis in the contributed partnership interest less the net debt relief.117
116See Regs. §1.752-1(f). The IRS has also permitted netting of debt relief under §752(b) and debt assumption under §752(a) in connection with a nonliquidating distribution of encumbered partnership property to a partner. Rev. Rul. 79-205, 1979-2 C.B. 255, amplified by Rev. Rul. 87-120, 1987-2 C.B. 161. See also Rev. Rul. 77-309, 1977-2 C.B. 216.
117Section 722 provides that the contributor's basis in his interest in the recipient partnership equals his basis for the contributed property. Under the netting approach described in the text, net debt relief would be treated as a cash distribution under §752. Under §733, a distribution reduces a partner's basis in his partnership interest.
Example: In the preceding example, assuming the debt relief and debt assumption may be netted, B's basis in his interest in partnership AD would be equal to his basis in ABC immediately before the contribution to AD ($500) less the net debt relief B is deemed to experience under §752 ($500). Thus, his initial basis in partnership AD would be $0.
Example: Assume, in the preceding example, that in addition to AD's $1,000 share of liabilities in ABC, AD also has $2,000 of liabilities that it incurred on its own behalf, of which $1,000 is B's share. In that case, B would have a net debt assumption of $500 ($500 net debt relief on contribution plus B's $1,000 share of unrelated AD debts). B's basis in AD would therefore be $1,000 ($500 basis in ABC plus $500 net debt assumption).
3.	Distribution by Partnership
A distribution of property other than money and marketable securities from a partnership to its partners generally results in no gain or loss recognition to the partnership or to the distributee partners.118 This rule generally does not change if the property distributed is an interest in another partnership.118.1 Thus, if partnership AB is a 40% partner in partnership ABC and AB distributes a 20% interest in ABC to each of AB's partners, no gain or loss would generally be recognized by AB or individuals A and B under §731(a) and  (b).
118§731.
118.1But see Regs. §1.460-4(k)(2)(iv)(A), T.D. 9137, 69 Fed. Reg. 42551 (7/16/04) (discussed in II, B, 1, e, above), which provides that the distribution by an upper-tier partnership of an interest in a lower-tier partnership that holds a long-term contract is a "constructive completion transaction," in which income from the long-term contract must be recognized.
There are several exceptions to this general rule of nonrecognition. First, as mentioned above, the rule of nonrecognition only applies if a partnership distribution is in property other than money. If money in excess of a partner's basis in the partnership interest distributed, the partner must recognize gain to the extent of the excess.119 Any reduction in the partner's share of partnership liabilities (through the debt being paid off or for any other reason) is treated as a distribution of money under §752(b). A question that has apparently not been definitively answered is whether a partnership's distribution of its interest in a subsidiary with liabilities in excess of the parent's basis in the subsidiary partnership causes the parent to recognize debt relief gain under §§731(a) and 752(b).
119§731(a)(1) and  (c)(1).
Example: In 1990, A contributed $25,000 for a 20% general partnership interest in AB and B contributed $100,000 for an 80% interest. AB, in turn, contributed $100,000 to ABC for a 33 1/3% limited partnership interest in ABC. In 1996, ABC purchased an office building for $1,500,000 by paying $300,000 down and incurring a $1,200,000 nonrecourse mortgage secured by the building. Under §752(a), AB is treated as contributing cash to ABC equal to AB's share of ABC's nonrecourse debt. Assume that AB's share of ABC debt is $400,000. Consequently, AB's basis in ABC is initially $500,000 ($100,000 cash contribution plus $400,000 share of nonrecourse debt). Under the rationale of Rev. Rul. 77-309,120 A and B each take into account their proportionate shares of AB debt for purposes of determining their basis in their respective partnership interests in AB. A's 20% share, therefore, gives him a $105,000 initial basis in AB ($25,000 cash contribution plus $80,000 share of debt) and B's initial basis is $420,000 ($100,000 plus $320,000).
Assume that ABC recognizes taxable losses of $600,000 through the end of 1998 and that it makes no distributions to its partners. AB's share of the ABC losses is $200,000 and, under §705, AB's basis in ABC is reduced to $300,000 ($500,000 original basis less $200,000 in losses). A and B share proportionately in AB's losses. A's 20% share is $40,000, which reduces his basis in AB to $65,000 and B's 80% share is $160,000, which reduces his basis in AB to $260,000.
If AB distributes its ABC interest proportionately to A and B (20% to A and 80% to B), the question is whether AB will be required to recognize gain under §752(b) due to the deemed cash distribution from ABC attributable to the ABC mortgage. When AB distributes its interest in ABC, it is deemed to receive a cash distribution equal to its share of ABC liabilities (which are assumed to be $400,000). Since AB's basis in ABC is only $300,000, the constructive cash distribution of $400,000 results in $100,000 of gain if §§752 and 731(a) are read literally.121 The $100,000 gain would flow through to A and B, who would have to report their proportionate share of the gain on their individual returns. However, gain recognition does not make sense in this situation. The economic position of A and B has not been changed by the distribution. They continue to share in ABC liabilities to the same extent that they did prior to the distribution (albeit indirectly before and directly after the distribution). The literal answer appears to be that AB has $100,000 of gain to be recognized, but the better, common sense view would be that no gain or loss should be recognized in this context.
1201977-2 C.B. 216.
121Netting of debt relief and debt assumption at the AB level that is permitted by Regs. §1.752-1(f) technically does not apply in this context because there is no debt increase.
If a partnership distributes an interest in a subsidiary partnership but the distribution is not proportionate with respect to the parent's partners, the tax results would be different even if one adopts the common sense, rather than the literal, approach to the application of §752.
Example: Assume, in the foregoing example, that AB distributes its entire interest in ABC to B. In that case, A would be relieved of $80,000 of ABC debt which would be deemed to be a cash distribution to him under §752(b). Since his basis is only $65,000 at the time of the deemed distribution, A would recognize a $15,000 gain under §731(a) in connection with the distribution to B. This would be in addition to A's share of AB's debt relief gain, illustrated in the preceding example, if one subscribes to the literal interpretation of §752(b). Perhaps this possibility of double counting gain recognition from debt relief in the context of a parent partnership's distribution of an interest in a subsidiary partnership is the best argument against requiring gain to be recognized at the AB level.
Another exception to the nonrecognition of gain rule in connection with a partnership's distribution of property is found in §751. If either a parent or a subsidiary partnership has §751 property, a disproportionate distribution by the parent of its interest in the subsidiary partnership could result in gain or loss recognition. This potential exception to nonrecognition of gain or loss is merely noted here since a detailed discussion of the intricacies of §751 is beyond the scope of this portfolio.122
122For a detailed discussion of §751, see 720 T.M., Partnership Transactions -- §751 Property.
Finally, in Rev. Rul. 93-7,122.1 the IRS concluded that §731(a) does not apply to a distribution of debt to the debtor partner in liquidation of that partner's partnership interest. In order to avoid the possibility that gain or loss with respect to the debt would permanently escape recognition upon the extinguishment of the debt, the IRS treated the partner in the ruling as if it exchanged all or a portion of its partnership interest for property in a taxable transaction.
122.11993-2 C.B. 125.
4.	Gift of Partnership Interest
A gratuitous transfer of an asset generally results in no gain or loss recognition to the transferor.123 An exception to this rule may come into play in the case of a gift of an asset encumbered by a liability if the donee assumes the liability or acquires the asset subject to the liability.
123Of course, a gift of an asset has gift tax consequences to the transferor aside from the income tax consequences.
If the liability exceeds the donor's adjusted basis in the gifted property, the gift is characterized as part gift and part sale. Gain must be recognized by the donor to the extent that the liability exceeds the donor's basis.124 A loss is never available in the gift context, however.125
124Regs. §1.1001-1(e); Diedrich v. Comr., 457 U.S. 191(1982), aff'g 643 F.2d 499 (8th Cir. 1981), rev'g T.C. Memo 1979-441.
125Regs. §1.1001-1(e).
The same rule that applies to gifts generally applies to a gift of a partnership interest. If the partnership has no liabilities (or if the donor partner has no share of partnership liabilities under the rules of §752), a gift of an interest in the partnership is not subject to income tax. However, if the partnership interest is subject to a liability, or if the donor partner has a share of partnership liabilities under §752, a gift of the partnership interest will be treated as part gift and part sale. If the liabilities exceed the donor's basis in the gifted partnership interest, the donor will be required to recognize taxable gain to the extent of the excess.126
126§752(d). It is unclear from a literal reading of the Code whether §752(b) or §752(d) applies in the context of a gift of an interest in a partnership with liabilities. §752(b), which treats any decrease in a partner's share of partnership liabilities as a constructive distribution of cash from the partnership to the partner, literally applies in the gift context. §752(d), on the other hand, literally applies only in the case of a "sale or exchange" of a partnership interest and, therefore, would not technically apply in the case of a gift. The latter provision treats a partnership liability, upon the sale or exchange of a partnership interest, in the same manner as any other liability (i.e., not in the partnership context). While the application of §752(b) and  (d) should result in the same tax consequences to a donor of an entire partnership interest, application of §752(b) would be more favorable to the donor of a portion of his partnership interest where he has a share of partnership liabilities. However, the IRS has issued rulings which suggest that it views §752(d) as the governing provision. See Rev. Ruls. 75-194, 1975-1 C.B. 80 (applying §752(d) to determine the amount of gain recognized upon a charitable contribution of a limited partnership interest) and 77-402, 1977-2 C.B. 222 (applying §752(d) to determine the amount by which the transferor's share of partnership liabilities were reduced when he transferred a partnership interest to a trust). See also Goodman v. U.S., 2000-1 USTC ¶50,162 (S.D. Fla. 1999), in which the district court affirmed the position of Rev. Rul. 75-194. The court found that §1011(b) plainly applies to bargain sales to charities, including gratuitous transfers of encumbered property, such as this taxpayer's donation of a partnership interest. Consequently, the court held that the taxpayer could not offset her distribution gain arising from her share of partnership liabilities by her full basis in the donated interest, but only by the portion allocable to the bargain sale under §1011(b).
Example: A is a 1/3 partner in partnership ABC, and A's adjusted basis in his partnership interest is $1,000. ABC has no liabilities. If A makes a gift of his partnership interest to his son, S, no income tax consequences result from the gift.
Assume, alternatively, that ABC has liabilities of $6,000 of which $2,000 is A's share under the §752 regulations. If A's adjusted basis in his partnership interest is $1,000, after taking his $2,000 share of partnership liabilities into account, a gift of A's interest to S of the partnership interest will result in $1,000 of taxable gain to A.
The character of a donor partner's gain from debt relief is determined under the ordinary income and loss principles discussed at II, B, 2, b, above (capital gain except as provided in §751).
5.	Charitable Contribution of Partnership Interest
A sale of property to a charity for an amount less than the fair market value of the property triggers the bargain sale rules of §1011(b). In general, under these rules the donor is entitled to a charitable contribution deduction equal to the difference between the value of the property and the sales price.127 The donor also must allocate a portion of his basis in the donated property to the sale portion of the bargain sale and recognize taxable gain on the difference between the sales price and the allocated basis.
127Regs. §1.170A-4(c).
The IRS has ruled that a charitable contribution of a partnership interest is subject to the bargain sale rules of §1011(b) if the partnership has liabilities in which the donor has a share.128 Under these rules, the donor has an amount realized equal to his share of partnership liabilities attributable to the donated interest. The partner's basis in the donated interest is allocated to the sale portion in the same ratio as the liabilities bear to the fair market value of the donated interest.
128Rev. Rul. 75-194, 1975-1 C.B. 80.
Example: Partner A in equal partnership ABC has a $2,000 basis in his partnership interest, which includes $1,500 in partnership liabilities allocable to A. The value of A's interest is $3,000 when he makes a charitable contribution of the entire interest to a public charity. Although A receives no consideration for the donation, the gift triggers the bargain sale rules of §1011(b) according to Rev. Rul. 75-194.129 A is therefore treated as having sold his partnership interest to the charity for an amount equal to A's share of partnership debt ($1,500). Subject to the limitations of §170, A would be entitled to a charitable contribution deduction of $1,500 (the difference between the value of the interest, $3,000, and A's debt relief, $1,500). A would also be required to recognize taxable gain equal to the difference between A's amount realized on the bargain sale ($1,500 debt relief) and A's adjusted basis allocated to the bargain sale ($2,000 basis × [$1,500 amount realized/$3,000 value] = $1,000 allocated basis). In addition to A's charitable contribution deduction, A, therefore, must recognize a $500 gain from the bargain sale of his partnership interest.
1291975-1 C.B. 80.
Note that if a partner's share of partnership liabilities is equal to or exceeds the fair market value of his partnership interest at the time of a charitable contribution of the interest, the bargain sale rules of §1011(b) do not apply. In that case, there is no bargain sale since the amount realized by the donor partner would be equal to or in excess of the value of the donated partnership interest. The rules that apply to a noncharitable gift of a partnership interest discussed in II, C, 4, above, would also apply to a charitable contribution of a partnership interest in those circumstances. In addition, since the charity would be considered to have paid an amount that is equal to or in excess of the value of the partnership interest due to its assumption of the donor's share of partnership liabilities, the donor would not be entitled to a charitable contribution deduction under §170.
Example: In the preceding example, assume that the value of A's interest in ABC is $750, rather than $3,000, but that all other facts are the same. A would, therefore, be treated as receiving $1,500 (his share of ABC liabilities) from the charity for his partnership interest that is worth $750. No charitable contribution deduction would be available and the noncharitable gift rules would apply. Since A's basis ($2,000) in the donated interest exceeds his share of partnership liabilities ($1,500), no taxable gain would arise from the gift but the $500 loss could not be recognized. If, on the other hand, A's basis is $750, his share of partnership debt remains $1,500, and the value of the interest is $750, A would have a $750 gain on the donation under the gift rules discussed above ($1,500 debt relief minus $750 basis).
6.	Gift or Charitable Contribution of Interest in Partnership Owning Installment Note
The IRS has ruled, on at least one occasion, that a charitable contribution of a partnership interest triggers unrecognized installment sale gain to the donor if the partnership owns installment notes reported under §453 at the time of the charitable contribution.130 At least one district court has held similarly in the case of a gift of a partnership interest.131 Under this line of reasoning, a donor partner's share of unrecognized partnership installment gain must be subjected to tax upon a charitable donation or gift of an interest in the partnership.
130Rev. Rul. 60-352, 1960-2 C.B. 208.
131Tennyson v. U.S., 76-1 USTC ¶9264 (W.D. Ark.1976).
Example: Partner A has a 1/3 interest in partnership ABC. A's basis in his interest is $10,000, and the interest has a value of $200,000. The partnership has no liabilities, and its assets consist of a parcel of undeveloped real estate with a current value of $300,000 and an adjusted basis to ABC of $30,000. The partnership also owns an installment note with a face amount and value of $300,000 that arose from the partnership's sale of another parcel of undeveloped real estate that had a zero basis in the hands of the partnership. Assume that the note calls for monthly payments of interest only at a market rate for a period of five years, at which time the full $300,000 face amount of the note becomes payable in full.
If A makes a charitable contribution of his 1/3 interest in ABC or makes a gift of the interest, the IRS, if it continues to adhere to the view expressed above, would claim that A's share of the gain inherent in the partnership installment note is subject to income tax in A's hands. Thus, A would be required to include $100,000 in taxable income upon a charitable donation or gift of the partnership interest.
Comment: In the author's view, the IRS has little, if any, statutory, regulatory or other precedential authority for its position that partnership installment gain is triggered upon a gift (charitable or otherwise) of an interest in the partnership. Nothing in Subchapter K or in the installment sale rules of §§453 and 453Bwarrants a conclusion that the installment gain is triggered. Nevertheless, until Rev. Rul. 60-352 is formally revoked, potential donors of partnership interests should be wary if the partnership owns installment notes.
7.	Transfer of Partnership Interest Upon Death
Upon the death of a partner, his partnership interest passes to his successors in interest. Usually the partnership interest of a deceased partner passes to the administrator of his estate, but in some circumstances it may pass to a successor named in his will as long as the other partners have agreed to the transfer under the governing partnership agreement or in an amendment to the partnership agreement.132 Although, as discussed at II, C, 4-6, above, other forms of gratuitous transfers of partnership interests may result in the realization of taxable income to the donor partner, the same is not the case upon a transfer at death of a decedent partner's interest in a partnership.133 Consequently, regardless of the level of partnership indebtedness or whether the partnership owns installment notes with unrecognized gain inherent in the notes, a transfer of a partnership interest upon the death of a partner does not result in gain from the disposition. Pre-death partnership income is taxable to the decedent's successors,134 but no gain is recognized from the transfer itself.
132See 716 T.M., Partnership Distributions; Death or Retirement of a Partner, for a thorough discussion of the consequences to all relevant parties upon the death of a partner.
133Since Regs. §1.752-1 and §752(d) treat partnership liabilities in the same manner as liabilities in the non-partnership context in the case of a disposition of a partnership interest, Crane v. Comr., 331 U.S. 1(1947), aff'g 153 F.2d 504 (2d Cir. 1945), rev'g 3 T.C. 585 (1944), nonacq., 1945 C.B. 8, supplies the necessary authority for exempting a transfer of a partnership interest upon the death of a partner from taxation even where the decedent's share of partnership liabilities exceeds his basis in the partnership interest.
134See 716 T.M., Partnership Distributions; Death or Retirement of a Partner.
8.	Conversion of General Partnership Interest to Limited Partnership Interest (or Vice Versa)
A conversion of a general partnership interest into a limited partnership interest or a conversion of a limited partnership interest into a general partnership interest alters the legal relationship among the partners. A general partner is personally liable for partnership liabilities in the event the partnership does not have the wherewithal to meet its obligations. A limited partner, on the other hand, is generally liable for partnership debts only to the extent of the limited partner's actual contributions to the partnership plus the amount, if any, that the limited partner has specifically agreed to contribute to the partnership in the future. A general partner generally has the right to participate in management of the partnership and the right to dissolve the partnership. A limited partner has a right to participate in management only in limited circumstances and generally does not possess the right to dissolve the partnership.
Thus, although there is generally no physical exchange of interests,135 as would be the case in an exchange of shares of stock in a corporation, a conversion of one type of interest in a partnership for another type of interest in that same partnership is an exchange. Unlike an exchange of a partnership interest for an interest in another partnership, which is a taxable transaction regardless of whether both interests are limited or general partnership interests,136 an exchange of one type of interest for another type of interest in the same partnership will in most cases be tax-free.
135A conversion of a general partnership interest into a limited partnership interest (or vice versa) in the same partnership is generally accomplished by amending the partnership agreement and by amending the certificate of limited partnership that is generally required to be on file with a state authority under the relevant state's version of the Uniform Limited Partnership Act. Additional filings and steps may be required if a general partner becomes a limited partner in what has, up until the conversion, been a general partnership.
136See II, B, 1, c, above, for a discussion of taxable exchanges of an interest in a partnership for an interest in another partnership.
In Rev. Rul. 84-52,137 the IRS concluded that a conversion of a general partnership interest into a limited partnership interest in the same partnership is governed by §721. The IRS also ruled that the converse (exchange of limited into general partnership interest) would also be covered by §721. Section 721 provides that no gain or loss is recognized by either the contributing partner or the partnership upon a contribution of capital in return for a partnership interest. Therefore, no gain or loss is recognized in a conversion of one interest into another in the same partnership (other than gain resulting from a constructive distribution of cash arising from liability relief under §752(b), as discussed below). See, e.g., PLR 200345007.
1371984-1 C.B. 157. See also PLR 9324011 (conversion of limited partnership reorganized as a state trust and classified as a partnership).
In Rev. Rul. 95-55,137.1 the IRS cited Rev. Rul. 84-52 in addressing the conversion of a New York general partnership, in the business of providing professional services, into a New York Registered Limited Liability Partnership (RLLP). Generally, under New York law, the liability of partners in an RLLP is limited to (1) any negligent or wrongful act committed by that partner or by someone under that partner's direct supervision or control, or (2) specific liabilities of the partnership as agreed by at least a majority of the partners. Relying on Rev. Rul. 84-52, the IRS ruled that the partnership's registration as an RLLP would not cause it to terminate where, after the conversion, each partner's percentage interest in the partnership's profits, losses, and capital remained the same, and the business of the general partnership continued to be carried on.
137.11995-35 I.R.B. 13. In the ruling, the IRS noted that the partnership must use the same method of accounting it used before its registration as an RLLP, unless it secured IRS consent to a change. See also PLR 9630012.
Although the facts of Rev. Rul. 84-52 were that converting partners retained the same percentage share of partnership profits, losses, and capital after the conversion as they had prior to the conversion, altering this factor will not necessarily be fatal to nontaxability. If a converting partner's percentage interest in the partnership is reduced due to the partnership's admission of new partners in consideration for a cash or other property contribution, the conversion should continue to be tax-free. Similarly, if the partnership liquidated one or more partners' interests at the time of a conversion, resulting in an increase in the converting partner's percentage interest, §721 should treat the conversion as tax-free.
If, on the other hand, the converting partner receives a distribution from the partnership of cash or other property at the time of the conversion, the distribution may be taxable under §731.138 A reduction of a converting partner's percentage interest, together with a distribution from the partnership at or near the same time as the admission of a new partner for a capital contribution, could also be recharacterized by the IRS as a direct sale of a portion of the converting partner's interest to the newly admitted partner under §707(a)(2)(B), resulting in gain or loss recognition.
138See 716 T.M., Partnership Distributions; Death or Retirement of a Partner.
A conversion of a partnership interest may also result in a constructive cash distribution, resulting in gain recognition to the converting partner, if there is a reduction in his share of partnership debt resulting from the conversion. Under Regs. §1.752-2 only general partners share in partnership recourse liabilities. No portion of partnership recourse liability is generally shared by limited partners.139 A partner whose interest is converted from a general to a limited partnership interest could, therefore, be deemed to receive a constructive cash distribution resulting in gain recognition if the partnership has recourse liabilities at the time of the conversion. If the partner's share of partnership recourse liabilities exceeds his adjusted basis in his interest at the time it is converted from a general to a limited partnership interest, the partner will have gain to the extent of the excess. Section 752(b) treats the reduction as a cash distribution, and the cash distribution results in gain to be recognized under §731(a) to the extent it exceeds the partner's basis in his interest immediately before the conversion.
139Limited partners may share in recourse liabilities to the extent of their obligation to contribute additional capital to the partnership. See Regs. §1.752-2(b).
9.	Converting a Partnership into a Limited Liability Company
The reasoning of Rev. Rul. 84-52,139.1 has been applied to other types of partnership conversions as well. Generally, the conversion of a partnership into another entity that is classified as a partnership for federal tax purposes will not result in the termination of the partnership.
139.11984-1 C.B. 157.
The IRS has issued various rulings on the tax treatment of a partnerships converting into limited liability companies (LLCs).139.2 Where an LLC is classified as a partnership for federal tax purposes, the situation is analogous to the conversion of a general partnership into a limited partnership. Accordingly, such conversions are treated as §721 exchanges, which, under Regs. §1.708-1(b)(2), do not result in a termination of the partnership. The conversion does not result in the termination of the partnership's taxable year and the LLC is not required to obtain a new taxpayer identification number.139.3 Except as provided in §752, no gain or loss is recognized by either entity or by the partner-members, and the partner-members' capital accounts remain the same after the conversion.139.4
139.2Rev. Rul. 95-37, 1995-1 C.B. 130 (conversion of domestic partnership into an LLC); PLRs 9432018, 9443024, 9511003, 9525058, 9618021, 9618022, 9618023, 199935065, 200414013.
139.3Rev. Rul. 95-37, 1995-17 I.R.B. 10.
139.4See, e.g., PLR 200414013.
10.	Tax-Free Reorganization of Corporation Owning Partnership Interest
The many intricacies of the rules relating to tax-free corporate reorganizations are beyond the scope of this portfolio. Nevertheless, the reader should keep in mind that certain, but not all, types of tax-free reorganizations will involve an exchange of assets owned by the reorganized corporation prior to the reorganization. Consequently, a corporation that owns an interest in a partnership at the time it is reorganized in a tax-free reorganization may be involved with an exchange of the partnership interest, depending on what type of tax-free reorganization the transaction falls within. For that reason, the rules relating to reorganizations are briefly summarized here.140
140For an indepth discussion of reorganizations, see 771 T.M., Corporate Acquisitions -- (A), (B), and (C) Reorganizations; 772 T.M., Corporate Acquisitions -- (D) Reorganizations; and 774 T.M., Single Entity Reorganizations: Recapitalizations and F Reorganizations. See also Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, (6th ed. 1994) Chapter 12, for additional discussion of corporate reorganizations.
A corporation that merges into another corporation in a statutory merger that qualifies as a "Type A" reorganization involves a transfer of assets from the merged corporation to the surviving corporation.141 A Type C reorganization (voting stock of transferee exchanged for assets of transferor), a Type D reorganization (transfer of assets to controlled corporation followed by distribution of stock or securities in controlled corporation to shareholders of controlling corporation), and a Type G reorganization (transfer of assets in bankruptcy or similar proceedings) would all involve a disposition of a partnership interest if the transferor corporation in the reorganization owns a partnership interest. Type B (voting stock exchanged for voting stock) and Type E (recapitalization) reorganizations would not involve an exchange of a partnership interest since neither involves an asset transfer. A Type F reorganization (mere change in identity, form or place of incorporation) also does not result in an exchange of a partnership interest owned by the reorganized entity, according to the IRS.142
141The various types of corporate reorganizations are described in different clauses of §368(a)(1) and are referred to by the clause designation in which they are described. Thus, a "Type A" reorganization is described in §368(a)(1)(A), a "Type B" reorganization is described in §368(a)(1)(B), etc.
142Rev. Rul. 87-110, 1987-2 C.B. 159.
An exchange of a partnership interest by the corporate transferor in a reorganization would generally not result in gain or loss recognition to the transferor under §361. Two narrow exceptions to this rule may apply if the corporate partner has a share of partnership liabilities. In order for the first exception from nonrecognition to apply, the partnership's incurring of debt would either have to be for tax avoidance purposes in connection with the corporate partner's participation in a reorganization or must have been without a business purpose.143 The determination of tax avoidance or lack of business purpose relating to the partnership's liabilities is made based on all facts and circumstances.144 Either circumstance would probably be relatively rare. It could arise, for example, where the corporate partner effectively controls management of the partnership, causes the partnership to incur debt, and finally distributes at least a portion of the debt proceeds to the corporate partner in anticipation of the reorganization of the corporate partner, all with a view to tax avoidance.
143§357(b).
144Whether a business purpose for incurring the debt exists should be determined at the partnership, rather than the partner, level since the transferee of a partnership interest essentially takes the interest subject to any existing partnership liabilities by operation of law. That is, a transfer of a partnership interest will be subject to partnership debt regardless of whether the transferee wants to acquire the interest, or whether the transferor wants to transfer the interest subject to partnership debt. Consequently, a determination that the partnership incurred the debt for a legitimate business purpose of the partnership should satisfy the business purpose requirement.
The second instance in which partnership debt would cause gain recognition in a corporate reorganization context would arise where the corporate transferor partner's share of partnership debt exceeds its basis in its partnership interest and it transfers the interest in a Type D reorganization.145 In that case, the partner's taxable gain would be the amount of liabilities in excess of basis.
145§357(c). Note that this section was amended by §3001 of the 1999 Miscellaneous Trade and Technical Corrections Act, P.L. 106-36, effective for transfers after Oct. 18, 1998. Generally, the distinction between assuming liabilities and acquiring property subject to liabilities has been eliminated. Instead, a determination of the amount of liability assumed is made based on whether the liability is recourse or nonrecourse. For further discussion of these amendments, see 758 T.M., Transfers to Controlled Corporations: In General.
11.	Conversion of Partnership to Corporation Under "Formless Conversion Statute"
A state "formless conversion" statute may allow an unincorporated entity classified as a partnership for federal tax purposes to convert to a corporation without requiring an actual transfer of the unincorporated entity's assets or interests. The IRS ruled in Rev. Rul. 2004-59145.1 that the following steps are deemed to occur in such a conversion: (1) the unincorporated entity is treated as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation; and (2) immediately thereafter, the unincorporated entity is treated as liquidating and distributing the stock of the corporation to its partners. For federal tax purposes, the IRS explained, a partnership that converts to a corporation under a state law formless conversion statute should be treated in the same manner as one that elects under Regs. §301.7701-3(c)(1)(i) to be treated as an association. Regs. §301.7701-3(g)(1)(i) provides that such a partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association and, immediately thereafter, to liquidate and distribute the stock of the association to its partners. The IRS explicitly ruled in Rev. Rul. 2004-59 that Rev. Rul. 84-111,145.2 discussed above in the context of an actual contribution of a partnership interest to a controlled corporation, does not apply to a conversion under a state law formless conversion statute.
145.12004-24 I.R.B. 105.
145.21984-2 C.B. 88.
D. Partnership Profit or Loss in Year of Disposition
1.	Closing of Partnership Taxable Year
Three events cause a premature closing of a partnership's taxable year: (1) a termination of the partnership under §708; (2) a sale or exchange of a partner's entire interest in the partnership; and (3) a liquidation of a partner's entire interest in the partnership.146 A termination causes the partnership's taxable year to close with respect to all partners.147 However, the sale, exchange or liquidation of a partner's entire interest closes the partnership's taxable year with respect to that partner only.148 A termination of a partnership is discussed elsewhere in this portfolio.149 Liquidation of a partner's interest is beyond the scope of this portfolio.150 This portion of the portfolio therefore discusses a closing of the partnership's taxable year with respect to a sale or exchange of a partner's entire interest in the partnership.
146§706(c)(2).
147Regs. §1.706-1(c)(1).
148§706(c)(2)(A).
149See discussion at Parts V and VI, below.
150See 716 T.M., Partnership Distributions; Death or Retirement of a Partner, for a discussion of the tax aspects of a liquidation of a partner's partnership interest.
a.	Bunching of Income
The significance of whether the partnership's taxable year closes with respect to a partner relates to the possibility of "bunching" as much as 23 months of partnership income or loss into a single year's tax return of the partner with respect to whom the partnership's year closes. As discussed in II, D, 1, b, below, the actual amount of partnership income or loss ultimately included by a partner who disposes of all or a portion of his interest is the same whether or not the partnership's year closes. Therefore, the significance is timing, with the possibility of bunching.
The potential for bunching of income from the termination of a partnership's taxable year arises only if the selling partner and the partnership have different taxable years. No bunching will occur if both have the same year end.151
151The incidence of partners with tax years that are different from their partnership was curtailed significantly with the amendment of §706(b) by the 1986 TRA, P.L. 99-514.
Example: Partner A individually and partnership ABC are both calendar year taxpayers. If A, who owns less than 50% of the partnership, sells his entire interest to D on June 30, 1992, the partnership's taxable year closes with respect to A on that date under §706(c)(2)(A). No bunching of ABC income is possible in this case. A will report six months of 1992 partnership income on his individual 1992 return for the period Jan. 1 through June 30. Partnership income for July 1 through Dec. 31, 1992 for A's interest will be picked up by D.
Assume, alternatively, that the partnership is a calendar year taxpayer and that A's tax year-end is June 30. In that case, A will be required to include 17 months of partnership income or loss on his individual return for the period ending June 30, 1992. This result is due to the language of §706(a), which requires the partners to include partnership income or loss in the "taxable year of the partnership ending within or with the taxable year of the partner." Consequently, A would include on his June 30, 1992, individual return a full year of partnership income for the period Jan. 1, 1991, through Dec. 31, 1991, since the partnership's calendar year ended within A's tax year beginning July 1, 1991. A will also be required to include an additional six months of ABC income for the period Jan. 1, 1992, through June 30, 1992, because the partnership's year closes with respect to A upon his sale of his entire interest to D on that date. Seventeen months of partnership profits or losses are therefore included in A's June 30, 1992, return.
The bunching to A would be even more dramatic if the partnership's year-end is July 31 rather than Dec. 31. In that case, A's sale of his entire partnership interest on June 30, 1992, would result in 23 months of partnership profits or losses being bunched into his June 30, 1992, return. A would include 12 months of partnership profits or losses for the period Aug. 1, 1990, through July 31, 1991, and an additional 11 months of partnership income or loss for the period Aug. 1, 1991, through June 30, 1992.
The adverse consequences that may result from the closing of the partnership's taxable year can be avoided with relatively simple tax planning. The simplest method is to cause the sale to occur on the last day of the partnership's taxable year. In that case, no bunching will occur because the partnership's taxable year will close with respect to the seller on the same day it would have closed in the absence of the sale. Thus, only the normal 12 months of income or loss will be included in the seller's return for his tax year that includes the date of sale.
Sometimes, however, business exigencies will not allow the date of sale to coincide with the partnership's year end. Bunching may be avoided in that event with another planning technique. The selling partner could sell most of his interest to the purchaser before the partnership's year-end and sell the remaining portion on the last day of the partnership's taxable year.152 Since the partnership's tax year closes with respect to the seller only upon the sale or exchange of his entire interest, this technique avoids closing the partnership's tax year for the seller at other than the partnership's regular year-end.
152Support for the position that a sale of less than all of a partner's interest prior to the partnership's year-end, followed by a sale of the remaining portion at the normal year-end, prevents a premature closing may be found in certain private letter rulings. PLR 8517022 concluded that a transfer of a 49% interest in partnership capital and profits to a corporation in a §351 exchange for stock did not cause a termination of the partnership resulting in closing of its taxable year even though one year and one day later an additional 1% was also exchanged for stock. PLR 7952057 concluded similarly upon a §351 exchange of 49.5% of partnership profits and capital followed by an exchange of the remaining 0.5% to the corporation for corporate stock one year and one day later. See also TAM 8851004. These rulings have a slightly different context since they involve the issue of whether a termination due to a sale or exchange of a 50% or more interest in a partnership within 12 months may be avoided by spreading the exchange of the requisite percentage interest. Nevertheless, the termination rulings demonstrate the formalistic approach adopted by the IRS in the sale or exchange of a partnership interest setting and therefore provide support for the position that a sale of less than all of a partner's interest does not meet the §706(c)(2)(A)(i) requirement for premature closing of the partnership's year with respect to the selling partner.
Example: Partner A has a 25% interest in partnership ABC. The partnership has a Jan. 31 year-end, and A is a calendar year taxpayer. D wishes to purchase A's interest but is willing to do so only if the purchase occurs on Dec. 31, 1992. If A sells his entire interest on that date, it will cause 23 months of ABC income or loss to be included in A's 1992 calendar year return -- 12 months for the period Feb. 1, 1991, through Jan. 1, 1992, plus 11 months for the period Feb. 1, 1992, through Dec. 31, 1992.
This may be avoided by A selling 24% (all but 1%) of his interest on Dec. 31, 1992, and selling the remaining 1% to D on Jan. 31, 1993. Since the partnership's year will not close when A sells less than his entire interest, closing the partnership's year with respect to A will be deferred until its normal closing on Jan. 31, 1993.
In order for this technique to be effective, the formalities of two separate sales must be followed. The seller must be entitled to his percentage share of partnership profits (or losses) for the interest retained through the date of sale of the remaining interest. It would be advisable for two separate amendments to the partnership agreement (if necessary under local law to permit the sale) to be drafted and signed by the partners acknowledging the first and, subsequently, the second transfer.
b.	Dispositions Causing Closing of Partnership Year
The parameters of the types of dispositions that will cause the partnership's year to close, with the resulting possibility of bunching, have not been drawn. The language of the statute and regulations is that a "sale or exchange"153 of a partner's entire interest causes a closing.
153§706(c)(2)(A); Regs. §1.706-1(c)(2)(i).
The regulations provide that a gift of a partner's entire interest in a partnership will not close the partnership year with respect to the donor.154 Clearly, a straight-forward cash sale of a partner's entire partnership interest would cause a closing. Additionally, a disposition of an entire interest that would be characterized as an exchange under federal income tax law, such as a contribution of a partnership interest to a corporation in exchange for stock in a §351 exchange, would also cause a closing. What about other dispositions not characterized as an exchange or a gift of the interest? For example, a dividend distribution of a corporation's entire partnership interest to its shareholders described in §301(c)(1) is not considered to be an exchange. Would the partnership year close as to the corporate partner when such a dividend is distributed? What about a distribution by an upper-tier partnership of its entire interest in a lower-tier partnership? Or what about an abandonment or forfeiture of a partner's entire interest in a partnership when the partnership has no liabilities that could cause the transaction to be characterized as a sale or exchange under §§751(b) and 731?
154Regs. §1.706-1(c)(5).
Whether a disposition of a partner's entire interest that does not constitute a sale, exchange or gift, causes the partnership year to close with respect to the disposing partner has apparently not been answered by the courts or the IRS. Reasonable arguments can be formulated for both sides of the issue. Due to this uncertainty, if adverse consequences could result from a premature closing of the partnership's year, a taxpayer should employ one of the techniques mentioned in II, D, 1, a, above, to avoid the closing if that is possible.
2.	Allocation of Share of Partnership Profits or Losses in Year of Disposition
a.	Rules Generally
The regulations provide that two methods are available for allocating items of partnership income, gain, loss and deduction between the transferor partner and his transferee: the interim closing of the books method and the proration method.155 The "standard" or "fallback" method is the interim closing of the books method. That is, unless the transferor partner and the remaining partners agree to use the proration method, the interim closing of the partnership's books method must be used.156 The transferee is required to claim the share of partnership income or loss attributable to the acquired interest that is not claimed by the transferor for the year of transfer.157 The transferee is therefore "stuck" with the choice made by the transferor partner and the remaining partners as to whether the interim closing of the books method or the proration method will apply in determining the transferee's share of partnership income or loss for the year of transfer.
155Regs. §1.706-1(c)(2)(ii).
156The regulations allow for an election between the interim closing of the books method and the proration method of allocating items of partnership income and expense between the transferor and transferee only in the case of a disposition of a partner's entire interest in a partnership. Regs. §1.706-1(c)(2)(ii). In the case of a disposition of only a portion of a partner's interest, however, the regulations are silent as to the allocation method to be used. In that case, the allocation is to be made "by taking into account . . . [the] varying interests in the partnership during the partnership taxable year in which such sale, exchange, or reduction of interest occurred." Regs. §1.706-1(c)(4). No other guidance is provided in the regulations or statute as to permissible allocation methods where a partial interest is disposed of. However, the legislative history to the changes made to §706(c) by the 1986 TRA indicates that the same methods should be available in the case of a partial disposition as in the case of a disposition of an entire partnership interest. See S. Rep. No. 938, 94th Cong., 2d Sess. 98 (1976). See also Regs. §1.460-4(k)(3)(v)(D), T.D. 9137, 69 Fed. Reg. 42551 (7/16/04), which provides that the "step-in-the-shoes" rules (under which one taxpayer's obligation to account for a long-term contract terminates and is assumed by another taxpayer) only apply to a transfer of an interest in a partnership holding a long-term contract if the partnership's books are "properly closed" with respect to the contract; otherwise, the partnership must allocate income or loss from the contract for the period before the transaction "under a reasonable method" complying with §706.
157Regs. §1.706-1(c)(2)(ii).
The method of allocating partnership income or loss between the transferor and the transferee is only relevant if the transfer occurs on other than the last day of the partnership's taxable year. The requirement to allocate income or loss between the transferor and transferee for a partial year is another reason (in addition to the bunching of income that may arise discussed in II, D, 1, a, above) for having the transfer occur on the last day of the partnership's taxable year.
Example: To illustrate the difference between the interim closing of the books method and the proration method of allocating income or loss between the transferor and the transferee, assume that A has a 30% interest in partnership ABC and that A sells his interest to D on June 30, 1992. A, D, and the partnership are all calendar year taxpayers. The mid-year sale will therefore not cause a bunching of more than 12 months of partnership income or loss into a single return of A. A has included 12 months of partnership income for calendar year 1991 in his 1991 individual return and will include six months of ABC partnership income on his 1992 return for the period Jan. 1 to June 30, 1992. The issue here is how to determine A's (and, therefore, D's) share of partnership income or loss for that period. Assume that the partnership has $100 of taxable income for the entire calendar year 1992 but that the $100 is comprised of a $200 loss for the first half of 1992 and $300 of income for the second half. Unless A and ABC have agreed to the proration method, the interim closing of the books method of allocation must be used. This requires that the partnership's books be closed as if June 30, 1992 was the last day of its taxable year and that A's share of ABC income or loss through that period be determined. Under this method, A's share of ABC income or loss for 1992 would be a $60 taxable loss (30% of the $200 loss). D would be required to include $90 of taxable income as his share of ABC income for 1992 for the period July 1 to Dec. 31, 1992 (30% of $300). If, on the other hand, A and the remaining partners agreed upon the proration method, A would include 1/2 of the partnership's taxable income allocated to the 30% interest in the partnership for the entire 1992 taxable year. A would, therefore, include $15 of taxable income ($100 partnership taxable income for 1992 × 30% × 1/2) as his share of 1992 partnership income and D would include the remaining $15 on his individual return.
According to the regulations, the method of proration between the transferor and transferee (if proration has been agreed to by the transferor and remaining partners) "may be based on the portion of the taxable year that has elapsed prior to the sale, exchange. . ., or may be determined under any other method that is reasonable."158 Clearly, if the transferor and the remaining partners agree to daily proration of partnership income, that would be permissible. Under the daily proration method, the transferor's share of partnership income is determined by calculating partnership income for the entire taxable year of the transfer and by assuming that 1/365 of that income or loss was earned by the partnership on every day of its year. The transferor's share for the year of transfer is then determined by multiplying the number of days he held his interest prior to the transfer by the partnership's prorated daily income or loss. That figure is then multiplied by the transferor's percentage interest in the partnership. For example, if a transfer occurs on July 31, 1992 and the transferor has a 30% interest in the partnership, the transferor's share of 1992 partnership income under the daily proration method would be determined by: partnership taxable income or loss for entire year of 1992 × (212/365) × 30%.
158Id.
It is unclear what other methods of proration in addition to daily proration would be reasonable under the regulations. Taxpayers are, therefore, sailing in uncharted waters if a method of proration other than daily proration is used. However, as long as tax avoidance or an unwarranted shifting of income or deductions is not the intent of the parties, another reasonable method of proration could probably be devised and used. For example, a partnership's utilization of a convention, such as a monthly convention, may be a permissible proration method.159 Under a monthly convention, all partners selling their partnership interests during the first half of a month would be treated as selling on the first day of the month. Sales occurring during the last half of the month would be treated as occurring on the first day of the succeeding month.
159The legislative history to the 1984 amendments to §706(d), which were designed to eliminate the retroactive allocation of partnership deductions by cash method partnerships, indicates that a monthly convention may be permissible. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 858 (1984).
b.	Special Rule for Cash Method Partnerships
Although, as discussed above, a transferor partner and the remaining partners may choose between the interim closing of the books method and the proration method of allocating partnership income or loss between the transferor and his transferee, a cash method partnership is required to use the proration method for certain expense items regardless of the method chosen by the parties. Mandatory proration for cash method partnerships is required for interest, taxes, payments for services, payments for the use of property, and other items to be specified in regulations.
The special rules applicable to cash method partnerships were adopted as part of the Tax Reform Act of 1984160 and were designed to limit a technique that was employed to provide deductions to a newly admitted partner that accrued economically before the partner was admitted to the partnership.161
160P.L. 98-369, §72, adding subsection (d) to §706.
161See H.R. Rep. No. 861, 98th Cong., 2d Sess. 855 (1984).
Example: To illustrate the technique that §706(d) now prohibits, assume that partnership ABC has no income or loss during 1983 other than a management fee payable to an affiliate of one of the partners. The partnership is a cash basis calendar year taxpayer, and the management fee is attributable to services provided during the entire year. D makes a capital contribution and is admitted to the partnership on Dec. 1, 1983. The capital contributed by D is used to pay the management fee on Dec. 2, 1983. If the partnership allocates income and loss to newly admitted partners under the interim closing of the books method, D will be entitled to a full year's worth of management fee deductions even though he joined the firm shortly before the end of 1983. However, under §706(d)(2), as amended in 1984, the management fee must be allocated on a daily basis over the entire year and, accordingly, D could be allocated only 1/12 of the management fee deduction times D's percentage interest rather than 100% of his full percentage interest.
Although the specific technique the 1984 amendment was designed to eliminate was the retroactive allocation of deductions to newly admitted partners, the provision applies to any shift in any partner's percentage interest in the partnership that occurs during the taxable year. The rules therefore apply equally to a sale, exchange or other disposition of a partnership interest.
If a cash basis partnership incurs any of the expenses listed above to which §706(d)(2) applies, partnership income or loss must be allocated between the transferor and transferee under the special rules of §706(d)(2). This essentially puts a cash method partnership on the accrual method of accounting for the specified items of expense in determining the share of those items to be allocated between the transferor and the transferee. The rules have no effect, however, if the partnership is an accrual method taxpayer.
Example: Partnership ABC is a cash method calendar year taxpayer and owns a single office building that is subject to a net lease. For 1992, the partnership collected monthly rent of $10,000 and claimed depreciation deductions of $35,000 for the year. ABC pays an annual management fee to a management company of $12,000 which is payable on Dec. 15. A has a 20% interest in the partnership which he sold to D on Dec. 1, 1992. If the interim closing of the books method of allocating items between A and D applies, in the absence of the special rules of §706(d)(2), the shares of partnership items would be allocated between A and D as follows: 
  Items Allocated to A:                                                 
  Rental income ($10,000 × 11 months)                           $110,000
  Depreciation ($35,000 × 11/12)                                (32,083)
  Management Fee                                                     -0-
  Net income 1/1/92 - 11/20/92                                    77,917
  A's share ( × 20%)                                             $15,583
                                                                        
  Items Allocated to D:                                                 
  Rental income ($10,000 × 1 month)                              $10,000
  Depreciation ($35,000 × 1)                                     (2,917)
  Management Fee                                                (12,000)
  Net loss 12/1/92 - 12/31/92                                   $(4,917)
  D's share ( × 20%)                                             $ (983)

However, under the rules of §706(d)(2), the management fee paid on Dec. 15, which is attributable to services provided for the entire year, must be allocated between A and D based on daily proration. The partnership income or loss to be allocated between A and D would therefore be as follows: 
  Percentage income for entire year:                                    
  Rental income                                                 $120,000
  Depreciation                                                  (35,000)
  Management fee                                                (12,000)
  Net income                                                     $73,000
  20% interest                                                   $14,600
  Allocated to A ( 11/12)                                         13,383
  Allocated to D ( 1/12)                                           1,217

E. Transferee Partner's Basis in Partnership Interest
1.	General Rule
The initial basis that a transferee partner has in a partnership interest acquired from a transferor is, according to §742, to be determined under the rules for determining basis generally (i.e., §§1011 et. seq.). Consequently, in the case of purchases and other acquisitions in which the transferor recognizes the full amount of gain or loss inherent in the partnership interest, the transferee's initial basis will be equal to his cost pursuant to §1012. Thus, in the case of a straightforward cash purchase, the transferee/ purchaser's basis is equal to the cash paid for the partnership interest. Where the transferee's partnership interest is acquired for property other than cash in a taxable exchange, the transferee's initial basis is equal to the fair market value of the property for which he exchanges the transferred partnership interest.
In the case of a transfer of a partnership interest in a non-taxable transaction, the transferee's initial basis in the interest is generally (but not always) equal to the transferor's basis in the interest prior to the transfer. The particular provisions which provide for non-recognition must be consulted in order to determine the transferee's basis.162 A full discussion of all of the rules governing tax-free transactions is beyond the scope of this portfolio. However, the rules applicable to a transferee's basis in a partnership interest acquired in a tax-free transaction may be summarized as follows: In the case of a contribution of a partnership interest to a corporation in a transaction qualifying for nonrecognition of gain or loss under §351, the corporation's basis in the transferred partnership interest is equal to the transferor's basis under §362.
162Section 1012 provides that, except to the extent otherwise provided in subchapters C, K, and P, a transferee obtains a cost basis for property acquired. Thus, §742 leads us to §1012 in order to determine a transferee partner's initial basis in his partnership interest, which leads us to subchapter C (the corporate provisions) and subchapter K in the case of partnership interests acquired in non-taxable transactions.
In the case of a tax-free reorganization of a corporation in which a transfer of a partnership interest occurs, a corporate transferee obtains a basis in the transferred interest equal to the transferor's basis in the interest under §362. If a shareholder acquires the partnership interest in connection with the tax-free reorganization, the shareholder transferee, under §358, also obtains a basis equal to the transferor's basis.
In the case of a partnership's acquisition of an interest in a lower-tier partnership in connection with a contribution to the capital of the upper-tier partnership the upper-tier partnership's basis in its interest in the lower-tier partnership is determined under §723. Under that provision, the transferee partnership obtains a basis in its interest in the lower-tier partnership equal to the transferor's basis in the interest before the transfer.
Where an upper-tier partnership distributes its interest in a lower-tier partnership to one or more of the upper-tier partnership's partners, the rules regarding the basis of distributed property are set forth in §732. In such circumstances, two rules regarding basis apply: one rule applies if the distribution is a "current" (i.e., nonliquidating) distribution, and the second rule applies in the case of a distribution in complete liquidation of the distributee partner's interest in the upper-tier partnership. If the distribution of a lower-tier partnership interest is a current distribution, the distributee partner's basis in the distributed interest is generally equal to the distributor partnership's basis in the interest immediately before the distribution.163 However, there is an overall limitation that applies to the distributee's basis in property distributed in a current distribution. If the distributee partner's basis in his interest in the upper-tier partnership exceeds the partnership's basis in the distributed interest, the distributee partner's basis in the distributed interest will be equal to his basis in the upper-tier partnership immediately before the distribution.164 If the distribution of the lower-tier partnership interest is in complete liquidation of the distributee's interest in the upper-tier partnership, the distributee's basis in the distributed interest will be equal to its basis in the upper-tier partnership immediately before the distribution, regardless of the upper-tier partnership's basis in the lower-tier partnership.
163§732(a)(1). For special rules governing the distributee's basis when an upper-tier partnership distributes an interest in a lower-tier partnership that holds a long-term contract, see Regs. §1.460-4(k)(2)(iv)(A), (D) (T.D. 9137, 69 Fed. Reg. 42551 (7/16/04)).
164§732(a)(2). The distributee partner's basis in the upper-tier partnership will be reduced to zero under §705(a)(2) where the §732(a)(2) limitation applies.
Example: To illustrate the difference in the basis of a lower-tier partnership interest received in a current, versus a liquidating distribution, assume that partnership ABC owns an interest in lower-tier partnership DEF. A's basis in ABC is $200, and ABC's basis in DEF is $100. If ABC distributes its interest in DEF to A as a current distribution, A's basis in the distributed partnership interest becomes $100 (ABC's basis before the distribution). A's basis in his interest in ABC is also reduced to $100 under §§705(a)(2) and 733. If, however, the distribution is in complete liquidation of A's interest in ABC, A obtains a $200 basis in DEF.
If, alternatively, A's basis in ABC is $100 and ABC's basis in DEF is $200, A's basis in DEF after the distribution will be $100 regardless of whether the distribution is a current or liquidating distribution. This result is due to the overall limitation on the basis of distributed property contained in §732(a)(2).
A donee's basis in a gifted partnership interest is governed by §1015. Under that provision, the donee of gifted property generally obtains the same basis in the property that the donor had. However, if the fair market value of the property is less than the donor's adjusted basis at the time of the gift, the donee obtains a split basis in the property. That is, the donee of depreciated property will obtain a different basis for the purpose of determining gain on a subsequent sale than for the purpose of determining loss on a subsequent sale. If the donee of a depreciated partnership interest subsequently disposes of the gifted interest at a gain, the donee's basis is equal to the donor's basis. If the donee subsequently disposes of the interest at a loss, the donee's basis equals the fair market value of the partnership interest at the time of the gift.
Example: Partner X has a basis of $200 in partnership XYZ and makes a gift of the entire interest to T when the value of the interest is $100. If T subsequently sells the interest for $250, T recognizes a gain of $50 because, for purposes of gain recognition, T's basis equals X's basis at the time of the gift. However, if T sells the interest for $50, T recognizes a loss of $50 because T's basis for purposes of loss recognition equals the $100 value at the time of X's gift. Alternatively, if T sells the the interest for $150, T recognizes neither gain nor loss.165
165See Regs. §1.1015-1(a)(2). Note that basis equals reduced fair market value basis solely for purposes of determining if a loss results from a subsequent sale of the donated partnership interest. The donee does not need to reduce retroactively the basis in the donated partnership interest that is sold at a loss to determine, for example, if the partner's share of partnership losses previously claimed must be recaptured when the partner later sells the interest at a loss and, using fair market value as original basis, the donee has claimed losses in excess of basis in contravention of §704(d).
A donee's basis in a gifted partnership interest is increased by a portion of any gift tax that the donor paid with respect to the gift. The increase equals the tax attributable to net appreciation in value of the gifted interest (i.e., the difference between the value of the partnership interest and the donor partner's adjusted basis in the interest).166
166§1015(d)(6).
In the case of a partnership interest acquired from a decedent, the successor's basis in the partnership interest is generally equal to the fair market value of the interest on the date of death (or six months after the date of death if the decedent's personal representative elects the alternative valuation date under §2032).167
167§1014. With respect to an asset (including a partnership interest) acquired from a decedent dying after 2009, §1022 provides that the successor's basis is the lesser of the decedent's adjusted basis or fair market value, increased by the portion of the "aggregate basis increase" allocated to the asset and, if the successor is the decedent's spouse, by the portion of the "aggregate spousal property basis increase" allocated to the asset. The "aggregate basis increase" is generally $1,300,000; the "aggregate spousal property basis increase" is $3,000,000.
Because the conversion of a general partnership interest to a limited partnership interest (or vice versa) in the same partnership, or the conversion of a partnership to a limited liability company, is not a taxable event, a partner's or member's basis in the converted interest remains the same as before the conversion.168
168See Rev. Rul. 95-37, 1995-1 C.B. 130; Rev. Rul. 84-52, 1984-1 C.B. 157. See also II, C, 8, above.
2.	Effect of Partnership Liabilities
In a sale or exchange of a partnership interest, §752(d) treats partnership liabilities in the same manner as liabilities are treated outside the partnership context. Thus, in the case of a taxable disposition of a partnership interest, the transferee partner's basis includes the value of consideration given for the interest, which, in turn, includes the share of partnership liabilities associated with the interest. In the case of a nontaxable transfer (in which the transferee generally takes the transferor's basis in the interest), partnership liabilities are also accounted for in the transferee's basis because, under §752(a), the transferor's basis already reflected the transferor's share of partnership liabilities before the transfer.
F. Adjustment to Basis of Partnership Property
1.	General Rule -- No Tax Consequences to Partnership on Transfer of Interest
A transfer of an interest in a partnership generally has no effect on the entity or on the remaining partners. Only the transferor partner and the transferee generally are affected. However, except in the rare case in which a taxable transfer is for consideration exactly equal to the transferor's adjusted basis in the transferred interest, a taxable transfer results in a disparity between the transferee's adjusted basis in the transferred partnership interest ("outside basis") and the transferee's share of the partnership's adjusted basis in its assets ("inside basis").
Example: Partner X has a 1/3 interest in partnership XYZ, which has the following assets and liabilities: 
  Assets                                      Basis               Value
  Cash                                      $ 5,000             $ 5,000
  Accounts Receivable                        10,000              10,000
  Inventory                                  20,000              21,000
  Depreciable Assets                         20,000              40,000
  Total Assets                             $ 55,000            $ 76,000
                                                                       
  Liabilities                              $ 10,000            $ 10,000
                                                                       
  Capital                                                              
  X                                        $ 15,000            $ 22,000
  Y                                          15,000              22,000
  Z                                          15,000              22,000
  Total Liabilities and Capital            $ 55,000            $ 76,000

If T purchases X's interest for its fair market value of $22,000, T's basis for the purchased interest is $22,000 plus 1/3 of the $10,000 of liabilities, or $25,333. Although T's basis in the purchased interest reflects the purchase price, T's share of the partnership's basis in its assets remains at $18,333 (55,000/3 or 15,000 + 1/3 of 10,000).169 If, on the day following T's purchase, the partnership sells the depreciable assets for fair market value, the partnership has a $20,000 gain, of which $6,667 is allocable to T. This is not a fair result, because X has already been subjected to tax on the gain inherent in T's share of the partnership's assets and T has paid an amount equal to the value of the assets. Nevertheless, unless an election under §754 is made with respect to T's purchase, T must pay tax on the $6,667 of gain.
169§743(a).
The disparity between inside basis and outside basis is created only when gain or loss is recognized on a transfer. A nontaxable disposition of a partnership interest (in which the transferee generally acquires the transferor's basis in the interest) creates no disparity. In the example above, if X had made a gift of X's partnership interest to T rather than selling the interest, T's basis would be equal to X's basis (unless §1015(d) increased the basis by a portion of any gift tax attributable to appreciation in the interest).
A §754 election with respect to a taxable disposition may eliminate the disparity between inside and outside basis that arises from a disposition.170 A §754 election adjusts the basis of partnership assets to eliminate inside and outside basis disparities and, therefore, put the transferee partner in approximately the same tax position as if the transferee had acquired a proportionate share of partnership assets rather than a partnership interest.
170Section 761(e), added in 1984 by P.L. 98-369, §75(b), resolved uncertainty regarding the treatment of dispositions other than sales and exchanges (e.g., taxable dividends) by providing that, except as otherwise provided in regulations, a distribution of a partnership interest that is not treated as an exchange under general tax principles is nevertheless an exchange for purposes of §708, §743, and any other subchapter K provisions specified in regulations.
A §754 election is irrevocable unless the IRS consents to a revocation, and an election may be adverse. Therefore, a partnership may refuse to make a §754 election.
Even if a §754 election is not in effect, however, a partnership must adjust the basis of partnership assets to eliminate inside and outside basis disparities if it has a substantial built-in loss immediately after the transfer of the partnership interest.170.1 A partnership has a substantial built-in loss if its adjusted basis in the partnership property exceeds the property's fair market value by more than $250,000.170.2
170.1§743(b), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §833(b)(2), effective for transfers after Oct. 22, 2004. If the partnership has a substantial built-in loss, it must comply with Regs. §1.743-1(k) as if a §754 election were in effect at the time of the transfer. Notice 2005-32, 2005-16 I.R.B. 895.
170.2§743(d), as added by the 2004 AJCA, §833(b)(3).
2.	Adjustment to Partnership's Basis in Assets Under §743(b)
a.	Measure of Adjustment
(1)	In General
If a §754 election applies to a transfer of a partnership interest, or the partnership has a substantial built-in loss immediately after such a transfer, §743(b) provides that the partnership's basis in its assets is adjusted upwards or downwards in an amount that reflects the difference between the transferee's basis in the transferred interest and the transferee's proportionate share of the partnership's basis in its assets.170.3
170.3§743(b), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §833(b)(2), effective for transfers after Oct. 22, 2004. A partnership has a substantial built-in loss if its adjusted basis in partnership property exceeds the property's fair market value by more than $250,000. §743(d), as added by the 2004 AJCA, §833(b)(3). If the partnership has a substantial built-in loss, it must comply with the reporting requirements of Regs. §1.743-1(k) as if a §754 election were in effect at the time of the transfer. Notice 2005-32, 2005-16 I.R.B. 895.
Two steps are necessary in determining the basis adjustment: (1) the amount of the total adjustment is determined under §743(b); and (2) the manner in which the total adjustment is to be allocated among the partnership's assets is then determined under §755 and the regulations under §755.171
171§743(c).
The total §743(b) adjustment is calculated first by determining the transferee partner's share of the partnership's adjusted basis in the partnership's property. The transferee partner's share of basis in partnership property is then compared with the transferee's basis in the transferred interest. The §743(b) adjustment is positive if the transferee's share of basis in partnership property is less than the transferee's basis in the transferred interest; the adjustment is negative if the transferee's share of basis in partnership property exceeds the transferee's basis in the interest.172
172§743(b); Regs. §1.743-1(b).
The transferee partner's basis in the transferred partnership interest is determined under §742 and Regs. §1.742-1 (that is, under general basis rules).172.1 Thus, the transferee's basis in a purchased partnership interest is the cost of the interest, and the basis of an interest acquired from a decedent is the fair market value of the interest on the decedent's date of death (or alternate valuation date) increased by the estate's share of partnership liabilities and decreased to the extent fair market value is attributable to income in respect of a decedent.172.2
172.1Regs. §1.743-1(c).
172.2See Regs. §1.742-1.
The transferee partner's share of the partnership's adjusted basis in the partnership's property is the sum of (i) the transferee's interest as a partner in the partnership's "previously taxed capital" plus (ii) the transferee's share of partnership liabilities.172.3 The transferee's interest in the partnership's "previously taxed capital" is generally equal to the combination of the following three factors, to the extent, in each case, that the factor is attributable to the transferred partnership interest:
(1) the amount of cash that the transferee would receive on a liquidation of the partnership following a hypothetical disposition (immediately after the transfer of the interest) by the partnership of all partnership assets in a fully taxable transaction in which the partnership receives cash equal to the fair market value of the assets;
(2) increased by the amount of tax loss (including Regs. §1.704-3(d) remedial allocations) that would be allocated to the transferee from the hypothetical disposition;
(3) decreased by the amount of tax gain (including Regs. §1.704-3(d) remedial allocations) that would be allocated to the transferee from the hypothetical disposition.172.4
172.3Regs. §1.743-1(d)(1).
172.4Regs. §1.743-1(d)(1),  (2).
Example 1: As in the last example above, partner X has a 1/3 interest in partnership XYZ, which has the following assets and liabilities:
  Assets                                      Basis               Value
  Cash                                      $ 5,000             $ 5,000
  Accounts Receivable                        10,000              10,000
  Inventory                                  20,000              21,000
  Depreciable Assets                         20,000              40,000
  Total Assets                             $ 55,000            $ 76,000
                                                                       
  Liabilities                              $ 10,000            $ 10,000
                                                                       
  Capital                                                              
  X                                        $ 15,000            $ 22,000
  Y                                          15,000              22,000
  Z                                          15,000              22,000
  Total Liabilities and Capital            $ 55,000            $ 76,000

T purchases X's interest for fair market value ($22,000). Under §742, T's basis in the transferred interest is $25,333 (the cash T paid for the interest plus T's share as a 1/3 partner of partnership liabilities). If XYZ (hypothetically) disposed of all its assets for cash equal to the assets' fair market value immediately after the transfer, and then liquidated, T would receive cash in the amount of $22,000 (X's, and thus T's, share of the fair market value of XYZ's capital). In XYZ's hypothetical disposition of its assets for cash, however, T would have been allocated $7,000 of tax gain (1/3 of the difference between the assets' fair market value [$76,000] and aggregate adjusted basis [$55,000]). T's interest in the partnership's previously taxed capital, therefore, is $15,000 ($22,000 minus $7,000). Under Regs. §1.743-1(d)(1), T's share of XYZ's adjusted basis in XYZ's property is $18,333 (T's share of previously taxed capital [$15,000] plus T's share of partnership liabilities [$3,333]). The §743(b) basis adjustment, therefore, is a positive adjustment of $7,000 (the excess of T's basis in the transferred interest over T's share of XYZ's adjusted basis in partnership property).172.5
172.5Regs. §1.743-1(d)(3) Ex. 1. The hypothetical disposition factor was added to Regs. §1.743-1 in 1999. T.D. 8847, 64 Fed. Reg. 69903 (12/15/99). Before the amendment, the regulation simply provided that a partner's share of the adjusted basis of partnership property was the sum of the partner's interest in "partnership capital and surplus" plus the partner's share of partnership liabilities. Former Regs. §1.743-1(b)(1). The hypothetical disposition factor was added because Treasury and the IRS believed that the old rule failed to take into account special allocations or varying treatment among partners resulting from §704(c) or the minimum gain chargeback. See preamble to REG-209682-94, 63 Fed. Reg. 4408 (1/29/98). In this example, however, the result is the same under the pre-1999 and post-1999 rules because there is no special allocation, §704(c) allocation, or minimum gain chargeback. See former Regs. §1.743-1(b)(1) Ex. (1).
Example 2: The facts are the same as in the foregoing example, except that XYZ has a basis in the depreciable assets of $50,000 rather than $20,000 at the time of T's purchase from X. XYZ's balance sheet is, therefore: 
  Assets                                      Basis               Value
  Cash                                      $ 5,000             $ 5,000
  Accounts Receivable                        10,000              10,000
  Inventory                                  20,000              21,000
  Depreciable Assets                         50,000              40,000
  Total Assets                             $ 85,000            $ 76,000
                                                                       
  Liabilities                              $ 10,000            $ 10,000
                                                                       
  Capital                                                              
  X                                        $ 25,000            $ 22,000
  Y                                          25,000              22,000
  Z                                          25,000              22,000
  Total Liabilities and Capital            $ 85,000            $ 76,000

T's basis in the purchased interest is $25,333 (cost plus 1/3 of partnership liabilities), as in Example 1. However, T's share of the adjusted basis of XYZ's property is $28,333 (cash T would receive in a liquidation following the hypothetical disposition [$22,000] plus tax loss allocated to T from the hypothetical disposition [$3,000], plus T's share of XYZ liabilities [$3,333]). Because T's share of XYZ's basis in partnership property exceeds T's basis in the transferred interest by $3,000, the §743(b) adjustment is a negative $3,000 adjustment, which causes a decrease in XYZ's basis in its assets.172.6
172.6The result, again, would have been the same under former Regs. §1.743-1(b) before its amendment by T.D. 8847, even though the computation would have been simpler (i.e., T's 1/3 share of XYZ's inside basis of $85,000 exceeds T's outside basis by $3,000).
(2)	Special Rules for Partnerships Holding Long-Term Contracts
Regs. §1.743-1(d)(2) 172.7 refers to special rules in Regs. §1.460-4(k)(3)(v)(B) for applying the hypothetical transaction on the transfer of an interest in a partnership that holds a long-term contract (i.e., a contract for the manufacturing, building, installation, or construction of property if the contract is not completed within the taxable year in which the contract is entered into172.8). The regulations under §460 pertaining to a change in the taxpayer engaged in completing a long-term contract include rules on transactions by partnerships that hold long-term contracts. To determine the amount of tax gain or loss that is allocated to the transferee in a hypothetical transaction involving a partnership that holds a long-term contract, the taxpayer must determine the amount of income (which is ordinary income) or loss that the partnership would take into account if, at the time of the transfer, the partnership disposed of the contract for fair market value in a "constructive completion transaction."172.9 Under the "constructive completion" rules, as applied to a partnership's hypothetical disposition of a long-term contract, the partnership is treated as completing the contract on the date of the disposition and as taking into account the "total contract price" or "gross contract price" (i.e., the sum of the amounts the partnership has received or reasonably expects to receive under the contract and the amount realized on the deemed disposition, reduced by transaction costs) less receipts that the partnership has already reported.172.10 The amount that the partnership is deemed to realize on the hypothetical disposition is the fair market value of the contract at the time of the transfer.172.11 Once the income or loss from the constructive completion transaction is determined, the income or loss is allocated among the partners as though the partnership closed its books on the date of the hypothetical disposition.172.12
172.7As amended by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04), applicable to transactions after May 14, 2002.
172.8§460(f)(1).
172.9Regs. §1.460-4(k)(3)(v)(B).
172.10Regs. §1.460-4(k)(2).
172.11Regs. §1.460-4(k)(2)(iv)(B), as amended by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04).
172.12Id.
Example: W, X, Y, and Z each contribute $100,000 to form an equal partnership in Year 1. Also in Year 1, the partnership enters into a long-term contract that has a total contract price of $1,000,000 and estimated contract costs of $800,000. The partnership receives $650,000 in payments under the contract and incurs costs of $600,000 attributable to the contract in Year 1. The partnership, therefore, reports receipts of $750,000 172.13 and costs of $600,000 in Year 1, for a profit of $150,000. In Year 2, W transfers W's interest in the partnership to T for $150,000. The partnership receives no payments on the contract in Year 2. The contract has a fair market value of $160,000 at the time of the transfer.
For purposes of determining the tax gain or loss allocated to T on the Regs. §1.743-1(d)(2) hypothetical transaction, the partnership is treated as taking into account $60,000 (total contract price of $810,000 [$650,000 + $160,000] at the time of the transfer minus $750,000 of receipts already reported as of the time of the transfer). T's share of the $60,000 that the partnership is treated as taking into account is $15,000, and this amount is allocated to T as tax gain under Regs. §1.743-1(d)(2). T's adjusted (cost) basis in the purchased partnership interest is $150,000. Assuming that the amount T would receive on a liquidation of the partnership following the hypothetical transaction is also $150,000, T's share of the adjusted basis of partnership property is $135,000 (the amount T would receive on liquidation [$150,000] decreased by tax gain allocated to T on the hypothetical transaction [$15,000]). The §743(b) basis adjustment, therefore, is $15,000.172.14
172.13To determine its receipts, the partnership must multiply the total contract price by the "completion factor" (i.e., the ratio of all costs allocable to the contract that the taxpayer has incurred to the estimated total costs allocable to the contract). See Regs. §1.460-4(b)(2)(i). Thus, in this example, the partnership multiplies the total contract price of $1,000,000 by a completion factor of $600,000/$800,000.
172.14See Regs. §1.460-4(k)(5) Ex. 13, added by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04).
The §743(b) basis adjustment with respect to the transfer of an interest in a partnership holding a long-term contract must decrease or increase, as the case may be, the transferee partner's subsequent income or loss from the contract.172.15 If the partnership accounts for the long-term contract under the "completed contract method" (i.e., the partnership takes into account in the year in which the partnership completes the contract (i) all amounts that the taxpayer is entitled by law or contract to receive and (ii) all contract costs incurred), the partnership must take the §743(b) basis adjustment into account in the year in which the contract is completed. If the partnership accounts for the contract under the "percentage of completion method" (i.e., the partnership includes in income for a taxable year the portion of the total amount that the partnership expects to receive under the contract that corresponds to the percentage of the entire contract that the partnership has completed during that year), the portion of the basis adjustment that the partnership recovers in each taxable year must be determined in a manner "that reasonably accounts for the adjustment over the remaining term of the contract."172.16 Thus, in the last example above, if the partnership is using the percentage of completion method, the partnership will recover the basis adjustment over the term of the contract and T's distributive share of income from the contract will be reduced in a corresponding amount for each year in which the partnership recovers the basis adjustment.172.17
172.15Regs. §1.460-4(k)(3)(v)(B), as amended by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04).
172.16Id.
172.17Regs. §1.460-4(k)(5) Ex. 13 provides computations that would "reasonably account" for the adjustment.
(3)	Effect of §704(c) on §743(b) Adjustment
If one or more partners have contributed property in kind in exchange for an interest or interests in the partnership, the amount of a §743(b) adjustment may vary, depending on whether the transferee obtains an interest from a partner who contributed cash or from a partner who made an in-kind contribution, because §704(c) requires that precontribution appreciation or depreciation be taken into account in determining the partners' allocable shares of income, gain, loss, and deduction attributable to contributed property.173 Section 704(c), in effect, requires that a contributing partner's share of the partnership's basis in its assets reflect the variation between the basis of the assets contributed by that partner and the value of the assets at the time of the contribution. The regulations issued under §743(b) direct that §704(c) be taken into account in determining the amount of a §743(b) adjustment.174
173Before 1984, a partnership had to elect under former §704(c)(2) to take into account the variation between the value and basis of contributed property in allocating tax items attributable to the property. The Tax Reform Act of 1984 made former §704(c)(2) mandatory in §704(c)(1). P.L. 98-369, §71.
174See Regs. §1.743-1(d)(3) Ex. 2.
Example: X, Y, and Z form partnership XYZ. X contributes unimproved land with a basis to X of $40,000 and a fair market value of $100,000. Y and Z each contribute $100,000 in cash. Each partner has a 1/3 interest in partnership capital, profits, and losses. The partnership's balance sheet is: 
  Assets                                      Basis               Value
  Cash                                     $200,000            $200,000
  Land                                       40,000             100,000
  Total Assets                             $240,000            $300,000
                                                                       
  Capital                                                              
  X                                        $ 40,000            $100,000
  Y                                         100,000             100,000
  Z                                         100,000             100,000
  Total Capital                            $240,000            $300,000

Section 704(c) requires that the first $60,000 of gain from the sale of the land be allocated exclusively to X. T purchases X's interest for its $100,000 fair market value and a §754 election applies to the sale. The amount of tax gain allocated to T from the Regs. §1.743-1(d)(2) hypothetical transaction is $60,000, all of it §704(c) built-in gain. Thus, T's interest in XYZ's previously taxed capital is $40,000 (the amount of cash T would receive if XYZ liquidated immediately after the hypothetical transaction [$100,000] less T's share of gain from the hypothetical transaction [$60,000]). The amount of T's §743(b) basis adjustment is $60,000 (the excess of T's cost basis in the purchased interest [$100,000] over T's share of the adjusted basis to XYZ in partnership property [$40,000]). If, however, T purchases Y's 1/3 interest in XYZ for the same price ($100,000), the §743(b) adjustment is $0 (T's cost basis in the purchased partnership interest [$100,000] less T's share of the adjusted basis to XYZ in partnership property [$100,000]).
Observation: The purchase of an interest to which a §704(c) allocation relates in effect negates the §704(c) allocation if a §754 election applies to the sale.
(4)	Effect of Prior §743(b) Adjustments
The amount of a §743(b) adjustment is based on the transferee's share of the adjusted basis to the partnership in partnership property without taking into account any prior §743(b) adjustments.175
175Regs. §1.743-1(f).
Example: X, Y, and Z form partnership XYZ. X and Y each contribute $100,000 in cash, and Z contributes land with a basis and fair market value of $100,000. When the land has appreciated to $130,000, X sells X's interest in XYZ to T1 for $110,000 (which is 1/3 of the fair market value of partnership property). A §754 election is in effect. T1, therefore, has a §743(b) basis adjustment of $10,000 (the excess of (a) T1's $110,000 cost basis in the purchased interest over (b) $110,000 in cash that T1 would receive on liquidation reduced by the $10,000 of tax gain that would be allocated to T1 from the hypothetical transaction).
After the land has appreciated further to $160,000, T1 sells T1's interest in XYZ to T2 for $120,000 (1/3 of the fair market value of partnership property). The §754 election is still in effect. T1, therefore, has a §743(b) adjustment of $20,000 (the excess of (a) T2's $120,000 cost basis in the interest over (b) $120,000 in cash T2 would receive on a liquidation reduced by $20,000, rather than $10,000, of tax gain that would be allocated to T2 from the hypothetical transaction).175.1
175.1Regs. §1.743-1(f) Ex.
A gift of a partnership interest does not itself give rise to a §743(b) adjustment, because a gift is not a sale, exchange, or transfer upon death, and is not a deemed sale or exchange under §761(e). The donee, however, succeeds to the donor's §743(b) adjustment.176 In the last example above, therefore, if T2 later made a gift to T3 of 50% of T2's interest in XYZ, T2 would be treated as transferring $10,000 (one-half) of T2's $20,000 basis adjustment to T3 with the gift.176.1
176See Regs. §1.743-1(f).
176.1Regs. §1.743-1(f) Ex.
(5)	Section 743(b) Adjustment in Tiered Partnerships
Legislative Change Note: The 2004 American Jobs Creation Act, P.L. 108-357, §833, amended §743 to provide that a partnership must adjust its basis in partnership property following the transfer of a partnership interest if the partnership has a §754 election in effect or the partnership has a substantial built-in loss immediately after the transfer, i.e., the partnership's adjusted basis in partnership property exceeds the property's fair market value by more than $250,000, effective for transfers after October 22, 2004. In Notice 2005-32, 2005-16 I.R.B. 895, the IRS stated that if a partnership has a substantial built-in loss, it must comply with the reporting requirements of Regs. §1.743-1(k) as if a §754 election were in effect. It would therefore seem that a substantial built-in loss has the same effect as a §754 election on whether the sale of an interest in a tiered partnership results in a §743(b) basis adjustment.
Whether a sale of an interest in an upper-tier partnership results in an adjustment to the basis of the assets in a lower-tier partnership depends on whether both the upper and lower-tier partnerships have §754 elections in effect. If both partnerships have a §754 election in effect, the upper-tier partnership adjusts its assets for the benefit of the purchaser of an interest in the upper-tier partnership, and the lower-tier partnership adjusts its assets to the extent attributable to the interest purchased in the upper-tier partnership. However, if only the upper-tier partnership has a §754 election in place, no §743(b) adjustment is made to the lower-tier entity's assets (although the upper-tier entity adjusts its basis in its own assets). If only the lower-tier partnership has a §754 election in effect, no adjustment to asset basis is made on the purchase of an upper-tier partnership interest.177
177Rev. Rul. 87-115, 1987-2 C.B. 163. See also PLR 9444013 (merger of two partnerships did not affect their §754 elections; resulting partnership retained §743(b) basis adjustments made by merged partnerships).
Example: W, X, Y, and Z each contribute $30,000 in cash to form equal partnership UTP. UTP and two other partners each contribute $110,000 in cash to form equal partnership LTP. In addition to its one-third interest in LTP, with a basis of $80,000 and a value of $120,000, UTP owns inventory with a basis of $40,000 and a value of $80,000. LTP's only asset is a capital asset with a basis of $330,000 and a fair market value of $360,000. W sells W's entire interest in UTP to B for $50,000 when UTP has a §754 election in effect. The results are as follows:177.1
• B's basis in B's newly acquired UTP interest is $50,000. B would receive $50,000 (25% of the $200,000 value of UTP's assets) in cash if UTP liquidated immediately after the hypothetical transaction. On the hypothetical transaction itself, B would be allocated $20,000 of tax gain (25% of the $80,000 gain inherent in UTP's two assets). Thus, B's §743(b) adjustment with respect to UPT is $20,000 ($50,000 - [$50,000 - $20,000]).
• One-half of B's $20,000 basis adjustment is allocated to B's adjusted basis in UTP's inventory and one-half to B's share of UTP's adjusted basis in LTP, because a basis adjustment is allocated among classes of property according to the proportions of income, gain, or loss that the transferee partner would receive on a hypothetical disposition by the partnership of its assets at fair market value for cash immediately after the partnership interest is transferred.177.2 As a result, B has an adjusted basis in UTP's inventory of $20,000 (one-fourth of UTP's original $40,000 basis in the inventory plus one-half of the $20,000 adjustment allocated to B's basis in the inventory) and an adjusted basis in UTP's interest in LTP of $30,000 (one-fourth of UTP's original $80,000 basis in LTP plus one-half of the $20,000 adjustment allocated to B's share of UTP's basis in LTP.
• If LTP also has a §754 election in effect, the sale of W's interest in UTP to B is treated as a deemed sale of an interest in LTP as well. The selling price of B's share of UTP's interest in LTP is deemed to equal B's share of UTP's adjusted basis in LTP ($30,000).177.3 The §743(b) adjustment for the deemed sale is $2,500 (the excess of (a) $30,000 over (b) the $30,000 in cash [$360,000 fair market value of LTP ÷ 3 ÷ 4] that B would receive on a liquidation of LTP less $2,500 tax gain [$30,000 inherent gain in LTP's asset ÷ 3 ÷ 4] that would be allocated to B in a hypothetical disposition).
If, alternatively, only UTP had a §754 election in effect, the §743(b) adjustment with respect to B's purchase of W's interest would be $20,000 and there would be no adjustment to LTP's basis in its property. If only LTP had a §754 election in effect, there would be no basis adjustment as a result of W's sale to B.
177.1This example is based on Rev. Rul. 87-115, 1987-2 C.B. 163. Although Rev. Rul. 87-115 was issued before Regs. §1.743-1 was amended to incorporate the hypothetical transaction and deemed liquidation, the result in this example is the same under the 1999 amendments as under the version of the regulation in effect when Rev. Rul. 87-115 was issued.
177.2Regs. §1.755-1(b)(1)(ii). See II, E, 2, b, below.
177.3Rev. Rul. 87-115, 1987-2 C.B. 163.
b.	Allocation of §743(b) Adjustment Among Partnership Assets
Section 755 determines the allocation of a §743(b) basis adjustment to specific partnership assets.178 Section 755 requires that the partnership's assets be divided into: (1) capital assets and property described in §1231(b) (generally, property used in a trade or business that is held for more than one year and is either depreciable property or nondepreciable real property); and (2) all other property. For simplicity, assets in category (1) are sometimes referred to here as "capital assets." After the partnership's assets have been divided into these two categories, the aggregate appreciation or depreciation in each category is determined. If assets in a category have experienced appreciation in the aggregate and the §743(b) adjustment is positive, all or a portion of the adjustment is allocated to that category. If the category has experienced depreciation in the aggregate and the §743(b) adjustment is positive, no portion of the adjustment is allocated to that category and basis is not adjusted in that category. If assets in a category have appreciated in the aggregate but the §743(b) adjustment is negative, no adjustment is made in that category.
178§743(c).
In addition to the asset division required by §755, the regulations under §755 divide all transfers of partnership interests into the following two groups, based on the way in which the transferee determines the basis of the transferred interes: (1) a transfer following which the transferee determines basis with no reference to the transferor's basis in the interest; and (2) a transfer following which the transferee determines basis entirely or partially by reference to the transferor's basis in the interest.179 In each group of transferred interests, the total basis adjustment is allocated first to the two classes of partnership property (capital assets and all other property). The portion of basis adjustment allocated to each of these classes is then allocated to the individual assets within each class.180 The following discussion summarizes the §755 basis adjustment rules. For further discussion, including examples, see 714 T.M., Partnerships -- Allocation of Liabilities; Basis Rules.
179Regs. §1.755-1(b)(1)(i).
180Regs. §1.755-1(a).
(1)	Transfers Without Reference to Transferor's Basis
If the transferee of a partnership interest determines the transferee's basis in the interest without reference to the transferor's basis, the allocations of basis adjustment between the two classes of assets and then to assets within each class are based on the total amounts of income, gain, or loss (including remedial allocations under Regs. §1.704-3(d)) that would be allocated to the transferee partner in a hypothetical sale of all of the partnership's assets for cash in a fully taxable transaction immediately after the transfer of the partnership interest.181 The allocations from the hypothetical sale are limited to the amounts attributable to the acquired partnership interest.181.1
181Regs. §1.755-1(b)(1)(ii).
181.1Id.
As in the hypothetical transaction under Regs. §1.743-1(d), discussed above, the amount of ordinary income or loss attributable to a long-term contract on the hypothetical sale of such a contract under the §755 regulations is the amount of income or loss that the partnership would take into account if, at the time of the hypothetical sale, the partnership disposed of the contract for fair market value in a "constructive completion transaction."181.2
181.2Regs. §§1.755-1(b)(1)(ii), 1.460-4(k)(3)(v)(B) (as amended by T.D. 9137, 69 Fed. Reg. 42551 (7/16/04)). The "constructive completion" rules for long-term contracts are found in Regs. §1.460-4(k)(2). For further discussion, see II, F, 2, a, (2), above.
The amount of the basis adjustment allocated to the ordinary income class equals the hypothetical sale amount attributable to the partnership's ordinary income property, and the amount of basis adjustment allocated to the capital gain class equals the total §743(b) basis adjustment less the adjustment amount already allocated to the ordinary income class.181.3 If a basis decrease is allocated to the capital gain class, however, the decrease may not exceed the partnership's basis in its assets in that class; any reduction in excess of this limit reduces the basis of the partnership's ordinary income property.181.4
181.3Regs. §1.755-1(b)(2).
181.4Regs. §1.755-1(b)(2)(i)(B). Note that in the case of property subject to the remedial allocation method, the partnership's basis in its capital gain assets includes the transferee's share of any remedial loss under Regs. §1.704-3(d) from the Regs. §1.755-1(b)(1) sale.
The bases of partnership assets can be adjusted even when the net §743(b) basis adjustment for the transferee is zero.181.5 If there has been net appreciation in one class of assets and net depreciation in the other class, the effect of the hypothetical sale is an ordinary gain (or loss) that causes a corresponding decrease (or increase) in the basis of the capital gain class.
181.5Regs. §1.755-1(b)(1)(i).
After allocating the total §743(b) adjustment between the classes of ordinary income and capital gain assets, the partnership must allocate each of these two amounts to the individual assets within each class. Starting with the ordinary income class, the partnership initially must assign to each asset the amount of income, gain, or loss (including any remedial allocations under Regs. §1.704-3(d)) that would be allocated to the transferee from the hypothetical sale of that asset (to the extent attributable to the transferred partnership interest). If the partnership had to increase the overall basis adjustment allocated to ordinary income property because the decrease in basis allocated to capital gain property exceeded the partnership's basis in that property, then it must reduce the initial basis adjustment assigned to each ordinary income asset by the following amount: the total basis decrease reallocated from the capital gain class to the ordinary income class, multiplied by a fraction equal to (i) the fair market value of the individual asset over (ii) the fair market value of  the entire ordinary income class.181.6
181.6Regs. §1.755-1(b)(3).
With respect to the capital gain class, the partnership initially assigns to each capital asset the amount of income, gain, or loss (including any remedial allocations under Regs. §1.704-3(d)) that would be allocated to the transferee from the hypothetical sale of that asset (to the extent attributable to the transferred partnership interest). Since the total basis adjustment assigned to the capital gain class is calculated by reducing the overall §743(b) adjustment by the amount already allocated to the ordinary income class, the capital gain class adjustment will frequently be greater or less than the total gain (or loss) from the hypothetical sale for the entire capital gain class.
Whenever the capital gain class adjustment differs from the total hypothetical sale gain (or loss), the partnership must adjust the amount of basis adjustment it has assigned to each capital gain asset by subtracting the following amount: the total amount of gain or loss (including any remedial allocations under Regs. §1.704-3(d)), either (1) reduced by the net positive basis adjustment to all items of capital gain property or (2) increased by the net negative basis adjustment to all items of capital gain property. This amount is then multiplied by a fraction composed of  (1) the fair market value of the item of property over (2) the fair market value of the entire capital gain class.
A transferee who receives a partnership interest as the result of the death of a partner does not adjust his basis under §1014 for the portion of that interest (if any) that is attributable to items representing income in respect of a decedent under §691. Section 1014(c). Therefore, if a transferee partner receives its interest as a result of the death of a partner, the partnership does not allocate any portion of the §743(b) basis adjustment to assets representing income in respect of a decedent.181.7
181.7Regs. §1.755-1(b)(4)(i). Cf. §1022, as added by 2001 Tax Relief Act, P.L. 107-16, §542, for basis considerations when property is acquired from a decedent dying after 2009.
(2)	Transferred Basis Exchanges
Legislative Change Note: The 2004 American Jobs Creation Act, P.L. 108-357, §833, amended §743 to provide that a partnership must adjust its basis in partnership property following the transfer of a partnership interest if the partnership has a §754 election in effect or the partnership has a substantial built-in loss immediately after the transfer, i.e., the partnership's adjusted basis in partnership property exceeds the property's fair market value by more than $250,000, effective for transfers after October 22, 2004. If the partnership has a substantial built-in loss, it must comply with the reporting requirements of Regs. §1.743-1(k) as if a §754 election were in effect at the time of the transfer.
When the transferee of a partnership interest determines its basis in the interest entirely or partially with reference to the basis of the transferor (for example, when a partner contributes its partnership interest to a corporation in a §351 transaction) and the partnership has a §754 election in effect, the partnership will adjust the basis of its assets only if there is a positive or negative §743(b) basis adjustment for the transferee partner. By contrast with the rules for transfers of partnership interests where basis is determined without reference to the transferor's basis, if the transferred basis which the transferee partner receives for its partnership interest equals the partner's share of the partnership's adjusted basis in all of its assets, then the partnership will not adjust the basis of any of its assets.181.8
181.8Regs. §1.755-1(b)(5)(ii).
If the transferee partner does receive a §743(b) basis adjustment which is greater or less than zero, then the partnership must first allocate the basis adjustment to the ordinary gain and capital gain classes. The rules for increases and decreases in partnership asset basis parallel each other.
If the partnership must allocate a basis increase as a result of a partner's §743(b) basis adjustment, such increase must be allocated to capital gain or ordinary income property, respectively, only if the total amount of gain or loss that the partnership would allocate to the partner from the hypothetical sale of all such property would result in a net gain or net income, as the case may be, to the transferee. The total amount of gain or loss that the partnership would allocate must include any remedial allocations under Regs. §1.704-3(d) and the allocation amount is limited by the extent that it is attributable to the transferred partnership interest.181.9 When the partnership must allocate this basis increase to both capital gain assets and ordinary income assets, the partnership shall allocate the increase in proportion to the net gain or net income, respectively, that would be allocated to the transferee partner from the hypothetical sale.181.10
181.9Regs. §1.755-1(b)(5)(ii).
181.10Id.
If the partnership must allocate a basis decrease as a result of a partner's §743(b) basis adjustment, the decrease must be allocated to capital gain or ordinary income property, respectively, only if the total amount of gain or loss that the partnership would allocate to the partner from the hypothetical sale of all such property would result in a net loss to the transferee. The total amount of gain or loss that the partnership would allocate must include any remedial allocations under Regs. §1.704-3(d) and the allocation amount is limited by the extent that it is attributable to the transferred partnership interest.181.11 When the partnership must allocate this basis increase to both capital gain assets and ordinary income assets, the partnership shall allocate the increase in proportion to the net loss that would be allocated to the transferee partner from the hypothetical sale.181.12
181.11Regs. §1.755-1(b)(5)(ii).
181.12Id.
If a partnership must allocate an increase in basis within a class of properties, it must first allocate the increase to properties with unrealized appreciation in proportion to the transferee's share of the respective amounts of unrealized appreciation before such increase (but only to the extent of the transferee's share of each property's unrealized appreciation). The partnership must allocate any remaining increase among the properties within the class in proportion to the transferee partner's share of the amount that would be realized by the partnership in the hypothetical sale of each asset in the class.181.13
181.13Regs. §1.755-1(b)(5)(iii)(A).
If a partnership must allocate a decrease in basis with a class of properties, it must first allocate the increase to properties with unrealized depreciation in proportion to the transferee's shares of the respective amounts of unrealized depreciation before such decrease (but only to the extent of the transferee's share of each property's unrealized depreciation). The partnership must allocate any remaining decrease among the properties within the class in proportion to the transferee partner's shares of their adjusted bases (as adjusted already for unrealized depreciation).181.14
181.14Regs. §1.755-1(b)(5)(iii)(B).
When a partnership must allocate a decrease of basis to capital gain assets, ordinary income assets or both, and the amount of the decrease otherwise allocable to a particular class exceeds the transferee's share of the partnership's adjusted basis in all depreciated assets in that class, the transferee's basis reduction is limited to the transferee's share of the partnership's adjusted basis in all depreciated assets in that class.181.15 When all or a portion of a basis decrease has been denied by this rule, however, the partnership may apply the adjustment (up to the denied amount) to new property of a like character when it acquires such property.181.16
181.15Regs. §1.755-1(b)(5)(iii)(C).
181.16Regs. §1.755-1(b)(5)(iii)(D).
(3)	Other Considerations
Legislative Change Note: The 2004 American Jobs Creation Act, P.L. 108-357, §833, amended §743 to provide that a partnership must adjust its basis in partnership property following the transfer of a partnership interest if the partnership has a §754 election in effect or the partnership has a substantial built-in loss immediately after the transfer, i.e., the partnership's adjusted basis in partnership property exceeds the property's fair market value by more than $250,000, effective for transfers after October 22, 2004. If the partnership has a substantial built-in loss, taxpayers must comply with the reporting requirements of Regs. §1.743-1(k) as if a §754 election were in effect at the time of the transfer. Notice 2005-32, 2005-16 I.R.B. 895.
In addition to gain or loss on sale of an asset, an adjustment to the basis of an asset under §743(b) for the benefit of a transferee also affects the depreciation or amortization deductions relating to the asset.182 Again, the increased or decreased depreciation or amortization deductions are solely for the benefit of the transferee.
182In general, if the basis of a partnership's recovery property is increased as a result of the transfer of a partnership interest, then the increased portion of the basis is taken into account as if it were newly-purchased recovery property, and any applicable recovery period and method may be used to determine the recovery allowance with respect to the increased portion of the basis. Regs. §1.743-1(j)(4)(i)(B). No change is made for purposes of determining the recovery allowance under §168 for the portion of the basis for which there is no increase. However, if a partnership elects to use the remedial allocation method with respect to an item of the partnership's recovery property, then the portion of any increase in the basis of the item of the partnership's recovery property under §743(b) that is attributable to §704(c) built-in gain is recovered over the remaining cost recovery period for the partnership's excess book basis in the property. Any remaining portion of the basis increase is recovered as if it were newly purchased property. For further discussion, see 714 T.M., Partnerships -- Allocation of Liabilities; Basis Rules. Generally, any increase in basis of qualified property, 50% bonus depreciation property, or Liberty Zone property due to a §754 election is not eligible for the special depreciation provisions of §168(k) or §1400L because any increase in basis of property does not satisfy the original use requirement; however, if the property is placed in service by a partnership in the taxable year the partnership terminates under §708(b)(1)(B), any increase in basis of the property due to a §754 election is eligible for the special depreciation deductions. Regs. §§1.168(k)-1T(f)(9), 1.1400L(b)-1T(f)(8), added by T.D. 9091, 68 Fed. Reg. 52985 (9/8/03).
If a purchaser of a partnership interest paid more for the interest than the seller's share of the aggregate value of the partnership's assets, it was previously believed that the excess purchase price could be allocated among the partnership's assets rather than to goodwill under the rules of §§743(b) and 755 if an election under §754 applied to the transfer.183 However, since the enactment of §1060 in 1986,184 if a purchaser pays more than the seller's share of the aggregate value of the partnership's assets, the excess must be allocated to "section 197 intangibles" if a §754 election applies to the purchase.185 The allocation to "section 197 intangibles" will not, of course, affect the remaining partners since the adjustment is solely for the benefit (or detriment) of the purchaser.
183See U.S. v. Cornish, 348 F.2d 175 (9th Cir. 1965), rev'g 221 F. Supp. 658 (D. Ore. 1963).
184P.L. 99-514, §641.
185Regs. §1.755-1(a)(2), T.D. 9059, 68 Fed. Reg. 34293 (6/9/03), effective for transactions occurring on or after June 9, 2003. "Section 197 intangibles" include §197 intangibles (as defined in §197) as well as any goodwill or going concern value. The excess is allocated first among §197 intangibles other than goodwill and going concern value, and then to goodwill and going concern value. Regs. §1.755-1(a)(5).
c.	Making the Section 754 Election
Legislative Change Note: The 2004 American Jobs Creation Act, P.L. 108-357, §833, amended §743 to provide that a partnership must adjust its basis in partnership property following the transfer of a partnership interest if the partnership has a §754 election in effect or the partnership has a substantial built-in loss immediately after the transfer, i.e., the partnership's adjusted basis in partnership property exceeds the property's fair market value by more than $250,000, effective for transfers after October 22, 2004. If the partnership has a substantial built-in loss, it must comply with the reporting requirements of Regs. §1.743-1(k) as if a §754 election were in effect at the time of the transfer . Notice 2005-32, 2005-16 I.R.B. 895.
In order to be entitled to make the adjustment to basis under §§743(b) and 755, an election under §754 must apply to a sale, exchange or transfer by reason of death of a partnership interest.186 An election, once made, applies to all subsequent transfers unless the election is revoked, which requires IRS consent.187 The election is made by the partnership's filing a written statement containing the information requested under regulations with its timely-filed tax return (including extensions) for the year in which the election is to first apply.188 See, e.g., PLRs 200316021, 200316006. If the deadline is missed, the IRS may grant an extension to file the election under its administrative discretion authorized by Regs. §301.9100-1. It is, of course, not wise tax planning to rely on the discretion of the IRS if it can be avoided.
186§743(a),  (b).
187Regs. §1.754-1(a),  (c).
188Regs. §1.754-1(b).
Although an adjustment under §743(b) affects only a transferee partner, an election under §754 also applies to adjustments under §734, which affect all partners. A §754 election is one avenue to adjustments under both §743(b) and §734(b). Section 734(b) provides for an adjustment to basis of the partnership's property upon a distribution of property to a partner in certain circumstances. If a §754 election is in effect, the adjustments under §§743(b) and 734(b) are mandatory. In Rev. Rul. 93-13,188.1 the IRS concluded that where a partnership, that has a §754 election in effect, completely liquidates the interest of a retiring partner (or a deceased partner's successor in interest) by agreeing to make a series of cash payments that are treated as distributions under §736(b)(1), the §734(b) basis adjustments to partnership property correspond in timing and amount with the recognition of gain or loss by the retiring partner as to those payments. The IRS stated that if a partner makes the election permitted by Regs. § 1.736-1(b)(6), the basis adjustments made by the partnership correspond with the gain recognized by the partner pursuant to that election; otherwise the partnership's basis adjustments correspond with the gain recognized by the partner under §731. Since a §754 election, once made, applies to all future transfers of partnership interests and property distributions to partners, unless the election is revoked with IRS consent, and since the adjustments can be negative as well as positive, partnerships are often reluctant to make the election. Partnerships are also reluctant due to the increased administrative burden that could be created by making the election. Therefore, a well advised purchaser of a partnership interest should require that the election be made as a condition of a purchase if it is important to him that the §743(b) adjustment be made.
188.11993-7 I.R.B. 12
d.	Revocation of Election
A §754 election applies to the taxable year with respect to which it is initially validly made and to all subsequent years unless the election is revoked.189 A revocation is permissible only with the consent of the IRS District Director for the IRS District in which the partnership files its return.190 Application for revocation of a §754 election, which may be granted or denied at the discretion of the District Director, must be filed within 30 days following the close of the partnership's taxable year for which the revocation is to apply.191 The following are listed in the regulations as examples of reasons why a request for a revocation may be granted: (1) a change in the nature of the partnership's business; (2) a substantial increase in the assets of the partnership; (3) a change in the character of the partnership's assets; or (4) an increased frequency of retirements or shifts of partnership interests causing an increased administrative burden on the partnership due to the §754 election.192 The regulations specifically point out, however, that "no application for revocation of an election shall be approved when the purpose of the revocation is primarily to avoid stepping down the basis of partnership assets upon a transfer or distribution."193
189§754.
190Regs. §1.754-1(c).
191Id.
192Id.
193Id.
3.	Exceptions to General Rule -- Electing Investment Partnerships and Securitization Partnerships
Electing investment partnerships (EIPs) and securitization partnerships are excepted from the general rule requiring basis adjustments to partnership property on the transfer of a partnership interest if the partnership has a substantial built-in loss.193.1 An EIP or securitization partnership that subsequently fails to so qualify, however, is subject to the partnership adjustment basis rules beginning with the first transfer of a partnership interest (and, in the case of a securitization partnership, the first distribution) that occurs after the partnership fails to meet the applicable definition.193.2 An EIP also may terminate its EIP election without the Commissioner's consent by filing a §754 election.193.3
193.1§743(e),  (f), added by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, effective for transfers after Oct. 22, 2004. See also Notice 2005-32, 2005-16 I.R.B. 895 (providing interim guidance for EIPs and their partners).
193.2Notice 2005-32, 2005-16 I.R.B. 895; H.R. Conf. Rep. No. 108-755, at 614 (2004).
193.3Notice 2005-32, 2005-16 I.R.B. 895.
An EIP is a partnership that satisfies the following requirements:193.4
(1) it makes an irrevocable election to be treated as an EIP;
(2) it would be an investment company under the Investment Company Act of 1940, §3(a)(1)(A), but for an exemption under §3(c)(1) or §3(c)(7)
(3) it has never engaged in a trade or business;
(4) substantially all of its assets are held for investment;
(5) at least 95% of the assets contributed to it consist of money;
(6) no assets contributed to it had an adjusted basis in excess of fair market value at the time of contribution;
(7) it issues all partnership interests by private offering within 24 months of the first capital contribution to it;
(8) its partnership agreement has substantive restrictions on each partner's ability to cause a redemption of its interest; and
(9) its partnership agreement provides for a term not in excess of 15 years.
193.4§743(e)(6). In the Conference Report accompanying the 2004 AJCA, venture capital funds, buyout funds, and funds of funds were described as probable types of EIPs. H.R. Conf. Rep. No. 108-755, at 613 (2004). See Notice 2005-32, 2005-16 I.R.B. 895, for interim guidance for making an EIP election and trades or businesses of lower-tier partnerships.
Although the otherwise required partnership basis adjustments do not apply, if a partnership interest in an EIP is transferred, a partner-level loss limitation rule applies. Under this rule, the transferee partner's distributive share of losses (without regard to gains) from the sale or exchange of partnership property is disallowed except to the extent it is established that the losses exceed the loss recognized by the transferor on the transfer of the partnership interest (or by a prior transferor to the extent not fully offset by a prior disallowance).193.5 Losses disallowed under this rule do not decrease the transferee partner's basis in the partnership interest, so that the transferee's gain is reduced (or loss increased) on a subsequent transfer of its partnership interest.193.6 If the transferee partner's basis in property distributed by the partnership in a nonliquidating distribution is reduced under §732(a)(2), the amount of the transferor's loss taken into account for purposes of the loss limitation rule is reduced by the amount of the basis reduction.193.7 These rules apply regardless of a partnership termination under §708(b)(1)(B).193.8
193.5§743(e)(2). See Notice 2005-32, 2005-16 I.R.B. 895, for interim guidance on the character of losses disallowed under this provision.
193.6§743(e)(3). See H.R. Conf. Rep. No. 108-755, at 611 (2004).
193.7§743(e)(5).
193.8§743(e)(4).
In Notice 2005-32,193.9 the IRS provided interim reporting requirements for EIPs. Under the guidelines, the transferor of an EIP interest must provide a written statement to the transferee and the EIP within 30 days after the transferor receives Schedule K-1 for the EIP's taxable year in which transfer occurred (or, if later, by May 19, 2005). The statement must contain certain identifying information as well as the amount of loss recognized by the transferor on the transfer, the amount of loss recognized by prior transferors but not offset by prior loss disallowances, and any other information necessary for the transferee to compute the amount of loss disallowed under the loss limitation rule. Notice 2005-32 also requires an EIP to separately state on Schedule K and K-1 all allocations of losses to all of its partners, including losses that otherwise could be netted against gains at the partnership level, and to attach a boilerplate statement to every statement provided to a partner or nominee under §6031(b) identifying the partnership as an EIP. In addition, Notice 2005-32 provides that if a transferor fails to provide the required information to the transferee, the transferee must treat all losses allocated from the EIP as disallowed.
193.92005-16 I.R.B. 895.
A securitization partnership is a partnership whose sole business activity is to issue securities that provide for a fixed principal (or similar) amount and that are primarily serviced by the cash flows of a discrete pool (fixed or revolving) of receivables or other financial assets that by their terms convert to cash in a finite period, but only if the pool's sponsor reasonably believes that the receivables and other financial assets comprising the pool are not acquired so as to be disposed of. Securitization partnerships are not subject to the partner-level loss limitation rule.193.10
193.10§743(f)(2). H.R. Conf. Rep. No. 108-755, at 614 (2004), states that it intended that rules similar to those applicable to sponsors of REMICs apply in determining whether a sponsor's belief is reasonable.
G. Miscellaneous Additional Tax Consequences Upon Disposition of Partnership Interest
1.	Losses Suspended Under §704(d)
Section 704(d) limits the extent to which a partner may deduct partnership losses in any year to the partner's adjusted basis in his partnership interest at the end of the partnership year in which the loss occurs. Any loss that is not allowed because of the §704(d) limitation is carried over to future years and may be claimed as a deduction when the partner's basis in his partnership interest increases above zero. In effect, disallowed losses are suspended and carried forward indefinitely into future years and are available for deduction when the partner's basis increases above zero, whether that increase is due to a capital contribution, the partnership having taxable income allocable to the partner, or any other reason.194
194Regs. §1.704-1(d)(4), Exs. (2) and (3).
If a partner has been allocated losses in prior years which he has not been able to use because of the limitation under §704(d), the suspended loss is apparently lost forever upon a transfer of the partnership interest. Although there is no specific prohibition in the regulations on transferring the suspended loss, the language of the regulations indicates that use of the suspended loss is personal to the partner who is allocated the loss.195 In addition, there is no statutory or regulatory provision that authorizes a transfer of a suspended loss account under §704(d) when the partner with a suspended loss transfers his partnership interest. On the other hand, it also appears that a partner who has a suspended loss under §704(d) and transfers only a portion of his partnership interest should be entitled to claim the full deduction in any subsequent year that his basis in the retained interest exceeds zero. A partner with a suspended loss account who is contemplating transferring his entire interest should therefore consider the possibility of retaining a portion in order to obtain the benefit of the suspended loss in future years.
195Regs. §1.704-1(d)(2).
A person who ceases being a partner due to a transfer of his partnership interest may not deduct suspended losses in the future even if he contributes cash to the partnership after he ceases being a member. That was the ruling of the Tax Court, which was affirmed by the Ninth Circuit, in Sennett v. Comr.196 In that case, the taxpayer's interest in a partnership was liquidated by the partnership. After the liquidation, the taxpayer made a payment to his former partnership for a portion of his allocable share of partnership losses that could not be deducted while he was a partner because of the §704(d) limitation. Since the partnership's taxable year ended with respect to the partner upon the liquidation of his entire interest in the partnership, the court concluded that the taxpayer's payments failed to come within the literal requirements of §704(d), which allow a deduction only "at the end of the partnership year in which such excess is repaid to the partnership."
19680 T.C. 825 (1983), aff'd per curiam, 752 F.2d 428 (9th Cir.1985).
Comment: The IRS and the Tax Court in Sennett did permit the taxpayer to take the excess undeducted loss into account by reducing the amount of capital gain on the sale by the amount of the repaid loss. Since the capital gain was long-term and the loss ordinary, however, the taxpayer was denied the benefit of a capital gain rate conversion. A partner contemplating the sale of his partnership interest and making a capital contribution to the partnership, in order to obtain the benefit of a suspended loss, should repay the loss before the sale to avoid the Sennett result.
2.	Losses Suspended Under §465 At Risk Rules
Under §465, a partner that is an individual, an S corporation, or a closely held C corporation that meets certain tests may deduct its allocable share of partnership losses only to the extent that the partner is "at risk" with respect to the partnership's "activity" (as defined in §465) at the close of the taxable year. Before 1986, the at risk provisions applied to virtually any activity other than holding real property. The at risk rules were extended to real estate activities by the Tax Reform Act of 1986.197
197P.L. 99-514, §503. For a detailed discussion of the §465 at risk rules, including the changes made by the 1986 TRA, see 550 T.M., At-Risk Rules.
Although the limitation on deduction of losses contained in §704(d) and the at risk rules of §465 are similar, they are not identical. A partner must clear both hurdles in order to claim partnership losses on his individual return. That is, he must have basis and an at risk amount in order to currently claim losses. Having an inadequate amount of either basis or at risk amount will limit the deductibility of partnership losses. Having basis but an inadequate at risk amount could occur, for example, where a partnership has nonrecourse indebtedness that is taken into account by a partner for basis determination purposes under §752, but because the debt is nonrecourse, does not increase the partner's at risk amount under §465.
As with the §704(d) limitations, a partner's distributive share of losses, which may not be claimed due to the at risk limitations, are suspended and may be claimed in any subsequent year in which the partner's at risk amount with respect to the activity increases. However, the partner's distributive share of partnership losses reduces his adjusted basis in his partnership interest even if the losses are disallowed under §465.198 Thus, if a partner has adequate basis but insufficient at risk amount to claim partnership losses, the partner will nevertheless be required to reduce his basis in his partnership interest by the amount of his share of partnership losses notwithstanding that he is unable to claim the losses due to the at risk limitations of §465.
198See Prop. Regs. §1.465-1(e).
As discussed at II, B, 2, a, above, upon a taxable disposition of a partnership interest, the measure of the partner's taxable gain or loss is based on his basis in the interest. The basis reduction that could apply even though a partner is not entitled to claim losses due to an at risk limitation would result in inequities when the partner disposes of his partnership interest in a taxable transaction. In order to correct this injustice, the regulations proposed under §465 provide that any gain realized on the disposition of a partnership interest is treated as an increase in the amount for which the partner is considered to be at risk, as a result of which the suspended losses are allowed as a deduction to the partner in the year of the sale to the extent of the increase.199
199Prop. Regs. §§1.465-66(a), 1.465-12.
Example: A is a partner in partnership ABC. As of the close of calendar year 1992, A's basis in the partnership is $3,000, A's amount at risk is zero, and A has $7,000 of losses from the partnership which would have been allowed as a deduction but for the at risk limitations of Section465. A's share of partnership nonrecourse debt is $10,000. On January 1, 1993, D purchases A's interest for $1,000 cash. A's amount realized is therefore $11,000 ($1,000 cash plus A's share of the nonrecourse liability pursuant to §752(d)), and his gain is $8,000. The gain is considered income from the activity which increases A's at risk amount. The net result of the transaction is that A will have an $8,000 taxable gain from the disposition of the partnership interest, the character of which will depend upon the character of the partnership's assets as discussed above, and he will be entitled to claim a deduction of $7,000 in 1993 attributable to the loss that was previously disallowed under the at risk provisions.
The proposed regulations discuss the at risk limitations of the transferee in a tax-free transfer. They do not, however, consider the transferee's at risk amount in the case of a taxable acquisition of a partnership interest. This issue arises because a purchaser does not appear to have contributed cash or other property "to the activity," as required in order for the purchaser to acquire an at risk amount under §465(b)(1)(A), since his cash purchase price goes to the selling partner rather than to the partnership. By analogy to Prop. Regs. §1.465-69, regarding amounts at risk with respect to transfers at death, the at risk amount of a purchaser should equal that of the selling partner, increased or decreased by the amount by which the purchase price differs from the transferor's adjusted basis.200
200Prop. Regs. §1.465-69.
The proposed regulations discuss the at risk consequences to the transferee in the case of a non-taxable transfer of a partnership interest, in which the transferee's basis in the interest is determined in whole or in part by reference to the basis of the transferor. If the transferor had suspended losses under §465 at the close of the taxable year in which the transfer occurs, the amount of the suspended loss may be added to the transferor partner's basis in the partnership interest for the purpose of determining the transferee's basis after the transfer.201 Conversely, if the transferor had a positive amount at risk, the transferor's amount at risk is added to the transferee's amount at risk (but not to exceed the amount by which the transferee's basis exceeds the amount paid by the transferee, including the amount of liabilities to which the transferred property is subject).202
201Prop. Regs. §1.465-67. This addition to basis is applied only to the extent that the transferor's suspended losses are not allowed due to the recognition of gain on the transaction. See Prop. Regs. §1.465-67(b).
202Prop. Regs. §1.465-68.
Example: A's adjusted basis in his partnership interest, as of December 31, 1992, is $100,000 and his §465 amount at risk is $70,000 (capital contribution of $20,000 plus his share of partnership recourse liabilities of $50,000). The differential between basis of $100,000 and at risk amount of $70,000 is attributable to A's $30,000 share of partnership nonrecourse liabilities. A gives his partnership interest to his son, S, on January 1, 1993. S succeeds to A's $100,000 adjusted basis for the partnership interest. In addition, A's $70,000 at risk amount under §465 is added to S's amount at risk in the venture.
The proposed regulations do not specifically address whether a suspended loss under §465 will be carried over to a transferee in the case of a nontaxable transfer. However, there is a strong inference in the proposed regulations that the suspended loss is personal to the transferor and will not be carried over to the transferee. This follows because, as mentioned above, the suspended loss is restored as an increase in basis of the partnership interest in the hands of the transferee. If a carryover of the suspended loss to the transferee were also allowed whereby the transferee could claim the suspended loss in a future year when his at risk amount is increased, a double benefit would be conferred on him. Consequently, any suspended loss of a transferor in a nontaxable transfer of a partnership interest apparently evaporates and is lost forever.
In the case of a transfer upon the death of a partner, losses that were suspended under the at risk provisions and not claimed by the decedent before his death are also apparently personal to the decedent and expire with his death. The proposed regulations provide that the value of a partnership interest as of the date of death is the successor's at risk amount.203
203Prop. Regs. §1.465-69(a).
Example: A deceased partner's adjusted basis for his partnership interest is $100,000 as of the date of death, and his amount at risk under §465 is also $100,000. The fair market value of the deceased partner's interest on the date of death is $200,000. Assuming that the alternate valuation rules of §2032 do not apply, the successor to the decedent will receive an increase of $100,000 in the adjusted basis of the decedent's partnership interest so that the successor's basis becomes $200,000 under §1014. This $100,000 increase also increases the successor's at risk amount by $100,000 so that both the successor's basis and at risk amount become $200,000.
Comment: The 2001 Tax Relief Act, P.L. 107-16, §542, added §1022 to the Code. Section 1022 serves to limit the aggregate basis step-up allowed on property acquired from a decedent who dies after 2009 (i.e., after repeal of the estate tax). See 560 T.M., Income Tax Basis: Overview and Conceptual Aspects, for further discussion.
3.	Losses Suspended Under Section 469 Passive Loss Limitations
Before 1986, partners had to contend with the basis limitation rules of §704(d) and the at risk rules of §465 in determining whether their allocable shares of partnership losses were currently deductible by them. A new regime was added to the Code in the form of §469 in 1986. Section 469 contains the "passive activity loss" rules. Since 1986, partners have had to contend with all three sets of rules in determining whether partnership losses are currently deductible. §469 further complicates this complex and rule-ridden area by providing its own exclusions and preferences.
A thorough discussion of §469 is beyond the scope of this portfolio.204 In summary, it must be kept in mind that, even after a partner has determined that: (1) he is entitled to losses because he has adequate basis and therefore the limitations of §704(d) do not come into play; and (2) he has adequate at risk amount and therefore §465 will not disallow the losses, the partner must also determine whether an overall loss from a partnership is active or passive in nature. If the loss is passive, it will generally be unavailable as a current deduction. Passive activity losses for the taxable year are generally allowed only to the extent that the taxpayer has aggregate income from passive activities.205 Any losses exceeding passive income may not be applied during the taxable year against income from non-passive sources.206 The losses from passive activities are suspended and carried forward indefinitely and applied against passive income (if any) that is generated in future taxable years.207
204For a detailed discussion of §469, see 549 T.M., Passive Loss Rules.
205See §469(d)(1); Regs. §1.469-2T(b)(1).
206Regs. §§1.469-1T(a)(1)(i),  -2T(b).
207§469(b).
A taxpayer who disposes of an interest in a passive activity may deduct suspended losses if: (1) the taxpayer disposes of his entire interest in the activity; (2) the disposition is in the form of a fully taxable transaction (i.e., one in which the full amount of the gain or loss inherent in the activity is recognized); and (3) the person acquiring the interest is not related to the taxpayer.208 For this purpose, related parties are those with any of the relationships described in §267(b) or §707(b)(1), including applicable attribution rules.209 A disposition of less than the taxpayer's entire interest in an activity has no effect on losses suspended under §469. Moreover, in order to trigger the allowance of suspended losses under §469, a taxpayer must dispose of his entire interest in the activity, which requires that the taxpayer dispose of his interest in all entities involved in the activity. For example, assume that a taxpayer is a partner in a partnership that is engaged in an activity and is a shareholder in an S corporation also engaged in the activity. Under §469(g), a disposition of the taxpayer's partnership interest in a fully taxable transaction to an unrelated party will not trigger suspended losses if the taxpayer does not also dispose of his interest in the S corporation.
208§469(g).
209§469(g)(1)(B). These related party provisions will generally be met if there is a family or fiduciary relationship between the transferor and transferee or if there is more than 50% direct or indirect common control between the transferor and transferee.
In the case of a disposition in an otherwise fully taxable transaction to a related party, suspended losses from the activity remain with the transferor. In the event that the transferee subsequently disposes of his entire interest acquired from the original transferor to a party who is not related to the original transferor, suspended losses are allowed to the original transferor at the time of the second disposition.210
210§469(g)(1)(B).
As mentioned, a disposition that is not fully taxable will not qualify for allowance of previously suspended losses. In most cases, a fully taxable disposition will be a sale or exchange of an interest in a partnership conducting a passive activity with respect to the taxpayer to a third party in a bona fide arm's-length transaction. However, other dispositions that give rise to the recognition of loss (such as an abandonment of a partnership interest) likewise trigger application of the disposition rules.211
211See H.R. Rep. No. 99, 99th Cong., 2d Sess. II-143-144 (1986).
Special rules apply to dispositions by reason of death and gifts of an interest in a passive activity. In the case of the death of a partner who had suspended losses under the passive activity provisions of §469, the suspended passive losses generally are allowed on the decedent's final income tax return. The amount of the suspended loss is reduced, however, to the extent that the basis of the decedent's partnership interest in the hands of the decedent's successor exceeds the adjusted basis of the partnership interest in the hands of the decedent immediately before death.212 If the suspended losses of the decedent are not allowable on his final return due to the stepped up basis limitation, the suspended losses of the decedent are not allowable to the initial transferee or to anyone else.213
212§469(g)(2).
213§469(g)(2)(B).
Example: Partnership ABC is engaged in a single activity of owning a single apartment building, which is a passive activity with respect to all of the partners. Partner A dies at a time when he has an adjusted basis in his partnership interest of $100,000, which has a fair market value of $300,000, and suspended losses of $350,000. Since the partnership interest is stepped up in basis under §1014 to its fair market value of $300,000, the amount of the passive activity losses which may be claimed on the decedent's final income tax return is only $150,000 ($350,000 suspended losses minus the $200,000 step-up in basis).
Comment: The 2001 Tax Relief Act, P.L. 107-16, §542, added §1022 to the Code. Section 1022 serves to limit the aggregate basis step-up allowed on property acquired from a decedent who dies after 2009 (i.e., after repeal of the estate tax). See 560 T.M., Income Tax Basis: Overview and Conceptual Aspects, for further discussion.
A gift by a donor partner of all or part of his interest in a partnership conducting a passive activity with respect to the donor partner does not trigger the allowance of suspended losses. Rather, the suspended losses are added to the donor's basis in the partnership interest immediately before the gift so that, in effect, the donee gets the benefit of the suspended losses in the form of a higher basis in the interest.214 However, because a special §743(b) basis step-up in the partnership's assets is not available in the gift context, the step-up in basis from the suspended losses will generally not provide a tax benefit to the donee until the donee subsequently disposes of the partnership interest in a taxable transaction. The suspended losses attributable to the gifted partnership interest cannot be recovered by the donor for any taxable year.215
214§469(j)(6).
215Id.
In the case of an installment sale under §453 of a partner's entire interest in a partnership with suspended losses, the amount of suspended losses allowable by reason of the disposition is reduced to reflect the fact that the gain from the sale is being included over time. The amount of suspended losses allowable as a deduction against nonpassive income by reason of the disposition is proportionate to the percentage of gain reported under the installment method for the taxable year.216
216§469(g)(3).
4.	Investment Credit Recapture
A partner may be subject to investment credit recapture if the partner's interest in partnership profits is reduced to less than 2/3 of his interest at the time the partnership claims an investment credit within the recapture period specified in §50(a)(1)(B).217 It does not matter whether the reduction is caused by a sale or exchange of all or a part of the partner's partnership interest, the admission of new partners, or a liquidation of all or a portion of the partner's interest in the partnership.218 If the partner's interest is reduced by the applicable percentage, the partner is treated as disposing of a proportionate share of the partnership's investment credit property subject to recapture. Additional recapture is required if the partner's interest is again reduced to less than 1/3 of his original interest.219
217Regs. §1.47-6(a)(2)(i),  (ii). Although the investment credit recapture rules were redesignated by the Revenue Reconciliation Act of 1990, P.L. 101-508, from §47 to §50(a), the regulations promulgated under §47 presumably continue to apply under §50(a).
218Regs. §1.47-6(a)(2)(i),  (ii).
219Regs. §1.47-6(a)(2)(ii).
5.	Taxable Dispositions by Foreign Partners
Gain from a disposition of personal property by a non-U.S. person (a nonresident alien individual, foreign corporation, or foreign estate or trust) is generally foreign source gain to the non-U.S. person and, accordingly, is not subject to U.S. tax.220 Similarly, losses on taxable dispositions of personal property by non-U.S. persons generally do not give rise to a deduction for U.S. tax purposes.221 Accordingly, gain or loss realized by a non-U.S. person from a disposition of a partnership interest generally should not be subject to U.S. income taxation except to the extent that the partnership owns U.S. real property, in which case the disposition is taxable to the extent of the partner's share of the U.S. real property pursuant to §897. See 912 T.M., Federal Taxation of Foreign Investment in U.S. Real Estate, for a discussion of the application of §897 to a non-U.S. partner's disposition of an interest in a partnership. However, the IRS adopted a different approach in the case of a taxable disposition of a partnership interest by a nonresident alien individual in Rev. Rul. 91-32.222
220§865(a). Certain limited categories of foreign source income that are attributable to a non-U.S. person's U.S. office or fixed place of business are subject to U.S. tax. See Regs. §1.864-6.
221In general, losses from sales of personal property are allocable to, and therefore deductible from, U.S. source gross income to the extent that the personal property generated U.S. source gross income in the hands of the seller. Regs. §1.865-1T(a)(1).
2221991-1 C.B. 107. Although the facts of Rev. Rul. 91-32 involve a nonresident alien individual partner, the same conclusion also presumably would apply to a foreign corporation or foreign estate or trust partner.
In Rev. Rul. 91-32, the IRS concluded that, if either a domestic or a foreign partnership is engaged in a U.S. trade or business through a fixed place of business located in the United States, a non-U.S. partner who disposes of an interest in the partnership in a taxable transaction must look to the partnership's assets in order to determine the tax consequences of the disposition. First, the partner must segregate the partnership's assets that are held for use in its U.S. trade or business from its other assets.223 The partner then must determine the gain or loss that would be allocable to the partner if the partnership sold all of its assets in each of the two categories.
223Although the ruling does not so specify, presumably, if the partnership held personal property located in the United States that was not held for use in the partnership's U.S. trade or business, any gain attributable to those assets would not generate gain to the selling partner subject to U.S. income tax.
The partner's gain or loss on the disposition of his partnership interest will be characterized as "effectively connected" gain or loss, and therefore subject to U.S. income tax, to the extent that the gain or loss is attributable to U.S. trade or business assets of the partnership.224 The character of the foreign partner's gain or loss that is subject to U.S. tax is then determined under §§741 and 751.
224The ruling reached the same conclusion in the case of a partnership with a permanent establishment located in the U.S. if the selling partner is a resident in a country that has an income tax treaty that is identical to the Draft United States Model Income Tax Treaty (June 1981).
Comment: In the author's view, the IRS' reasoning in Rev. Rul. 91-32 is flawed and the ruling is an incorrect interpretation of relevant law. First, there is no statutory or regulatory authority for looking to the partnership's assets for purposes of determining whether the gain or loss on a disposition of a partnership interest is subject to U.S. income tax. Second, the ruling ignores the explicit language of §865(a), which sources the gain on sale of a partnership interest with reference to the residence of the seller, except as otherwise provided in §865. Thus, under the general rule of §865(a), a non-U.S. partner's sale of a partnership interest would generate foreign source income to the partner, who is, generally speaking, not subject to U.S. tax. The exception to the general rule of §865(a) relied upon in the ruling is §865(e), which generally provides that gain recognized by a non-U.S. person from the sale of personal property will be taxable U.S. source gain to the extent that the gain is attributable to a U.S. office or other fixed place of business of the non-U.S. person. However, the facts of the ruling do not indicate that the partner has a U.S. office or other fixed place of business and therefore the exception is not applicable.225
225The facts of the ruling are that the partnership (rather than the partner) has a U.S. office or other fixed place of business. The ruling reasons that the partnership's office or other fixed place of business is attributed to its partners pursuant to §875. However, that section merely provides that a U.S. trade or business of a partnership will be attributed to its partners. It says nothing about attribution of an office or other fixed place of business.
6.	Look-Through Capital Gain on Sale of Partnership Interest
a.	Background
(1)	General Treatment of Sale of Partnership Interest
The Code generally treats a partnership interest as a property interest distinct from the assets held by the partnership.225.1 Traditionally, the sale or exchange of a partnership interest with a long-term holding period results in capital gain and is taxed at a 15% rate.225.2 However, to the extent that amounts received are attributable to unrealized receivables and/or inventory, the taxpayer must recognize ordinary income.225.3
225.1See II, A, above.
225.2§1(h)(1)(C), as amended by P.L. 108-27, §301(a). Transitional rules to account for the former 20% capital gains rate apply in taxable years that include May 6, 2003. P.L. 108-27, §301(c)(2).
225.3§751(a). Under §751(c), unrealized receivables include §1250 property to the extent of the amount that would be treated as gain to which §1250(a) would apply. See II, B, 2, b, (2), above.
(2)	Look-Through Treatment for Certain Capital Gain
The Taxpayer Relief Act of 1997 added a 25% capital gains rate applicable to "unrecaptured §1250 gain," and a 28% rate applicable to collectibles gain.225.4 In addition, the legislation authorized the IRS to issue regulations applying those provisions to sales of interests in passthrough entities,225.5 and specifically provided that any gain from the sale of a partnership interest attributable to unrealized appreciation in the value of collectibles is to be treated as gain from the sale of a collectible.225.6 Accordingly, the IRS issued regulations that provide that, if a taxpayer sells an interest in a partnership that holds collectibles, rules similar to those under §751(a) apply to determine the amount of capital gain attributable to unrealized gain in the collectibles.  In addition, similar rules apply to determine the capital gain attributable to unrealized gain in §1250 property held by a partnership upon the sale of an interest in the partnership.225.7 The regulations do not apply in the case of a redemption of a partnership interest.225.8
225.4See 507 T.M., Income Tax Liability: Concepts and Calculation.
225.5§1(h)(9), as redesignated by P.L. 108-27, §301(b).
225.6§1(h)(5)(B), as redesignated by P.L. 108-27, §301(b). Congress specified that rules similar to those under §751 should be applied for this purpose.
225.7Regs. §1.1(h)-1, T.D. 8902, 65 Fed. Reg. 57092 (9/21/00), effective for all transfers of interests in a partnership, S corporation, or trust on or after Sept. 21, 2000.
225.8Regs. §1.1(h)-1(b)(2)(ii),  (b)(3)(ii). See preamble to T.D. 8902, 65 Fed. Reg. 57092 (9/21/00).
b.	Collectibles Gain
Effective for taxable years ending after May 6, 1997, if a partnership interest held for more than one year (or more than 18 months during certain periods in 1997) is sold or exchanged, any gain from the sale attributable to unrealized appreciation in the value of collectibles held by the partnership is treated as gain from the sale or exchange of a collectible.225.9 The regulations provide that "look-through capital gain" consists in part of "collectibles gain" allocable to an interest in a partnership.225.10 "Collectibles gain" is gain from the sale or exchange of a collectible (as defined in §408(m) without regard to §408(m)(3)) that is a capital asset held for more than one year.225.11 If an interest in a partnership held for more than one year is sold or exchanged, the transferor must recognize as collectibles gain the net gain that would be allocated to the partner if the partnership transferred all of its collectibles for cash equal to the fair market value of the assets in a fully taxable transaction immediately before the transfer of the interest.225.12
225.9§1(h)(5)(B), as redesignated by P.L. 108-27, §301(b).
225.10Regs. §1.1(h)-1(b)(1).
225.11Regs. §1.1(h)-1(b)(2)(i).
225.12Regs. §1.1(h)-1(b)(2)(ii). If less than the full amount of the gain realized on the transfer of the interest is recognized, a proportionate portion of the collectibles is deemed to have been sold. Id.
c.	Section 1250 Capital Gain
The second component of "look-through capital gain" is "section 1250 capital gain" allocable to an interest in a partnership.225.13 If an interest in a partnership held for more than one year is sold or exchanged in a transaction in which all realized gain is recognized, there is taken into account, for purposes of determining the partner's unrecaptured §1250 gain, the amount of §1250 capital gain that would have been allocated to that partner if the partnership transferred all of its §1250 property for cash equal to the fair market value of the assets in a fully taxable transaction immediately before the transfer of the interest.225.14
225.13Regs. §1.1(h)-1(b)(1).
225.14Regs. §1.1(h)-1(b)(3)(ii). If less than the full amount of the gain realized on the transfer of the interest is recognized, a proportionate portion of the §1250 property is deemed to have been sold. Id.
Note:  Section 1(h)(6)(B) (as redesignated by P.L. 108-27, §301(b)) limits the amount of unrecaptured §1250 gain recognized as a consequence of sales, exchanges, and conversions described in §1231(a)(3)(A) to the taxpayer's net §1231 gain for the year.  The regulations provide that the transferor partner's allocable share of §1250 look-through capital gain is not treated as §1231 gain for this purpose.225.15 Because the transfer of an interest in a partnership is not described in §1231(a)(3)(A), the limitation is not applicable.
225.15Regs. §1.1(h)-1(b)(3)(iii).
Comment:  A significant unresolved issue is how to determine the proportionate part of the §704(c) built-in gain or loss that is transferred to the purchaser when a §704(c) partner sells only a portion of his partnership interest.  This is necessary to determine the amount of the taxable gain or loss that would be allocated to the purchaser of a partial interest.  In addition, it is necessary under the regulations to calculate how much of the gain would be allocated with respect to the partnership interest sold if the collectibles or §1250 property were sold at fair market value.  This in turn requires the determination of how much §704(c) gain relating to the collectibles or §1250 property is allocable to the portion of the partnership interest sold.  The IRS determined that the issue is beyond the scope of the regulations.
d.	Residual Long-Term Capital Gain or Loss
The amount of "residual long-term capital gain or loss" recognized by a partner on account of the sale or exchange of a partnership interest equals the amount of long-term capital gain or loss that the partner would recognize under §741 ("pre-look-through long-term capital gain or loss") minus the amount of look-through capital gain.225.16
225.16Regs. §1.1(h)-1(c).
Example: (i) Five years ago partnership XYZ invested in antiques. Subsequent to the purchase, the antiques appreciated in value by $300. X owns one-third of ABC and has held his interest for more than one year. X's adjusted basis in his interest in XYZ is $100. If X sold his entire interest in XYZ to T for $150, X would realize $50 of pre-look-through long-term capital gain.
(ii) If XYZ sold its antiques in a fully taxable transaction for cash equal to the fair market value of the assets immediately before the transfer to T, X would be allocated $100 of gain on account of the sale. Therefore, X will recognize $100 of collectibles gain (look-through capital gain) on account of the collectibles held by XYZ.
(iii) The difference between the transferor's pre-look-through long-term capital gain or loss ($50) and the look-through capital gain determined under this section ($100) is the transferor's residual long-term capital gain or loss on the sale of the interest in XYZ. Under these facts, X will recognize $100 of collectibles gain and a $50 residual long-term capital loss on account of the sale of X's interest in XYZ.225.17
225.17See Regs. §1.1(h)-1(f), Ex. 4.
e.	Tiered Entities
In determining whether an entity has gain from collectibles or §1250 gain, the entity is treated as owning its proportionate share of the collectibles or §1250 property of any entity in which it owns an interest.225.18
225.18Regs. §1.1(h)-1(d).
f.	Notification Requirements
The regulations impose reporting rules similar to those applicable under §751(a) in the case of sales and exchanges of interests in entities that result in the recognition of collectibles gain or §1250 gain.225.19
225.19Regs. §1.1(h)-1(e).
7.	Divided Holding Period of Partnership Interest
a.	In General
In contrast to the sale of a proprietorship, in which the holding period is determined for each individual asset, upon the sale of a partnership interest a partner's holding period for his partnership interest is determined separately from the partnership's holding period of the assets.225.20 Generally, a partner has a unitary holding period in his partnership interest.  However, the holding period will be divided if: (i) the partner acquired portions of an interest at different times; or (ii) the partner acquired portions of his interest in exchange for property in certain transactions giving rise to different holding periods.225.21
225.20See GCM 36196 (undated); Lehman v. Comr., 7 T.C. 1088 (1946), aff'd, 165 F.2d 383 (2d Cir. 1948).
225.21Regs. §1.1223-3(a), T.D. 8902, 65 Fed. Reg. 57092 (9/21/00). The regulations reference §1223 as the operative provision that gives rise to different holding periods.
The holding period of a portion of a partnership interest generally is determined based on a fraction equal to the fair market value of the portion of the partnership interest to which the holding period relates over the fair market value of the entire partnership interest (determined immediately after the acquisition).225.22
225.22Regs. §1.1223-3(b)(1).
Example:  X contributes $5,000 in cash and a nondepreciable capital asset X has held for two years to a partnership (PRS) for a 50% interest in PRS. X's basis in the capital asset is $5,000, and the fair market value of the asset is $10,000. After the exchange, X's basis in X's interest in PRS is $10,000, and the fair market value of the interest is $15,000. X received one-third of the interest in PRS for a cash payment of $5,000 ($5,000/$15,000). Therefore, X's holding period in one-third of the interest received (attributable to the contribution of money to the partnership) begins on the day after the contribution. X received two-thirds of the interest in PRS in exchange for the capital asset ($10,000/$15,000). Accordingly, X has a two-year holding period in two-thirds of the interest received in PRS.225.23
225.23See Regs. §1.1223-3(f), Ex. 1.
b.	Sale of a Partnership Interest
If a partner sells or exchanges his entire interest in a partnership, any capital gain or loss recognized must be divided between long-term and short-term capital gain or loss in the same proportion as the holding period of the partnership interest is divided between the portion of the interest held for more than one year and the portion of the interest held for one year or less.225.24 A similar proportionality rule applies to the sale of a portion of a partner's interest in a partnership.225.25
225.24Regs. §1.1223-3(c)(1).
225.25Regs. §1.1223-3(c)(2)(ii). In certain cases, a portion of the interest in a publicly traded partnership may be treated as having an ascertainable holding period. Regs. §1.1223-3(c)(2)(i).
Example:  Assume the facts in the Example, above.  Six months later, when X's basis in PRS is $12,000 (due to a $2,000 allocation of partnership income to X), X sells the interest in PRS for $17,000. Assuming PRS holds no inventory or unrealized receivables, and no collectibles or recapture property, X realizes $5,000 of capital gain. As determined above, one-third of X's interest in PRS has a holding period of one year or less, and two-thirds of X's interest in PRS has a holding period equal to two years and six months. Therefore, one-third of the capital gain is short-term capital gain, and two-thirds of the capital gain is long-term capital gain.225.26
225.26See Regs. §1.1223-3(f), Ex. 1.
c.	Multiple Cash Contributions and Distributions Within One Year of Sale
If a partner makes one or more cash contributions and receives one or more cash distributions from a partnership during the one-year period before sale of all or a portion of the partnership interest, the net cash contribution to the partnership determines the portion of the interest held for one year or less.  Thus, in applying the rules for determining the partner's holding period in its partnership interest with respect to cash contributions, the partner may reduce the cash contributions made during the year by cash distributions received on a last-in-first-out basis, treating all cash distributions as if they were received immediately before the sale or exchange.225.27 This rule also applies in determining the holding period of a partnership interest if gain or loss is recognized under §731(a) upon a distribution by the partnership.225.28
225.27Regs. §1.1223-3(b)(2).
225.28Id.
Example:  On Jan. 1, 2001, X held a 50% interest in the capital and profits of a partnership (PS). The value of X's PS interest was $900, and X's holding period in the entire interest was long-term. On Jan. 2, 2001, when the value of X's PS interest was still $900, X contributed $100 to PS. On June 1, 2001, X received a distribution of $40 cash from the partnership. On Sept. 1, 2001, when the value of X's interest in PS was $1,350, X contributed an additional $230 cash to PS, and on Oct. 1, 2001, X received another $40 cash distribution from PS. X sold X's entire partnership interest on Nov. 1, 2001, for $1,600. X's adjusted basis in the PS interest at the time of the sale was $1,000.
For purposes of netting cash contributions and distributions in determining the holding period of X's interest in PS, X is treated as having received a distribution of $80 on Nov. 1, 2001. Applying that distribution on a last-in-first-out basis to reduce prior contributions during the year, the contribution made on Sept. 1, 2001, is reduced to $150 ($230-$80). The holding period then is determined as follows: Immediately after the contribution of $100 on Jan. 2, 2001, X's holding period in X's PS interest was 90% long-term ($900/($900 + $100)) and 10% short-term ($100/($900 + $100)). The contribution of $150 on Sept. 1, 2001, caused 10% of X's partnership interest ($150/($1,350 + $150)) to have a short-term holding period. Accordingly, immediately after the contribution on Sept. 1, 2001, X's holding period in X's PS interest was 81% long-term (.90 × .90) and 19% short-term ((.10 × .90) + .10). Accordingly, $486 ($600 × .81) of the gain from X's sale of the PS interest is long-term capital gain, and $114 ($600 × .19) is short-term capital gain.225.29
225.29See Regs. §1.1223-3(f), Ex. 3.
d.	Deemed Cash Contributions
An increase in a partner's share of partnership liabilities, or an increase in a partner's individual liabilities by reason of the partner's assumption of partnership liabilities, is treated as a contribution of money by the partner to the partnership.225.30 A deemed contribution of cash resulting from a shift among partners in their share of liabilities or as a result of a partnership incurring new debt does not create a new holding period. However, to the extent that a partner actually assumes a debt of the partnership, a new holding period with respect to a portion of the partner's interest arises.225.31
225.30§752(a).
225.31Regs. §1.1223-3(b)(3). The regulations incorporate the rule in Regs. §1.704-1(b)(2)(iv)(c). The rationale for this rule is that a deemed contribution of cash resulting from a shift among partners in their shares of liabilities or as a result of a partnership incurring new debt does not expand the net asset base of the partners represented by their interests in the partnership.
e.	Receipt of Interest in Exchange for Receivables or Inventory
The sale of a partnership interest produces ordinary income or loss, rather than capital gain or loss, if the partnership holds unrealized receivables or inventory items.225.32 If a partner who received a portion of his partnership interest in exchange for such assets recognizes ordinary income or loss on account of such assets, either as a result of the sale of all or part of the partnership interest or as a result of the sale by the partnership of such assets, those assets are disregarded in determining the division of the holding period of the partnership interest upon a sale of the partnership interest within one year of the contribution. This rule does not apply if, in the absence of the rule, the partner would not be treated as having held any portion of the interest for more than one year.225.33 Accordingly, if a partner's only contributions to a partnership are contributions of unrealized receivables and inventory, or such assets and cash within the prior one-year period, the adjustment is not available and the partner is treated as having a short-term holding period with respect to the entire interest.
225.32§751.
225.33Regs. §1.1223-3(b)(4).
Under a special rule, properties and potential gain treated as unrealized receivables are treated as separate assets that are not capital assets or assets that produce capital gain or ordinary loss upon disposition.225.34
225.34Regs. §1.1223-3(e).
III. Comparison of Disposition of Partnership Interests with Other Transactions
A. Sale of Partnership Assets
Before the enactment of §751, whether a partner sold an interest in a partnership or sold a proportionate share of the assets owned by the partnership was of critical importance in determining whether gain or loss recognized was capital or ordinary in nature. Generally, a sale of a partnership interest resulted in capital gain or loss while a sale of assets could be ordinary or capital gain or loss, depending on the character of the assets owned by the partnership. Various judicial doctrines developed under prior law whereby a sale of a partnership interest could be recharacterized as a sale of assets or vice versa. These doctrines are summarized below.
The enactment of §751 significantly reduced the ability of a partner to convert ordinary income into capital gain that was previously available upon the sale of an interest in a partnership that owned ordinary income property. Nevertheless, although the stakes have been reduced, disparate tax consequences between the sale of a partnership interest and the sale of partnership assets continue to exist and the distinction continues to have important tax consequences to selling partners in certain circumstances. Some of the differences include: (1) the characterization may be important if there are differences between a selling partner's holding period for his partnership interest and the partnership's holding period for its assets; (2) the application of certain provisions concerning transactions between related parties, such as §§267, 707(b), and 1239, may be affected based on the characterization of a sale transaction; (3) if a partner's basis in his partnership interest differs from his share of the partnership's basis in its assets, characterization of a sale or exchange may have significance as to both the timing and amount of the gain or loss recognized; and (4) if a partnership owns ordinary income property that is not within the definition of §751 assets, characterization of a sale of a partnership interest rather than a sale of assets would have characterization ramifications.
1.	Assignment of Income Doctrine
In several cases decided under the 1939 Code, the courts refused to treat the gain realized on the sale of an interest in a service partnership as capital gain under the theory that the sale was in substance an impermissible assignment of the right to receive future income.226 There is authority under existing law that the assignment of income doctrine continues to apply to dispositions of partnership interests, notwithstanding the enactment of §751.227
226See, e.g., Tunnell v. U.S., 259 F.2d 916 (3d Cir. 1958), aff'g 148 F. Supp. 689 (D. Del. 1957); Spicker v. Comr., 26 T.C. 91 (1956). But see U.S. v. Donoho, 275 F.2d 489 (8th Cir. 1960), aff'g 168 F. Supp. 679 (D. Minn. 1958).
227Tennyson v. U.S., 76-1 USTC ¶9264 (W.D. Ark. 1976), and Rev. Rul. 60-352, 1960-2 C.B. 208 (gift of interest in partnership holding installment receivable held to be disposition of the receivable); Seyburn v. Comr., 51 T.C. 578 (1969) (donor of partnership interest to charity taxed on rents received by partnership under assignment of income principles); Hale v. Comr., 24 T.C.M. 1497 (1965) (gain realized on sale of profits interest in partnership holding appreciated inventory was ordinary income rather than capital gain under assignment of income principles).
2.	Sale of Interest in Collapsible Partnership
In several cases decided under the 1939 Code, the courts recharacterized the sale of all interests in a partnership that had substantially completed its business activities as sales of partnership assets.
In Haggard v. Wood,228 for example, the taxpayers formed a partnership to cultivate cotton. When the crop was ready for harvest, the partners sold their partnership interests to a relative (after expressly rejecting a buyer's offer to purchase the crop from the partnership). The partners reported the sale of their partnership interests as capital gain. The Ninth Circuit affirmed the district court's holding that the taxpayers were required to recognize ordinary income because the transaction was in substance a sale of the cotton crop, resulting in ordinary income. The court emphasized that the work of the partnership had been completed, the partnership had no employees or other assets other than the cotton crop, and the transfer took place just prior to the fulfillment of the purpose of the partnership. The court also suggested that it viewed the transaction as a distribution of the cotton crop to the partners in complete liquidation of the partnership immediately followed by the sale by the partners of their undivided interests in the crop.
228298 F.2d 24 (9th Cir. 1961), aff'g 60-2 USTC ¶9740 (D. Ariz. 1960).
To the same effect was Trousdale v. Comr.,229 in which the court characterized the income recognized on the sale of a partnership interest as ordinary income. The partnership had substantially completed the construction of a housing project at the time of the sale. The partnership had no employees or assets, other than accounts receivable for services rendered at the time of the sale. After the sale, no business was conducted by the partnership (which technically remained in existence) other than the incidental performance of services and the collection of accounts. In reaching the conclusion that the gain recognized was ordinary income, the court held that the payments made to the taxpayer "were merely payments made to a retiring partner which represented his distributive share of earnings for past services."230
229219 F.2d 563 (9th Cir. 1955), aff'g 16 T.C. 1056 (1951).
230Id. at 567-68.
Although Haggard and Trousdale were decided under the 1939 Code, a court or the IRS could rely on them as precedent under current law in egregious situations in which a partnership has substantially completed its business activities at the time of a sale of a partnership interest.
3.	Sale of a Going Business Doctrine
A judicial doctrine developed under the 1939 Code, known as the "sale of a going business" doctrine, taxed the sale of an entire continuing partnership business as a sale of partnership interests even though the form of the transaction was the sale of the partnership assets. Although the early cases establishing this doctrine relied on the theory that a transfer of a going business should be treated as a transfer of a single capital asset,231 later cases adopted the rationale that a sale of an entire going partnership business is, in substance, a sale of all of the interests in the partnership.232
231See Hatch Est. v. Comr., 198 F.2d 26 (9th Cir. 1952), rev'g14 T.C. 251(1950); Thornley v. Comr., 147 F.2d 416 (3d Cir. 1945), rev'g 2 T.C. 220 (1943), acq., 1949-1 C.B. 4; Comr. v. Shapiro, 125 F.2d 532 (6th Cir. 1942).
232See, e.g., Barran v. Comr., 334 F.2d 58 (5th Cir. 1964), aff'g, rev'g and rem'g in part 39 T.C. 515 (1962); Kaiser v. Glenn, 216 F.2d 551(6th Cir. 1954), rev'g and rem'g per curiam 114 F. Supp. 356 (D. Ky.1953); Maxwell v. Frank, 182 F. Supp. 823 (W.D. Wash. 1960); Nieman v. Comr.,T.C. Memo 1960-120, motion to correct 33 T.C. 411 (1959).
While the doctrine has its origins under the 1939 Code, before the enactment of subchapter K, the doctrine apparently continues to have vitality under Subchapter K. It has been held, however, that the doctrine does not apply in the case of a sale of all of the assets of an inactive partnership.233
233Baker Commodities, Inc. v. Comr., 48 T.C. 374(1967), aff'd,415 F.2d 579(9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).
The IRS has implicitly rejected the doctrine in its published rulings.234 Tax planners should, therefore, be aware of the existence of the doctrine, but should not be sanguine about the IRS' likely acquiescence to the doctrine when its application would be to the detriment of the national risk.
234Rev. Rul. 72-172, 1972-1 C.B. 265.
While the doctrine may apply to characterize the gain or loss recognized by the seller of a partnership's business, the purchaser of a partnership's ongoing business is apparently not affected by the sale of a going business doctrine. Rather, the purchaser may be treated as acquiring the assets of the partnership even if the transaction is structured as a purchase of all partnership interests. For example, in McCauslen v. Comr,235 a partner in a two-member partnership purchased the entire partnership interest from the other partner as a result of which the partnership terminated under §708(b) and its assets were transferred to the purchaser. Less than six months later, the purchaser sold some of the assets and realized a gain, which he reported as long-term capital gain. The acquiring partner claimed that, under §735(b), he was entitled to "tack" the partnership's holding period for its assets because he received all of its assets in a liquidating distribution from the partnership. However, the Tax Court held that the taxpayer was not entitled to tack the holding period of the 1/2 interest in the partnership assets acquired from the other partner, reasoning that he acquired that interest by purchase.236
23545 T.C. 588 (1966).
236See also Rev. Rul. 67-65, 1967-1 C.B. 168.
B. Liquidation of Partnership Interest
1.	Tax Treatment of Liquidation Payments in General
The economic consequences to a partner who withdraws from a partnership are generally the same to him whether he receives compensation for his partnership interest from third parties, from the remaining partners, or from the partnership. Further, the economic consequences to the remaining partners are generally the same if the withdrawing partner receives compensation for his partnership interest from the continuing partners or from the partnership. However, the tax consequences to the parties from a sale by the withdrawing partner of his partnership interest to a third party or to the continuing partners on the one hand, or upon a liquidation of the partner's interest by the partnership, on the other hand, vary significantly. This portion of the portfolio summarizes the tax consequences to the parties upon a liquidation of a withdrawing partner's interest in the partnership. §III, B, 2, below, summarizes the differences between the tax consequences of a sale of a partnership interest and the liquidation of the interest. It should be noted, however, that a thorough discussion of all of the tax implications of a liquidation of a partner's interest in a partnership is beyond the scope of this portfolio. For a thorough discussion, see 716 T.M., Partnership Distributions; Death or Retirement of a Partner.
If a partner withdraws from a partnership due to his death, retirement, or expulsion and receives one or more payments from the partnership in liquidation of his interest, §736 applies to the payments. For simplicity, a retiring partner (whether the retirement is voluntary or forced) and the successors of a deceased partner whose interest is liquidated by the partnership will be referred to in this portion of the portfolio generally as a withdrawing partner.
The purpose of Section736 is to classify payments made by a partnership to a withdrawing partner. §736 does not determine the tax consequences which follow from that classification. Once the classification of liquidating payments to a withdrawing partner is made, other provisions of Subchapter K determine the tax consequences to the withdrawing and continuing partners. §736 generally classifies payments from a partnership to a withdrawing partner into one of three categories: (1) payments in consideration for the withdrawing partner's interest in partnership assets under §736(b);236.1 (2) a distributive share of partnership income under §736(a)(1); or (3) a guaranteed payment under §736(a)(2).
236.1Note that, under §736(b)(2), payments in consideration of a withdrawing partner's interest in partnership assets do not generally include amounts attributable to unrealized receivables and partnership goodwill. However, as a result of amendments made to §736(b)(3) by the Revenue Reconciliation Act of 1993 (1993 RRA), §13262, this exclusion applies to partners who retired or passed away on or after January 5, 1993 only if (i) capital is not a material income producing factor for the partnership, and (ii) the retiring or deceased partner was a general partner in the partnership. Congress did provide a grandfather rule, however, under which the amended §736(b)(3) does not apply to partners who retired from their partnership on or after January 5, 1993 if a written contract to purchase the partner's interest was binding on January 4, 1993 (and at all times thereafter before the purchase).
Payments classified as Section736(b) payments generally result in capital gain or loss to a withdrawing partner. To the extent that §736(b) payments exceed the withdrawing partner's adjusted basis in his partnership interest, capital gain results. To the extent that total §736(b) payments are less than the partner's adjusted basis for his partnership interest, capital loss will result. No tax consequences generally result to the remaining partners to the extent that liquidation payments to a withdrawing partner are characterized as §736(b) payments, unless the partnership has a §754 election in effect at the time of the transaction or there is a substantial basis reduction, in which case the partnership adjusts the basis of its properties under §734(b).236.2
236.2§734, as amended by the 2004 American Jobs Creation Act, P.L. 108-357, §833(c)(2), effective for dispositions made after Oct. 22, 2004. Under §734(d), there is a substantial basis reduction with respect to a distribution if the partnership would make a downward basis adjustment of more than $250,000 under §734(b)(2)(A) and  (b)(2)(B). For a complete discussion of §734(b) basis adjustments, see 714 T.M., Partnerships -- Allocation of Liabilities; Basis Rules.
Payments that constitute a distributive share of partnership income described in §736(a)(1) are included in income of the withdrawing partner under §702 and the distributive shares of the remaining partners are reduced accordingly. The character of the withdrawing partner's §736(a)(1) distributive share of partnership income depends upon the character of the partnership's income.
Example: Partnership ABC has ordinary income of $100,000, long-term capital gain of $200,000, and tax-exempt income of $200,000 and has no deductible expenses. Partner A is entitled to 10% of the partnership's income in complete liquidation of his interest which is characterized as a distributive share of partnership income under §736(a)(1). Consequently, A receives $50,000 in liquidation of his interest. Of the $50,000 received under §736(a)(1), $10,000 is ordinary income, $20,000 is long-term capital gain, and $20,000 is tax-exempt income. The remaining partners' distributive shares of those items are correspondingly reduced. Therefore, the remaining partners' share in the aggregate of partnership income would be $90,000 of ordinary income, $180,000 of long-term capital gain, and $180,000 of tax-exempt income.
Section736(a) payments that are determined without regard to the income of the partnership are considered to be guaranteed payments under §707(c) in accordance with §736(a)(2). This type of payment to a withdrawing partner is deductible by the partnership under §162(a) and is taxable as ordinary income to the recipient partner under §61(a).237
237Regs. §1.736-1(a)(4).
2.	Comparison of Tax Consequences of Disposition Versus Liquidation of Partnership Interest
This section compares the tax consequences to a withdrawing partner upon a taxable sale of his interest with those arising from a liquidation of his interest. It also compares the consequences to the continuing partners of a sale with a liquidation of a withdrawing partner's interest, assuming that, in the case of a sale, the continuing partners are the purchasers. The same consequences would result, of course, to a third party purchaser as would result to the continuing partners upon a taxable purchase of the withdrawing partner's interest.
One of the principal distinctions between a liquidation and a sale of a partnership interest relates to the treatment of partnership goodwill. Section 736 provides a maximum of flexibility in structuring a liquidating payment to a withdrawing partner that is attributable to partnership goodwill. Goodwill payments may generally be structured as §736(b) payments, resulting in capital gain or loss to the withdrawing partner and no deduction or other tax benefit to the continuing partners (unless the partnership has a §754 election in effect at the time of the transaction or there is a substantial basis reduction), or §736(a)  payments, resulting in the withdrawing partner receiving either a distributive share of partnership income or ordinary income and an exclusion or deduction from income for the remaining partners. On the other hand, any payment received upon a purchase of a partnership interest that is attributable to partnership goodwill is treated as capital gain or loss to the recipient and is not deductible or excludible by the continuing partners.
If the partnership has made a §754 election before either a liquidation of the retiring partner's interest or a purchase of the interest by the continuing partners, or there is a substantial basis reduction, the continuing partners will receive §197  amortization for any capital gain that the retiring partner recognizes with regard to that partner's share of the partnership's goodwill. In the case of a liquidation, the partnership will increase its basis in the goodwill under §734(b)  and allocate shares of the resulting amortization deductions for a new §197  intangible to its continuing partners. If the continuing partners purchase the retiring partner's interest, they will receive their shares of the same amount of basis increase in the partnership's goodwill under §743(b) and again be entitled to amortization deductions for new §197 intangibles.
Example: A, B and C are equal partners in partnership P, which has goodwill that the partners value at $3,000. B retires from the partnership in exchange for a payment from the partnership that includes $1,000 for B's share of the partnership's goodwill. B recognizes the entire $1,000 as long-term capital gain. If P has a §754 election in effect at the time, P will increase the basis of its goodwill from $0 to $1,000. P will then have a §197 intangible which it will amortize over the next 15 years, with the amortization deductions allocable in equal shares to A and C. If, instead, A and C purchase B's interest themselves, they will each receive, under §743(b), a $500 basis increase in their shares of the goodwill and may take amortization deductions for these increases as new §197 intangibles.
For further discussion of  the amortization of goodwill, see 533  T.M., Amortization of Intangibles.
Another significant distinction between a liquidation and a purchase of a partnership interest relates to the termination of the partnership. As discussed in Part V, below, a "sale or exchange" of 50% or more of partnership profits and capital within a 12-month period results in a termination of the partnership for tax purposes under §708(b)(1)(B). A liquidation of a partner's interest is not a sale or exchange for purposes of §708. Accordingly, a liquidation of a partner's interest in the partnership will not cause a termination, even if the partner has a 50% or greater interest in profits and capital.
If a partner sells his entire interest in a partnership, the partnership's taxable year closes with respect to him as of the sale date, pursuant to §706(c)(2)(A), even if he does not receive the entire consideration for the purchase on that date. While the taxable year of the partnership closes with respect to a withdrawing partner upon the final payment in liquidation of his interest, if liquidation payments are made over time, the partnership's taxable year does not close with respect to him until the final payment in liquidation of his interest is made.238
238Regs. §1.736-1(a)(1)(ii).
Timing of income inclusion by a withdrawing partner varies significantly depending on whether his interest is liquidated or sold. In the case of a liquidation, §736(b) payments received by the withdrawing partner over time will not result in taxable gain until the withdrawing partner receives payments in the aggregate in excess of his adjusted basis in his partnership interest pursuant to §731. Loss on liquidation of a partnership interest is not recognized until the final §736(b) payment is made. §736(a) payments made to a withdrawing partner generally must be included in the recipient's income in his taxable year ending with or within the partnership's taxable year in which the payments are made. In the case of a sale of a partnership interest in which part of the purchase price is deferred, the seller must include the total gain or loss in the year of sale or, if the sale results in a taxable gain and the installment method is elected, the taxable gain is reported proportionately with each installment payment.
Another distinction between a liquidation and a sale of a partnership interest relates to the optional basis adjustment to partnership property that may be made if a §754 election is in effect. As discussed in II, F, 2, above, if a §754 election is in effect with respect to a sale of a partnership interest, or the partnership has a substantial built-in loss immediately after such a transfer, basis adjustments are determined under §§743(b) and 755.238.1 On the other hand, in the case of a liquidation of a partner's interest in a partnership in which a §754 election is in effect, or if there is a substantial basis reduction, the optional adjustment to basis rules are governed by §734(b).238.2 Consequences to the continuing partners may differ depending upon whether the operative basis adjustment provision is §743(b) or §734(b).
238.1§743(b), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §833(b)(2), effective for transfers after Oct. 22, 2004. A partnership has a substantial built-in loss if its adjusted basis in partnership property exceeds the property's fair market value by more than $250,000. §743(d), as added by the 2004 AJCA, §833(b)(3). See Notice 2005-32, 2005-16 I.R.B. 895 (providing interim procedures on mandatory partnership adjustments).
238.2§734(b), amended by the 2004 AJCA, §833(c)(2), effective for transfers after Oct. 22, 2004. Under §734(d), there is a substantial basis reduction with respect to a distribution if the partnership would make a downward basis adjustment of more than $250,000 under §734(b)(2)(A) and  (b)(2)(B). See Notice 2005-32, 2005-16 I.R.B. 895 (providing interim procedures on mandatory partnership adjustments).
3.	Distinguishing Sale and Liquidation
Since the tax consequences to both a withdrawing partner and the continuing partners may vary significantly depending on whether a transaction is characterized as a sale or as a liquidation of a partner's interest, properly characterizing the transaction becomes important. The parties are afforded a maximum amount of flexibility in structuring a withdrawal as either a purchase or a liquidation. Where the relevant documentation is unambiguous and reflects either a sale to the continuing partners on the one hand or a liquidation by the partnership on the other hand, the form of the transaction will generally be respected and the tax consequences flowing from that form will control.239
239See, e.g., Cooney v. Comr., 65 T.C. 101 (1975); Foxman v. Comr., 41 T.C. 535(1964), aff'd, 352 F.2d 466 (3d Cir. 1965). See also Miller v. U.S., 67-2 USTC Para.9685 (Ct.Cl. 1967); Sloan v. Comr., T.C. Memo 1981-641; Champlin v. Comr., T.C. Memo 1977-196; Zager v. Comr., T.C. Memo 1987-107.
Two caveats should be kept in mind in this context. First, if the transaction is structured as a liquidation and the parties desire liquidation tax treatment, the funds for the liquidation payments should come from internally generated sources of the partnership or from partnership loans. If the cash necessary to liquidate a partner's interest is received as a capital contribution from all or some of the remaining partners, the capital contribution and related liquidation distributions could be recharacterized by the IRS as a sale by the withdrawing partner to the contributing partners under §707(a)(2)(B).240
240Section 707(a)(2)(B) was amended by §73(a) of the Tax Reform Act of 1984, P.L. 98-369. That amendment effectively reversed legislatively the conclusion reached in Jupiter Corp. v. U.S., 2 Cl. Ct. 58 (1983). In that case, funds were contributed to a partnership by new limited partners and part of the contributions were used to reduce the general partner's interest in the partnership. The Claims Court rejected the IRS' assertion that the transaction was in fact a sale by the general partner of a portion of its interest to the new limited partners and respected the parties' form as a contribution/partial liquidation. See Prop. Regs. §1.707-7, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04) (disguised sales of partnership interests). See also, Colonnade Condominiums, Inc. v. Comr., 91 T.C. 793 (1988).
The second caveat in this area is that a liquidation of a partner's interest may be recharacterized as a sale where all continuing partners' interests in the partnership do not increase proportionately. In that case, whether or not capital contributions from the continuing partners whose interests are disproportionately increased can be tied to the liquidation payments, IRS scrutiny is invited. The economics are such that the partners whose interests are disproportionately increased must have given up something to the remaining partners and, accordingly, the transaction could be recharacterized as a sale of the withdrawing partner's interest to the continuing partners where interests are disproportionately increased.
In PLR 9715008, the partners of a limited partnership planned to revise the partnership agreement with respect to the withdrawal of a partner. Instead of having the limited partnership make payments to a withdrawing partner in complete liquidation of the withdrawing partner's interest, the revised partnership agreement would provide that the withdrawing partner would sell, and the remaining partners would purchase, the withdrawing partner's entire interest in the limited partnership. The IRS ruled that the payments made by the remaining partners to the withdrawing partner under the revised agreement would be treated as a purchase of the withdrawing partner's interest under §741 and not as a liquidation of that interest under §736. In addition, in the case of a deceased partner, the purchase price paid by the remaining partners constitutes income in respect of a decedent under §691 only to the extent it is allocable to limited partnership items that would have been income in respect of a decedent had the items been owned directly by the deceased partner. Where part of the payment is contingent on the partnership profits, a portion of such payment is treated as interest and is deductible under §163, subject to any applicable limitations.
Two-person partnerships have the same flexibility to structure the liquidation of a withdrawing partner as either a liquidation or sale as do partnerships with larger numbers of partners. The regulations explicitly recognize that one partner in a two-person partnership may either sell his interest to the other partner241 or receive liquidation payments under §736.242 Careful drafting of the relevant documents to reflect the parties' intent is even more critical here. Whether the remaining partner purchases the withdrawing partner's interest or whether the "partnership," consisting only of the remaining partner, liquidates the withdrawing partner's interest, the same economic consequences result to the remaining partner. Documents should therefore be clear and unambiguous, and payments should come from the separate funds of the proper party (from the remaining partner if sale treatment is desired or from the partnership if liquidation treatment is desired).
241Regs. §1.741-1(b).
242Regs. §1.736-1(a)(6).
C. Subchapter K Anti-Abuse Regulations
In December 1994, the IRS issued final subchapter K anti-abuse regulations.242.1 The regulations authorize the IRS to recharacterize a transaction that involves the use of a partnership, if a principal purpose of the arrangement is to reduce substantially the present value of the partner's aggregate federal tax liability in a manner inconsistent with subchapter K.242.2 In addition, the regulations provide authority for the IRS to treat a partnership as an aggregate of its partners to carry out the purpose of any provision of the Code or regulations.242.3
242.1Regs. §1.701-2, T.D. 8588, 60 Fed. Reg. 23 (1/3/95). The regulations subsequently were amended by T.D. 8592, 60 Fed. Reg. 18741 (4/13/95).
242.2Regs. §1.701-2(b).
242.3Regs. §1.701-2(e).
The anti-abuse regulations represent the IRS' response to its perception that the partnership rules sometimes are used in a manner inconsistent with the intent of Congress in enacting subchapter K: to permit taxpayers to conduct business for joint economic profit through a flexible arrangement that accurately reflects the partners' economic agreement without incurring an entity-level tax. The anti-abuse regulations were greeted with a storm of criticism by practitioners, who expressed concern that the rules would create unprecedented uncertainty in planning partnership transactions. Although the regulations were designed to curb only abusive transactions, the rules are vague and susceptible to an overboard application. Moreover, the regulations permit the IRS to recharacterize a transaction that satisfies the literal terms of the Code and more specific partnership regulations. Thus, virtually any partnership transaction may have to run the gauntlet of the anti-abuse regulations. For example, it is conceivable that the regulations could be employed to recharacterize a liquidation of a partnership interest as a sale of property. Several examples in the regulations address the use of the §754 election.
The anti-abuse regulations are discussed in 710 T.M., Partnerships; Overview, Conceptual Aspects, and Formation.
IV. Incorporation of a Partnership
A. Reasons for Incorporation
The business reasons for converting an entity that was formerly operated as a partnership into the corporate form of doing business may vary depending upon the aims of the partners. There are many business considerations that enter into a decision to convert the form of conducting a business from a partnership to a corporation. One such reason for operating in the corporate form is the limited liability it affords its shareholders. Shareholders of a corporation are generally not subject to liabilities of the corporation except to the extent of their capital contribution. Partners, on the other hand, are generally personally liable for liabilities of their partnership. Limited liability may be obtained, however, in the partnership form by operating as a limited partnership in which limited partners are liable for partnership debts only to the extent of their capital contributions. In that case, only general partners have unlimited personal liability for partnership debts.243
243The liability of general partners may also be effectively limited in many circumstances by having a corporation own the general partnership interest in a limited partnership.
Another business reason for operating in the corporate form is that it is often easier to raise capital (debt or equity) in the corporate form. Equity is generally easier to raise because equity investors are more familiar, and therefore more comfortable, with investing in corporate stock than they are with investing in partnership interests. Debt is generally easier to raise by a corporation because lenders are also more familiar with loaning to corporations than to partnerships. In addition, state usury laws often apply to partnership borrowers but not to corporate borrowers, or the rate of interest which is statutorily determined to be usurious is often higher for a corporation than for a partnership.
A third business reason for operating in the corporate form is that a corporation has unlimited life. Under state partnership laws, the withdrawal of a partner, or the death or bankruptcy of a partner, generally results in the dissolution of the partnership. The death, bankruptcy or withdrawal from the business by a corporate shareholder, by contrast, does not cause a dissolution of a corporation.
A final reason why owners often prefer to operate as a corporation is that a transfer of corporate stock is often less cumbersome and expensive than the transfer of ownership interests in a partnership. State partnership laws often require that new state filings be made upon each admission of a new partner. Corporate stock generally may be transferred without any additional filings.244
244Securities laws, both state and federal, may prove to be an impediment to a transfer of either a partnership interest or a share of corporate stock. The securities laws generally apply to a partnership interest to the same extent that they apply to corporate stock.
While non-tax considerations often weigh in favor of operating a business as a corporation, tax considerations generally favor operating as a partnership. The principal benefit of the partnership form is that a partnership is not a taxpayer in its own right. Partnership profits and losses flow through to the partners and are reflected only on the individual tax returns of the partners. This characteristic of partnership taxation has two benefits tax-wise. First, if the enterprise generates a taxable loss, the partners generally obtain the benefit of that loss by claiming it on their individual tax returns. A loss incurred by a corporation generally provides no current tax benefit to its owners. Second, if the business generates profits, partnership profits are subject to a lower rate of taxation than corporate profits. Only a single partner level tax applies to partnership income. Profits of an ordinary "C corporation," on the other hand, are subjected to two levels of tax. The first tax applies at the corporate level. When the profits are ultimately distributed to shareholders in the form of dividends, the shareholders again pay an individual tax.
While the double taxation inherent in operating as a corporation may be avoided by making an election to be taxed as an "S corporation," the rules relating to ownership of the shares of an S corporation are quite restrictive, which often makes operating as an S corporation impractical or impossible. For example, an S corporation may have no more than 75 shareholders for taxable years beginning after 1996 (the limit was 35 shareholders for taxable years beginning before 1997), and only individual U.S. citizens or residents, and other S corporations, may be shareholders.245 Thus, an S corporation may not have a C corporation, a partnership, a nonresident alien, or most types of trusts as a shareholder. The capital structure that is permissible for an S corporation is also quite restrictive. Only one class of stock is permissible and, if the owners attempt to avoid this restriction by creating an equity flavored debt instrument, they run the risk that the debt will be recharacterized as a second class of stock causing the corporation's S status to be retroactively terminated. Conversely, the capital structure of a partnership is virtually unlimited.
245Section 1361(b). The Small Business Job Protection Act of 1996, P.L. 104-188, made a number of changes to the S corporation provisions that are intended to provide taxpayers with greater flexibility in forming and operating S corporation. Section 1301 of the Act amended §1361 to increase the number of shareholders that an S corporation can have from 35 to 75 for taxable years beginning after 1996. Section 1308(a) of the Act removed former §1361(b)(2)(A), under which a member of an affiliated group was ineligible to elect S corporation status, and §1308(b) of the Act added §1361(b)(3), under which a wholly owned subsidiary of an S corporation (a qualified subchapter S subsidiary) is not treated as an entity separate from its S corporation parent. The Act also created a new type of trust, an "electing small business trust," that can own stock in an S corporation. For a detailed discussion of the changes made by the Act concerning S corporations, see 730 T.M., S Corporations: Formation and Termination, and 731T.M., S Corporations: Operations.
Profit sharing and pension plan benefits and other employee fringe benefits at one time favored corporations over partnerships. That distinction often resulted in a decision to operate as a corporation rather than a partnership despite some of the other tax disadvantages. However, that is no longer the case, and the tax rules affecting pension and profit sharing plans and employee fringe benefits are generally the same for corporations and partnerships. This factor has therefore become neutral.
B. Tax Consequences of Incorporating a Partnership
There are three basic methods of incorporating a partnership: (1) the partners may contribute their partnership interests to a newly-formed corporation in return for stock in the corporation, in which case the corporation becomes a direct owner of the assets and liabilities of the partnership due to a termination of the partnership;246 (2) the partnership may distribute all of its assets and liabilities to its partners in complete liquidation and the partners contribute the assets and liabilities received to a newly-formed corporation in return for corporate stock; or (3) the partnership may contribute its assets and liabilities to the corporation in consideration for the corporation's issuance of stock, and the partnership distributes the corporate stock to the partners in complete liquidation of the partnership. Except where the partnership's liabilities exceed the basis of its assets, no gain or loss will generally be recognized by the partnership, any of the partners, or the corporation under any of the three incorporation techniques as long as the partners ultimately end up with 80% or more control of the corporation. However, the basis the corporation obtains in the partnership assets it receives and the holding period of those assets, as well as the holding period of the stock ultimately acquired by the partners, could vary depending upon the incorporation method chosen.
246See the discussion of the termination of a partnership in this context at V, C, 2, below.
Although the consequences could vary depending upon which of the three methods of incorporation is followed, the IRS nevertheless ruled in Rev. Rul. 70-239247 that all three methods would be treated identically. Regardless of the method chosen, the IRS ruled that the partnership would be considered to have transferred its assets and liabilities to a corporation in exchange for its stock under §351, followed by a distribution of the stock to the partners in liquidation of the partnership (method number (3) mentioned above). Realizing that there could be business reasons for choosing one method over another and that the tax consequences could vary depending upon the method chosen, Rev. Rul. 70-239 was revoked by Rev. Rul. 84-111.248 Consequently, the IRS' view announced in the latter ruling is that the method selected by the parties of incorporating a partnership will generally be respected by the Service.
2471970-1 C.B. 74.
2481984-2 C.B. 88.
The primary difference in tax consequences that could arise depending on the incorporation method chosen is the basis the corporation will have in the assets received on the incorporation. This difference would arise in situations in which there is a disparity between the partnership's basis in its assets and the aggregate basis the partners have in their partnership interests.
The following example is used to illustrate the tax consequences to the parties and the differences in basis that could arise depending on which of the three incorporation transactions is selected:
Example: Partnership ABC has the following balance sheet: 
  Assets                                 Adjusted Basis            Value
  Cash                                          $ 9,000          $ 9,000
  Inventory                                       6,000           12,000
  Capital Assets                                 21,000           36,000
  Total                                        $ 36,000         $ 57,000
                                                                        
  Capital                                                               
  A                                              19,000           19,000
  B                                              12,000           19,000
  C                                              12,000           19,000
  Total                                        $ 43,000         $ 57,000

Partnership ABC decides to incorporate the business and forms ABC, Inc.
If the parties select method (1), above, for incorporating the business (partners contribute partnership interests to newly-formed ABC, Inc. in return for ABC, Inc. stock), the consequences would be as follows: Under §351, no gain or loss will be recognized by the partners in connection with the transfer of their partnership interests to ABC, Inc. At the time of the transfer, the partnership would terminate under §708(b)(1)(A) and the partnership's assets would thereby be owned directly by ABC, Inc. ABC, Inc.'s basis for the assets received in the exchange will equal the basis that the partners had in their partnership interests before the transfer under §§362 and 732(b). Consequently, the corporation would have an aggregate basis in all of its assets equal to $43,000. Under §358, each of the partners would receive a basis in the ABC, Inc. stock equal to the basis of their partnership interests before the transfer. Thus, B and C would each receive a $12,000 basis in the stock and A would receive a $19,000 basis. The corporation's holding period for the partnership's assets would include the holding period of the partnership for the assets under §1223(2). That is, ABC, Inc., would be able to "tack" the partnership's holding period for the assets. The partners would also generally be able to tack the holding period of their partnership interests to their ABC, Inc., stock except to the extent their stock basis is attributable to their proportionate share of the partnership's substantially appreciated inventory under §§735(b) and 1223. Thus, each of the partners will have a split holding period for their stock.
If method (2) (the partnership is liquidated and the partners transfer the assets received in liquidation to the corporation in return for stock) mentioned above is chosen, the consequences would generally be as follows: under §732(b), the basis of the assets received by the partners in liquidation of the partnership would equal the adjusted basis of their partnership interests. Thus, A would have a $19,000 basis and B and C would each have a $12,000 basis in the assets received in liquidation of the partnership. The basis would be allocated among each of the assets in accordance with the rules of §732(c). Upon the contribution of the assets to the corporation under §351, the corporation would obtain a basis equal to $43,000 in the assets in the aggregate. The holding period of ABC, Inc., in its assets would include the holding period of the partnership under §1223(2). The partners would again receive a split holding period for the stock received due to the existence of the §751 assets under §§735 and 1223.
If method (3) (contribution by partnership to corporation of its assets in exchange for stock followed by distribution of the stock in liquidation of the partnership) is chosen, the consequences would be as follows: under §362, the corporation's basis in the assets would be equal to the partnership's basis. Therefore, the corporation's basis would only be $36,000 (rather than the $43,000 as in the other two methods). Under §358, the partnership's basis in the ABC, Inc., stock would be equal to the basis it had in the assets transferred ($36,000). The basis in the stock distributed to the partners will equal the adjusted basis of each partner in its partnership interest ($19,000 for A and $12,000 for each of B and C). The holding period of the partners in the stock will again be split.
The IRS issued final regulations248.1 under §1223 addressing the allocation of a divided holding period with respect to partnership interests. Regs. §1.1223-3(a) provides that the holding period of a partnership interest will be divided if a partner acquires portions of an interest at different times or if an interest is acquired in a single transaction that gives rise to different holding periods. If a partner sells, or in this case exchanges, its entire partnership interest, any capital gain or loss recognized will be divided between long-term and short-term capital gain or loss in the same proportions as the holding period of the partnership interest under Regs. §1.1223-3(c).
248.1T.D. 8902, 65 Fed. Reg. 57092 (9/21/00). The regulations are applicable to partnership interests transferred after Sep. 20, 2000 (as well as to capital gain or loss that a partner recognizes from a partnership distribution under §731 after that date). For a more detailed discussion, see 710 T.M., Partnerships; Overview, Conceptual Aspects and Formation.
C. Assignment of Income Problems on Incorporation
Under prior law, when corporate tax rates were lower than individual tax rates, an assignment of income issue could have arisen in connection with the incorporation of a partnership. Under the assignment of income doctrine, the IRS could assert that the right to receive income transferred by a partnership in the incorporation transaction was rightfully the income of the partnership and attempt to tax that income accordingly.249 However, in these days of corporate tax rates exceeding individual tax rates, it is unlikely that the IRS would assert that a right to receive income transferred to a corporation should, in fact, be taxed to the partners. The courts,250 and eventually the IRS,251 ultimately have held that the doctrine does not apply to an incorporation provided that there is no intentional tax avoidance connected with the incorporation.
249See Rooney v. U.S., 305 F.2d 681(9th Cir. 1962).
250 E.g., Hempt Brothers v. U.S., 490 F.2d 1172 (3d Cir.1974).
251Rev. Rul. 80-198, 1980-2 C.B. 113.
D. Taxable Incorporation of a Partnership
If the literal requirements of Section351 are not met in connection with an incorporation of a partnership (i.e., the transferring partners and other transferors in the aggregate do not receive 80% control of the corporation), or if boot is received in the transaction, an incorporation of a partnership could be partially or totally a taxable transaction. In that case, the normal rules of taxation would apply. The partners would be subject to tax measured by the difference between the fair market value of the corporate stock received and the adjusted basis of their partnership interests. The corporation would generally receive a cost (fair market value) basis for the assets received and the partner's basis in the corporate stock would also generally equal value. The holding period for the partners' stock and the corporation's assets would commence at the time of the incorporation and no tacking would be allowed.
V. Events Resulting in Termination of Partnership
A. Section 708 in General
Section 708(a) sets forth the basic rule that, for purposes of subchapter K, "an existing partnership shall be considered as continuing if it is not terminated." This seemingly self-evident statement emphasizes that, in most circumstances, state law rules and principles do not control the tax consequences of a particular transaction or event.252 Thus, for example, under the Uniform Partnership Act, liquidation of a partner's interest in a partnership may cause a termination of the partnership for state law purposes,253 but the liquidation generally would not cause the partnership to terminate for federal tax purposes.254 On the other hand, an event may result in dissolution, for purposes of the Code, where the partnership is not dissolved for local law purposes.255
252See Regs. §301.7701-1(a). Local law governs in determining legal relationships among members of an entity but the Code controls in determining the classification consequences of those legal relationships. See also Chef's Choice Produce Ltd. v. Comr., 95 T.C. 388 (1990) (dissolution of partnership under state law had no bearing on federal audit and litigation procedures commenced against partnerships).
253Uniform Partnership Act §31. For application of the rule that a state law dissolution does not cause a termination for federal income tax purposes, see Fuchs v. Comr., 80 T.C. 506 (1983). In that case, the taxpayer, who owned a 25% interest in a partnership which owned real estate, withdrew from the partnership, causing a dissolution under state law. When the realty, owned by the partnership, was condemned (three years after the dissolution), the taxpayer received a share of the condemnation award. Because, under §703(b),an election to defer gain realized on a condemnation pursuant to §1033 must be made by the partnership the Tax Court held that the taxpayer's individual election was not effective.
254The liquidation of a partner's interest could cause a termination for federal income tax purposes in two circumstances. First, a cash liquidation of a partner's interest in a two-person partnership would cause a termination under §708(b)(1)(A). Second, if the liquidation of a partner's interest would result in a termination of the partnership if the interest were sold rather than liquidated (i.e., the interest constitutes a 50% or more interest in partnership profits and capital), the liquidation could be recharacterized as a sale if, shortly before or after the liquidation, a new partner is admitted to the partnership. Section 707(a)(2)(B), which was added by the Tax Reform Act of 1984, P.L. 98-369, codified the rule that would allow such a recharacterization. If the liquidation of a 50% or more interest in capital and profits preceded or followed by the admission of a new partner making a capital contribution to the partnership in return for his interest is recharacterized as a sale from the liquidated partner to the newly-admitted partner, the partnership would terminate.
255For example, the sale of a limited partner's interest constituting 50% or more of partnership profits and losses may not result in a dissolution of the limited partnership for state law purposes, but such a sale would cause a termination of the partnership under §708(b)(1)(B).
The events giving rise to a termination of a partnership, set forth in §708(b) are: (1) cessation of all business, financial operations or ventures of the partnership;256 (2) the happening of an event that results in the partnership ceasing to operate in the partnership form (for example, the purchase by one partner of another partner's interest in a two-person partnership);257 or (3) a sale or exchange of an interest in 50% or more of the profits and capital of the partnership during a 12-month period.258 Each of these three events is dealt with separately below.
256§708(b)(1)(A).
257Id. Section 708(b)(1)(A) provides that "if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership," the partnership will terminate for tax purposes. There are, consequently, two distinct events which give rise to a termination under that provision: business cessation and failure to continue as a partnership. Extensive business operations may continue but, if the business entity is no longer a partnership, the partnership terminates under §708(b)(1)(A).
258§708(b)(1)(B).
It is important to keep in mind the differences in terminology used in the Code and under state law in this area. Without keeping these differences in mind, concepts can become confusing. For state law purposes, certain events (for example, the death or bankruptcy of a partner) give rise to a "dissolution" of a partnership.259 A "winding-up" period then follows, in which business is completed, receivables are collected, assets are sold, and bills are paid.260 After the "winding-up" period, assets are distributed first to remaining creditors and then to the partners.261 Only after all three events (dissolution, winding-up, and distribution of assets) have occurred is a partnership terminated for state law purposes. The three steps are also sometimes referred to as a "liquidation" of a partnership, though the Uniform Partnership Act does not use that term.
259Uniform Partnership Act §31.
260Uniform Partnership Act §30.
261Uniform Partnership Act §40.
On the other hand, the Code only contains the concept of a partnership "termination." If one of the three events set forth in §708(b)(1) occurs, the partnership is terminated for federal income tax purposes. Otherwise, as stated in §708(a), the partnership continues. There is no concept of a "liquidation" of a partnership under the Code.262
262Confusion is sometimes created for non-partnership tax specialists by use of the term "liquidation" of a partnership. There is no such concept in subchapter K. There is, however, the concept of a liquidation of a partner's interest in the partnership under §§731 and 736, but technically not a liquidation of a partnership.
B. Cessation of Business Activity
The first circumstance giving rise to a termination of a partnership is when "no part of any business, financial operation, or venture of the partnership continues to be carried on" by any of its partners in a partnership.263 The regulations interpret the "no part of any" language quite literally. According to the regulations, when the partners agree to dissolve their partnership but carry on the business through a winding-up period, the partnership is not terminated until "all remaining assets, consisting only of cash, are distributed to the partners . . .."264
263§708(b)(1)(A) (Emphasis added).
264Regs. §1.708-1(b)(1).
Although Regs. §1.708-1(b)(1)(i) states that the partners "carry on the [partnership] business through a winding up period," only very minimal activities presumably would be carried on by the partnership during the latter part of the winding-up period, since only cash is remaining at the end of the winding-up period. Nevertheless, the regulation provides that the partnership is not terminated under §708(b)(1)(A) until the date on which all assets are distributed to the partners, rather than some earlier date, such as when business activities are terminated and only administrative activities are carried on (i.e., collection and disbursement of cash).265 This aspect of the regulation could be interpreted in one of two ways: (1) that even minimal activities prevent a termination, or (2) that no termination occurs under §708(b)(1)(A) until a formal "winding-up period" is complete.266
265Id.
266From a policy point of view, the first interpretation (that only minimal activities prevent a termination) seems preferable. The latter interpretation (that no termination occurs until completion of the winding-up period) leaves room for manipulation since it would be easy for partners trying to postpone a termination under §708(b)(1)(A) to agree informally to a prolonged winding-up period. However, the latter interpretation is supported by Regs. §1.708-1(b)(3), which provides that, while a partnership taxable year closes immediately upon termination due to a sale or exchange of a 50% interest in partnership profits and capital, when termination is due to a cessation of business, the partnership taxable year closes only when the winding-up period is complete. If the partnership taxable year closes on the date of its termination, for purposes of §708(b) (which seems likely), the latter interpretation of the regulation seems correct. Manipulation could be limited by a court's determination that the winding-up period has ended prior to a final distribution of assets if the winding-up period is unduly prolonged in order to avoid a termination. See Harbor Cove Marina Partners Partnership v. Comr., 123 T.C. No. 4 (7/15/04) (Tax Court, noting that partnership terminates on date it winds up affairs in cessation of business operations by distributing remaining assets to partners, held that partnership did not terminate for federal tax purposes because (i) its business operations were not completed when partner filed lawsuit against partnership legitimately challenging winding-up procedures and (ii) resolution of challenge could lead to partnership's reporting significant change as to remaining assets in subsequent year); PLRs 9436032 and 9440019 (a limited partnership in receivership continued to be a partnership for federal tax purposes until its affairs were wound up; the winding up consisted of collecting liabilities, selling assets, and continuing and commencing legal actions beneficial to the partnership's liquidation, and was complete when a formal accounting was made from which the overall status of the partnership could be evaluated).
The courts have also interpreted the language of §708(b)(1)(A) literally.
 In Ginsburg v. U.S.,267 for example, the Court of Claims stated that a complete cessation of activity was necessary in order to cause a termination. Similarly, in Hoagland v. Comr.,268 the Tax Court held that a partnership did not terminate from business cessation where the land development business for which the partnership was formed was frustrated and the partnership's only function was holding land pending its sale. Other decisions have held that the mere collection of interest on notes269 and minor purchases270 were sufficient to prevent termination for income tax purposes.
267396 F.2d 989 (Ct. Cl. 1968).
26830 T.C.M. 1326 (1971), appeal dism'd (9th Cir. 1972).
269Baker Commodities, Inc. v. Comr., 415 F.2d 579 (9th Cir.1969); cert. denied, 397 U.S. 988 (1970); Foxman v. Comr., 41 T.C. 535 (1964), aff'd, 352 F.2d 466 (3d Cir. 1965).
270Foxman v. Comr., 41 T.C. 535 (1964), aff'd, 352 F.2d 466 (3d Cir. 1965).
The extent to which the courts have gone in finding no termination from business cessation is illustrated by two cases. In Foxman v. Comr.,271 a partnership sold all of its assets and retained only promissory notes realized from the disposition while in Baker Commodities Inc. v. Comr.,272 a partnership sold its only asset (a convalescent home) and retained only the note received on the sale. Although, in both cases, the only activity of the partnerships was collection of payments on notes and distributions of the payments to the partners, both the Third and Ninth Circuits held that no termination under §708(b)(1)(A) had occurred.273
271Id.
272415 F.2d 579 (9th Cir. 1969).
273The courts have not addressed the sale of a going business doctrine in the context of a partnership termination. Under this judicially created doctrine, discussed at III, A, 3, above, the sale of an entire ongoing partnership business by the partnership is treated as a sale of the partners' interest in the partnership. See, e.g., Barran v. Comr., 334 F.2d 58 (5th Cir. 1964). If the doctrine were applied in the context of a §708 termination, a partnership would terminate upon the sale of the partnership's business under §708(b)(1)(B) (rather than under §708(b)(1)(A)) since the requisite sale of interests in 50% or more of partnership capital and profits would be deemed to have occurred. However, such a conclusion would be difficult to reconcile with Regs. §1.708-1(b)(1), which provides that, upon the sale of partnership assets, the partnership terminates only after a winding-up period. Perhaps the language of the regulation could be reconciled with the sale of a going partnership concern doctrine by arguing that the example given in the regulation only addresses a sale of partnership assets (i.e., a sale of assets on a piecemeal basis) rather than a sale of the business of the partnership. In any event, it is unclear whether the doctrine would apply to terminate a partnership upon a sale of the partnership's entire business to a purchaser.
In Goulder Est. v. U.S., 95-2 USTC ¶50,464 (6th Cir. 1995), rev'g and rem'g, 93-2 USTC ¶50,421 (N.D. Ohio 1993), the court held that a partner could claim a capital loss when his partnership interest terminated on the dissolution of and distribution of a partnership's assets, even though a reasonable amount of funds was retained to pay outstanding liabilities. These funds were later distributed to the partners the following year. Both the partner and the IRS stipulated to the fact that the partnership ceased all business and financial operations in the year the partnership assets were distributed. However, the court rejected the IRS's argument that the partnership dissolved in the year the remaining funds were distributed. The court stated that there was no per se rule that the mere retention of certain assets or the management of particular activities in anticipation of liabilities amounts to a continuation of the partnership.
It is interesting to note that the above authorities concluded that activities that are probably not sufficient to give rise to a partnership for federal income tax purposes in the first instance are sufficient to prevent a partnership from terminating for tax purposes. Section 761 defines a partnership as including "a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on."274 This language, which is nearly identical to the language of §708(b)(1)(A), is interpreted by the regulations to exclude from the definition of a "separate entity" an entity which merely holds passive investment property: "Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a separate entity."275 Thus, an entity whose only activity from the day of formation is the mere holding of a debt instrument and passing payments on to its owners would probably not qualify as a partnership under §761. Yet, once engaged in active business activities, a partnership that subsequently reduces its activities to collecting and disbursing debt payments will not be terminated for tax purposes.
274See also §7701(a)(2).
275Regs. §301.7701-1(a)(2).
C. Business Not Carried on as a Partnership
1.	Conversion to Sole Proprietorship
In addition to cessation of business activities, §708(b)(1)(A) provides that a partnership will be terminated if the operations of the partnership are no longer "carried on by any of its partners in a partnership." This circumstance giving rise to a termination is illustrated in the regulations: 
[O]n November 20, 1956, A and B, each of whom is a 20-percent partner in partnership ABC, sell their interests to C, who is a 60-percent partner. Since the business is no longer carried on by any of its partners in a partnership, the ABC partnership is terminated as of November 20, 1956.276
276Regs. §1.708-1(b)(1). In Rev. Rul. 99-6, 1999-6 I.R.B. 6, the IRS ruled that a two person partnership (an LLC with a valid Regs. §301.7701-3 election) will terminate under §708(b)(1)(A) when one partner purchases the other partner's entire interest. Rev. Rul. 99-6 is reproduced in the Working Papers.
Thus, unlike cessation of business activities, where the termination for tax purposes does not occur until the winding up process is complete, termination occurs immediately when only one partner remains. While the example in the regulations is a purchase of the partnership interest, a liquidation by the partnership of the departing partners' interests would likewise result in a termination.277
277If the partnership interests of partners A and B were not liquidated for cash but they continued to receive payments described in §736, the partnership would not be terminated until the payments are complete. See Regs. §1.708-1(b)(1)(ii); Regs. §1.736-1(a)(6).
The regulations set forth two exceptions from the general rule terminating a partnership when only one partner remains. First, where only one partner remains because of the death of the other partner, the partnership will not be terminated if the estate or other successor in interest of the deceased partner continues to share in partnership profits or losses.278 Under the regulations, the estate or successor of a deceased partner need not be a partner for state law purposes but only needs to share in partnership profits or losses in order to continue the partnership. However, where the estate's interest in the partnership is purchased by the surviving partner, the partnership terminates under §708(b)(1)(A).279
278Regs. §1.708-1(b)(1)(i). See also Haines v. U.S., 76-1 USTC ¶9222 (N.D. N.J. 1976). Even where the estate or successor in interest of a deceased partner does not explicitly share in profits or losses of the partnership under the partnership agreement, a two-person partnership apparently would not terminate upon the death of one partner until the partnership is wound up. See Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir. 1982).
279Rev. Rul. 67-65, 1967-1 C.B. 168.
Second, a partnership will not be terminated when only one partner remains if the interest of the former partner(s) (or the estate or successor of a deceased partner) is liquidated over time by the partnership's making a series of payments under §736. As long as §736 payments continue to a deceased or retired member of what was formerly a two-person partnership, there will be no termination of the "partnership" under §708(b)(1)(A).280
280Regs. §1.708-1(b)(1)(ii), 1.736-1(a)(6). Note, however, that a partnership will terminate even though payments continue to a retired partner under §736 if the termination is due to a circumstance other than the retirement of the recipient of the §736 payments (such as the cessation of business activities). Rev. Rul. 75-154, 1975-1 C.B. 186.
Both exceptions to the general termination rule arising from a partnership's conversion to a proprietorship again emphasize the fact that subchapter K does not follow state law partnership rules. If only one partner remains, the "partnership" no longer meets the definition of a partnership set forth in the Uniform Partnership Act.281 Thus, under state law, the business automatically becomes a proprietorship if only one partner remains. Nevertheless, the regulations continue to treat the proprietorship under state law as a partnership for federal tax purposes until all §736 payments are made to the retired partner or the deceased partner's successor or until the deceased partner's successor no longer shares in partnership profits or losses.
281Section 6 of the Uniform Partnership Act defines a partnership as "an association of two or more persons to carry on as co-owners of a business for profit."
It, therefore, appears to be a relatively simple matter to avoid a partnership termination, even when only one partner remains. The regulations do not give an indication that the retired or deceased partner's payments or share of profits or losses must be more than nominal or that they must be discontinued after a specified time. However, if only a de minimis amount of partnership profits is distributed for an indefinite period, a court could ignore the payment as a sham and conclude that a termination has occurred.
The language of §708(b)(1)(A) (that a termination occurs where the business is no longer carried on by any of its partners in a partnership) was quite literally applied by the IRS in Rev. Rul. 66-264.282 The Service concluded that, when the assets of a five-person partnership were purchased at a judicial sale by a partnership comprised of three of the original five partners, the new three-person partnership was a continuation of the five-person partnership. In addition to ignoring the asset sale, the IRS declined to rule whether the transaction resulted in a sale or a liquidation of the interests of the two partners excluded from the "new" entity.283
2821966-2 C.B. 248.
283The determination of whether the interests of the two partners were liquidated by the partnership or purchased by the three remaining partners was not relevant for §708 termination purposes because the two interests together represented less than 50% of partnership profits and capital. See also Neubecker v. Comr., 65 T.C. 577(1975), in which the Tax Court held that a partner in a three-person partnership was not entitled to a loss on liquidation of his interest under §731(a)(2) where the taxpayer and another of his partners formed a new two-person partnership. The court held that the new partnership was a continuation of the dissolved three-person partnership. On the other hand, merely because some of the same partners form another partnership does not mean the new partnership will be considered a continuation of the old partnership. The new entity must acquire assets and assume liabilities of the old partnership. See Sloan v. Comr., 42 T.C.M. 1606 (1981).
2.	Incorporation of Partnership
There are three basic methods of incorporating a partnership: (1) the partners may contribute their partnership interests to a newly formed corporation in return for stock; (2) the partnership could liquidate and the partners contribute the partnership assets received to the corporation in return for stock; and (3) the partnership could contribute its assets to the corporation in consideration for its issuance of stock to the partnership and assumption of partnership debt and the partnership could distribute the corporate stock to the partners in liquidation. While the issuance of the corporate stock should be tax free under §351, the tax consequences (which are discussed more fully in Part IV, above) to the partners and the basis of the partnership assets in the hands of the corporation may vary, depending upon the method chosen. In Rev. Rul. 84-111,284 the IRS ruled that each of the three methods results in a termination of the partnership under §708(b)(1)(A).285
2841984-2 C.B. 88, revoking Rev. Rul. 70-239, 1970-1 C.B. 74, in which the IRS ruled that all three methods of incorporating a partnership would be treated as a contribution to the corporation of the partnership assets by the partnership in return for corporate stock followed by a liquidation of the partnership.
285It is interesting to note that Rev. Rul. 84-111 concluded that all three incorporating alternatives result in a termination under §708(b)(1)(A). However, the transfer of partnership interests to the corporation in return for corporate stock could technically result in a termination under either §708(b)(1)(A) or (B). As discussed in VI, below, the subsection of §708(b)(1) that the termination comes within could make a difference in the tax consequences resulting from the termination.
For purposes of §708, the method chosen for incorporating the partnership makes a difference as to the date of the termination. As discussed at VI, A, 1, below, the date of the termination is significant because it may result in bunching of income. In addition, to the extent that any of the partners has gain or loss to be recognized on the termination, the timing of his recognition is effected by the timing of the termination.
In the case of the transfer of partnership interests to the newly formed corporation in return for stock, the termination occurs when the partners contribute their partnership interests to the corporation since the circumstance giving rise to the termination is that only one partner remains. If the partnership liquidates and the partners exchange the partnership assets received for stock, the partnership is liquidated as of the date of distribution to the partners of the partnership assets. Having the partnership contribute its assets to the corporation in exchange for stock and then distributing the stock to the partners in liquidation leaves the most flexibility for planning because, as the IRS ruled in Rev. Rul. 84-111 the event giving rise to the termination is the distribution of the corporate stock to the partners. If desirable, the partnership could delay the distribution until an advantageous time. While the IRS could assert that the mere holding of stock by the partnership lacks a business purpose (or contest the timing of the distribution on various other grounds) and argue that the termination occurred upon the distribution of the stock to the partnership, as discussed at V, B, above, the mere ownership of investment assets has proved sufficient activity to prevent a termination under §708(b)(1)(A).
The IRS ruled in Rev. Rul. 2004-59285.1 that Rev. Rul. 84-111 does not apply to the conversion of an unincorporated entity classified as a partnership for federal tax purposes to a corporation under a state law "formless conversion statute" (i.e., a statute allowing such a conversion without requiring the actual transfer of assets). The IRS stated that the consequences of a conversion under a formless conversion statute are similar to the consequences under Regs. §301.7701-3(g)(1)(i) for a partnership electing under Regs. §301.7701-3(c)(1)(i) to be treated as an association. Thus, a partnership converting under a state law formless conversion statute is deemed for federal tax purposes to contribute all of its assets and liabilities to the corporation in exchange for stock in the corporation and, immediately thereafter, to liquidate and distribute the stock of the corporation to the liquidating partnership's partners.
285.12004-24 I.R.B. 1050.
D. Sale or Exchange of 50% Interest
1.	In General
Under §708(b)(1)(B), a partnership will terminate if "within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits." The 12-month period referred to in the statute is not a calendar year or the taxable year of the partnership but a period of 12 consecutive months.286 The regulations also point out that a sale or exchange which causes a termination must be of an interest in 50% or more of partnership profits and capital. Thus, a sale of an interest in a partnership consisting of 30% of partnership capital and 60% of partnership profits would not cause a termination.287
286Regs. §1.708-1(b)(2). See PLR 9440017 (transfer of a 49% interest in a partnership (P) followed by a transfer of a 1% interest in P which occurs at least one year and one day after the original transfer does not terminate P); PLR 9529037 (sales of partnership interests that occur one year and one month apart are not aggregated for purposes of determining if the partnership has terminated).
287Regs. §1.708-1(b)(2).
While the statute refers to "a sale of 50 percent or more" of an interest in profits and capital as causing a termination, the regulations combine all sales occurring within 12 months.288 The statute, nevertheless, implies that all sales occurring within 12 months will be combined; otherwise, there would be no need to include the additional requirement that the sale occur within the 12 months provided in the statute. The regulations also point out that more than one sale of the same partnership interest within a period of 12 consecutive months is only to be counted once.
288Regs. §1.708-1(b)(2).
Example: On May 12, 1956, A, a partner in the ABC partnership, sells a 30% interest in captial and profits to D. Before Mar. 27, 1957, B sells a 30% interest in capital and profits to E. Accordingly, the partnership is terminated as of Mar. 27, 1957. However, if, on Mar. 27, 1957, D, instead of B, sold his 30-percent interest in capital and profits to E, there would be no termination because only one 30% interest would have been sold or exchanged within a 12-month period.289
289Regs. §1.708-1(b)(2).
2.	Definition of Interest in Capital
Neither the Code nor regulations define the term "interest in partnership capital." The regulations do, however, specify that, in making the determination of whether the requisite 50% has been sold or exchanged, the interest in capital (and profits) is to be determined as of the date of the sale or exchange.290 This factor becomes important where a partner's capital (or profits) interest fluctuates during the year.291
290Regs. §1.708-1(b)(2).
291A partner's capital interest could fluctuate during the year in a number of circumstances. For example, new partners could be admitted, generally decreasing the existing partners' interests in capital proportionately. Alternatively, one or more partners' partnership interests could be liquidated, generally increasing the remaining partners' interests in capital.
Although a definition is not set forth in the Code or regulations, a partner's percentage interest in partnership capital probably should be calculated by determining what the partner would be entitled to if the partnership were liquidated on the determination date (i.e., the date of the sale or exchange of the partner's interest for purposes of §708(b)(1)(B)).292 This will require: (1) a determination of the partner's capital account balance; and (2) a careful reading of the portions of the partnership agreement dealing with distributions upon liquidation of the partnership.
292Although a comprehensive definition of the term "interest in partnership capital," as used in §708, is not set forth in the Code or regulations, Regs. §1.704-1(e)(1)(v) defines the term "capital interest in a partnership" for purposes of §704(e) (relating to family partnerships) as: "an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership." Various courts have held that §704(e) applies to partnerships generally, not just to family partnerships.
See, e.g., Evans v. Comr., 447 F.2d 547, 550 (7th Cir. 1971), aff'g 54 T.C. 40 (1970), acq., 1978-2 C.B. 2; Atlas v. U.S., 555 F. Supp. 110, 113 (N.D. Ill. 1982); Carriage Square, Inc. v. Comr., 69 T.C. 119, 126 fn. 4 (1977). Although the above definition of "capital interest in a partnership" applies, by its terms, only to §704(e), it could be argued that the definition should apply to subchapter K generally, particularly in view of the lack of a definition elsewhere.
Example: A and B each contributed $100 upon formation of the AB partnership, and the partnership purchased property with the $200. If the partnership agreement provides that A and B each will be entitled to 50% of profits and losses and an equal share of liquidation proceeds, the share of A and B each in partnership capital is 50% and the balance of the capital accounts will not have to be determined in order to determine their entitlement to liquidation proceeds.
However, if the partnership agreement provides that A and B will share profits equally but that A will be entitled to the first $100 of losses, complications arise. Assume that the AB partnership agreement has a "gain charge-back" provision so that, upon any sale of partnership assets, gain will first be charged to A to the extent that losses were previously allocated to him. If the partnership agreement further provides that liquidation proceeds will be distributed in accordance with capital accounts after giving effect to the gain charge-back, the fair market value of partnership property must be determined before each partner's percentage of partnership capital can be determined. If partner A has been allocated $25 of losses at the time of termination so that his capital account has been reduced to $75 and if partnership losses reflect economic depreciation of partnership property so that the value of partnership property is only $175, A would be entitled to $75 on liquidation and B would be entitled to $100. Thus, A's percentage of partnership capital would only be 42.9% and a sale of his entire interest would not cause a termination of the partnership. However, if the value of partnership property had remained at $200, A would have a 50% interest in partnership capital because the first $25 of gain would be allocated to A, bringing his capital account back to $100, and A and B would therefore share liquidation proceeds equally. In the latter case, a sale of A's entire interest would cause a termination under §708(b)(1)(B).
3.	Definition of Interest in Profits
As in the case of a capital interest, neither the Code nor regulations defines the term "interest in partnership profits." A partner's right to a "guaranteed payment" under §707(c) is not to be included as an interest in profits for purposes of §708(b), however.293 Again, in the simple case where the partnership agreement provides that partnership profits and losses are to be allocated among the partners in fixed percentages, the determination of a partner's interest in partnership profits is easy. However, not all partnership agreements are so simple.
293Regs. §1.707-1(c).
For example, a partnership agreement may provide that income and cash flow from partnership operations are to be allocated in accordance with one set of percentages but that gain from the sale of partnership assets is to be allocated in different percentages. Arguably, a partner's interest in partnership profits means that partner's interest in "bottom-line" profits described in §702(a)(8). However, this conclusion is not supported by published authority for purposes of §708.
In addition, in certain cases, a partner's share of profits cannot be determined until the end of the year. For example, in some partnerships (notably personal service partnerships such as law and accounting firms), the partners' share of profits is determined at the end of the year based on each partner's performance during the year. Another example is where partnership profits are to be shared in one way if certain goals (such as sales quotas) are met and another way if the goals are not met. Thus, although the regulations under §708 require that a determination of a partner's interest in profits be made as of the date of the sale or exchange, the partner's interest may not be determinable until year-end.
Finally, it is unclear what effect the fact that the allocation of partnership profits does not have "substantial economic effect," for purposes of §704(b), will have on a §708 termination. Section 704(b) provides that a partner's share of profits (and other tax attributes) will be determined "in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances)" if the allocations provided in the partnership agreement do not have "substantial economic effect." The "substantial economic effect" test has been interpreted in a detailed and complex set of regulations.294 If a partner's share of profits under the partnership agreement is 50%, but the agreement does not pass the substantial economic effect test, it is not clear what the partner's interest in profits will be for purposes of §708.295 It may be that the parties treat a sale of a partner's interest as a §708(b) termination because, under the partnership agreement, the partner has a 50% interest in profits and capital. If on later examination, however, it is determined that the allocations do not pass the substantial economic effect test and the selling partner's profits interest under all facts and circumstances was less than 50%, the partnership was incorrectly treated as terminated, and retroactive reconstitution of the partnership presumably would be required.
294Regs. §1.704-1(b).
295Regs. §1.704-1(b)(3)(ii) states that the factors to be considered in determining a partner's interest in the partnership include: the partners' relative contributions to the partnership; the partners' interests in economic profits and losses (if different than that in taxable income and losses); the partners' interests in cash flow and nonliquidating distributions; and the rights of the partners to distributions of capital upon liquidation.
4.	Sale or Exchange
In order for a termination to arise under §708(b)(1)(B), a "sale or exchange" of the requisite percentage in capital and profits to either a third party or another member of the partnership is necessary.296 A sale of an interest which constitutes a breach of the partnership agreement and which does not effectively transfer the partner's interest to the transferee under state law is apparently sufficient to cause a termination under §708(b)(1)(B). For example, in Evans v. Comr.,297 the Tax Court held that a transfer of a 50% interest made without the knowledge or consent of the other 50% partner to a wholly-owned corporation of the transferor was a sale or exchange causing a termination even though, for state law purposes, the transferor remained a partner.298
296Regs. §1.708-1(b)(2). A sale or exchange may occur even if the transferee is an entity wholly owned by the transferor. See, e.g., FSA 200132009 (attribution rule under §707(b) has no application to §708, so that partner does not attribute related parties' partnership interests to himself in determining whether a 50% partnership interest has been sold or exchanged).
29754 T.C. 40 (1970), aff'd, 447 F.2d 547 (7th Cir.1971).
298Accord Rev. Rul. 77-137, 1977-1 C.B. 178 (under partnership agreement requiring consent of general partner in order to become substituted limited partner, assignee of limited partner's interest became a substituted limited partner for federal income tax purposes even though general partner's consent to assignment was not obtained and assignee was not a substituted limited partner for state law purposes).
According to the regulations, certain dispositions of a partnership interest will not constitute a "sale or exchange" for purposes of §708. A gift, bequest, inheritance or liquidation of an interest does not constitute a sale or exchange for this purpose.299 While there is apparently no published authority so holding, a charitable contribution of a partnership interest should similarly not be considered a sale or exchange giving rise to a partnership termination.300
299Regs. §1.708-1(b)(2).
300Some support for this position may be found in PLR 8228094 (contribution by 50% corporate partner of a 1% profits interest to a charity did not result in a §708(b) termination, even though the remaining interest of the corporation (i.e., a 49% profits interest and 50% capital interest) was distributed in liquidation of the corporation). While the ruling implies that the liquidating distribution of the corporation's partnership interest to its shareholders was a sale or exchange of the partnership interest for purposes of §708(b), it also implies that the charitable contribution of the 1% profits interest was not.
An issue which remains to be resolved is whether a gift of a partnership interest which creates a constructive exchange is a sale or exchange of the interest for purposes of §708. If a partnership has liabilities outstanding at the time of a gift of an interest in the partnership, the donor partner is deemed to realize taxable gain to the extent the partnership liabilities attributable to the gifted interest exceed the donor's basis in the interest.301
301§752(d); Regs. §1.1001-1(e). It is unclear from reading the Code whether §752(b) or §752(d) applies to a gift of a partnership interest where the donor's share of partnership liabilities exceeds his basis in the interest. The former would create a constructive sale of the donor's partnership interest under §731(a)(1) while the latter would create a constructive sale under the part sale, part gift rules of Regs. §1.1001-1(e). The better view appears to be that §752(d) and Regs. §1.1001-1(e)apply in this context. See discussion at II, C, 4, above. 
Example: If the AB partnership has $100 of indebtedness at the time A gives his 50% interest to C, A will be deemed to have an amount realized on the transfer of $50.302 If, at the time of the gift, A's basis in his 50% interest is less than $50 (the amount realized from the debt relief), A will have a taxable gain to be recognized to the extent that debt relief exceeds his adjusted basis.303 Thus, A has constructively received consideration in exchange for at least a portion of his partnership interest. Does this constitute a sale or exchange under §708? The regulations under §708(b)(1)(B) apparently ignore this possibility.
302§752(d); Regs. §1.1001-1(e).
303Id.
The regulations also provide that a contribution of capital to a partnership in exchange for a partnership interest is not a sale or exchange for purposes of §708.304 Thus, in Rev. Rul. 75-423,305 the IRS ruled that the payment of cash by newly-admitted partners as contributions to capital in exchange for 60% of partnership profits and capital did not cause a termination of the partnership.306 This rule seemingly provides an easy method of avoiding a termination under §708(b)(1)(B). Rather than selling a partnership interest directly to a third party, the partnership arguably could liquidate a 50% partner's interest (or a portion thereof) and, shortly thereafter, a third party could contribute cash to the partnership in return for a similar interest. However, the IRS could ignore the two steps and treat the transaction as a direct sale between the partner and the third party under §707(a)(2)(B).307
304Regs. §1.708-1(b)(2).
3051975-2 C.B. 260.
306Similarly, in PLR 8015088, the IRS concluded that cash contributions in exchange for an aggregate interest of 99% of partnership profits and losses (and presumably a greater than 50% interest in capital) in connection with a private placement of limited partnership interests did not cause a termination of the partnership. See also PLR 8520105.
307See Prop. Regs. §1.707-7, REG-149519-03, 69 Fed. Reg. 68838 (11/26/04). Regs. §1.731-1(c)(3) (cross-referenced by Regs. §1.708-1(b)(1)(ii) (Former Regs. §1.708-1(b)(1)(i)(b)) provides a similar line of attack where property is contributed by a partner to a partnership and shortly thereafter the property is distributed to another partner or the contributing partner receives a distribution of other property and the partnership retains the contributed property. In such a case, the transaction will be treated as an exchange between the partners or the contributing partner and the partnership (which would be a taxable exchange in most cases) rather than a tax-free contribution to capital under §721 and a tax-free (in most cases) distribution under §731.
In addition, the conversion of partnership interests into other partnership interests does not result in a termination, even if more than 50% of the partnership interests are converted, provided that each partner's percentage ownership interest remains the same after the conversion.307.1
307.1See, e.g., PLR 200345007, in which the IRS ruled that an LLC taxed as partnership would not terminate when its existing membership interests were converted into newly created membership interests, regardless of whether 50% of the interests were converted. The IRS cited Rev. Rul. 84-52, 1984-1 C.B. 158 (discussed below), in which it had ruled that a conversion of partnership interests is a §721 transaction and, thus, not a sale or exchange.
Tax-free, as well as taxable, exchanges of partnership interests may cause a termination under §708(b)(1)(B). In Long v. Comr.,308 for example, the Tax Court held that a §1031 exchange of partnership interests resulted in a termination.309 The Tax Court has also held that a contribution of a partnership interest comprising 50% or more of the capital and profits in the partnership to a corporation in a §351 exchange will cause a termination.310
30877 T.C. 1045 (1981).
309Note, however, that §77(a) of the Tax Reform Act of 1984, P.L. 98-369, amended §1031(a) to exclude exchanges of partnership interests from qualifying for tax-free treatment under §1031. But see Mason v. Comr., T.C. Memo 1988-273 (termination of two partnerships followed by exchange of assets received by partners in liquidation of their partnership interests qualified as §1031 exchange). Prior to the amendment, case law generally held that an exchange of a general partnership interest for another general partnership interest or an exchange of a limited partnership interest for a limited partnership interest qualified as like-kind exchanges while an exchange of a general partnership interest for a limited partnership interest in another partnership did not. Long v. Comr., 77 T.C. 1045 (1981); Gulfstream Land & Development v. Comr., 71 T.C. 587 (1979); Meyer Est. v. Comr., 58 T.C. 311 (1972), nonacq., 1975-1 C.B. 3, aff'd per curiam, 503 F.2d 556 (9th Cir. 1974).
310Evans v. Comr., 54 T.C. 40 (1970), acq., 1978-2 C.B. 2, aff'd, 447 F.2d 547 (7th Cir. 1971); Rev. Rul. 81-38, 1981-1 C.B. 386. But cf., PLR 8819083 (contribution of 99% interest in profits and capital of partnership to new holding partnership did not terminate existing partnership). PLR 8517022 illustrates the mechanical approach to §708(b) adopted by the IRS in connection with §351 exchanges of partnership interests. The PLR concluded that a transfer to a corporation of a 49% interest in partnership capital and profits in exchange for corporate stock did not cause a termination of the partnership even though one year and one day later, an additional 1% interest in capital and profits was also exchanged for stock. PLR 7952057 concluded similarly upon a §351 exchange of 49.5% of partnership profits and capital followed, one year and one day later, by an exchange of 0.5%.
Section 761(e), added to the Code by the Tax Reform Act of 1984,311 provides that, for purposes of §§708 and 743 (and other provisions to be specified in regulations), "any distribution of an interest in a partnership (not otherwise treated as an exchange) shall be treated as an exchange" except to the extent otherwise provided in regulations. Thus, where a partnership interest is distributed by a corporation to its shareholders or by a partnership (which owns an interest in a second-tier partnership) to its partners, a termination will result if the distribution consists of a 50% or more interest in capital and profits.312 A contribution of a 50% partnership interest to the capital of a corporation with no stock received in return is also likely to cause a termination under §§761(e) and 708(b)(1)(B).
311P.L. 98-369, §75(b).
312PLR 8720046 (distribution of partnership interest representing 50% or more of profits and capital in liquidation of corporate partner caused termination of partnership); TAM 8929003 (distribution of 50% or more interest in lower-tier partnership to partners in upper-tier partnership causes termination of lower-tier partnership); FSA 200219008 (liquidation of the upper-tier partnerships caused their termination and distribution to lower-tier partnership treated as a distribution of marketable securities). A sale or exchange of a 50% or more interest in an upper-tier partnership which causes a termination of that partnership also constitutes a sale or exchange of an interest in a lower-tier partnership owned by the terminating partnership. Thus, if the upper-tier partnership owns 50% or more of the capital and profits of the lower-tier partnership, the lower-tier partnership will also terminate under §708(b)(1)(B). Regs. §1.708-1(b)(2); GCM 39643. The legislative history of the Tax Reform Act of 1986 indicates that the Treasury may make exceptions to these rules. For example, "[i]t is intended that exceptions might include a distribution of a partnership interest by an estate or testamentary trust by reason of the death of a partner will not be treated as a sale or exchange for purposes of section 708(b)." S. Rep. No. 99-313, 924 (1986).
The enactment of §761(e) could explain the Service's revocation of PLR 8444069. In that ruling, a corporate partner merged into another corporation in a Type A reorganization described in §368(a)(1)(A) and the surviving corporation succeeded to all of the assets of the merged corporation. The IRS determined that the merger, whereby the surviving corporation became the partner by virtue of its succession to the assets of the merged corporation, "is an assignment to a successor in interest and not a sale or exchange" under §708. PLR 8643062 revoked PLR 8444069, reasoning that the former ruling's "conclusion concerning whether the acquisition by [the surviving corporation] of its interest in [the partnership] as a result of the merger is a sale or exchange under section 708 does not reflect the views of the Internal Revenue Service . . . ."
Various types of corporate reorganizations, in addition to a Type A reorganization (statutory merger), could result in a termination of a partnership where the corporation owns a 50% or more partnership interest at the time of the reorganization and the reorganization involves an actual transfer of assets. Thus, a Type C reorganization (voting stock of one corporation exchanged for assets of another corporation),313 a Type D reorganization (transfer of assets to controlled corporation followed by distribution of stock or securities in controlled corporation to shareholders of controlling corporation),314 and a Type G reorganization (transfer of assets in bankruptcy or similar proceeding)315 may result in a termination of a partnership if the reorganization involves a transfer of a 50% or more interest in a partnership.316 On the other hand, corporate reorganizations should not result in a partnership termination where the form of the reorganization does not involve an asset transfer by the reorganizing company. In this category would be a Type B reorganization (voting stock exchanged for voting stock)317 and a Type E reorganization (recapitalization).318 Although a Type F reorganization (mere change in identity, form or place of incorporation by one corporation)319 could technically involve an asset transfer, the announced position of the IRS is that an F reorganization will not cause a termination of a partnership even if the reorganization results in a transfer of assets, including a 50% or more interest in profits and capital of the partnership.320
313§368(a)(1)(C).
314§368(a)(1)(D).
315§368(a)(1)(G).
316Rev. Rul. 87-110, 1987-2 C.B. 159, concluded that a transfer of a 50% or more interest in partnership profits and capital pursuant to a tax-free corporate reorganization (other than a Type F reorganization) would cause a termination of the partnership.
317§368(a)(1)(B).
318§368(a)(1)(E).
319§368(a)(1)(F).
320See Rev. Rul. 87-110, 1987-2 C.B. 159 (Section 361 exchange of a partnership interest made pursuant to a §368(a)(1)(F) reorganization is not an exchange for purposes of §708(b)). See also GCM 39673.
The distribution by a corporation of a partnership interest pursuant to §301 (dividend), §302 (redemption), or §303 (redemption to pay death taxes) also probably would constitute a sale or exchange of the partnership interest for purposes of §708(b)(1)(B) by virtue of §761(e). Similarly, a sale or exchange of a partnership interest probably would occur if a corporation holding the partnership interest liquidates under §331 or §332.321 That gain or loss is not recognized in connection with a liquidation qualifying under §332 would make no difference since, as mentioned above, gain or loss recognition is not a factor in determining whether a sale or exchange has occurred under §708.
321Accord PLR 8529097 (transfer of 99% partnership interest to liquidating trust in connection with a §337 liquidation (prior to the amendment of §337 by the Tax Reform Act of 1986, P.L. 99-514) resulted in termination of partnership under §708(b)(1)(B)).
Whether a sale or exchange of a partnership interest results from a partner "abandoning" his interest by withdrawing from the partnership, without receiving consideration in connection with the withdrawal, apparently depends upon whether the partnership has any outstanding indebtedness at the time of the abandonment. If there are no partnership debts, such a withdrawal apparently is not a sale or exchange.322 Such an abandonment would also probably not be a "distribution" of the interest so that §761(e) would not treat the abandonment as a sale or exchange under §708.322.1
322 Accord Gannon v. Comr., 16 T.C. 1134(1951), acq., 1951-2 C.B. 2; Hutcheson v. Comr., 17 T.C. 14 (1951), acq., 1951-2 C.B. 2 (both involving the withdrawal of partners from the same law firm). See also Zeeman v. U.S., 275 F. Supp. 235 (S.D.N.Y. 1967) (limited partner entitled to ordinary loss rather than capital loss from worthlessness of partnership interest because there was no sale or exchange), aff'd and rem'd on other issues, 395 F.2d 861 (2d Cir. 1968); Rev. Rul. 70-355, 1970-2 C.B. 51 (partner who received no consideration upon dissolution of limited partnership entitled to ordinary loss because no sale or exchange of partnership interest). Cf. Rev. Rul. 76-189, 1976-1 C.B. 181 (constructive sale or exchange arises under §731 upon dissolution of partnership even though partnership had no assets or liabilities at time of dissolution). Cf., Weiss v. Comr., T.C. Memo 1990-492 (forfeiture of general partnership interest constituting 50% interest in profits and capital to remaining partners resulted in termination of partnership).
322.1The IRS has addressed many of these issues in Rev. Rul. 93-80, 1993-2 C.B. 239, which clarifies and supersedes Rev. Rul. 70-355, 1970-2 C.B. 51, and revokes Rev. Rul. 76-189, 1976-1 C.B. 181. For a discussion of Rev. Rul. 93-80, see II, B, 1, b, above.
In the case of an abandonment of a partnership interest that has liabilities at the time of the abandonment, however, a constructive sale or exchange of the interest would be deemed to occur. Under §752(a), a partner is deemed to have contributed cash to a partnership to the extent of any increase in his proportionate share of partnership liabilities or the assumption by the partner of partnership liabilities. A decrease in a partner's share of partnership liabilities or the assumption by the partnership of individual liabilities of a partner is treated as a distribution of cash from the partnership to the partner under §752(b). Therefore, when a partner's share of partnership debt is reduced by virtue of his withdrawal from the partnership (or otherwise), the constructive cash distribution results in a sale or exchange of his partnership interest under §731. This result follows even in the case of the withdrawal of a limited partner, where the partner receives no consideration, if the limited partnership has nonrecourse liabilities at the time of the withdrawal.323
323O'Brien v. Comr., 77 T.C. 113 (1981).
E. Structural Changes to Partnership
1.	Merger or Consolidation
In January 1999, the IRS proposed regulations redesignating Regs. §1.708-1(b)(1) and amending and redesignating Regs. §1.708-1(b)(2).324 As finalized, the regulations apply to partnership mergers, consolidations, and divisions occurring after January 3, 2001, but with optional application for such transactions occurring after January 10, 2000.
324REG-111119-99, 65 Fed. Reg. 1572 (1/11/00). Former Regs. §1.708-1(b)(1) was redesignated as Regs. §1.708-1(b)(1) through -1(b)(5) and Former Regs. §1.708-1(b)(2) was amended and redesignated as Regs. §1.708-1(c) (mergers and consolidations) and  (d) (divisions).
As with Former Regs. §1.708-1(b)(2)(i), two or more partnerships may merge into one of the existing entities or two or more partnerships may consolidate into a newly formed partnership. The resulting entity is considered to be a continuation of the partnership whose members obtain more than 50% of the profits and capital in the resulting entity, whereas the other constituent partnerships are considered terminated.325
325Regs. §1.708-1(c).
If the resulting partnership can be considered a continuation of more than one of the merging or consolidating partnerships, it is considered a continuation of the partnership credited with the contribution of the greatest dollar value of assets (net of liabilities) to the resulting partnership.326 Again, the resulting partnership can be a continuation of only one of the constituent partnerships with all other constituent partnerships terminating for federal income tax purposes.
326 Regs. §1.708-1(c)(1). The regulations, however, still do not address the result when the members of more than one partnership have obtained more than 50% of the profits and capital in the resulting partnership and the relevant partnerships have contributed an equal dollar value of assets (net of liabilities) to the resulting partnership.
Example: Partnership EFGH has $100,000 worth of assets (net of liabilities) and partnership GHI has assets worth $150,000 (net of liabilities). The two partnerships consolidate, forming EFGHI, with each partner receiving a 20% interest in profits and capital. Partners of EFGH receive an 80% interest and partners of GHI receive a 70% interest. EFGHI is considered a continuation of GHI only, with EFGH terminating for federal income tax purposes.327
327EFGH terminates even if, under state law, GHI contributed its liabilities and assets to EFGH in exchange for an interest in EFGH, with GHI then liquidating and distributing to its partners the EFGH interests. Regs. §1.708-1(c)(5), Ex. 2(i).
The exact tax consequences of a partnership merger or consolidation depend on whether the transaction is classified as the "assets-over" form or the "assets-up" form.328 If the partnership merges or consolidates without meeting the requirements of the assets-up form, the partnership is treated as following the assets-over form. The assets-up form will only be respected if the merged or consolidated partnership that is considered terminated distributes all of its assets to its partners in liquidation of their partnership interests, with the partners immediately contributing the assets to the resulting partnership in exchange for interests in the resulting partnership.329 Additionally, all of the partners in the terminating partnership must follow the assets-up form or the form of the merger will be assets-over.330
328Cf. Rev. Rul. 84-111, 1984-2 C.B. 88 (providing three forms: assets-over, assets-up, and interest-over).
329 Regs. §1.708-1(c)(3)(ii). Further, the terminating partnership must distribute its assets in such a manner that the partners are, under state law, the owners of the assets.
330See Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01). The IRS also may disregard the prescribed form if the merger is part of a larger series of transactions. Regs. §1.708-1(c)(6).
Under the assets-over form, the merging partnership is treated as having contributed its assets to another partnership in exchange for an interest in the latter, with the merging partnership then transferring the interest received to its own partners in liquidating distribution.
Example: Equal partnership WX contributes all of its assets to partnership YZ in exchange for a 30% interest in YZ. WX then dissolves and distributes a 15% interest in YZ to W and a 15% interest in YZ to X in liquidation of their interests in WX.331
331See, e.g., Rev. Rul. 84-111, 1984-2 C.B. 88; Rev. Rul. 77-458, 1977-2 C.B. 220; and Rev. Rul. 68-289, 1968-1 C.B. 314. Both Rev. Rul. 77-458 and Rev. Rul. 68-289 were clarified by Rev. Rul. 90-17, 1990-1 C.B. 119, which ruled that  §761 does not cause the resulting partnership to terminate under §708(b)(1)(B).
The regulations adopt two rules to soften the effects of the assets-over form. First, increases or decreases in partnership liabilities associated with the merger are netted before applying §752. Consequently, a partner in the terminating partnership will recognize gain on the contribution only if the net deemed distribution exceeds the partner's adjusted basis in the resulting partnership interest.331.1 Second, the buyout of a partner pursuant to the merger or consolidation, in certain circumstances, will be treated as a sale of that partner's interest in the terminating partnership to the resulting partnership, rather than being treated as a disguised sale of the terminating partnership's assets. The merger agreement, however, must specify that the resulting partnership is purchasing the exiting partner's interest in the terminating partnership and the amount paid for the interest. Further, the exiting partner must consent to the sale treatment.332
331.1 Regs. §1.752-1(f), Regs. § -1(g), Ex. 2. The regulation is effective for liabilities incurred or assumed by a partnership after Jan. 3, 2001, but, subject to certain conditions, may be relied on for earlier liabilities. See Regs. §1.752-5(a).
332 Regs. §1.708-1(c)(4). It should be noted that, if the exiting partner sells 50% or more of the total interest in the buyout provision, then, under §708(b)(1)(B), the partnership will terminate before the merger. See Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01).
Under the assets-up form, the merging partnership is treated as having distributed all of its assets to its partners in liquidation of their partnership interests, after which, the partners contribute these assets to a new partnership in exchange for interests in the latter.
Example: Equal partnership WX distributes all of its assets in equal shares to W and X and dissolves. W and X immediately contribute these assets to partnership YZ, with each receiving a 15% partnership interest in YZ in exchange.332.1
332.1As emphasized in the Preamble to Final Regulations, the partnership must follow the state law requirements necessary to convey ownership of the assets distributed to the partners or the form of the merger will default to assets-over. For most types of assets, however, the actual transfer and recording of a deed or certificate of title will not be required. See Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01).
The IRS takes the position that an assets-over partnership merger creates new §704(c) gain that the contributing partner may have to recognize. In Rev. Rul. 2004-43,332.2 the IRS had ruled that: (1) §704(c)(1)(B) applies to §704(c) gain or loss that is created in an assets-over merger if the assets contributed in the merger are distributed to a partner other than the contributing partner within seven years of the merger; and (2) the gain or loss created in the merger must be considered in determining the amount of net precontribution gain for §737 purposes if the continuing partnership distributes other property to the contributing partner within seven years of the merger. In response to comments asserting that Rev. Rul. 2004-43 is inconsistent with the regulations under §§704(c)(1)(B) and 737, and that the ruling's conclusions should not apply retroactively, the IRS revoked Rev. Rul. 2004-43 and announced that it would instead issue regulations implementing the principles of Rev. Rul. 2004-43, effective for distributions occurring after January 19, 2005.332.3
332.22004-18 I.R.B. 842, revoked by Rev. Rul. 2005-10, 2005-7 I.R.B. 492.
332.3Notice 2005-15, 2005-7 I.R.B. 527.
According to the IRS, the regulations will apply to both: (1) distributions of property with newly created §704(c) gain or loss, regardless of whether the gain or loss is treated as reverse §704(c) gain or loss; and (2) distributions of property with original §704(c) gain or loss that existed on the contribution of the property to the transferor partnership.  However, under the regulations, the seven-year periods in §§704(c)(1)(B) and 737 will not restart as a result of the merger with respect to the original §704(c) gain or loss.332.4
332.4Id. In Rev. Rul. 2004-43, the IRS had ruled that §§704(c)(1)(B) and 737 would not apply to reverse §704(c) gain or loss created in an assets-over merger as a result of the revaluation of property in the continuing partnership.
The regulations will provide two exceptions to these rules if the assets-over merger involves partnerships owned by the same owners in the same proportions: (1) §704(c)(1)(B) will not apply to newly created §704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership; and (2) for purposes of §737, net precontribution gain will not include newly created §704(c) gain or loss in property contributed by the transferor partnership to the continuing partnership. To qualify for these exceptions, each partner's percentage interest in the transferor partnership's capital, profits, losses, distributions, liabilities, and all other items must be the same as the partner's percentage interest in those items of the continuing partnership.
Example 1: W contributes asset 1 (with a $200 basis and a $300 fair market value) to partnership WX in exchange for a 50% interest, and X contributes $300 in cash to WX for a 50% interest. At the same time, Y contributes asset 2 (with a basis of $100 and value of $200) to partnership YZ for a 50% interest, and Z contributes $200 in cash to YZ for a 50% interest. Two years later, WX and YZ undertake an assets-over merger in which WX is the continuing partnership. At the time of the merger, WX's only assets are asset 1 (with a value of $900) and $300 in cash, and YZ's only assets are asset 2 (with a value of $600) and $200 in cash. After the merger, W and X each have a 30% interest in the continuing partnership, and Y and Z each have a 20% interest. Six years after the merger, the continuing partnership has the same assets that it had after the merger; each asset has the value that it had at the time of the merger, and the continuing partnership distributes asset 2 to W in liquidation of W's partnership interest.
Because YZ contributes asset 2 with a value of $600 and a basis of $100 to WX in the merger, asset 2 has built-in gain of $500 at the time of the merger. Of the built-in gain, $100 is pre-existing §704(c) gain attributable to Y's contribution of asset 2 to YZ, and $400 is §704(c) gain created in the merger. Y and Z succeed to YZ's partnership interest in WX and, therefore, each succeeds to $200 of the new §704(c) gain. Y's share of total §704(c) gain is $300; Z's share is $200. The distribution of asset 2 to W occurs more than seven years after Y contributed asset 2 to XY. Therefore, §704(c)(1)(B) does not apply to the $100 of pre-existing §704(c) gain attributable to Y's contribution. However, the distribution occurs within seven years of YZ's contribution of asset 2 to WX in the merger (which created $400 of §704(c) gain). Section 704(c)(1)(B) does apply to that §704(c) gain, causing Y and Z each to recognize $200 of gain.332.5
332.5Rev. Rul. 2004-43, 2004-18 I.R.B. 842, Situation 1, revoked by Rev. Rul. 2005-10, 2005-7 I.R.B. 492. Although Rev. Rul. 2004-43 is revoked, this example remains a useful illustration of the principles that will be included in the regulations.
Example 2: The facts are the same as in Example 1, except that six years after the merger asset 1 has a value of $275, and the continuing partnership distributes asset 1 to Y in liquidation of Y's partnership interest.
Section 704(c)(1)(B) does not apply to the distribution of asset 1 to Y, because the distribution occurs more than seven years after the contribution of asset 1 to WX. Furthermore, because the distribution of asset 1 occurs more than seven years after the contribution of asset 2 to WX, Y's net precontribution gain at the time of the distribution does not include Y's $100 of pre-existing §704(c) gain attributable to that contribution. However, the distribution of asset 1 does occur within seven years of the contribution of asset 2 in the merger. Y and Z each succeed to one-half of YZ's net precontribution gain created by the merger (i.e., $200 each). However, the excess of asset 1's fair market value ($275) over the adjusted basis of Y's interest in the continuing partnership immediately before the distribution ($100) is $175. Because this amount is less than C's $200 of net precontribution gain, C recognizes $175 of gain under §737 as a result of the distribution. (D recognizes no gain because no property contributed by D is distributed to another partner.)332.6
332.6Rev. Rul. 2004-43, 2004-18 I.R.B. 842, Situation 2, revoked by Rev. Rul. 2005-10, 2005-7 I.R.B. 492. Although Rev. Rul. 2004-43 is revoked, this example remains a useful illustration of the principles that will be included in the regulations.
2.	Division of a Partnership
An existing partnership may divide into two or more partnerships. A partnership resulting from the division is considered to be a continuation of the prior partnership (the "divided" partnership) if its members had an interest of more than 50% in the capital and profits of the prior partnership.333 Should the division result in two such partnerships, the partnership having assets with the greatest fair market value (net of liabilities) will be treated as the divided partnership.333.1
333 §708(b)(2)(B). The divided partnership will terminate for tax purposes if none of the resulting partnerships meets the prior interest requirement. Regs. §1.708-1(d)(1) (effective for divisions occurring after Jan. 3, 2001, with optional application to divisions occurring after Jan. 10, 2000). Similarly, any resulting partnership that is not classified as a "divided" partnership is a new partnership. Id. See PLR 199944016 for an example of §708(b)(2)(B) applied to an LLC taxable as a partnership.
333.1 Regs. §1.708-1(d)(4)(i).
As with partnership mergers and consolidations, the tax consequences of the division depend on the form of the division and whether the division results in a "divided" partnership. The regulations only recognize two forms and, if the specific requirements of the "assets-up" form are not met, the default form is "assets-over."333.2 Further, under the assets-over form, the prior partnership's momentary ownership of all the interests in a resulting partnership does not prevent the resulting partnership from being classified as a partnership.334
333.2See Regs. §1.708-1(d)(3)(i). The prescribed form, however, may be disregarded if the division is part of a larger series of transactions. Regs. §1.708-1(d)(6).
334See Preamble to Proposed Regulations, REG-111119-99, 65 Fed. Reg. 1572 (1/11/00). Cf. McCauslen v. Comr. 45 T.C. 588 (1966); Rev. Rul. 99-6, 1999-6 I.R.B. 6. Both McCauslen and Rev. Rul. 99-6 apply the general rule that a partnership goes out of existence when its interests are transferred to a single person.
Although the regulations do not define "division," it is clear that at least two members of the prior partnership must be members of each resulting partnership that exists after the transaction before a division can occur.335
335See Regs. §1.708-1(d)(4)(iv); Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01).
Example: EFG partnership owns two lines of business: X and Y. E and F each own 20% of EFG, with G owning the remaining 60% interest. G does not wish to remain partners with E and F and would prefer to operate X with H. Consequently, EFG distributes X to G in liquidation of his EFG interest, with G immediately dropping X into the subsequently formed GH partnership. Because G is the only member of the EFG partnership in the GH partnership, the transaction is not a division for federal income tax purposes.336
336Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01). Although the Preamble does not directly state its motive for denying division status to the above transaction, the reasoning is clear: G has received a liquidating distribution, which will result in the termination of the EFG partnership because G held 50% or more of the interest in capital and profits. See Regs. §1.708-1(b)(2) (Former Regs. §1.708-1(b)(1)(ii)). Similarly, it is to be assumed that had F received X and then dropped X into the FH partnership (with E and G retaining Y), a partnership division would not have occurred, despite EG having members who held interests of more than 50% in the capital and profits of the prior partnership. F merely received a liquidating distribution from the EFG partnership.
3.	Conversion of General Partnership to Limited Partnership or Limited Partnership to General Partnership
In Rev. Rul. 84-52,337 the IRS adopted the position publicly that it had previously adopted in several private letter rulings,338 that the conversion of a general partnership into a limited partnership or a limited partnership into a general partnership does not result in a termination under §708. While the ruling states that the partners of the "old" partnership exchanged their interests for interests in the "new" partnership, the exchanges do not result in a termination of the old partnership because, according to the ruling, the partners of the old partnership are treated as making a contribution to the new partnership under §721. Because, under Former Regs. §1.708-1(b)(1)(ii) (redesignated as Regs. §1.708-1(b)(2)), a contribution of property to a partnership under §721 is not an exchange giving rise to a termination under §708, no termination resulted, according to the Service.
3371984-1 C.B. 157. In PLR 9501033, the IRS ruled that the conversion of a Maryland general partnership into a Maryland limited liability company, classified as a partnership for federal tax purposes, does not result in gain to the members provided there is no change the partners' share of liabilities as a result of the conversion.
338See, e.g., PLRs 8211121, 8150134, and 7948063. See also PLR 9029019 (division of single general partnership into four general partnerships and conversion of one of resulting partnerships to limited liability company characterized as limited partnership did not result in termination); PLRs 9423037, 9423040, 9424038, and 9426037(conversion of N.Y. general partnership to Delaware limited partnership will not result in termination); PLRs 9424036 and 9424037, as supplemented by PLRs 9448026 and 9448025, respectively (conversion of Ill. general partnership to Ill. limited partnership will not result in termination); PLRs 9407030and 9422034 (conversion of general partnership to limited liability company (LLC) will not result in termination); PLR 9443024 (conversion of limited partnership to LLC will not result in termination); PLR 9419017 (conversion of State A limited partnership to State B limited partnership will not result in termination); PLR 9802012 (conversion of general partnership to limited liability partnership will not result in termination).
The rationale of Rev. Rul. 84-52 with respect to the §708 issue is not particularly persuasive. First, if in fact there is a contribution of property to the new partnership under §721, that contribution would not protect the old partnership from terminating. Former Regs. §1.708-1(b)(1)(ii) (Regs. §1.708-1(b)(2)) would protect only the new partnership from termination. There is no contribution of property, constructive or actual, to the old partnership. Second, it is not clear from the ruling what property is contributed to the new partnership. If the partners are deemed to constructively contribute their partnership interests in the old partnership to the new partnership, under Rev. Rul. 84-111,339 there is a termination of the old partnership pursuant to §708(b)(1)(A). If the transaction is considered to be a constructive contribution to the new partnership of the assets of the old partnership by the partners, the old partnership would terminate under §708(b)(1)(A) because the old partnership would cease all activities upon the distribution. Despite the faulty reasoning, the position of the Service is that a conversion of a limited to a general partnership or a general to a limited partnership will not cause a termination.
3391984-2 C.B. 88.
VI. Income Tax Consequences Upon Termination
A. Closing of Taxable Year
1.	Bunching of Income
Upon the termination of a partnership, the partnership taxable year closes with respect to all partners.340 If the partners and the partnership have the same taxable year, this circumstance should not give rise to any significant tax problems. However, up to 23 months of a partner's share of partnership income could be bunched into one year where a partner has a different taxable year than the terminated partnership.
340Regs. §1.708-1(b)(3); Former Regs. §1.708-1(b)(1)(iii).
Example: Partnership AB, and A and B, individually, are all calendar year taxpayers. If AB is terminated because A sold his interest to C on June 30, 1992, AB's taxable year closes under §706(c)(1). Therefore, AB must report six months of income, and A and B would each report on his individual tax return for his taxable year ending Dec. 31, 1992, his proportionate share of AB's six months of income. If BC continues in existence, the second six months of partnership income through Dec. 31, 1992, will be included on the tax returns of B and C for the year ending Dec. 31, 1992 (assuming BC is also a calendar year taxpayer).341 Thus, B will report only 12 months of partnership income (six months attributable to AB and six months attributable to BC), and no bunching of partnership income will occur.
However, assume that partnership AB has a taxable year ending Jan. 31, but that all other parties are on a calendar year. Under §706(a), each partner's share of the income of the partnership is to be included in the "taxable year of the partnership ending within or with the taxable year of the partner." Thus, AB's income for its taxable year ending Jan. 31, 1992, is to be included in the income of A and B for their taxable year ending Dec. 31, 1992 (because Jan. 31, 1992, falls within the 1992 calendar year). If AB is terminated on December 31, 1992, each partner's share of the income of AB for its full taxable year ended January 31, 1992, and the income of AB for the period February 1, 1992, through December 31, 1992, must be included in each partner's individual return. This follows because two of the partnership's taxable years end within the 1992 calendar year. A and B must therefore report 23 months of partnership income on their 1992 calendar year tax returns.
341As discussed at VI, B, 2, a, (1), below, a partnership's ability to adopt a taxable year that results in the deferral of income to its partners was substantially curtailed with revisions to §706 adopted by the 1986 TRA, P.L. 99-514.
2.	Date of Termination
The date of termination varies depending on the event giving rise to the termination. If the termination occurs because of a sale or exchange of an interest in 50% or more of partnership profits and capital, the termination occurs, and the taxable year of the partnership closes, on the date of the sale or exchange causing the termination.342 However, where the termination is due to a cessation of business under §708(b)(1)(A), the partnership is not considered to have terminated for the purpose of closing the partnership's taxable year until "the date on which the winding up of the partnership affairs is completed."343 Thus, in the case of a cessation of business causing the termination, the taxable year of the partnership closes upon the final distribution of partnership assets to the partners.
342Regs. §1.708-1(b)(3)(ii).
343Regs. §1.708-1(b)(3)(i).
The regulations are not clear as to when the partnership year closes where a termination results from a partnership converting to a sole proprietorship. The example in Regs. §1.708-1(b)(1) states that the termination occurs as of the date that there is only one remaining partner. However, Regs. §1.708-1(b)(3)(i), dealing specifically with the closing of the partnership's taxable year, provides that the date of termination is the date on which the winding up of the partnership affairs is completed for purposes of §708(b)(1)(A). Because a termination due to converting to a sole proprietorship is described in §708(b)(1)(A), the regulation could be read as not requiring an immediate closing of the partnership's taxable year in this circumstance. However, this fact should be viewed as a mere oversight in drafting the regulation because there is no "winding up" of business where the business is continued as a proprietorship. The termination and closing of the partnership's year should, therefore, occur when only one partner remains.
In the case of a §708(b)(1)(A) termination due to the incorporation of a partnership, in accordance with Rev. Rul. 84-111,344 the date of termination and closing of the partnership's taxable year depends on which of the three incorporation methods mentioned in the ruling is adopted.345 The termination date is discussed at V, C, 2, above, for each of the three methods.
3441984-2 C.B. 88.
345Final regulations on mergers and divisions, however, recognize only two methods--assets-up and assets-over. See discussion, below, at VI, B, 3, a.
In the case of a merger or consolidation of partnerships, the regulations provide that any constituent partnership terminated under §708 must close its taxable year and file a return for the short period ending on the date of the merger or consolidation.346 The resulting partnership files a return for the entire taxable year of the partnership for which it is deemed to be a continuation and includes the income of the continued partnership. The return must "state that the resulting partnership is a continuation of such merging or consolidating partnership, shall retain the employer identification number (EIN) of the partnership that is continuing, and shall include the names, addresses, and EINs of the other merged or consolidated partnerships."347
346Regs. §1.708-1(c)(2).
347Id.
If the resulting partnership in a merger is considered a continuation of none of the constituent partnerships (because the members of none of the constituent partnerships received more than 50% of the capital and profits of the resulting partnership), the taxable years of all of the constituent partnerships will close as of the date of the merger or consolidation.348 In such event, the resulting partnership's first taxable year will commence on the date of its organization (i.e., the date of its formation under state law) and will end on the day it chooses as its taxable year-end.349
348Id.
349Regs. §1.443-1(a)(2).
In the case of a partnership division, a termination may result under Regs. §1.708-1(d)(1), requiring a closing of the divided partnership's taxable year, only if the partners of none of the resulting partnerships owned an interest of more than 50% of the capital and profits of the divided partnership. The revised regulations explicitly call for a termination and taxable year close in the case of a division. Thus, the divided partnership will terminate and its taxable year will close under §706(c) as of the date of the division if none of the resulting partnerships qualifies as a continuation of the divided partnership.
A resulting partnership that is a continuation of a divided partnership must report the income of the divided partnership for the partial year prior to the division as well as its own income after the division. As in the case of a merger or consolidation, the return is to "state that the partnership is a continuation of the prior partnership and shall set forth separately the respective distributive shares of the partners for the periods prior to and including the date of the division and subsequent to the date of division."350 A resulting partnership that does not qualify for continuation status must file a short period return for the period commencing with the date of its formation and ending with the day it has elected as its taxable year end.351
350Regs. §1.708-1(d)(2)(i).
351See Regs. §1.443-1(a)(2). If a resulting partnership (that is not a continuation of a divided partnership) was formed before the division, its first taxable year commences on the day of its formation rather than the day of the division.
B. Other Income Tax Consequences
1.	Termination Under §708(b)(1)(A)--Cessation of Business Activity
In the case of a termination due to a cessation of business activities, the date of termination is the "date on which the winding up of the partnership affairs is completed."352 Although neither the Code nor regulations define what is meant by the "winding up of partnership affairs," it probably has the same meaning as under state law. Thus, if a termination is due to a cessation of business, the date of the termination for purposes of §708 is probably the date upon which all partnership assets are distributed to the partners in complete liquidation of the partnership.353 Therefore, unlike the other circumstances giving rise to a partnership termination, there is no need to resort to a constructive distribution of partnership assets to the partners (and a constructive recontribution in the case of a termination due to a sale or exchange of partnership interests) because the termination will arise only in connection with the actual final distribution of assets.
352Regs. §1.708-1(b)(3)(i). See the discussion at V, B, above.
353See Austin v. U.S., 461 F.2d 733 (10th Cir. 1972); Harbor Cove Marina Partners Partnership v. Comr., 123 T.C. No. 4 (7/15/04). See also PLRs 9436032 and 9440019, discussed at V, B, above.
If a §708(b)(1)(A) termination results from a conversion of a partnership into a sole proprietorship, however, a constructive distribution of partnership assets must be assumed, though the Code and regulations are not explicit on this point. The partnership terminates as of the date that only one partner remains. Because the regulations assume that this is a taxable event, it must also be assumed that the former partnership constructively distributes its assets to the remaining partner on such date.354 In Rev. Rul. 99-6,355 the IRS ruled on this issue when a 50% partner purchased the other 50% ownership interest in a partnership (an LLC classified as a partnership under Regs. §301.7701-3), resulting in "partnership status" terminating under §708(b)(1)(A). The IRS determined that the partnership was deemed to make a liquidating distribution of all its assets to the partners, with the purchasing partner treated as acquiring the partnership assets deemed distributed to the selling partners in liquidation of his partnership interest. The selling partner must treat the purchase as the sale of his interest in accordance with §741. The IRS in Rev. Rul. 99-6 also applied the same "constructive distribution" methodology when an unrelated person purchased the partnership interests of two equal partners.
354It is necessary to assume the constructive distribution in complete liquidation of the sole remaining partner's interest in order that the proper tax treatment under subchapter K follows. For example, if no constructive distribution of partnership assets is deemed to occur, the former partner's proper basis for the partnership assets, as determined under §732, would not be reflected.
3551999-6 I.R.B. 6 (reproduced in the Working Papers, below).
The principal consequences arising under subchapter K upon a distribution in complete liquidation of a partnership (whether constructive or actual) are, in general, as follows: (1) under §731, a partner recognizes taxable gain only to the extent that money (for purposes of this rule, §731(c) generally treats marketable securities as money) distributed exceeds his basis in his partnership interest, and loss is recognized if he receives only cash, certain receivables and inventory (and then only in certain circumstances); (2) the basis of property received by the partner generally is the same as his basis in his partnership interest reduced by any money distributed in the same transaction pursuant to §732; (3) the holding period of the partnership in the assets distributed generally is "tacked" on to the partner's holding period as set forth in §735; and (4) the partnership recognizes no gain or loss on the liquidation under §731(b).
2.	Termination Under §708(b)(1)(B)--Sale or Exchange of Partnership Interest
a.	Rules for Terminations After May 8, 1997, or May 8, 1996
In May 1997, the IRS revised the regulations under §708(b)(1)(B) relating to the termination of a partnership when there is a sale or exchange of 50% or more of the total interest in partnership capital and profits within a 12-month period and related provisions.356 As revised, Regs. §1.708-1(b)(4) (redesignated from Regs. §1.708-1(b)(1)(iv)) provides: 
If a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur: The partnership transfers all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and, immediately thereafter, the terminated partnership distributes an interest in the new partnership to the purchasing partner and the other remaining partners in liquidation of the terminated partnership, either for the continuation of the business of the new partnership or for its dissolution and winding up.
356T.D. 8717, 62 Fed. Reg. 25498 (5/9/97) (subsequently redesignated by T.D. 8925, 66 Fed. Reg. 715 (1/4/01)). The revised regulations are generally effective for terminations occurring after May 8, 1997, but may be applied to post-May 8, 1996, terminations provided certain conditions are met. For a discussion of the revised regulations prior to their redesignation, see Schachat and Mahoney, "A Step Towards Simplification: The Final Section 708(b)(1)(B) Regulations," Tax Mgmt Memo, Spec. Ed. 1997-7: Corp. Tax and Bus. Plan. Rev. S-179 (7/21/97). The revised regulations also obsoleted Rev. Ruls. 86-73, 1986-1 C.B. 282; 87-50, 1987-1 C.B. 157; 87-51, 1987-1 C.B. 158; 88-42, 1988-1 C.B. 265; and 93-90, 1993-2 C.B. 238.
Therefore, under the revised regulations, a termination under §708(b)(1)(B) no longer results in a deemed distribution of the terminated partnership's assets to the purchasing and remaining partners as was required in the former regulations.357 As a result, the federal tax consequences of a termination that resulted from the deemed distribution of assets no longer occur on a §708(b)(1)(B) termination. As noted in the Preamble to the Proposed Regulations, such consequences included the possibility of gain under §731(a), a change in the partnership's basis in partnership property, and the commencement of a new seven-year period for purposes of §§704(c)(1)(B) and 737.
357See, e.g., PLR 9751048.
In revising the regulations under §708(b)(1)(B), the IRS also amended the regulations under §704(b) to provide that the deemed contribution of assets to a new partnership and the distribution of the new partnership interests to the partners of the terminated partnership are disregarded for purposes of maintaining capital accounts.358 As a result, the termination of a partnership does not change the capital accounts of the partners or the books of the partnership and the deemed contribution of assets to a new partnership does not create additional §704(c) property. In addition, the new partnership is not bound by the §704(c) method used by the terminated partnership.359 Property deemed contributed to a new partnership as the result of the termination of a partnership under §708(b)(1)(B) is treated as §704(c) property in the hands of the new partnership only to the extent that the property was §704(c) property in the hands of the terminated partnership immediately prior to the termination.360
358Regs. §1.704-1(b)(2)(iv)(l).
359Regs. §1.704-3(a)(2).
360Regs. §1.704-3(a)(3)(i).
A §708(b)(1)(B) termination does not begin a new five-year period for each partner with respect to the built-in gain and built-in loss property that the terminated partnership is deemed to contribute to the new partnership.361 Nor does such termination result in the application of §704(c)(1)(B) to the deemed distribution of interests in the new partnership.362 A subsequent distribution of §704(c) property by the new partnership to a partner of the new partnership, however, is subject to §704(c)(1)(B) to the same extent that a distribution by the terminated partnership would have been.363
361Regs. §1.704-4(a)(4)(ii).
362Regs. §1.704-4(c)(3).
363Id.
In addition, the revised regulations also: 
(1) provide that a §708(b)(1)(B) termination no longer triggers recapture of the investment tax credit under the "mere change in form" exception in Regs. §1.47-3(f);364
(2) note that the final regulations under §731(c) provide that the deemed distribution of partnership interest under Regs. §1.708-1(b)(4) (redesignated from Regs. §1.708-1(b)(1)(iv)) does not trigger the application of §731(c);365
(3) provide that any special basis adjustment a partner has under §743(b) in assets of the terminated partnership will carryover to the new partnership;366 and
(4) provide that the distribution of interests in the new partnership by the terminated partnership is not treated as a sale or exchange of the interests in the new partnership.367
364Preamble to T.D. 8717, 62 Fed. Reg. 25498 (5/9/97).
365See Regs. §1.731-2(g)(2).
366See Regs. §1.743-1(d).
367See Regs. §1.761-1(e).
The regulations do not change the federal tax consequences of a termination under §708(b)(1)(B) to the extent that the consequences are not dependent on the deemed distribution.368 Continuing consequences under the revised regulations are listed below.
368However, the new partnership does retain the taxpayer identification number (TIN) of the terminated partnership. If the new partnership has already applied for a new TIN, the partnership should continue to use the new TIN. See Regs. §301.6109-1(d)(2)(iii).
(1)	Loss of Taxable Year
As discussed at VI, A, above, a partnership's taxable year closes upon a termination.369 Since, under the regulations, the terminated partnership is deemed to be a new partnership, it must adopt a new taxable year. Pursuant to §706(b),370 the ability of a partnership to elect a taxable year other than a calendar year is quite limited. A permissible taxable year for a partnership is: (1) the taxable year of one or more partners having an aggregate interest in profits and capital of greater than 50%; (2) if no partners with an aggregate interest of more than 50% have the same taxable year, the taxable year of all the principal partners (i.e., partners having a 5% or more interest in partnership profits or capital); or (3) if no partners with an aggregate interest of more than 50% have the same taxable year and if the taxable year of all partners with a 5% or more interest is not the same, the partnership must adopt a calendar year or a taxable year prescribed in regulations as its taxable year. If a partnership establishes to the satisfaction of the IRS a business purpose for the adoption of a taxable year other than the one required by the statute, it may adopt such a taxable year.371
369The termination continues to be treated as a liquidation for non-subchapter K purposes.
370As amended by P.L. 99-514.
371Regs. §1.706-1; Rev. Proc. 2002-39, 2002-22 I.R.B. 1046 (setting forth guidance for establishing a business purpose and obtaining IRS approval to adopt, change, or retain an annual accounting period); Rev. Proc. 2002-38, 2002-22 I.R.B. 1037, superseding, Rev. Proc. 87-32, 1987-2 C.B. 396 (setting forth the procedures to be followed in order for a partnership to receive automatic approval to adopt, retain or change its taxable year). The rules of §706(b) concerning a permitted taxable year of a partnership apparently apply continuously so that, if new partners are admitted, partnership interests are sold or partners change their taxable years, the partnership may be required to change its taxable year. However, with respect to the rule requiring that the partnership adopt the taxable year of partners owning a majority interest in the partnership, the partnership will not be required to change its year to that of the majority partners unless they have owned the majority interest for three years. See S. Rep. No. 99-313, 166 (1986).
The legislative history of the changes to §706(b) made by the Tax Reform Act of 1986 indicates that a partnership that had established a business purpose for a fiscal taxable year prior to the effective date of the amendment (taxable years beginning after 1986) would not be required to re-establish a business purpose.372 However, since a termination of a partnership results in the constructive creation of a new partnership, the new partnership apparently would have to apply to the IRS for a fiscal year, even though the "old" partnership had already established a business purpose.
372H.R. Rep. No. 841, 99th Cong., 2d Sess. II-319 (1986).
(2)	Revocation of Elections
Under §703(b), all elections which affect the computation of taxable income derived from a partnership, other than certain enumerated elections,373 are to be made by the partnership rather than the individual partners. The "new" partnership resulting from a termination under §708(b)(1)(B) must apparently make all new elections required to be made by the partnership. This includes a §754 election, although a §754 election will apply to an incoming partner whose acquisition resulted in the termination.374
373The elections that must be made under §703(b) at the individual partner level are elections under: (1) §108(b)(5)(relating to income from cancellation of indebtedness); (2) §617(relating to mining exploration expenditures deductions and recapture); and (3) §901 (relating to the foreign tax credit).
374Rev. Rul. 86-73, 1986-1 C.B. 282.
(3)	Disposing and Acquiring Partners' Income or Loss for Year of Termination
Under §706(c)(2), the partner who disposed of his partnership interest that gave rise to the termination includes partnership income or loss for the "old" partnership on his return, and the transferee includes the income or loss of the "new" partnership on his return. In accordance with Regs. §1.706-1(c)(2)(ii), it could be argued that the income or loss of the "old" and the "new" partnership could be allocated, at least with respect to the interest transferred, by prorating all items of partnership income or loss for the entire year of the transfer on a daily basis. The regulation allows a proration in the case of a sale or exchange of a partnership interest in order to avoid an interim closing of the partnership's books as long as the selling partner and the continuing partners so agree. However, it could also be argued, perhaps more persuasively, that the proration method may be used only where an interim closing of the partnership books would thereby be avoided. In the case of a termination, the books of the partnership must be closed because the partnership terminates for tax purposes. Thus, the income or loss of the partnership to be allocated between the transferor and the transferee most likely must be determined based on actual partnership results determined by closing the partnership's books.
Example: To illustrate the difference between the closing of the books method and the proration method of allocating income or loss, assume that A has a 60% interest in calendar year partnership AB and that A sells his interest on June 30 to C. The partnership has $100 of taxable income for the entire calendar year of the sale, but the $100 is comprised of a $200 loss arising in the first half of the year and $300 of income arising in the last half. If the proration method were available, A would include $30 of the partnership income for the entire year (60% of $50) and B would include the other $30. However, under the interim closing of the books method, A would include a loss of $120 (60% of the $200 loss incurred during the period A held his interest) and C would include income of $180 (60% of the $300 income realized while C held the interest).
(4)	MACRS Depreciation Consequences
One major disadvantage of a technical termination under §708(b)(1)(B), existing both before and after the IRS issued the revised regulations,374.1 is that the new partnership must treat property held by the terminated partnership on the date of termination as newly acquired property for MACRS depreciation purposes.  Consequently, the new partnership must depreciate the adjusted basis of depreciable property deemed contributed to it as if it acquired the property and placed the property in service on the termination date.374.2 This result is dictated by statute and is not dependent upon the specific mechanics of the termination prescribed by the §708 regulations.374.3
374.1See preamble to PS-5-96, 61 Fed. Reg. 21985 (5/13/96). In addition to citing §168(i)(7), which effectively provides that the MACRS depreciation carryover rules for nontaxable §721 or §731 transactions do not apply in the case of a technical termination, the preamble to the proposed regulations refers to and cites various anti-churning rules applicable to property placed in service before 1987 and before 1981. The anti-churning rules were of little consequence by 1997 because most personal property placed in service before 1987 was depreciated over a 5-year recovery period and therefore was fully depreciated by 1997, and residential rental property and nonresidential real property placed in service after 1986 is not subject to the anti-churning rules. See  §168(f)(5)(B)(i).
374.2§168(i)(7).
374.3See preamble to PS-5-96, 61 Fed. Reg. 21985 (5/13/96).
Example: Partnership XY was formed in 1990 and acquired a commercial office building that it placed in service in 1990. XY was depreciating the office building over the 31.5 year period prescribed for nonresidential real property placed in service at that time. X, who held a 60% interest in XY, sold that interest on June 30, 2001, to new partner Z. On June 30, 2001, the adjusted basis of the office building was $5,000,000. Partnership YZ must depreciate the remaining $5,000,000 basis over the 39-year recovery period applicable to nonresidential real property placed in service in 2001.
Comment: This adverse depreciation result is a primary reason many partnerships and LLC agreements prohibit partners or members from collectively selling or exchanging 50% or more of the capital and profits interests during any 12-month period. If, in the Example, above, X had sold 48% of his partnership interest to Z on June 30, 2001, and the 12% balance on July 2, 2002, there would have been no technical termination of XY and, consequently, no change in the depreciation of the remaining $5,000,000 basis. That basis would continue to be depreciated over the remaining period in the original 31.5-year recovery schedule.
On the other hand, in the event of a technical termination, qualified property, 50% bonus depreciation property, or New York Liberty Zone property placed in service by the terminated partnership during the taxable year of termination may be eligible for the additional first year or "bonus" depreciation under §168(k) or §1400L.374.4 In order to qualify for the special depreciation provisions, among other requirements,374.5 the depreciable property must be placed in service by a specified date. Regulations treat the property as originally placed in service by the new partnership on the date the qualified property, the 50% bonus depreciation property, or the New York Liberty Zone property is contributed by the terminated partnership to the new partnership.374.6
374.4As added by the 2002 Job Creation and Worker Assistance Act, P.L. 107-147, §§101, 301(a), and modified by the 2003 Jobs and Growth Tax Relief Reconciliation Act, P.L. 108-27, §201. In general, the requirements to use the special depreciation provisions are: (1) the depreciable property must be of a specified type; (2) the original use of the depreciable property must commence with the taxpayer after certain specified dates; (3) the depreciable property must be acquired by the taxpayer within a specified time period; and (4) the depreciable property must be placed in service by a specified date. Regs. §1.168(k)-1T(b)(5).
374.5Regs. §1.168(k)-1T(b)(5).
374.6Regs. §§1.168(k)-1T(b)(5)(iii), 1.1400L(b)-1T(c)(6), added by T.D. 9091, 68 Fed. Reg. 52985 (9/8/03).
Example: X and Y are equal partners in Partnership XY, a general partnership. On Feb. 1, 2002, Partnership XY purchased and placed in service new equipment at a cost of $30,000. On Mar. 1, 2002, X sells its entire 50% interest to Z in a transfer that terminates the partnership under §708(b)(1)(B). As a result, terminated Partnership XY is deemed to have contributed the equipment to new Partnership XY. Pursuant to Regs. §1.168(k)-1T(f)(1)(ii), new Partnership XY, not terminated Partnership XY, is eligible to claim the 30% additional first year depreciation deduction allowable for the equipment for the taxable year 2002 (assuming all other requirements are met).374.7
374.7Regs. §1.168(k)-1T(f)(1)(iv) Ex. 1. However, if the property is both placed in service and contributed to a new partnershp after a technical termination during the taxable year of termination, and if the property is disposed of by the new partnership in the same taxable year, then no additional first year depreciation deduction is allowable to either partnership. Regs. §1.168(k)-1T(f)(1)(ii).
In addition, generally, for purposes of §168(k) any increase in basis of qualified property, 50% bonus depreciation property, or New York Liberty Zone property due to a §754 election is not eligible for the special depreciation provisions. However, if the property is placed in service by a partnership in the taxable year the partnership terminates under §708(b)(1)(B), any increase in basis of the property due to a §754 election is eligible for the additional first year depreciation deduction.374.8
374.8Regs. §§1.168(k)-1T(f)(9), 1.1400L(b)-1T(f)(8), added by  T.D. 9091, 68 Fed. Reg. 52985 (9/8/03).
b.	Rules for Terminations Before May 9, 1997, or May 9, 1996
Section 708 does not specify the consequences resulting from a termination of a partnership. In fact, the only consequence resulting from a termination specifically mentioned in the Code is set forth in §706(c), which provides that the partnership taxable year will close as to all of the partners upon termination. Prior to May 1997, 375 regulations under §708 provided for significant consequences for terminations arising under §708(b)(1)(B). Pre-May 9, 1997, Regs. §1.708-1(b)(1)(iv) provided: 
If a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur: The partnership distributes its properties to the purchaser and the other remaining partners in proportion to their respective interests in the partnership properties; and, immediately thereafter, the purchaser and the other remaining partners contribute the properties to a new partnership, either for the continuation of the business or for its dissolution and winding up. In the latter case, the new partnership terminates in accordance with subdivision (i) of [pre-May 9, 1997, Regs. §1.708-1(b)(1)(iv)].
375The revised regulations are generally effective for terminations of partnerships under §708(b)(1)(B) occurring after May 8, 1997. However, the revised regulations may be applied to terminations occurring after May 8, 1996, provided certain requirements are met.
Thus, the former regulations provided for a constructive liquidation of all partners' interests in the partnership and an immediate constructive recontribution of the same assets to a "new" partnership. Many commentators decried the lack of support in the legislative history of §708 for the deemed distribution from the "old" partnership and deemed recontribution to a "new" partnership.376 The deemed distribution and deemed recontribution resulted in a number of potential consequences under subchapter K, discussed below.
376See generally Birkeland and Postlewaite, "The Uncertain Tax Ramifications of a Terminating Disposition of a Partnership Interest -- The Constructive Termination of a Partnership," 30 Tax Law. 335 (1977).
(1)	Gain or Loss on Deemed Distribution
Section 731(b) insulates the partnership from recognition of gain or loss on the deemed liquidation of the partnership. However, as a consequence of Pre-May 8, 1997, Regs. §1.708-1(b)(1),376.1 the partner acquiring the interest and the continuing partners recognized gain or loss on the termination, depending on the partners' bases in their partnership interests and the character of the assets owned by the partnership at the time of the termination. Generally, recognized gain or loss generally was capital gain or loss under §§731 and 741.
376.1This consequence was acknowledged as a potential result of the pre-May 8, 1997, regulations in the revised regulation's preamble. See PS-5-96, 1996-1 C.B. 877.
Under §731(a)(1), gain is recognized by a partner upon a partnership distribution only if money (including marketable securities) distributed exceeds the partner's basis for his partnership interest immediately before the distribution. Therefore, if a partner's proportionate share of partnership money377 exceeded the partner's basis in his partnership interest at the time of the termination,378 the partner had taxable gain.
377A partner's share of partnership money (and other partnership property) probably should be determined based on what each partner would be entitled to if the partnership actually made distributions in complete liquidation. Thus, reference to the partnership agreement must be made in making this determination. See II, D, 2, above.
378Each partner's basis in his partnership interest was increased (or decreased) by the partnership income (or loss) arising for the period prior to the deemed liquidation under §705.
A previously unanswered question in this connection was whether a partner recognized gain from a deemed distribution of cash attributable to partnership liabilities. Under §752(a), an increase in a partner's share of partnership liabilities or an increase in his personal liabilities upon an assumption of partnership debts379 is considered to be a cash contribution to the partnership by the partner. Any decrease in a partner's share of partnership debt or any decrease in a partner's individual liabilities that were assumed by the partnership was considered to be a cash distribution to the partner from the partnership under §752(b). The unanswered question was whether liability assumption under §752(a) could be netted against liability relief under §752(b) for purposes of determining a partner's gain under §731(a) in connection with a deemed liquidating distribution in the context of a §708(b)(1)(B) termination. The IRS's announced position allowed netting. Thus, no gain attributable to debt relief arose in connection with a termination.380
379Property taken subject to a liability was considered assumed, for this purpose, to the extent of the fair market value of the property. §752(c).
380Regs. §1.752-1(f) specifically provides that netting liability assumption against liability relief is permissible in connection with a termination of a partnership. Rev. Rul. 87-120, 1987-2 C.B. 161, which was issued before the promulgation of Regs. §1.752-1(f), reached the same conclusion. Netting liability assumption and liability relief in connection with a partnership termination is the proper treatment whether or not partnership liabilities are covered by Regs. §1.752-1(f) (generally applicable to partnership liabilities incurred on or after Dec. 28, 1991). The IRS also has permitted netting of debt relief under §752(b) and debt assumption under §752(a) in connection with a current distribution of partnership property. See Rev. Rul. 79-205, 1979-2 C.B. 255.
Under §731(a)(2), loss may be recognized by a partner upon the liquidation of his interest in a partnership if: (1) only cash, unrealized receivables (as defined in §751(c)),381 and inventory items (as defined in §751(d)),382 are distributed to the partner; and (2) the partner's basis in his partnership interest immediately prior to the distribution exceeds the cash distributed plus the partnership's basis in the unrealized receivables and inventory distributed to the partner. Because a constructive distribution under pre-May 9, 1997, Regs. §1.708-1(b)(1)(iv) required that partnership assets be distributed in proportion to the partners' "respective interests in the partnership properties," loss was recognized by a partner in connection with a §708(b)(1)(B) liquidation only if the partnership's only assets were cash, inventory items, or unrealized receivables at the time of the termination.
381Section 751(c) defines the term "unrealized receivables" as including to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for: (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2) services rendered, or to be rendered. In addition, for purposes of §731 (and certain other purposes), the term includes most types of "recapture" property, such as §1245 property. In order to have potential recapture income, other property (such as tangible personal property in the case of §1245 recapture) must be distributed. If the property to which the recapture was attributable was distributed, the condition for recognition of loss under §731(a)(2) was not be present.
382The definition of "inventory items," includes: (1) property of the partnership of the kind described in §1221(a)(1); (2) any other property of the a partnership which, on sale or exchange by the partnership, would be considered property other than a capital assets and other than property described in §1231; and (3) any other property held by the partnership which, if held by the selling or distributee partner, would be considered property of the type described in paragraph (1) or (2). §751(d), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §413(c)(11). Prior to amendment, §751(d) also included as an inventory item any other item that would result in gain taxable under former §1246(a) relating for foreign investment company stock. As the 2004 AJCA, §413(a), repealed §1246, this item was removed from §751, effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end.
(2)	Adjusted Basis of Assets in Hands of "New" Partnership

Under §§708, 723, and (Former) 732(c),383 and regulations thereunder, as they existed before May 9, 1997, the new partnership obtained a basis in the assets equal to the basis of the assets in the hands of the continuing and acquiring partners on the deemed recontribution, often resulting in the partnership receiving an increase (or decrease) in the basis of its assets following the termination under §708(b)(1)(B).
383The allocation rules of §732(c) were revised by the Taxpayer Relief Act of 1997 (1997 TRA) in the same year that the IRS issued revised regulations applying to §708(b)(1)(B) terminations. Changes made to  §732(c) by the 1997 TRA are discussed, in depth, in 714 T.M., Partnerships -- Allocation of Liabilities; Basis Rules.
Similarly, the basis allocation rules of §732(c) led to some interesting results for the acquiring partner: that is, the acquiring partner could have been benefited (or burdened) with a built-in gain (or loss) absent an election by the partnership under §754 or by the acquiring partner under §732(d). Following a typical transaction, the basis of property received by a partner in liquidation of his interest, under §732(b), was equal to the basis of his partnership interest immediately before the liquidating distribution, less any cash received in the distribution (with the acquiring partner receiving a deemed distribution followed by his immediate recontribution). The allocation of basis among the assets received was determined under §732(c), with basis allocated first to unrealized receivables and inventory, but only to the extent of the partnership's basis in such assets prior to the distribution, and then to all other assets in proportion to their respective bases to the partnership prior to the distribution.
The disparity that sometimes resulted between the basis of the "new" partnership's assets and the value of the assets was reduced or eliminated in most cases if the acquiring partner made an election to adjust the basis of partnership property distributed to him under §732(d) or if the partnership had a §754 election in effect for the year of the acquiring partner's purchase. If the acquiring partner made an election under §732(d), the basis of the partnership assets with respect to the acquiring partner were adjusted as if the partnership had made an election under §754. If a §754 election applied to the sale or exchange that caused the termination, the partnership adjusted the basis of its assets for the benefit of the acquiring partner, in general, as if the acquiring partner had purchased an interest in each of the partnership's assets.384
384If the "old" partnership had previously made a §754 election, the election applied to the incoming partner whose acquisition of a partnership interest caused the termination. Rev. Rul. 86-73, 1986-1 C.B. 282. Even if the partnership did not have a §754 election in effect at the time of the terminating transfer, a §754 election made on its final return was effective for the incoming partner whose acquisition of a partnership interest caused the termination. See Rev. Rul. 88-42, 1988-1 C.B. 265. The rationale of the IRS in so concluding was that the election was effective for all property distributions and transfers of partnership interests occurring in the year of termination and the incoming partner was considered to be a partner of the terminating partnership for the instant before its termination. Rev. Rul. 88-42, 1988-1 C.B. 265.
The §732(d) (or §754) election reduced the disparity between bases and values of assets, rather than increasing the disparity as would have resulted in the absence of the election. Again, under §704(c), the inherent gain in the inventory and the receivables was properly allocated to the continuing partner, resulting in the continuing partner recognizing gain while the acquiring partner recognized no gain or loss upon sale of the inventory and realization of the receivables at their respective values as of the termination date.
(3)	Holding Period of Assets
Under §735(b), the "old" partnership's pre-distribution holding period of assets constructively distributed to the partners upon the §708(b)(1)(B)termination was "tacked" on to the holding period of the partners. Under §1223, the partners' holding period of assets contributed to a partnership was also "tacked" to the partnership's holding period. Thus, the holding period of the "new" partnership was the same as the holding period of the "old" partnership.385
385But see McCauslen v. Comr., 45 T.C. 588 (1966), which reached a different conclusion where a two-person partnership terminated under §708(b)(1)(A) when one partner purchased the other's interest on the second's death. The Tax Court denied a tacked holding period with respect to the assets acquired by the survivor that were attributable to the buy-out. See also Rev. Rul. 67-65, 1967-1 C.B. 168, and Rev. Rul. 99-6, 1999-6 I.R.B. 6 (§708(b)(1)(A) context), reproduced in the Working Papers. The proposed revised regulation's preamble also noted the potential change in the partner's holding periods in their partnership interests. See PS-5-96, 1996-1 C.B. 877.
(4)	Section 724 Taint
Pursuant to §735(a)(1), if a partnership distributes unrealized receivables (as defined in §751(c)) to a partner, the receivables retain their character as ordinary income property in the hands of the partner. Inventory items (as defined in §751(d)) distributed by a partnership to a partner retain their character as ordinary income assets in the hands of the partner for a period of five years from the date of distribution, under §735(a)(2). Similar rules are found in §724386 with respect to property contributed to a partnership by a partner.
386Added to the Code by §74 of the Tax Reform Act of 1984, P.L. 98-369.
387-398[Reserved.]
Under §724(a), unrealized receivables in the hands of a partner contributed by the partner to his partnership retain their character as ordinary income assets in the hands of the partnership. In addition, capital loss items (i.e., capital assets with bases in excess of values at the time of contribution) and inventory items in the hands of a partner retain their character as capital assets (if the capital assets are sold at a loss to the extent the loss is attributable to pre-contribution decline in value) and inventory, respectively, in the hands of the partnership upon contribution by the partner for a period of five years from the date of contribution under §724(b) and (c).
The foregoing rules created no significant problems upon a §708(b)(1)(B) termination with respect to unrealized receivables since the receivables merely retain the same character in the hands of the "new" partnership as they had in the hands of the "old" partnership. That is, it is unlikely, under the Pre-May 8, 1997, regulations, that §724 would convert the character of an asset that was not an unrealized receivable in the hands of the "old" partnership into an asset that was an unrealized receivable in the hands of the "new" partnership. The same cannot be said with respect to inventory and capital loss assets. Under §§735 and 724, inventory in the hands of the "old" partnership retains its character in the hands of the "new" partnership. However, some assets that were not  inventory or capital loss assets with respect to the "old" partnership could be tainted with that character with respect to the "new" partnership upon a §708(b)(1)(B) termination.
Example: Under the Pre-May 8, 1997, regulations, Partnership AB, which is not a dealer in real estate, owned (for the last 15 years) a tract of appreciated undeveloped real estate. If AB sold the realty, it would be entitled to report the gain as long-term capital gain. However, if AB terminated because C purchased A's interest and C was a real estate dealer, the realty presumably would become inventory in the hands of BC (at least with respect to the portion of the basis of the real estate deemed to be contributed by C) for five years. Thus, if BC sold the realty within five years of the termination, at least a portion of the gain would have been ordinary income. Absent a provision in the partnership agreement specially allocating all of the ordinary income, which results solely from C's status as a dealer, to C, the ordinary income probably would have been allocated between B and C in accordance with their general profit-sharing ratios.
3.	Tax Consequences of Merger, Consolidation or Division
a.	Mergers and Consolidations
Where two or more partnerships merge or consolidate and the resulting partnership is considered to be a continuation of one of the constituent partnerships, the resulting partnership must file a return for the full taxable year (including the pre-merger and post-merger portions).399 The distributive shares of partnership income or loss must be allocated by the partnership, taking into account the partners' respective interests before and after the merger or consolidation pursuant to §706(c).
399Regs. §1.708-1(c)(1) and (2).
Comment: It is unclear whether such allocation may be determined on the basis of a proration of partnership income or loss or whether the allocation must be made on the basis of an interim closing of the partnership books. Regs. §1.706-1(c)(2)(ii) provides for an interim closing of the books method, if agreed to by the partners, but only in connection with a sale or exchange of a partner's entire interest in the partnership.
Any of the constituent partnerships which are not continued upon a merger or consolidation are terminated (see V, E, 1, above). Arguably, the same consequences resulting upon a termination under §708(b)(1)(B) would follow.
When two or more partnerships merge, the resulting partnership can be treated as the continuation of only one of the former entities. Where the members of one of the merged partnerships now own more than 50% of the capital and income interests in the resulting partnership, the resulting partnership will be the continuation of that merged partnership. If the partners of more than one of the merged partnerships hold the majority of capital and income interests in the resulting partnership, then the merged partnership which contributed the greatest amount of assets, by fair market value and net of liabilities, to the resulting partnership will be the merged partnership that continues. (The IRS may permit another of the merged partnerships to be the continuing partnership. However, the regulations do not specify the circumstances under which it may grant this alternative.) Any merged partnership that does not continue under these rules is considered terminated. When none of the merged partnerships had members who now control more than 50% of the capital and income interests of the resulting partnership, all of the merged partnerships terminate and the resulting partnership is a new entity.400
400Regs.  §1.708-1(c)(1). Regs.  §1.708-1(c) generally deals with the forms of partnership mergers and consolidations and is effective for transactions occurring after January 3, 2001, although a partnership may apply its provisions to any merger occurring after January 10, 2000.
The taxable year of any merging partnership that does not continue as a resulting partnership closes and the partnership must file a return for the taxable year ending on the date of the merger. If the resulting partnership is the continuation of one of the merged partnerships, it will file a return for the taxable year of the merger partnership. The return must identify the resulting partnership as a continuation of the merged partnership with the latter's employer identification number (EIN) and include the EINs of the other merged partnerships, as well as the distributive shares of the partners for partners for the periods through the date of the merger and after the merger.401
401Regs. §1.708-1(c)(2).
To determine the tax form that partnership mergers and consolidations will take, Regs. §1.708-1(c)(3) provides two forms that mergers and consolidations will fall into: (1) the assets-over form, in which the terminated merging partnership is considered to have contributed all of its assets and liabilities to the resulting partnership in exchange an interest in the latter, after which the terminated partnership immediately distributed the interest it received to its own partners in liquidation of itself; and (2) the assets-up form, in which the terminated merging partnership is considered to have distributed its assets and liabilities to its partners in liquidation of their interests, after which the former partners immediately contributed these assets and liabilities to the resulting partnership. The IRS selected the assets-over form as the default pattern for partnership mergers (and divisions) because, at least at the time, this form appeared to provide more favorable tax treatment for taxpayers and the government.402
402In the preamble to REG-111119-99, 65 Fed. Reg. 1572 (1/11/00), the IRS stated that the assets-over form would not trigger gain for any partner under §§704(c)(1)(B) and 737, and that §732 would not cause partnership assets to lose basis in the transaction. In Rev. Rul. 2004-43, 2004-18 I.R.B. 842, revoked by Rev. Rul. 2005-10, 2005-7 I.R.B. 492, the IRS ruled that any §704(c) gain or loss created in an assets-over merger is triggered under §704(c)(1)(B) if the assets contributed in the merger are distributed to a partner other than the contributing partner within seven years of the merger, and that the gain or loss created in the merger must be considered in determining the amount of net precontribution gain for §737 purposes if the continuing partnership distributes other property to the contributing partner within seven years of the merger. In response to comments asserting that Rev. Rul. 2004-43 is inconsistent with the regulations under §§704(c)(1)(B) and 737, and that the ruling's conclusions should not apply retroactively, the IRS revoked Rev. Rul. 2004-43 and announced that it would instead issue regulations implementing the principles of Rev. Rul. 2004-43, effective for distributions occurring after Jan. 19, 2005. See Notice 2005-15, 2005-7 I.R.B. 527; Rev. Rul. 2005-10, 2005-7 I.R.B. 492. For further discussion, see V, E, 1, above.
Any partnership merger or consolidation will take the assets-over form unless the parties undertake a form specifically described as the assets-up form in Regs. §1.708-1(c)(3)(ii).403 The only requirement that the regulations cite for the assets-up form is that the terminated partnership "distributes all of its assets and liabilities to its partners (in a manner that causes the partners to be treated, under the laws of the applicable jurisdiction, as the owners of such assets) in a liquidation of the partners' interests in the termination partnership . . .." 404 The regulations do not require the partners of the terminated partnership to take title to the distributed assets to qualify the merger for tax treatment in the assets-up form; however, if the partners do take title to these assets, the merger must receive the tax consequences of the assets-up form. Although the regulations generally respect the form which the parties give to the merger or consolidation, the IRS may recast the form of any merger that is part of larger series of transactions, the result of which is inconsistent with the merger form designated by the parties.405 For example, the regulations allow the IRS to disregard an assets-up merger if it is part of a planned series of transactions in which members of different partnerships exchange their interests with each other in what would otherwise be a taxable transaction.
403Regs. §1.708-1(c)(3)(i).
404Regs. §1.708-1(c)(3)(ii).
405Regs. §1.708-1(c)(6).
When a partner of a terminating partnership does not wish to join the resulting partnership and receives a liquidation payment from the latter as part of an assets-over merger, the regulations respect the treatment of this transaction as the sale to the resulting partnership of the exiting partner's interest in the terminating partnership, so long as two conditions are met: (1) the merger agreement states that the resulting partnership is purchasing the interest of the particular partner in the merging partnership, and (2) the agreement specifies the consideration that the resulting partnership will pay for the interest.406 This rule will prevent the other partners of the terminating partnership from recognizing gain on consideration that only the exiting partner receives, even when another partnership in the transaction initially pays this consideration to the terminating partnership, which in turn pays the consideration to the exiting partner to liquidate the latter's interest. The existing partner must consent to the sale treatment provided by the special buy-out rule either before or at the time of the transfer, although the exiting partner does not have to a be a party to the merger agreement in order to obtain the benefit of the rule.407
406Regs. §1.708-1(c)(4).
407Id.
The regulations also deal with the treatment of the partners' combined shares of liabilities in partnership mergers and consolidations. The partners in the terminating and resulting partnerships will net their increases and decreases in partnership liabilities to determine the effect of the merger under §752.408 For example, a partner who was a member of two partnerships that merged will subtract his share of liabilities in the resulting partnership from its combined liabilities in the two merging partnerships and will treat the result as a distribution of cash if the amount is positive (the pre-merger total exceeded the post-merger share of liabilities). If the amount is negative (the post-merger share of liabilities exceeded the combined pre-merger shares of liabilities), then presumably the partner would increase its basis by this amount.409
408Regs. §1.752-1(f).
409Regs. §1.752-1(g), Ex. 2.
The regulations are consistent with the IRS's previous treatment of partnership combinations it has considered in revenue rulings For example, in Rev. Rul. 68-298,410 each of the constituent partnerships which terminate as a result of a merger is considered to transfer its assets and liabilities to the resulting partnership in return for a partnership interest. Thereafter, each terminated partnerships is deemed to distribute the interest it received to its partners in liquidation of the partners' partnership interests.
4101968-1 C.B. 314. See PLR 9444013 (partnership which terminated as a result of a merger was deemed to have transferred all its assets to the resulting partnership in return for a partnership interest, and then to have liquidated).
Similarly, in Rev. Rul. 77-458,411 the tax consequences of the merger of 10 partnerships, each of which was owned equally by partners A and B, were discussed. The mergers of partnerships P2-P10 into partnership P1 was accomplished by P2-P10 transferring all of their assets and liabilities to P1 in exchange for partnership interests in P1. P2-P10 then distributed the P1 partnership interests to A and B. P1 was the largest partnership by dollar value of assets. The IRS ruled that partnerships P2-P10 terminated for federal income tax purposes and P1 was considered a continuation of the merged entities. The ruling also concluded that none of the partnerships, nor A nor B, recognized any gain or loss on the merger and that the bases of A and B in the P1 interests distributed to them by P2-P10 would be equal to their respective bases in their interests in P2-P10. Thus, the bases of A and B in the merged partnerships was preserved. The ruling further determined that, in accordance with Regs. § 1.167(c)-1(a)(6), P1 could not use an accelerated method of depreciation with respect to the assets contributed to P1 by P2-P10.
4111977-2 C.B. 220. See also PLRs 9719015, 9719019-029 (partnership formed from three LLCs classified as partnerships is a continuation of one of the partnerships).
Finally, the Service ruled that investment credit would not be required to be recaptured by P2-P10 because P1 received a carryover basis in the assets contributed by P2-P10 under §723. At least with respect to a merger or consolidation of partnerships, the ruling sets forth a method of avoiding investment credit recapture. If the assets of P2-P10 were distributed to A and B in liquidation of their interests and then A and B contributed the assets to P1, the exception from investment credit recapture set forth in Regs. § 1.47-3(f) would not apply because A and B would receive a substituted basis in the P2-P10 assets rather than a carry-over basis, as required by the regulation.
b.	Divisions
In the case of a partnership division, the regulations explicitly provide that the divided partnership is considered to have liquidated the partnership interests of the partners who become members of a partnership which is not a continuation of the divided partnership.412 Thus, the same consequences discussed in connection with a §708(b)(1)(B) termination should also follow with respect to a partnership which is terminated due to a division.
412Regs. § 1.708-1(b)(2)(ii).
When a partnership divides into two or more partnerships, any resulting partnership whose members owned than 50% of the capital and profits in the prior partnership will be a continuation of the prior partnership. A partnership that divides may have more than one continuation, although only one continuing partnership will constitute the "divided partnership" (discussed below). A partnership that results from a partnership division but does not constitute a continuation of the prior partnership will be a new partnership. Similarly, if none of the resulting partnerships has members who owned a majority of the capital and profits of the prior partnership, then all of the resulting partnerships will be new entities and none will be a continuation of the prior partnership. When members of a partnership that divided do not become members of a resulting partnership that is a continuation of the prior partnership, their interests in the prior partnership are considered liquidated as of the date of the division.413
413Regs. §1.708-1(d)(1). Regs.  §1.708-1(d) generally deals with the forms of partnership divisions and is effective for transactions occurring after January 3, 2001, although a partnership may its provisions to any division occurring after January 10, 2000.
To determine the tax consequences of a partnership division, the regulations specify two forms of such divisions, (1) the assets-over form and (2) the assets-up form, and provides that all partnership divisions will be treated for federal taxation under the assets-over form, except for those in which the parties specifically undertake the assets-up form.414 As with mergers, the IRS selected the assets-over form as the default pattern for partnership divisions because, at least at the time, this form appeared to provide more favorable tax treatment for taxpayers and the government.415
414Regs. §1.708-1(d)(3).
415In the preamble to REG-111119-99, 65 Fed. Reg. 1572 (1/11/00), the IRS stated that the assets-over form would not trigger gain for any partner under §§704(c)(1)(B) and 737, and that §732 would not cause partnership assets to lose basis in the transaction. In Rev. Rul. 2004-43, 2004-18 I.R.B. 842, revoked by Rev. Rul. 2005-10, 2005-7 I.R.B. 492, the IRS ruled that any §704(c) gain or loss created in an assets-over merger is triggered under §704(c)(1)(B), and that the gain or loss created in the merger must be considered for §737 purposes. In response to comments asserting that Rev. Rul. 2004-43 is inconsistent with the regulations under §§704(c)(1)(B) and 737, and that the ruling's conclusions should not apply retroactively, the IRS revoked Rev. Rul. 2004-43 and announced that it would instead issue regulations implementing the principles of Rev. Rul. 2004-43, effective for distributions occurring after Jan. 19, 2005. See Notice 2005-15, 2005-7 I.R.B. 527; Rev. Rul. 2005-10, 2005-7 I.R.B. 492. For further discussion, see V, E, 1, above. Neither Rev. Rul. 2004-43 nor Notice 2005-15 address partnership divisions, although their rationale would seem to apply to divisions. As the examples in the proposed regulations show, a partnership that divides into three or more new partnerships may use both the assets-over and assets-up forms for different parts of the division.
In setting out the two forms of partnership divisions, the regulations use four definitions.416 The first two definitions separate partnerships by their existence under applicable local law before or after the division.
(1)  The prior partnership is the partnership that existed under local law and that was subject to division.
(2) The resulting partnership is any partnership that results from a partnership division under local law.
416Regs. §1.708-1(d)(4).
The remaining definitions separate partnerships based on whether the transferred or received assets as part of the division.

(3) A recipient partnership is defined as any partnership that is treated as receiving assets and liabilities from a divided partnership (defined below).
(4) The divided partnership is defined as the partnership which will be treated, under federal tax law, as having transferred assets and liabilities, directly or indirectly, to one or more recipient partnerships. The divided partnership may be one of the partnerships that results from the division. For example, if a resulting partnership, in form, transferred assets to a recipient partnership and qualifies as a continuation of the prior partnership, it will be treated as the divided partnership. If a prior partnership divides into two resulting partnerships only one of which is a continuation of the prior partnership, the continuing entity will be the divided partnership. If a prior partnership divided into two or more resulting partnerships without undertaking the assets-up form for any part of the division and two or more resulting partnerships are continuations of the prior partnership, the continuing partnership having assets with the greatest fair market value (net of liabilities) will be the divided partnership. Similarly, if the resulting partnership that actually transferred assets to a recipient partnership is not a continuation of the prior partnership, the continuing partnership with the greatest asset value will be the divided partnership.
Generally, the assets-over form treats the division as if one partnership transferred assets and liabilities to two or more new partnerships in exchange for recipient partnership interests, which the old partnership then distributes to its own partners. Once the identity of the divided partnership and recipient partnerships is established, a partnership division that falls into the assets-over form will receive either or two tax treatments: (1) if at least one resulting partnership is a continuation of the prior partnership, the divided partnership is treated as having exchanged assets and liabilities for one or more recipient partnership interests, after which it distributed the recipient interests to its partners in partial or complete liquidation of their interests in the divided partnership;417 and (2) if there is no continuing partnership in an assets-over form division, the prior partnership is treated as exchanging assets and liabilities for recipient partnership interests, after which it immediately distributes the recipient interests to its partners in complete liquidation of the prior partnership.418
417Regs. §1.708-1(d)(3)(i)(A).
418Regs. §1.708-1(d)(3)(i)(B).
In the assets-up form, the prior partnership is treated, generally, as having distributed is assets to its partners, who subsequently contributed the assets and liabilities to two or more new recipient partnerships in exchange for interests in the recipients. A partnership division will receive the tax consequences of the assets-up form when the prior partnership actually distributes assets and liabilities to its partners in complete or partial liquidation of their interests in the prior partnership, so long as the divided partnership (the partnership distributing assets) is a continuation of the prior partnership.419 When none of the resulting partnerships is a continuation of the prior partnership,  the regulations respect the assets-up form so long as the prior partnership distributes assets and liabilities to some or all of its partners in complete or partial liquidation of their prior partnership interests and the partners immediately contribute these assets and liabilities to new partnerships.420 If, however, the prior partnership does not liquidate after these transaction, it is treated as having transferred any retained assets to a new resulting partnership under the assets-over form.
419Regs. §1.708-1(d)(3)(ii)(A).
420Regs. §1.708-1(d)(3)(ii)(B).
When more than one resulting partnership is regarded as continuing, the resulting partnership that is treated as the divided partnership will file a return for the taxable year of the partnership that has been divided and will retain the employer identification number (EIN) of the prior partnership. All other resulting partnerships that are regarded as continuing and all new partnerships (i.e., resulting partnerships that are not continuing partnerships) will file separate returns for the taxable year beginning on the day after the date of the division with new EINs for each partnership.421
421Regs. §1.708-1(d)(2)(i).
All resulting partnerships that are continuing partnerships are subject to preexisting elections that the prior partnership made. However, a post-division election that a resulting partnership makes will not bind any of the other resulting partnerships.422
422Regs. §1.708-1(d)(2)(ii).
The IRS may disregard the form that the parties give to a partnership division if the divisions is part of a larger series of transactions which, together, have a result that is inconsistent with the form of the division.423
423Reg. §1.708-1(d)(6).

WORKING PAPERS
Table of Worksheets
CHECKLIST
Worksheet 1		Checklist of Tax Consequences of Dispositions of Partnership Interests and Partnership Terminations.
SAMPLE PARTNERSHIP AGREEMENT
Worksheet 2		Sample ABCD Partnership Agreement (Buy-Sell Article).
SAMPLE PURCHASE AGREEMENT
Worksheet 3		Sample Purchase Agreement.
LEGISLATIVE HISTORY AND IRS RULINGS
Worksheet 4		Excerpts from House Ways and Means Committee Report to H.R. 8300 [1954 Code]; H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954) (Explanation of provisions of Subchapter K).
Worksheet 5		Excerpts from Senate Report to H.R. 8300 [1954] Code; S. Rep. No. 1622, 83d Cong., 2d Sess. (1954) (Explanation of provisions of Subchapter K).
Worksheet 6		Excerpts from House Ways and Means Committee Report to the Deficit Reduction Act of 1984; H.R. Rep. No. 432, 98th Cong., 2d Sess. (1984) (1984 revision of Subchapter K).
Worksheet 7		Excerpts from Senate Explanation of Provisions Approved by the Finance Committee on March 2, 1984 [Deficit Reduction Act of 1984]; S. Rep. No. 169, 98th Cong., 2d Sess. (1984) (1984 revision of Subchapter K).
Worksheet 7A		Rev. Rul. 93-80, 1993-2 C.B. 239 (Loss from abandonment of partnership interest).
Worksheet 7B		Rev. Rul. 99-6, 1999-6 I.R.B. 6 (Sale of all interests of an LLC to one person).
ELECTION STATEMENTS
Worksheet 8		[Reserved.]
Worksheet 9		Election to Adjust Basis of Partnership Property Under Section 754 (Regs. Section 1.754-1(b)).
Worksheet 10		Request for Revocation of Section 754 Election to Adjust Basis of Partnership Property (Regs. Section 1.754-1(c)).
See the Working Papers in 714 T.M., Partnerships -- Allocation of Liabilities; Basis Rules, for a sample Partnership's Basis Adjustment Computation Statement under Regs. Section 1.734-1(d).

Worksheet 1
Checklist of Tax Consequences of Dispositions of Partnership Interests and Partnership Terminations.
In General

• Entity vs. Partnership Level. Dispositions of partnership interests are partner level transactions generally not involving the partnership as an entity. Structural changes to a partnership, on the other hand, such as divisions, mergers and consolidations, are transactions occurring at the partnership entity level. Some dispositions of partnership interests and some structural changes to a partnership result in a termination of the partnership while some dispositions and structural changes do not.

In general, Subchapter K of the Code adopts an entity approach to partnership taxation. Under this approach, a partnership is treated as an entity separate and distinct from its partners for tax purposes. Generally, a partner who disposes of his partnership interest is treated as if he disposes of a single asset rather than his pro rata share of all of the partnership's underlying assets.
Dispositions of Partnership Interests

• Gain or Loss on Disposition of Partnership Interest. A partner who disposes of his interest in a partnership in a taxable transaction generally recognizes gain or loss measured by the difference between the amount realized and his adjusted basis in the interest immediately before the disposition under Section 741. This gain or loss is generally capital in nature. Whether the gain or loss is short or long-term capital gain or loss depends on how long the partner has held his interest prior to the disposition as determined under Section 1223.

An exception to the general rule treats a partnership as an entity for purposes of determining the tax consequences arising from a taxable disposition of an interest in the partnership. The exception is found in Section 751. If, at the time of a partner's taxable disposition of his partnership interest, the partnership owns assets described in Section 751, the partner is taxed as though he sells his proportionate share of the partnership's Section 751 assets to the purchasing party. The portion of the purchase price received for the seller's share of partnership Section 751 assets is taxed as ordinary income or loss, with the remaining gain or loss on the disposition being taxed as capital gain or loss.

• Treatment of Purchaser. The person who acquires a partnership interest from a partner is also generally treated as though he acquires an interest in an entity rather than an interest in each of the partnership's assets. A transferee generally obtains a unitary basis in the acquired interest equal to the consideration given for the interest under Sections 742 and 1012 and his holding period for the interest generally begins at the time of his acquisition under Section 1223. Absent an election under Section 754 that applies to the transfer, the adjusted basis of partnership assets is not affected by a disposition of a partnership interest. If a Section 754 election applies to the transfer, however, the transferee partner's share of the partnership's basis in its assets is adjusted to reflect fair market values under Section 743(b).

• Tax-Free Dispositions. In general, the same types of dispositions of assets that are tax-free are also tax-free if the asset involved happens to be a partnership interest. One significant exception is an exchange described in Section 1031. An exchange of a partnership interest for an interest in another partnership cannot qualify for Section 1031 benefits. Except for Section 1031 exchanges, the tax consequences to the transferor and the transferee in a tax-free disposition of a partnership interest are the same as would be the case in tax-free dispositions generally. Thus, the transferor recognizes no gain or loss in connection with the disposition and the transferee generally takes the transferor's basis and holding period for the transferred partnership interest.

• Treatment of Partnership Income or Loss in Year of Disposition. Whether a disposition of a partnership interest is taxable or tax-free, a tax consequence of concern in connection with the disposition is the treatment of partnership income or loss in the year of disposition. Although a partnership is treated as an entity that is distinct from its partners, it is not itself subject to taxation. Rather, each partner must include on his own tax return his proportionate share of partnership income or loss. When a partner disposes of his partnership interest, partnership income or loss for the year of disposition must be apportioned between the transferor and the transferee. The apportionment is generally made by closing the partnership's books as of the day of the transfer and calculating the transferor's share of partnership income or loss through that date. The parties, however, may elect an alternative method in which partnership income or loss is apportioned between the transferor and transferee based on the portion of the year each holds the interest in accordance with Section 706(c) and the Section 706(c) regulations.
Termination of a Partnership

• Circumstances Giving Rise to a Termination

Under Section 708 three circumstances give rise to a termination of a partnership for federal income tax purposes: (1) the cessation of all business, financial operation or ventures of the partnership; (2) the discontinuation of operations in partnership form; and (3) the sale or exchange of 50% or more of partnership profits, and capital within a 12-month period. While these events may result in the termination of a single partnership, a merger or consolidation of two or more partnerships may result in the termination of one or more of the constituent partnerships. Conversely, the division of a single partnership into two or more resulting partnerships may result in the termination of one or more of the resulting firms.

• Consequences of Partnership Termination.

The only consequence specifically referred to in the Code which results from a partnership termination is the closing of the partnership's taxable year under Section 706(c). Under the Section 708 regulations, however, a termination also results in a constructive (and in some cases actual) distribution of all partnership assets in complete liquidation of all partners' interests in the partnership. In addition, where the terminated firm continues its operations as a partnership, a constructive recontribution of the partnership assets to a "new" partnership is deemed to occur. While certain consequences resulting from the constructive distribution/recontribution in a partnership termination are referred to in the regulations, other consequences may also arise.

• Recognition of Gain or Loss.

The tax consequences resulting from a distribution of assets by a partnership in complete liquidation of a partner's interest are set forth in Sections 731 and 732. In general, neither the partner nor the partnership recognizes gain or loss in most cases. Gain will be recognized by the partner only to the extent that cash distributed to him exceeds his basis in his partnership interest. Loss will be recognized by the distributee partner only if specified types of assets are distributed in liquidation of his interest. The partner's basis in distributed assets is generally equal to his basis in his partnership interest immediately before the distribution, plus (or minus) gain (or loss) recognized in connection with the distribution.

With respect to a partner's constructive recontribution of assets to the "new" partnership in return for an interest in that partnership, no gain or loss generally is recognized by the partner or the partnership under Section 721. The partnership's basis in the contributed assets is generally the same as the contributing partner's bases in those assets, and the partner's basis in his partnership interest generally is equal to the aggregate bases of all assets contributed by him to the partnership under Sections 722 and 723.
Worksheet 2
Sample ABCD Partnership Agreement (Buy-Sell Article).

THIS PARTNERSHIP AGREEMENT is entered into this ______ day of _______________, 19__, among A, B, C, and D, referred to herein collectively as "partners" and individually as a "partner" or by their names. In consideration of the mutual promises contained herein, the parties agree as follows:
* * *
ARTICLE XI
BUY OUT OF PARTNERSHIP INTEREST

11.1. Buy-Sell. At any time during the term of the Partnership, any partner may make a written offer (the "Offer") to buy the interest of any other partner for cash or for cash and installment cash payments. For purposes of this Article XI, the partner making the Offer is referred to as the "Offeror" and the partner to whom the Offer is made is referred to as the "Offeree." The Offer by the Offeror shall set forth in detail the purchase price and all terms and conditions of the purchase (including the amount of the down payment, the time and amount of any deferred payments and the interest rate on any deferred payments) and shall be delivered as provided in Section 11.4. The Offeree shall have thirty (30) days after receipt of the Offer to elect by written notice to the Offeror to either (1) accept the Offer or (2) purchase the partnership interest of the Offeror at the same price and on the same terms and conditions as those set forth in the Offer made by the Offeror. If the Offeree does not elect either (1) or (2) above by written notice to the Offeror within such thirty (30) day period, the Offeree shall be deemed to have elected option (1) and the sale of the Offeree's interest to the Offeror shall be consummated in accordance with the terms set forth in the Offer by the Offeror. If the Offeree elects (2) above within such thirty (30) day period, the sale of the Offeror's interest to the Offeree shall be consummated in accordance with the terms set forth in the Offer by the Offeror.

11.2. Release and Indemnification of Selling Partner. Upon any purchase under Section 11.1, the purchasing partner shall use his best efforts to obtain releases of the selling partner from personal liability for Partnership debts and the purchasing partner shall indemnify and hold harmless the selling partner from all debts and liabilities of the Partnership (except, however, any debt or liability incurred by the selling partner on behalf of the Partnership which the selling partner was not authorized to incur).

11.3. Closing. The closing of the purchase and sale of the selling partner's interest in the Partnership to the purchasing partner shall occur on a date and time and at a place mutually agreeable to the selling and purchasing partners, which shall not be later than sixty (60) days after the Offeree's election or deemed election in accordance with Section 11.1. At the closing, the purchasing partner shall pay to the selling partner the entire amount of the purchase price, or the down payment on the purchase price as specified in the Offer, in cash or certified funds. The selling partner shall deliver to the purchasing partner any and all instruments necessary for transfer and assignment of his interest in the Partnership to the purchasing partner.

11.4. Method of Notices. All notices required or permitted by this Article shall be in writing and shall be hand delivered or sent by registered or certified mail addressed as set forth on the signature page hereof (except that any partner may from time to time give notice changing his address for that purpose) and shall be effective on the date hand delivered or the date set forth on the receipt of registered or certified mail, or on the seventh day after mailing, whichever is earliest. Notices to the Partnership shall be addressed to the Partnership at its principal office.

11.5. Computation of Time. In computing any period of time under this Agreement, the day of the act, event or default from which the designated period of time begins to run shall not be included. The last day of the period so computed shall be included, unless it is a Saturday, Sunday or legal holiday, in which event the period shall run until the end of the next day which is not a Saturday, Sunday or legal holiday.
* * *

IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the date first written above. 
                                 A                                      
                                 ______________________________________ 
                                 Address: _____________________________ 
                                 ______________________________________ 
                                                                        
                                 B                                      
                                 ______________________________________ 
                                 Address: _____________________________ 
                                 ______________________________________ 
                                                                        
                                 C                                      
                                 ______________________________________ 
                                 Address: _____________________________ 
                                 ______________________________________ 
                                                                        
                                 D                                      
                                 ______________________________________ 
                                 Address: _____________________________ 
                                 ______________________________________ 

Worksheet 3
Sample Purchase Agreement.
THIS AGREEMENT is entered into as of the ______ day of _______________, 19__ by and between A (the "Seller") and E (the "Purchaser").
WITNESSETH:

WHEREAS, Seller is a partner in a general partnership known as the ABCD Partnership (the "Partnership") engaged in the business of manufacturing and selling widgets, which was created pursuant to the ABCD Partnership Agreement dated _________________, 19__ (the "Partnership Agreement"); and

WHEREAS, Seller owns a 20% interest in the Partnership (the "Interest"); and

WHEREAS, Seller desires to sell and Purchaser desires to purchase the Interest in accordance with the terms of this Agreement.

NOW, THEREFORE, the parties agree as follows:
1. Price. The price to be paid for the interest shall be $100,000 in cash or certified funds. In addition to the cash payment, Purchaser shall assume and be liable for 20% of the total Partnership liabilities existing as of the day of closing in accordance with paragraph 3, which liabilities are estimated to be $500,000 and the portion of such liabilities attributable to the Interest is estimated to be $100,000.
2. Allocation of Purchase Price. The parties hereby agree that the purchase price for the Interest shall be allocated among the assets of the Partnership attributable to the Interest as follows:
              Partnership Asset                     Purchase Price      
  Cash                                                           $10,000
  Inventory                                                       20,000
  Plant and equipment                                             60,000
  Building and Real Estate                                        50,000
  Goodwill                                                        60,000
  Total Partnership Assets                                              
  Attributable to Interest                                      $200,000
  Partnership Liabilities                                               
  Attributable to Interest                                     (100,000)
                                                                $100,000

The Seller and the Purchaser mutually agree that neither such parties shall take a position on any tax return that is inconsistent with such allocation.
3. Release and Indemnification of Selling Partner. Purchaser hereby covenants, which covenant shall survive the closing of the sale and purchase of the Interest, that he shall assume 20% of the total liabilities of the Partnership, and shall and does hereby agree to indemnify Seller and each other Partner in the Partnership from personal liability up to 20% of such liabilities. In addition, Purchaser shall use his best efforts to obtain releases of Seller from personal liability for all Partnership debts and shall hold Seller harmless from all debts and liabilities of the Partnership (except, however, any debt or liability incurred by Seller on behalf of the Partnership which Seller was not authorized to incur.)
4. Terms of Partnership Agreement. Purchaser hereby agrees to be bound by all terms and conditions of the Partnership Agreement, effective as of the closing of the purchase and sale of Interest in accordance with the terms hereof.
5. Required Amendments. Seller shall have prepared and timely filed, at Seller's sole cost and expense, all necessary amendments, reports and other documents required by law in order to evidence the transfer of the Interest contemplated hereunder.
6. Closing. The closing of the purchase and sale of the Interest shall occur on a date and time to be mutually agreed upon by Seller and Purchaser, which shall not be later than sixty (60) days after the date first above written. At the closing, Purchaser shall pay to Seller the purchase price specified in paragraph 1 in cash or certified funds and Seller shall deliver to Purchaser any and all instruments necessary for transfer and assignment of the Interest to Purchaser.
7. Binding Affect. The Agreement shall inure to the benefit of and be binding upon the parties to this Agreement and their respective successors and permitted assigns.
8. Nonassignability. This Agreement and any rights pursuant hereto shall not be assignable by either party without the prior written consent of the other party.
9. Applicable Law. This Agreement and the legal relations between the parties hereto shall be governed by and construed in accordance with the laws of the State of New York.
10. Entire Agreement. This Agreement, including any exhibits and attachments hereto, embodies the entire agreement and understanding of the parties with respect to the subject matter hereof. There are no restrictions, promises, representations, warranties, covenants or undertakings other than those expressly set forth or referred to herein. This Agreement supersedes all prior discussions, agreements and undertakings between the parties with respect to the subject matter hereof.

IN WITNESS WHEREOF the parties have executed this Agreement as of the date first above written. 
                                  Seller:                                
                                  _________________________________      
                                  A                                      
                                                                         
                                  Purchaser:                             
                                  _______________________________________
                                  E                                      

Consent to Sale

The undersigned partners of the ABCD Partnership hereby consent to the transfer of A's 20% Interest in such Partnership to E in accordance with the terms and conditions of the foregoing Purchase Agreement. 
  ________________________________________________                       
  B                                                                      
                                                                         
  ________________________________________________                       
  C                                                                      
                                                                         
  ________________________________________________                       
  D                                                                      

Worksheet 4
Excerpts from House Ways and Means Committee Report to H.R. 8300 [1954 Code]; H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954).
(GENERAL EXPLANATION)
[p. 65]
XXII. Partners and Partnerships

The existing tax treatment of partners and partnerships is among the most confused in the entire income tax field. The present statutory provisions are wholly inadequate. The published regulations, rulings, and court decisions are incomplete and frequently contradictory. As a result partners today cannot form, operate, or dissolve a partnership with any assurance as to tax consequences.

This confusion is particularly unfortunate in view of the great number of business enterprises and ventures carried on in partnership form. It should also be noted that the partnership form of organization is much more commonly employed by small businesses and in farming operations than the corporate form.

Because of the vital need for clarification, your committee has undertaken the first comprehensive statutory treatment of partners and partnerships in the history of the income tax laws. In establishing a broad pattern applicable to partnerships generally, the principal objectives have been simplicity, flexibility, and equity as between the partners.

In general, the proposed statutory treatment retains the existing scheme of regarding the partnership as merely an income-reporting, and not a taxable, entity. In addition, a statutory pattern has been established for contributions to a partnership, distribution by a partnership, transfers of partnership interests by sale or on the death of a partner, termination of partnership taxable years, transactions between a partner and the partnership, and the treatment of payments to a retiring partner or a deceased partner's estate or heir.
A. General rules (secs. 701-707)

(1) Income of partners. -- Under your committee's bill, as under present law, partners will be liable individually for income tax on their distributive shares of partnership income. The bill provides that the partnership will act as a mere conduit as to income and loss items, transferring such items directly to the individual partners.

The items required to be segregated will retain their original character in the hands of the partner as though they were realized directly by him from the same source from which realized by the partnership and in the same manner. After excluding the items required to be separately treated, the remaining income or loss, which
[p. 66]

corresponds to the ordinary income or loss of the partnership under present law, is attributed to the partners.

The computation of partnership income is generally on the same basis as existing law. The partnership is allowed the usual business deductions, but is denied the deductions peculiar to individuals.

The bill provides that all elections with respect to income derived from a partnership (other than the election to claim a credit for foreign taxes) are to be made at the partnership level and not by the individual partners. This rule recognizes the partnership as an entity for purposes of income reporting. It avoids the confusion which would occur if each partner were to determine partnership income separately for his own purposes.

(2) Distributive shares. -- The taxation of partnership income or other items directly to the partners requires a determination of each partner's share of such items. It general, such shares will be determined in accordance with the partnership agreement as under existing practice.

In the case of property contributed to a partnership, there has been considerable doubt, under present law, as to the partners' distributive shares of gain and loss upon the sale of such property and as to the allocation among the partners of depreciation on such property. This problem arises when the tax basis of the contributed property is greater or less than the value of such property at the time of contribution. Under the approach adopted by your committee, the allocation of gain or loss and of depreciation is to be in accordance with the distributive shares of the partners generally. Thus, if 1 of 2 equal partners contributes to a partnership property which is worth $100 but has a tax basis of $40, and the other partner contributes cash of $100 which is used to purchase property with a value of $100, the partners will share equally in the depreciation allowance, notwithstanding the low basis of the property contributed by the first partner. The sharing of gain or loss upon a sale or exchange of either property will also be identical as between the partners. However, upon the liquidation of the partnership the partners who have received too large depreciation deductions (or too small a gain) will receive relatively larger capital gains than will be true in the case of the other partners. This general treatment was adopted because of its extreme simplicity as contrasted with any other alternative and because it conforms to the usual expectations of partners.

(3) Taxable years of partners and partnerships. -- Under existing law a partner treats his distributive share of partnership income as income to him at the close of the partnership taxable year. Such income is not reportable by the partner until he files his return for the taxable year in which such partnership year ends. Because of these rules it has been possible, generally by the selection of a fiscal year as partnership year, to postpone the realization of partnership income by as much as 11 months. To prevent this practice, the bill provides, in general, that a partnership may not, without the consent of the Secretary or his delegate, either adopt a fiscal year or change from a calendar year to a fiscal year. The same requirement is made applicable to partners shifting from a calendar year to a fiscal year basis. It is contemplated that the use of a fiscal year will be approved where valid business reasons for such an accounting period are shown.
[p. 67]

Under present law the death of a partner may result in the closing of the partnership year and the bunching of more than a year's income in the decedent's last year. Where the partnership and the partners are on different taxable years, this rule may have the effect of concentrating as much as 23 months' income in the final return of the deceased partner, that is, the income for the partnership year ending within his taxable year and the income for the taxable year closed by the partner's death. The bill provides relief in this situation by preventing the partnership year from closing on the death of the partner. The partnership year will then run to its normal conclusion, and the decedent's share of the income for such year will be taxable to the estate. To the extent that the right to receive such income constitutes income in respect of a decedent, the estate is entitled to a deduction for estate tax attributable to the inclusion of such right in the decedent's estate.

The bill further provides that the taxable year of a partnership is not to close as a result of the admission of a new partner, the liquidation of a partner's interest by means of a distribution, or a sale or exchange of a partner's interest in the partnership. Thus, it will not be possible by the admission of a new partner to terminate the partnership taxable year and commence a new partnership year. However, the partnership year does close if there is a termination of the partnership. A termination is defined for this purpose as a discontinuance of the business activities carried on by the partnership, or the sale of an interest of more than 50 percent in partnership capital or profits to persons not members of the partnership. The partners may choose to ignore the termination if they wish to continue to the close of the normal partnership year.

While the partnership year does not close for the continuing partners when a partner severs his interest in the partnership, the partnership year does close with respect to such partner. When a partner merely reduces his interest in a partnership, there is no change in the partnership taxable year with respect to him, but the amount of his distributive share must be determined with regard to his ownership of varying interests during the year.

(4) Transaction between partner and partnership. --When a partner sells property to, or performs services for the partnership, the problem arises whether the transaction is to be treated in the same manner as though the partner were an outsider dealing with the partnership (the "entity" approach). An alternative ("aggregate" approach) is to view the partner as dealing with himself to the extent of his own interest and as dealing with the partnership with respect to the balance of the transaction. The present code fails to cover the problem and judicial decisions on the subject go in either direction. Because of its simplicity of operation, the "entity" rule has been adopted.

However, certain safeguards are included to prevent the sale of property between the partnership and a "controlling" partner for the purpose of recognizing losses or raising the basis of property. Under the prescribed rule, a sale between the partnership and a partner will not be recognized if it involves a "controlling" partner, that is, a partner who owns 50 percent or more of a capital or income interest in the partnership. Where a sale involves a controlling
[p. 68] partner, any money or property passing between the partner and the partnership will be treated in a manner which, in general, prevents the recognition of gain or loss. The basis of the property transferred will remain unchanged.

The payment of a salary by the partnership to a partner for services again raises the problem as to whether the partnership is to be viewed as an entity or merely as an aggregate of the activities of the members. Under present law, fixed payments to a partner are not recognized as a salary but considered as a distributive share of partnership earnings. This creates obvious difficulties where the partnership earnings are insufficient to meet the salary. The existing approach has been to treat the fixed salary in such years as a withdrawal of capital, taxable to the extent that the withdrawal is made from the capital of other partners. Such treatment is unrealistic and unnecessarily complicated. The bill provides that payment of a fixed or guaranteed amount for services shall be treated as salary income to the recipient and allowed as a business deduction to the partnership.
B. Contributions to a partnership (secs. 721-723)

Contributions to a partnership will have the same effect under the proposed provisions as under present practice. No gain or loss will be recognized either to the contributing partner or to the partnership. The property contributed to a partnership will have the same basis to the partnership for purposes of gain, loss, depreciation, etc., as in the hands of the contributor.

The basis of the contributing partner for his interest in the partnership will be increased by the basis of the property transferred to the partnership. If the contributed property is subject to indebtedness, the basis of the contributing partner's interest will be reduced by the portion of the indebtedness assumed by the other partners.
C. Distributions by a partnership (secs. 731-735, 737)

Distributions of money or other property by a partnership are among the most common partnership transactions. Your committee's bill provides a simple and uniform method for determining the basis of property distributed by a partnership and the resulting adjustments to the basis of the interest in the partnership. These rules are applicable whether the distribution is out of income or partnership capital, and whether the distribution is pro rata to all the partners or has the effect of changing the respective partnership interests.

Under the bill, any property distributed by the partnership to a partner will, in general, have the same basis to the distributee partner as in the hands of the partnership, i.e., a "carryover" basis. The money and property distributed will be applied in reduction of the basis of the interest of the distributee partner. After the basis of his interest has been used up, any further distribution of money or property will be taxed as capital gain to the distributee.

The distribution of money or property does not result in gain or loss to the partnership. Gain or loss is recognized to the recipient partner only in two cases. Gain is recognized, as indicated above, where the basis of any money or property received by a partner exceeds the basis of the partner for his interest in the partnership. The recognition of gain may occur either in a current distribution not affecting the partner's interest in the partnership, or in a
[p. 69]

distribution which reduces or terminates the partner's interest in the partnership. The recognition of loss is limited to a distribution terminating the interest of the partner. In such a liquidating distribution, capital loss is recognized to the extent that the basis of the partner for his interest in the partnership exceeds the fair market value of the property distributed.

An exception is made to the use of the "carryover" basis where the basis of the property distributed exceeds its value at the time of the distribution. In this situation, safeguards were necessary to prevent the distribution, for tax-avoidance purposes, of property with respect to which there is a potential loss upon sale or exchange. Accordingly, when the basis of the distributed property is greater than the fair market value of such property, the basis of the property to the distributee is reduced to such fair market value. The partnership, however, is permitted to retain this "unused basis" and apply it to similar property held by the partnership.

Consistent with the use of the "carryover" basis, the holding period to the partner of distributed property includes the holding period of the property to the partnership.

A special rule has been provided for the purpose of distinguishing bona fide distributions which are subject to the rules discussed above from transactions involving a loan by the partnership to the partner. When a partner is obligated to make repayment to the partnership with respect to money or property received from the partnership, he will be treated as receiving a loan to the extent of his obligation, and no reduction will be made in the basis of his interest. If, however, such an obligation is canceled by the partnership without repayment, the partner will then be considered to have received a distribution equal to the amount of debt canceled. The transfer of property subject to an obligation to make repayment is treated as a sale by the partnership, so that gain or loss will be recognized to the partnership.

The provisions relating to distributions are subject to the special rules, discussed below, relating to unrealized receivables or fees, inventory or stock in trade which has substantially appreciated or depreciated in value, and payments to a retiring partner or the estate or heir of a deceased partner.

The system thus described avoids the complexities of present law which requires that a portion of the basis of the distributee for his interest in the partnership be assigned to the property distributed. The use of the "carryover" basis eliminates the need for rules of allocation of basis as between capital assets and noncapital assets, and renders unnecessary any adjustment to the basis of the remaining assets in the partnership other than in the case where the distributed property has a value less than its basis.

The proposed rules for contributions to, and distributions by, a partnership, in effect, permit the tax-free transfer of property into or out of a partnership. Generally speaking, the basis of the property remains unchanged through the formation and dissolution of a partnership. This relatively simple approach is made possible by reducing the basis of the distributee's interest in the partnership by the basis of the distributed partnership property and by the recognition of gain or loss in the case of certain distributions.
[p. 70]
D. Transfer of an interest in a partnership (secs. 741-743, 751)

(1) General rules. -- Under present decisions the sale of a partnership interest is generally considered to be a sale of a capital asset, and any gain or loss realized is treated as capital gain or loss. It is not clear whether the sale of an interest whose value is attributable to uncollected rights to income gives rise to capital gain or ordinary income. There is also doubt under present law whether the basis of the assets of the partnership may be adjusted, or is required to be adjusted, to reflect the purchase price paid by a new partner for his interest.

Because of the confusion in this area, basic rules have been set forth in order to clarify tax treatment and at the same time to prevent the use of the sale of an interest in a partnership as a device for converting rights to income into capital gain.

The general rule that the sale of an interest in a partnership is to be treated as the sale of a capital asset is retained. In general, the transfer of an interest will not affect the basis of partnership assets. Provision is made, however, whereby the partnership may elect to adjust the basis of partnership assets to reflect the increase or decrease in the basis of partnership interest transferred by sale or upon the death of a partner. Such an election, once filed, is irrevocable until the termination of the partnership and will require similar basis adjustments with respect to all future transfers of partnership interest. By making adjustments to the basis of partnership assets, the same effect is achieved as though the partnership had dissolved and been reformed, with the transferee of the interest as a member of the partnership. The increase or decrease in the basis of partnership assets may be allocated to such assets in accordance with their respective bases or in any other equitable manner approved by the Secretary or his delegate.

It is anticipated that many partnerships will prefer not to make an election which entails the adjustment to the basis of partnership assets each time a transfer of an interest in a partnership takes place. The possible tax advantages of such an adjustment may be outweighed by the bookkeeping expense and inconvenience. However, the adjustment may be desirable in cases where there is a substantial increase in the tax basis of the transferred partnership interest.

It is to be noted that, if the election to increase or decrease the basis of partnership property is made, the change in the basis of the partnership assets will affect all members of the partnership according to their distributive shares and not merely the transferee partner.

(2) Unrealized receivables or fees and inventory or stock in trade. -- In order to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests, certain rules have been adopted by your committee which will apply to all dispositions of partnership interests. The bill provides that, if in connection with the transfer of a partnership interest, the partner receives any amount attributable to his share of (1) the unrealized receivables and fees of the partnerships or (2) substantially appreciated or depreciated inventory or stock in trade, such amounts are to be treated as ordinary gain or loss. In effect, the partner is treated as though he disposed of such items independently of the rest of his partnership interest.
[p. 71]

Since an ordinary income tax is paid by the seller on these items, the purchaser of an interest is permitted to exclude from his gross income an amount equal to the income recognized by the seller with respect to such items. This amount may be spread ratably over the period of time in which it is estimated that the unrealized receivables and fees will be collected or the inventory will be disposed of, or may be allocated in any other equitable manner which is approved by the Secretary.

A decedent partner's share of unrealized receivables and fees will be treated as income in respect of a decedent. Such rights to income will be taxed to the estate or heirs when collected, with an appropriate adjustment for estate taxes. However, a decedent's share of appreciated or depreciated inventory or stock in trade is not treated as income in respect of a decedent. The decedent's interest in such inventory or stock in trade will be increased or decreased in basis in the same manner as other property held by the decedent. The change in basis at the time of death will not be reflected in the basis of partnership assets but will be used by the estate or heir as an adjustment to the income received on the disposition of such property. The estate or heir is thus treated in the same manner as a purchaser with respect to the decedent's interest in appreciated or depreciated inventory or stock in trade.

The term "unrealized receivables or fees" is used to apply to any rights to income which have not been included in gross income under the method of accounting employed by the partnership. The provision is applicable mainly to cash basis partnerships which have acquired a contractual or other legal right to income for goods or services. "Substantially appreciated or depreciated inventory or stock in trade" includes any noncapital assets, the value of which exceeds by more than 20 percent the basis of such inventory and exceeds by more than 10 percent the basis of all partnership property other than money.

The treatment thus provided upon the sale of an interest in income items is also extended to any distribution by the partnership to a partner which has the same effect as a sale of such ordinary income or loss items.

The provisions relating to unrealized receivables or fees and appreciated or depreciated inventory are necessary to prevent the use of the partnership as a device for obtaining capital-gain treatment on fees or other rights to income. Amounts attributable to such rights would be treated as ordinary income if realized in normal course by the partnership. The sale of a partnership interest or distributions to partners should not be permitted to change the character of this income. The statutory treatment proposed, in general, regards the income rights as severable from the partnership interest and as subject to the same tax consequences which would be accorded an individual entrepreneur.
E. Payments to a retiring partner or a successor in interest of a deceased partner (sec. 736)

When a partner retires or payments are made to the estate or heir of a deceased partner, the amounts paid may represent several items. They may, in part, represent the withdrawing partner's capital interest in the partnership. They may include his pro rata interest in
[p. 72]

unrealized receivables and fees of the partnership and its potential gain or loss on inventory. Part of such payments may be attributable to an arrangement in the nature of mutual insurance among the partners. The present code contains no provisions relating to the tax treatment of such payments and existing case law presents no consistent approach. Consequently, specific provisions have been adopted by your committee which will result in more equitable tax treatment of distributions to retiring partners or the successor in interest of a deceased partner.

When a retiring partner or the successor of a deceased partner receives a share of partnership income in return for the complete relinquishment of the interest in the partnership, the distributions will be allocated between (a) payments for the value of the capital interest and (b) other payments. Such allocation will be made in accordance with regulations prescribed by the Secretary or his delegate.

The amounts paid for the capital interest of the withdrawing partner are treated in the same manner as a distribution. The remaining partners, of course, are allowed no deductions for such payments. Essentially, these payments represent a purchase by the remaining partners of the withdrawing partner's capital interest in the partnership. For this purpose payments for a "capital interest" do not include amounts attributable to a partner's interest in unrealized receivables and fees, amounts paid for substantially appreciated or depreciated inventory, and amounts paid for good will in excess of its fair market value.

A different treatment is provided for the portion of the payments to a withdrawing partner which is not made in exchange for the capital interest of such partner. Such payments are treated as a distributive share of partnership income to the withdrawing partner. Thus, they are taxable to the withdrawing partner in the same manner as if he continued to be a partner and are excluded in determining the income of the remaining partners. However, if such payments are continued for a period of more than 5 years after the retirement or death of the partner, they are treated as a gift from the remaining partners to the withdrawing partner. As a gift, the payments made after 5 years are taxable to the remaining partners (with no increase in the basis of such partners for their interest in the partnership) and are exempt from income tax in the hands of the recipient.

Where a retiring partner receives a lump sum or fixed payments determined without regard to the income of the partnership, the portion of such payments attributable to the capital interest of the retiring partner is to be treated as the purchase of a capital interest by the remaining partners. The balance, however, will be treated like a salary paid by the partnership. It will constitute ordinary income to the recipient and a deduction to the partnership. Payments of this nature, however, are subject to the 5-year limitation.
* * *
(DETAILED DISCUSSION OF THE TECHNICAL PROVISIONS OF THE BILL)
[p. A225]

Section 706. Taxable years of partner and partnership

Subsection (a) corresponds to section 188 of the 1939 Code and makes no substantive change. It requires a partner, in computing his individual income tax to include his distributive share of partnership items for any partnership year ending within or with his taxable year. A partnership taxable year shall be determined as though the partnership were a taxpayer. For example, the partnership must annualize its income for a short year caused by a change of its accounting period.

Subsection (b) provides that a partnership may not change its taxable year from a calendar year to a fiscal year unless it receives the approval of the Secretary or his delegate. Partnerships organized after June 30, 1954, must adopt a calendar year unless they obtain the approval of the Secretary or his delegate to the adoption of a fiscal year. Furthermore, no member of a partnership may, without prior approval from the Secretary or his delegate, change his taxable year. It is contemplated that the adoption of a fiscal year by either the partnership or the partner will be approved if a valid business purpose is shown. This provision does not affect partnerships or partners using different taxable years prior to January 1, 1954.

Paragraph (1) of subsection (c) provides that, as a general rule, the taxable year of a partnership shall not, unless the partnership agreement otherwise provides, be closed as the result of the death of a partner, the addition of a new partner, or the liquidation or the sale or exchange of a partner's interest. Thus, in the case of the death of a partner the partnership taxable year will continue to its normal conclusion unless the partnership agreement provides for a lump sum payment to the partner's estate resulting in an immediate termination of the partner's interest.
[p. A227]
SUBPART B -- DISTRIBUTIONS BY A PARTNERSHIP
Section 731. Extent of recognition of gain or loss on distribution

This section sets forth the rules for the recognition of gain or loss upon distributions of money and property by the partnership to a partner. Ordinarily, no gain or loss is recognized upon such a distribution. The circumstances in which gain or loss is recognized are described in paragraphs (1) and (2) of subsection (a).

Where money is distributed, no gain will be recognized to the distributee partner except to the extent that such distribution exceeds the basis of his interest in the partnership. This rule is in accord with present practice, and is applicable to current distributions as well as distribution in exchange for all or part of the distributee partner's interest (i.e., complete or partial liquidations).

Loss, on the other hand, is to be recognized to the distributee partner only upon the liquidation of his interest in the partnership. The term "liquidation" is defined in section 761 (d) as the termination of the partner's entire interest in the partnership. Loss will be
[p. A228]

recognized to the partner whose interest is being liquidated to the extent that the basis of his interest exceeds the amount of money received by him (assuming he receives no property).

In the event that the distribution includes property, then the unadjusted basis to the distributee of such property, as determined under section 732 (generally, the adjusted basis in the hands of the partnership) shall be used in the computation of the distributee's gain or loss. Thus, if a partner with a basis for his interest of $10,000 receives a distribution of $8,000 in cash and property with a basis, determined in section 732, of $3,000, he realizes a gain of $1,000. If a partner whose basis for his interest is $10,000 retires from the partnership receiving $5,000 in cash and property with a basis to him of $3,000, a loss of $2,000 will be recognized to him. Generally, the gain or loss recognized will be treated as gain or loss from the sale or exchange of the interest in the partnership.
* * *
[p. A232]
SUBPART C -- TRANSFERS OF INTERESTS IN A PARTNERSHIP
Section 741. Recognition and character of gain or loss on sale or exchange

This section provides that the sale or exchange by a partner of his interest in the partnership shall be treated generally as the sale or exchange of a capital asset. Any gain or loss shall be treated as capital gain or loss unless the partnership has unrealized receivables or fees, or inventory or stock in trade which has substantially appreciated or depreciated in value, as defined in section 751. If section 751 is applicable, a portion of the gain or loss shall be treated as ordinary income or loss.
Section 742. Basis of transferee partner's interest

This section provides that, in general, the unadjusted basis to a transferee partner of an interest in a partnership shall be determined under the basis rules for property provided by part II of subchapter O (sec. 1011 and following). For example, the basis of a purchased interest will be its cost, and the basis of an interest transferred upon the death of a partner will be the fair market value of the interest at death or the optional valuation date.

Special rules are provided in section 751, however, if the partnership owns unrealized receivables or fees, or inventory or stock in trade which has substantially appreciated or depreciated in value (as defined in sec. 751). Section 743. Optional adjustments to basis of partnership property

Subsection (a) provides that the transfer of an interest in a partnership, either by sale or exchange, or as the result of the death of a partner, although affecting an adjustment to the basis of the transferred interest, will not result in an adjustment to the bases of the partnership properties.

Subsection (b) provides, however, that the partnership may make an election to adjust the bases of the partnership assets in order to reflect the increase or decrease in the basis of transferred interest in the partnership. A partnership making this election shall increase the adjusted bases of the partnership properties by the amount by which the unadjusted basis of the transferee partner's interest in the partnership exceeds the adjusted basis of the transferor's interest immediately prior to the transfer. In the event that the adjusted basis of the transferor partner's interest in a partnership immediately prior to the transfer exceeds the unadjusted basis of the transferee partner for his interest, then the adjusted bases of the partnership properties shall be decreased by the amount of this excess.

The amount of any increase or decrease in the adjusted bases of partnership properties as the result of a transfer of a partnership interest is to be allocated to such properties in proportion to their respected adjusted bases, unless the partnership receives permission from the Secretary or his delegate to use another method of allocation.

In order to make the permissive basis adjustments, the partnership must file a statement of election, under regulations with the partnership return for the taxable year of the partnership in which a
[p. A233]

transfer of an interest occurs. Once the election is made, it shall be irrevocable until the termination of the partnership (as defined in sec. 761 (e)). The adjustment to the basis of partnership properties must then be made each time there is a transfer of an interest in the partnership. Thus, a partnership which makes an election to step-up the basis of its assets upon a sale of a partnership interest for an amount in excess of the adjusted basis of such interest will, in the event of a subsequent sale of such an interest for an amount less than its adjusted basis, be required to decrease the basis of its assets. Such increases or decreases must also be made in the case of transfers resulting from the death of a partner based on the market value of the interest at the time of death.

The election to increase the basis of partnership properties upon the transfer of a partnership interest is not applicable with respect to the deposition by a partner of his interest in unrealized receivables or fees or substantially appreciated or depreciated inventory or stock in trade. The partner acquiring an interest in such properties retains individually the basis applicable to such properties for purposes of his own income computations, as provided in section 751.

It will be noted that the optional adjustment to basis provided in section 743 (b) will, under the rules provided in section 704 (c), be shared equally by all the partners in accordance with their distributive shares of partnership income or loss. The benefits of a step-up in the basis of partnership properties (or the detriments of a step-down in basis) will not therefore be limited to the partner the transfer of whose interest results in such adjustment.

The application of subsection (b) may be illustrated as follows:

Assume that partner A dies when the balance sheet of the ABC partnership is as follows: 
                     Assets                              Liabilities and capital        
                            Adjusted    Market                    Adjusted      Market  
                              basis     value                      basis        value   
  Cash                         $5,000   $5,000   Liabilities        $10,000      $10,000
  Accounts receivable          10,000   10,000   Capital:                               
  Property X (inventory)       20,000   21,000   A                   15,000       22,000
  Property Y (depreciable      20,000   40,000   B                   15,000       22,000
  assets)                                                                               
                                                 C                   15,000       22,000
  Total                        55,000   76,000                       55,000       76,000

The partnership has made the election to adjust the basis of partnership assets upon transfer of an interest and therefore the difference between the adjusted basis of A's partnership interest, $15,000, and the value of such interest at death, $22,000, must be allocated to the basis of partnership assets. The allocation is made in proportion to adjusted basis of property other than cash and accounts receivable, and in the example above would be divided equally between property X and property Y (an increase of $3,500 in the basis of each property). The bases of the interests of B and C in the partnership would remain unchanged.

Assuming that A's son M takes over his father's interest, the balance sheet of the new partnership M B C, would be as follows:
[p. A234]
          Assets            Adjusted     Liabilities and     Adjusted 
                              basis          capital           basis  
  Cash                      $5,000      Liabilities          $10,000  
                                        Capital:                      
  Accounts receivable       10,000      M                    22,000   
  Inventory                 23,500      B                    15,000   
  Fixed assets              23,500      C                    15,000   
  Total                     62,000                           62,000   

The same adjustment as that described above would be made if partner A had sold his partnership interest to an outsider for $22,000.
Worksheet 5
Excerpts from Senate Report to H.R. 8300 [1954] Code; S. Rep. No. 1622, 83d Cong., 2d Sess. (1954).
(GENERAL EXPLANATION)
[p. 89]
XXIII. Partners and Partnerships

The existing tax treatment of partners and partnerships is among the most confused in the entire income tax field. The present statutory provisions are wholly inadequate. The published regulations, rulings, and court decisions are incomplete and frequently contradictory. As a result partners today cannot form, operate, or dissolve a partnership with any assurance as to tax consequences.

This confusion is particularly unfortunate in view of the great number of business enterprises and ventures carried on in Partnership form. It should also be noted that the partnership form of organization is much more commonly employed by small businesses and in farming operations than the corporate form.

Because of the vital need for clarification, the House and your committee have undertaken the first comprehensive statutory treatment of partners and partnerships in the history of the income tax laws. In establishing a broad pattern applicable to partnerships generally, the principal objectives have been simplicity, flexibility, and equity as between the partners.

In general, the proposed statutory treatment retains the existing scheme of regarding the partnership as merely an income-reporting, and not a taxable, entity. In addition, a statutory pattern has been established for contributions to a partnership, distributions by a partnership, transfers of partnership interests by sale or on the death of a partner, termination of partnership taxable years, transactions between a partner and the partnership, and the treatment of payments to a retiring partner or a deceased partner's estate or heir.
A. Determination of Tax Liability (secs. 701-708)

(1) House changes accepted by committee

(a) Income of partners. -- Under the House and your committee's bill, as under present law, partners will be liable individually for income tax on their distributive shares of partnership income. The partnership will act as a mere conduit as to income and loss items, transferring such items directly to the individual partners.

The items required to be segregated will retain their original character in the hands of the partner as though they were realized directly by him from the same source from which realized by the partnership and in the same manner. After excluding the items
[p. 90]

required to be separately treated, the remaining income or loss, which corresponds to the ordinary income or loss of the partnership under present law, is attributed to the partners.

The computation of partnership income is generally on the same basis as existing law. The partnership is allowed the usual business deductions, but is denied the deductions peculiar to individuals.

Both versions of the bill provide that all elections with respect to income derived from a partnership (other than the election to claim a credit for foreign taxes) are to be made at the partnership level and not by the individual partners. This rule recognizes the partnership as an entity for purposes of income reporting. It avoids the confusion which would occur if each partner were to determine partnership income separately for his own purposes.

(b) Distributive shares. -- The taxation of partnership income or other items directly to the partners requires a determination of each partner's share of such items. In general, such shares will be determined in accordance with the partnership agreement as under existing practice.

In the case of property contributed to a partnership, there has been considerable doubt, under present law, as to the partners' distributive shares of gain and loss upon the sale of such property and as to the allocation among the partners of depreciation on such property. This problem arises when the tax basis of the contributed property is greater or less than the value of such property at the time of contribution. Under the approach adopted by the House bill, the so-called entity rule, the allocation of gain or loss and of depreciation is to be in accordance with the distributive shares of the partners generally. Thus, if 1 of 2 equal partners contributes to a partnership property which is worth $100 but has a tax basis of $40, and the other partner contributes cash of $100 which is used to purchase property with a value of $100, the partners will share equally in the depreciation allowance, notwithstanding the low basis of the property contributed by the first partner. The sharing of gain or loss upon a sale or exchange of either property will also be identical as between the partners. However, upon the liquidation of the partnership the partners who have received too large depreciation deductions (or too small a gain) will receive relatively larger capital gains than will be true in the case of the other partners. This general treatment was adopted because of its extreme simplicity as contrasted with any other alternative and because it conforms to the usual expectations of partners.

Your committee has accepted as a general rule the "entity" rule provided by the House bill but, as is in indicated in the discussion below, also permits the use of the so-called aggregate rule for contributed property.

(c) Determination of basis of partner's interest. -- The House bill provides the basis of a partner's interest in a partnership is to be his basis for any contributions he made to the partnership and the amount he paid for any purchased interest, subject to certain adjustments. This basis is to be increased by the partner's share of income received from the partnership, whether or not it was taxable to him. It also is to be decreased by any distributions of money or property made to the partner and by his share of the partnership losses and expenditures
[p. 91]

of the partnership which were not deductible for tax purposes and were not capital expenditures.

Although the present statutory provisions do not provide for the adjustments described above with respect to the basis of a partner's interest in a partnership, these adjustments are implicit in the present provisions and regulations. Your committee has in general adopted these House provisions but, as indicated below, has provided an alternative method for determining the basis of a partner's interest in certain cases.

(d) Taxable years of partners and partnerships. -- Under existing law a partner treats his distributive share of partnership income as income to him at the close of the partnership taxable year. Such income is not reportable by the partner until he files his return for the taxable year in which such partnership year ends. Because of these rules it has been possible, generally by the selection of a fiscal year as partnership year, to postpone the realization of partnership income by as much as 11 months.

To prevent this practice, the House bill provides, in general, that a partnership may not, without the consent of the Secretary or his delegate, either adopt a fiscal year or change from a calendar year to a fiscal year. The same requirement is made applicable to partners shifting from a calendar year to a fiscal year basis. The House report suggests that the use of a fiscal year would be approved where valid business reasons for such an accounting period are shown.

As indicated below, your committee has revised considerably this provision of the House bill.

Under present law there has been the contention that the death of a partner closes the partnership year and the bunching of more than a year's income in the decedent's last year. Where the partnership and the partners are on different taxable years, this would have the effect of concentrating as much as 23 month's income in the final return of the deceased partner, that is, the income for the partnership year ending within his taxable year and the income for the taxable year closed by the partner's death. Both the House and your committee's bill make it clear that the partnership year does not close upon the death of the partner. The partnership year will run to its normal conclusion, and the decedent's share of the income for this year will be taxable to the estate. To the extent that the right to receive this income constitutes income in respect of a decedent, the estate is entitled to a deduction for estate tax attributable to the inclusion in the decedent's estate.

Both versions of the bill also provide that the taxable year of a partnership is not to close as a result of the admission of a new partner, the liquidation of a partner's interest by means of a distribution, or a sale or exchange of a partner's interest in the partnership. Thus, it will not be possible by any of these events in themselves to terminate the partnership taxable year and commence a new partnership year. However, the partnership year does close if there is a termination of the partnership. A termination is defined for this purpose as a discontinuance of the business activities carried on by the partnership, or the sale of an interest of more than 50 percent in partnership capital or profits to persons not members of the partnership. The partners may elect to ignore the termination if they wish to continue to the close of the normal partnership year.
[p. 92]

While the partnership year does not close for the continuing partners when a partner severs his interest in the partnership, the partnership year does close with respect to such partner. When a partner merely reduces his interest in a partnership, there is no change in the partnership taxable year with respect to him, but the amount of his distributive share must be determined with regard to his ownership of varying interests during the year.

(e) Transaction between partner and partnership. -- When a partner sells property to, or performs services for the partnership, the problem arises whether the transaction is to be treated in the same manner as though the partner were an outsider dealing with the partnership (the "entity" approach). An alternative ("aggregate" approach) is to view the partner as dealing with himself to the extent of his own interest and as dealing with the partnership with respect to the balance of the transaction. The present code fails to cover the problem and judicial decisions on the subject go in both directions. Because of its simplicity of operation, the "entity" rule has been adopted by the House and your committee.

However, certain safeguards are included to prevent the sale of property between the partnership and a "controlling" partner for the purpose of recognizing losses or raising the basis of property. Under the rule provided by the House bill, a sale between the partnership and a partner will not be recognized if it involves a "controlling" partner, that is, a partner who owns 50 percent or more of a capital or income interest in the partnership. Where a sale involves a controlling partner, any money or property passing between the partner and the partnership under the House bill is treated as a distribution or a contribution, the basis of the property transferred remaining unchanged. Your committee while retaining the entity approach has, as is indicated below, adopted treatment more nearly like that provided in the case of similar transactions between a corporation and its shareholder.

The payment of a salary by the partnership to a partner for services again raises the problem as to whether the partnership is to be viewed as an entity or merely as an aggregate of the activities of the members. Under present law, fixed payments to a partner are not recognized as a salary but considered as a distributive share of partnership earnings. This creates obvious difficulties where the partnership earnings are insufficient to meet the salary. The existing approach has been to treat the fixed salary in such years as a withdrawal of capital, taxable to the extent that the withdrawal is made from the capital of other partners. Such treatment is unrealistic and unnecessarily complicated. The House bill provides that payment of a fixed or guaranteed amount for services is to be treated as salary income to the recipient and allowed as a business deduction to the partnership. As indicated below, your committee makes slight changes in the case of these service payments and extends the rule to interest payments.

(2) Changes made by committee

In general your committee has retained the House provisions described above. It has, however, made a number of perfecting amendments and also the substantive changes, described below, which are intended primarily to make the House partnership provisions more flexible.
[p. 93]

(a) Aggregate rule for contributed property. -- As an alternative to the entity rule described above for determining the basis of property contributed to a partnership, your committee's bill provides that, if the partnership agreement so provides, the basis of contributed property may, in effect, be divided among the partners in a way which attributes precontribution appreciation or depreciation in value to the contributor. This is to be available for purposes of computing depreciation, depletion, and gain or loss upon sale but not in the case of distributions. Thus, in an equal partnership where one partner contributed cash of $100 to a partnership and the other contributed property with a basis of $40 but a current value of $100, the partners could agree that the partner contributing the cash would have all of the $40 basis for allocating depreciation and also allocating the gain or loss if the property is sold.

This rule is admittedly more complicated than the entity rule which is provided unless the partnership agreement provides otherwise. However, while the partnership remains in operation, this aggregate rule more equitably computes the taxable income of the partners. Since this is not a matter involving revenue considerations to the Government, and since partners are not compelled to use this rule, your committee believes that partners should be free to choose this more complicated rule for dividing basis of property if they desire the more accurate tax results it brings.

Your committee has also provided that in the case of undivided interests, such as joint tenancies, that basis of property is to be determined (except for distributions) in the same manner as if there were no partnership, unless the partnership agreement provides otherwise. This is designed primarily to avoid the shifting of rules for computing depreciation, depletion, and gain or loss when a joint tenancy or similar undivided interest is unintentionally handled in such a way as to constitute a partnership.

(b) Alternative method of determining basis of partner's interest. -- Your committee has in general followed the House provision outlined above for determining adjustments to the basis of a partner's interest. It has made it clear, however, that these adjustments need only to be made when it is necessary to determine the basis of a partner's interest and need not be made annually. It is generally necessary to know the basis of a partner's interest only in the case of a transfer of an interest or in the case of unusual distributions to the partner. Your committee has also provided, however, that in lieu of the relatively detailed adjustments outlined in the House bill for determining the basis of a partner's interest, this basis may be determined by reference to the partner's proportionate share of the adjusted basis of partnership property. The cases in which this alternative, or variations of this alternative, may be available to a partner are left to regulations.

(c) Changing or adopting new taxable years. -- Your committee is as concerned about the postponement of the reporting of partnership income by the partners as is the House. However, it also objects to the House provision which compels partners and partnerships to adopt calendar years unless permitted to do otherwise by the Secretary or his delegate. Without any standards in the statute, this leaves in too uncertain a status the types of cases which will be required to use a calendar year.
[p. 94]

In lieu of this provision your committee has provided that partners and partnerships may change to or adopt any year they see fit so long as both the principal partners and partnership change to or adopt the same year. For this purpose a principal partner is one who has an interest of 5 percent or more in the partnership. Moreover, different taxable years may be adopted by the partnership and its principal partners if a business purpose is established to the satisfaction of the Secretary or his delegate for different years.

(d) Transactions between partners and partnerships. -- Your committee believed that the House rule which treats gains from transactions between partners and partnerships as distributions or contributions was unduly harsh since there is little opportunity in this area to convert potential ordinary income into capital gains. Moreover, much more lenient treatment is already provided in the case of similar transactions between corporations and their stockholders.

In view of this your committee substituted for the House rules the present provisions applicable in the case of corporations. Thus, gains in such transactions will be recognized unless the partner involved has an interest of 80 percent or more. Where the interest is in excess of 80 percent, the gain is to be an ordinary gain. In the case of losses, the 50 percent rule is retained, as is provided for corporations. However, if the loss is in a transaction with a partner having an interest of more than 50 percent, the deduction for the loss is denied.

In the case of guaranteed salary payments your committee followed the House bill but made it clear that such income is to be reported for tax purposes at the end of the partnership year in which it is paid and that this treatment is only provided for purposes of the reporting of the income by the partner and the deducting of the payments by the partnership. Your committee also extended this treatment to guaranteed interest payments on capital.
B. Contributions to a Partnership (secs. 721-723)

(1) House changes accepted by committee

Contributions to a partnership will have the same effect under the provisions adopted by the House and your committee as under present practice. No gain or loss is to be recognized either to the contributing partner or to the partnership. The property contributed to a partnership is to have the same basis to the partnership for purposes of gain, loss, depreciation, and so forth, as in the hands of the contributor.

The basis of the contributing partner for his interest in the partnership is to be increased by the basis of the property transferred to the partnership. If the contributed property is subject to indebtedness, the basis of the contributing partner's interest is to be reduced by the portion of the indebtedness assumed by the other partners.

(2) Changes made by committee

Your committee made no changes in this provision.
C. Distributions (secs. 731-735)

(1) House changes accepted by committee

As is indicated below, your committee adopted quite different rules from those provided by the House for the tax treatment of distributions.
[p. 95]

Under the House bill, any property distributed by the partnership to a partner would, in general, have the same basis to the distributee partner as in the hands of the partnership, that is, a "carryover" basis. The money and property distributed would be applied in reduction of the basis of the interest of the distributee partner. After the basis of his interest has been used up, any further distribution of money or property would be taxed as capital gain to the distributee.

The distribution of money or property under the House bill would not result in gain or loss to the partnership. Gain or loss was to be recognized to the recipient partner where the basis of any money or property received by a partner exceeded the basis of the partner for his interest in the partnership. The recognition of gain would occur either in a current distribution not affecting the partner's relative interest in the partnership, or in a distribution which reduced or terminated the partner's interest in the partnership. The recognition of loss was limited to a distribution terminating the interest of the partner. In such a liquidating distribution, capital loss was recognized to the extent that the basis of the partner for his interest in the partnership exceeded the basis of the property distributed.

An exception is made to the use of the "carryover" basis where the basis of the property distributed exceeds its value at the time of the distribution. In this situation, the basis of the property to the distributee was to be reduced to the fair market value of the property. The partnership, however, was permitted to retain this "unused basis" and apply it to similar property held by the partnership.

A special rule was provided under the House bill for the purpose of distinguishing bona fide distributions which are subject to the rules discussed above from transactions involving a loan by the partnership to the partner. When a partner is obligated to make repayment to the partnership with respect to money or property received from the partnership, he was to be treated as receiving a loan to the extent of his obligation, and no reduction was to be made in the basis of his interest. If, however, such an obligation was canceled by the partnership without repayment, the partner would then be considered to have received a distribution equal to the amount of debt canceled. The transfer of property subject to an obligation to make repayment was treated as a sale by the partnership, so that gain or loss would be recognized to the partnership.

(2) Changes made by committee

Your committee has revised the general distribution rules provided by the House bill because of several objections which have been raised with respect to them. It has been pointed out that the assigning to the distributee of the partnership's basis for property distributed in liquidation of his interest and the recognition of gain or loss on the difference between this basis and the basis for his interest in many cases would result in the taxation of gains where there were no real gains and the recognition of losses where there were no real losses.

In lieu of the House rules for distributions, your committee has provided that in the case of liquidating distributions the distributee will substitute for the partnership basis of the property distributed the basis he had for his interest in the partnership. The basis to the distributee of inventory items and unrealized receivables, however, is to be limited to the basis they had in the partnership to prevent the
[p. 96]

conversion of ordinary income into capital gains. With respect to property other than inventory items or unrealized receivables, the basis of the partnership interest is to be allocated to such property in accordance with the basis of the property to the partnership.

To the extent the basis of the distributee for his interest in the partnership differs from the partnership basis for the distributed property the partnership may (if it has generally elected to make such adjustments) make adjustments to the basis of the property remaining in the partnership to the account of this difference.

The "carryover" provided by the House bill is continued by your committee in the case of nonliquidating distributions. However, instead of realizing gain where this basis for the property distributed exceeds the partner's basis for his interest, your committee's bill provides that the basis of the property distributed is not to exceed the partner's basis for his interest.

An exception to these rules is provided, as an optional arrangement, for a purchaser or transferee of an interest in a partnership. The purchaser or transferee may, in the case of a distribution within 2 years after the acquisition of the interest, apply as the basis of the distributed property the amount which he paid therefor and for partnership property of a like character in which he has relinquished his interest.

These new distribution rules limit quite narrowly the area in which gain or loss is recognized upon a distribution. Gain is to be recognized only where the money distributed is in excess of a partner's basis for his interest; and loss is to be recognized in the case of a liquidating distribution where only money, inventory items and unrealized receivables are distributed and their basis to the partnership is less than the basis of the partner's interest. These rules, combined with the nonrecognition of gain or loss upon contribution of property to a partnership, will remove deterrents to property being moved in and out of partnerships as business reasons dictate.

Your committee was also able to remove the House provision providing special rules where a partner's share of partnerships losses exceeds the basis of his interest by providing in a prior provision that such losses would be recognized to the partner when he repaid to the partnership the excess of the losses not offset by the basis for his interest.
D. Transfers of an Interest in a Partnership (secs. 741-743)

(1) House changes accepted by committee

The House and your committee's bill retain the general rule of present law that the sale of an interest in a partnership is to be treated as the sale of a capital asset. In general, the transfer of an interest will not affect the basis of partnership assets. Provision is made, however, whereby the partnership may elect to adjust the basis of partnership assets to reflect the increase or decrease in the basis of partnership interest transferred by sale or upon the death of a partner. The House bill provides that such an election, once filed, is irrevocable until the termination of the partnership and will require similar basis adjustments with respect to all future transfers of partnership interest. Your committee's bill provides, however, that the Secretary or his delegate may permit a new election. By making adjustments to the basis of partnership assets, the same effect is
[p. 97]

achieved as though the partnership had dissolved and been reformed, with the transferee of the interest as a member of the partnership. The increase or decrease in the basis of partnership assets may be allocated to such assets in accordance with their respective bases or in any other equitable manner approved by the Secretary or his delegate.

It is to be noted that under the House bill, if the election to increase or decrease the basis of partnership property is made, the change in the basis of the partnership assets will affect all members of the partnership according to their distributive shares and not merely the transferee partner. As indicated below, this is not true in the case of your committee's bill.

(2) Changes made by committee

In general, your committee has adopted the House provisions relating to transfers. There is one important exception, however. If the partnership elects to adjust the basis of partnership properties with respect to transfers, the adjustment, to the extent it represents appreciation or depreciation in the value of assets after their contribution to the partnership, is to be available only for the transferee partner. Thus, for purposes of depreciation, depletion, gain or loss, and in the case of distributions, the transferee partner, if the partnership elects to make any adjustment, will have a special basis for partnership properties wholly apart from the other partners.

Your committee believes that assigning this special basis largely to the transferee partner is desirable because it is more accurate than the House bill in reflecting the increase (or decrease) in basis to the partner to whom it is attributable. It should be clear, however, that partnerships are not required to make such adjustments if they do not desire to do so.
E. Payments to a Retiring Partner or Successor of a Deceased Partner (sec. 736)

(1) House changes accepted by committee

When a partner retires or payments are made to the estate or heir of a deceased partner, the amounts paid may represent several items. They may, in part, represent the withdrawing partner's capital interest in the partnership. They may include his pro rata interest in unrealized receivables and fees of the partnership and its potential gain or loss on inventory. Part of such payments may be attributable to an arrangement in the nature of mutual insurance among the partners. The present code contains no provisions relating to the tax treatment of such payments and existing case law presents no consistent approach.

Both the House and your committee's bill provide that when a retiring partner or the successor of a deceased partner receives a share of partnership income in return for the complete relinquishment of his interest in the partnership, the distributions are to be allocated between (a) payments for the value of the capital interest and (b) other payments. Such allocation will be made in accordance with regulations prescribed by the Secretary or his delegate.

The amounts paid for the capital interest of the withdrawing partner under both bills are treated in the same manner as a distribution. The remaining partners, of course, are allowed no deductions for such payments. Essentially, these payments represent a purchase by the
[p. 98]

remaining partners of the withdrawing partner's capital interest in the partnership. For this purpose payments for a "capital interest" do not include amounts attributable to a partner's interest in unrealized receivables and fees.

The House and your committee provide different treatment for the portion of the payments to a withdrawing partner which is not made in exchange for his capital interest. Under the House bill these payments are taxable to the withdrawing partner in the same manner as if he continued to be a partner and are excluded in determining the income of the remaining partners. However, the House bill provides that if such payments are continued for a period of more than 5 years after the retirement or death of the partner, they are to be treated as a gift from the remaining partners to the withdrawing partner. As a gift, the payments made after 5 years would be taxable to the remaining partners (with no increase in the basis of such partners for their interest in the partnership) and exempt from income tax in the hands of the recipient. The provision in your committee's bill, which has no 5-year limitation, is described below.

Where a retiring partner receives a lump sum or fixed payments determined without regard to the income of the partnership, the portion of such payments attributable to the capital interest of the retiring partner is to be treated as the purchase of a capital interest by the remaining partners. The balance, however, will be treated like a salary paid by the partnership. It will constitute ordinary income to the recipient and a deduction to the partnership. This part of the provision is the same under both versions of the bill except that payments of this nature, however, are subject to the 5-year limitation.

(2) Changes made by committee

Your committee made one major change in the House provision relating to the treatment of payments to a retiring partner or successor to a deceased partner. The 5-year rule in the House bill has been abandoned. Thus, to the extent that payments to a retiring partner or deceased partner's successor are not in exchange for a capital interest, they are treated as deductions to the remaining partners and as income to the withdrawing partner or his successor irrespective of over how long a period they may be paid. In addition, amounts paid for unrealized receivables and for goodwill (unless the partnership agreement provides otherwise) are also treated as deductions to the remaining partners and as income to the withdrawing partner or his successor.
F. Collapsible Partnership and Other Provisions Common to Distributions and Transfers (secs. 751-755)

(1) House changes accepted by committee

In order to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests or by distributions of property, certain rules have been adopted by the House and your committee which will apply to all dispositions of partnership interests. The bill provides that if, in connection with the transfer of a partnership interest, the partner receives any amount attributable to his share of (1) the unrealized receivables of the partnership or (2) substantially appreciated inventory or stock in trade, such amount are to be treated as ordinary gain or loss. In effect, the partner is treated as though he disposed of such items independently of the rest
[p. 99]

of his partnership interest. The same situation exists where a distribution to a partner has the effect of a sale of all or a part of his proper share of receivables or appreciated inventory items.

Since, in the case of a transfer an ordinary income tax is paid by the seller on these items, the purchaser of an interest is permitted under the House bill to exclude from his gross income an amount equal to the income recognized by the seller with respect to such items. This amount was to be spread ratably over the period of time in which it is estimated that the unrealized receivables will be collected or the inventory disposed of, or could be allocated in any other equitable manner which is approved by the Secretary. These exclusions are also available in the case of disproportionate distributions since essentially this also is an exchange. Under your committee's bill this special exclusion is unnecessary because the transferee may have, if the partnership so elects, a special basis for partnership assets.

The term "unrealized receivables" applies to any rights to income which have not been included in gross income under the method of accounting employed by the partnership. The provision is applicable mainly to cash basis partnerships which have acquired a contractual or other legal right to income for goods or services. "Substantially appreciated inventory items" includes any noncapital assets, the value of which exceeds by more than 20 percent the basis of such inventory and exceeds by more than 10 percent the value of all partnership property other than money.

The provisions relating to unrealized receivables and appreciated inventory items are necessary to prevent the use of the partnership as a device for obtaining capital-gain treatment on fees or other rights to income and on appreciated inventory. Amounts attributable to such rights would be treated as ordinary income if realized in normal course by the partnership. The sale of a partnership interest or distributions to partners should not be permitted to change the character of this income. The statutory treatment proposed, in general, regards the income rights as severable from the partnership interest and as subject to the same tax consequences which would be accorded an individual entrepreneur.

The House bill provides that a decedent partner's share of unrealized receivables are to be treated as income in respect of a decedent. Such rights to income are to be taxed to the estate or heirs when collected, with an appropriate adjustment for estate taxes. However, a decedent's share of appreciated inventory or stock in trade is not treated as income in respect of a decedent. The decedent's interest in such inventory or stock in trade may be increased or decreased in basis in the same manner as his partnership interest and other property held by the decedent. Any change in the basis of partnership assets will be used by the estate or heir as an adjustment to the income received on the disposition of such property. The estate or heir is thus treated in the same manner as a purchaser with respect to the decedent's interest in appreciated or depreciated inventory or stock in trade. Your committee's bill agrees substantially with the House in the treatment described above but also provides that other income apart from unrealized receivables is to be treated as income in respect of a decedent.
[p. 100]

(2) Changes made by committee

Your committee's bill in general follows closely the House bill in the area described above but differs or several points, the more important of which are listed below:

(a) No exclusion needs to be provided the transferee or in the case of distributions of unrealized receivables or inventory items since the transferee or partnership may obtain a special basis for such assets or may elect to adjust the basis of partnership property.

(b) Substantially depreciated inventory items have been removed from the category of assets receiving separate treatment.

(c) The definition of substantially appreciated inventory items has been revised to relate to 10 percent of the value instead of the basis of total partnership assets.

(d) The treatment for income in respect of decedents has been expanded to include any payments to a deceased partner's successor not considered a payment for the partner's capital interest.

(e) The election to adjust the basis of partnership assets upon a transfer or distribution have been made operative as one election.
* * *
(DETAILED DISCUSSION OF THE TECHNICAL PROVISIONS OF THE BILL)
* * *
[p. 385]
Section 706. Taxable years of partner and partnership

Subsection (a) of the House bill and your committee's bill corresponds to section 188 of the 1939 Code and makes no substantive change. It requires a partner, in computing his individual income tax to include his distributive share of partnership items for any partnership year ending within or with his taxable year. A partnership taxable year shall be determined as though the partnership were a taxpayer.

The provision has been amended by your committee by including a reference to section 707 (c), in order to make clear that payments made to a partner for services or for the use of capital are includible in his income at the same time as his distributive share of partnership income for the partnership year when the payments are made or accrued namely, in the taxable year of the partner with or within which the partnership year ends.

Subsection (a), as revised by your committee, may be illustrated as follows:

Partner A is on a calendar year while the partnership is on a fiscal year ending June 30. A receives payments regularly during the partnership year ending June 30, 1956, representing a guaranteed salary and guaranteed payments for the use of capital loaned to the partnership. During this partnership fiscal year, half of the total amount paid to him is received between July 1 and December 31, 1955. The other half is received between January 1 and July 31, 1956. The entire amount received is includible in A's return for the calendar year ending December 31, 1956, along with his distributive share of partnership income for the partnership year ending June 31, 1956.

Subsection (b) has also been amended by your committee in order to liberalize the rule stated therein. Under the amended provisions a partnership may change to, or adopt, a taxable year which is the same as that of all its principal partners, without receiving permission of the Secretary or his delegate. It may also change to, or adopt a taxable year of its own selection if the principal partners are on the same taxable year, or simultaneously change to the same taxable year. Similarly, a principal partner may adopt a taxable year the same as that of the partnership without receiving permission. Of course any change of taxable year by a partner would be subject to the law and regulations applicable to changes in taxable years of individuals.

It is recognized that in many cases it will not be practical for all the principal partners to adopt the same taxable year as the partnership, or that it may become necessary for a principal partner to change to a taxable year other than that of the partnership. It is, therefore, provided that a partnership may adopt or change to a fiscal year other than that of all its principal partners, and that a principal partner may change to a fiscal year other than that of the partnership, if a business purpose for the desired change is established to the satisfaction of the Secretary or his delegate.

The term "principal partner" is defined in subsection (b) (3) to include any partner having an interest in partnership profits or capital of 5 percent or more.

Subsection (c) provides rules relating to the closing of the partnership taxable year in the case of changes in the membership of the partnership.
[p. 386]

Paragraph (1) provides that, as a general rule, the taxable year of a partnership shall not, unless the partnership agreement otherwise provides, close as the result of the death of a partner, the addition of a new partner, or the liquidation or the sale or exchange of a partner's interest.

Paragraph (2) provides that, in the case of a partner whose entire interest is liquidated, or sold or exchanged, the taxable year of the partnership shall close with respect to such a partner. The partner's distributive share of items described in section 702 (a) with respect to the short partnership taxable year shall be determined under regulations. However, in the case of a partner who dies, the partnership taxable year shall not close with respect to such partner prior to the end of the normal partnership year, unless (1) the deceased partner's interest is liquidated before that date, and (2) the partnership agreement provides that the partnership year will close with respect to the deceased partner on such a liquidation.

The closing of the partnership taxable year under paragraph (2) occurs only in the case of a partner who no longer retains any interest in the partnership. If a partner's interest is merely reduced, the partnership year with respect to that partner will continue. His distributive share of partnership items required to be included by him in accordance with section 702 (a) will be determined by taking into account the fact that his profits interest may have varied during the partnership taxable year.

The application of these provisions in the case of the death of a partner may be summarized as follows. The partnership taxable year will continue to its normal conclusion both for the remaining partners and with respect to the decedent partner. The last return of the decedent partner will include only his share of partnership income for the partnership taxable year ending with or within the last taxable year of the decedent partner. The income of the succeeding partnership taxable year which is attributable to the interest of the decedent in the partnership will be includible in the return of his estate or successor in interest. In general, the same rule applies, except as modified by the partnership agreement, where the interest of the decedent partner in the partnership is liquidated in connection with his death.

If, however, the partnership is terminated, the taxable year of the partnership will close with respect to all the partners. The termination of a partnership is defined in section 708 (b).
Section 707. Transactions between partner and partnership

Subsection (a) provides the general rule that a partner who engages in a transaction with the partnership, other than in his capacity as a partner, shall be treated as though he were an outsider. Such transactions include the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership or by the partnership to the partner. Transactions involving contributions of money or property to the partnership by the partner, or distributions of money or property by the partnership to the partner are not governed by this section.

Subsection (b) provides an exception to the general rule in the case of sales of property between the partnership and a controlling
[p. 387]

partner which is designed to prevent tax avoidance through the realization of fictitious losses or increasing the basis of property for purposes of deprecation. The provisions of the House bill, however, have been amended by your committee by adopting the rules comparable to those which are applicable in the case of sales of property between corporations and controlling shareholders under sections 267 and 1240.

Under paragraph (1) deductions for losses on the sale or exchange of property, directly or indirectly, between a partnership and a partner owning, directly or indirectly, more than 50 percent of the capital or profits interest in such partnership, are disallowed. Similarly, losses from sales of property between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital or profits interests are disallowed.

Where a loss is disallowed under paragraph (1), the last sentence of paragraph (1) provides that section 267 (d) shall be applicable as though the loss were disallowed under section 267 (a) (1). Accordingly, when the purchaser of the property with respect to which the loss was disallowed subsequently sells or disposes of such property gain shall be recognized only to the extent it exceeds the disallowed loss properly allocable to the property.

Paragraph (2) provides that upon a sale or exchange, directly or indirectly, of property, which in the hands of the transferee is depreciable property, inventory, stock in trade, or any other property which is not a capital asset, any gain recognized shall be ordinary gain, if the sale or exchange takes place between a partnership and a partner owning, directly or indirectly, more than 80 percent of the capital or profits interest in such partnership, or between two partnerships in which the same persons own, directly or indirectly, more than 80 percent of the capital or profits interests in each partnership.

Paragraph (3) provides that for purposes of paragraphs (1) and (2), the ownership of a capital or profits interest in a partnership is to be determined in accordance with the rules relating to the determination of stock ownership provided in section 267 (c) other than paragraph (3) thereof.

Subsection (c) provides a rule with respect to guaranteed payments to members of a partnership. A partner who renders services to the partnership for a fixed salary, payable without regard to partnership income, shall be treated, to the extent of such amount, as one who is not a partner, and the partnership shall be allowed a deduction for a business expense. The amount of such payment shall be included in the partner's gross income, and shall not be considered a distributive share of partnership income or gain. A partner who is guaranteed a minimum annual amount for his services shall be treated as receiving a fixed payment in that amount.

The House provisions were amended by your committee to accord the same treatment as that provided in the case of guaranteed salaries to payments for the use of capital, to the extent the payments are determined without regard to partnership income. It should be noted that such payments, whether for services or for the use of capital, will be includible in the recipient's return for the taxable year with or within which the partnership year in which the payment was made, or accrued, ends.
[p. 388]
Section 708. Continuation of a partnership

This section is essentially the same as section 761 (e) of the House bill with minor additions.

Subsection (a), which has been added by your committee, makes clear that a partnership will be considered as continuing until such time as it is deemed terminated under section 708 (b). Subsection (a) has general application for purposes of subchapter K.

Subsection (b) is, with minor technical changes, essentially the same as section 761 (e) of the House bill. Paragraph (1) provides that a partnership shall be deemed terminated only if no part of the business, financial operations, or ventures of the partnership continue to be carried on by the partners in any partnership, or if, within a 12-month period, there is a sale or disposition of 50 percent or more of the total interest in partnership capital or the total interest in partnership profits.

Paragraph (2) provides rules applicable to mergers or divisions of partnerships. When two partnerships merge or consolidate, the resulting partnership shall be considered a continuation of the original partnership, the members of which own an interest of more than 50 percent in the capital or the profits of the resulting partnership. When a partnership is divided into two or more partnerships, all resulting partnerships shall, for the purpose of applying the general rule for termination of a partnership, be considered a continuation of the partnership existing before the division. However, any of the resulting partnerships whose members had held a combined interest in the original partnership of 50 percent or less in such partnership's capital or profits shall not be treated as a continuation of the original partnership.

Subsection (c) makes clear that termination of a partnership is optional, and that partnerships qualifying under subsection (b) to be terminated may elect, subject to regulations to be prescribed by the Secretary or his delegate, to be considered as continuing in existence.
* * *
[p. 396]
SUBPART C -- TRANSFERS OF INTERESTS IN A PARTNERSHIP
Section 741. Recognition and character of gain or loss on sale or exchange

Except for technical amendments, this section corresponds to the House provision. It provides that the sale or exchange by a partner of his interest in the partnership shall be treated generally as the sale or exchange of a capital asset. Any gain or loss shall be treated as capital gain or loss unless the partnership has unrealized receivables, or inventory items which have substantially appreciated in value, as defined in section 751. If section 751 is applicable, a portion of the gain or loss shall be treated as ordinary income or loss.
[p. 397]
Section 742. Basis of transferee partner's interest

Except for technical amendments, this section corresponds to the House provision. It provides that, in general, the unadjusted basis to a transferee partner of an interest in a partnership shall be determined under the basis rules for property provided by part II of subchapter O (sec. 1011 and following). For example, the basis of a purchased interest will be its cost, and the basis of an interest transferred upon the death of a partner will be the fair market value of the interest at death or the optional valuation date.
Section 743. Optional adjustments to basis of partnership property

This section contains several amendments, both substantive and technical, to section 743 of the House bill. Your committee's bill provides that, with certain exceptions, the adjustment to the basis of partnership assets will affect only the transferee partner. In addition, the House provisions with respect to the allocation of basis adjustments among the partnership properties and the manner of electing to make such adjustments (sec. 743 (c) and (d) of the House bill) have been transferred to sections 755 and 754 of your committee's bill.

Subsection (a) states the general rule that the transfer of an interest in a partnership, either by sale or exchange, or as the result of the death of a partner, although affecting an adjustment to the basis of the transferred interest, will not result in an adjustment to the bases of the partnership properties.

Subsection (b) provides, however, that a partnership may elect to adjust the bases of the partnership assets in order to reflect the increase or decrease in the basis of a transferred interest in the partnership. A partnership making this election shall increase the adjusted bases of the partnership properties by the amount by which the basis of the transferee partner's interest in the partnership exceeds the adjusted basis of the transferor's interest immediately prior to the transfer. In the event that the adjusted basis of the transferor partner's interest in a partnership immediately prior to the transfer exceeds the basis of the transferee partner for his interest, then the adjusted bases of the partnership properties shall be decreased by the amount of this excess. Rules relating to the method of making the election and the effect of the election upon subsequent transfers of interests in the partnership are set forth in section 755.

Subsection (b) further provides that, under regulations prescribed by the Secretary or his delegate, increases and decreases in the basis of the partnership assets are to constitute an adjustment affecting the transferee partner only. However, such adjustment shall be allocated among the partners to the extent that the increase or decrease is attributable to the difference between the value and the unadjusted basis to the partnership of contributed property at the time of its contribution. The application of this provision is described below.

Subsection (b) also provides that when an adjustment is made to the basis of depletable property under subsection (b) as the result of a transfer of an interest in the partnership, any future depletion allowance shall be determined separately with respect to the transferee partner's interest in such property.

Subsection (c) provides that the allocation of the increase or decrease in basis provided in subsection (b) among the partnership properties shall be in accordance with the rules set forth in section 755.
[p. 398]

The application of subsection (b) may be illustrated as follows:

Assume that partner A dies when the balance sheet of the ABC partnership is as follows: 
                    Assets                          Liabilities and capital     
                            Adjusted   Market                 Adjusted   Market 
                             basis     value                   basis      value 
  Cash                        $5,000   $5,000   Liabilities    $10,000   $10,000
  Accounts receivable         10,000   10,000   Capital:                        
  Property X (inventory)      20,000   21,000   A               15,000    22,000
  Property Y (depreciable                                                       
  assets)                     20,000   40,000   B               15,000    22,000
                                                C               15,000    22,000
  Total                       55,000   76,000                   55,000    76,000

The partnership has made the election to adjust the basis of partnership assets upon transfer of an interest and, therefore, $7,000, the difference between the adjusted basis of A's partnership interest and the value of such interest at death is to be allocated to the basis of partnership assets.

In accordance with section 755, the allocation may be made in a manner which has the effect of reducing the difference between the fair market values and the adjusted bases of the partnership properties, except that adjustments attributable to capital and depreciable assets must be allocated to properties of a like character, and adjustments attributable to other assets, such as inventory or stock in trade, must be allocated to properties of a like character. Applying this rule to the instant illustration, the total amount of appreciation is $21,000 ($1,000 on property X, and $20,000 on property Y). The basis adjustment is $7,000, or one-third of the $21,000 of appreciation. Applying the rule of section 755, $333 (one-third of $1,000, the excess of the market value over the basis of property X) is allocable to property X, and $6,666 (one-third of $20,000, the excess of the market value over the basis of property Y) is allocable to property Y. The amount so allocable constitutes an adjustment with respect to the transferee partner only (assuming that property X and property Y were not contributed to the partnership).

Assume that A's son, M, takes over his father's interest and that following the transfer of the partnership interest, the partnership sells its inventory, property X which has further appreciated in value, for $24,000. Since the basis of such inventory to the partnership is $20,000, there is $4,000 of ordinary income to be allocated to the partners, $1,333 to each partner. The tax positions of B and C remain unchanged as the result of the transfer and each has $1,333 of income to report. M, on the other hand, has additional basis of $333 will respect to the inventory which reduces his gain to $1,000. The amount of gain to each partner is as follows: $1,333 to B, $1,333 to C, and $1,000 to M.

Assume that for the partnership year following the transfer of the partnership interest, the partnership's allowance for depreciation with respect to property Y, which is depreciable at a rate of 10 percent, is $2,000 (or 10 percent of $20,000, the partnership common basis) of which each of the three equal partners would receive the benefit of a depreciation deduction of $667. The tax position of B and C remains
[p. 399]

unchanged as the result of the transfer, and each will still have an annual deduction of $667. M, on the other hand, has additional basis of $6,667 with respect to Y, the depreciable property, and consequently, an additional depreciation deduction of $667. The depreciation deductions allowable with respect to property Y are as follows: $667 to B, $667 to C, and $1,333 to M.

The same adjustment as that described above would be made if partner A had sold his partnership interest to an outsider for $22,000.

The provision in subsection (b) that the adjustment to the basis of partnership property shall be allocated among the partners, rather than solely to the transferee, to the extent that it is attributable to the difference between the basis of contributed property and its value at the time of contribution may be illustrated as follows:

(1) Assume that A and B form a partnership AB to which A contributes X, a depreciable asset worth $1,000, with an adjusted basis to him of $400. B contributes $1,000 in cash. During the partnership's first taxable year X appreciates in value to $1,200, and A sells his half interest in the partnership to C for $1,100. Under the rule stated in subsection (b) (1), the adjusted basis of the partnership property, $400, will be increased by the excess of the transferee's basis for his partnership interest, $1,100, over the transferor's basis for his interest immediately prior to the transfer, $400. The amount of the increase is $700. Of this amount, only $100 is attributable to the post-contribution appreciation of X. $600 is attributable to the difference between the basis and the value of X at the time it was contributed. Thus, there is a $100 basis adjustment with respect to the transferee only. The remaining $600 is to be allocated among the partners.

Assuming that the partnership has no special partnership agreement with respect to the allocation of gain or loss or depreciation with respect to X, the $600 will simply be added to the basis of the property for the equal benefit of both partners. Thus, if X which now has a basis of $1,000 to the partnership (the original $400 increased by the $600, available to all the partners), is sold for $1,400, the gain of $400 is allocable $200 to B and $200 to C. However, C has a special basis adjustment of $100 which reduces his taxable gain to $100. The gain recognized therefore is $200 to B and $100 to C.

(2) Assume that the original partnership AB had a special agreement with respect to X, stating that upon the sale of property X, gain to the extent attributable to pre-contribution appreciation was to be allocated entirely to the contributing partner A, and that all the depreciation with respect to X while held by the partnership was to be allocable to B. As the result of a sale by A of his interest in the partnership to C, the $100 attributable to post-contribution appreciation would be allocated to the transferee and the $600 attributable to the pre-contribution appreciation would be allocated to the partnership. The $1,000 of basis belonging to the partnership generally (the $400 original basis plus the $600 adjustment under section 743) would now be shared between the partners exactly as under illustration (1) ($500 to each partner) with a special adjustment to the transferee only of $100 additional basis. In effect, the original partnership agreement with respect to X could be said to have allocated X's original basis of $400 entirely to B with nothing to A. As the result
[p. 400]

of the purchase by C, however, the $700 added to the basis of X is divided as follows: Of the $600 attributable to pre-contribution appreciation, $500 is allocable to C and $100 to B. Thus B's share of the $1,000 for X is $500 ($400 allocated to him under the partnership agreement, plus $100 resulting from the adjustment) and C's share is $500 (attributable to the pre-contribution appreciation). C has an additional special basis of $100.

In the event of a distribution by a partnership to a transferee partner of property with respect to which the distributee has special transferee basis under subsection (b), such property shall, for purposes of distributions by the partnership, be deemed to have a basis to the partnership equal to the sum of its common basis shared by all partners and its special basis with respect to the transferee only. In the case of a non-transferee partner receiving a distribution of property with respect to which special basis is allocated to a transferee partner, the property will be deemed to have a basis to the partnership consisting only of its common basis shared by all the partners. No special basis allocated to a transferee will be included. A transferee partner receiving a distribution of property in exchange for his interest in like property with respect to which he has a special transferee basis, will be permitted to apply to the property received his special basis with respect to the interest relinquished in such other property. The property in which he has relinquished his interest may remain in the partnership or may be distributed to the other partners.

The above principle may be illustrated as follows: C is a transferee partner in partnership BC. The partnership owns, among other assets, X, a depreciable asset, with a common basis to the partnership of $100 and an additional transferee basis to C of $20, and Y, another depreciable asset, with a common basis of $80 and an additional transferee basis to C of $30. B and C agree that B will receive a distribution of Y, and C will receive a distribution of X without diminishing either partner's relative interest in the partnership. With respect to B, the partnership basis of Y is $80, the common partnership basis. Y will, therefore, continue to have a basis of $80 in B's hands under section 732 (a), which provides for the use of a carryover basis in the case of nonliquidating distributions. With respect to C, however, the partnership basis of X is $150, the common partnership basis of $100, plus C's additional transferee basis of $20 for property X, plus C's additional transferee basis of $30 for property Y, in which he has relinquished his interest.

The requirement that depletion with respect to partnership property the basis of which has been adjusted as the result of a transfer of a partnership interest, is to be determined separately with respect to the transferee's interest in such property may be illustrated as follows:

A and B each contribute $5,000 to partnership AB which purchases oil property for $10,000. Shortly thereafter, oil is discovered and B sells his partnership interest to C for $100,000. The difference between B's and C's basis, $95,000, is allocated to the oil property. A's share of basis with respect to the oil property remains $5,000. C's basis is $100,000 -- $5,000, his half share of the common partnership basis, plus $95,000, his additional transferee basis. Assume that, at the end of the partnership year, cost depletion with respect to A's half interest which has a basis of $5,000 is $500, and cost depletion with respect to C's half interest with a basis of $100,000 is
[p. 401]
$10,000. Under the percentage method, however, A and B would each be entitled to a $7,000 allowance. With respect to A, percentage depletion is greater. A will, therefore, be allowed a deduction of $7,000. With respect to C, cost depletion is greater. C will, therefore, be allowed a deduction of $10,000.
Worksheet 6
Excerpts from House Ways and Means Committee Report to the Deficit Reduction Act of 1984; H.R. Rep. No. 432, 98th Cong., 2d Sess. (1984).
[p. 1211]
2. Retroactive Allocations (sec. 72 of the bill and Sec. 706 of the Code)
Present Law
General rules

The Tax Reform Act of 1976 amended the partnership provisions to preclude a partner who acquires his interest late in the taxable year from deducting partnership expenses incurred prior to his entry into the partnership (so-called "retroactive allocations" of partnership losses). The 1976 Act provided that when partners' interests change during the taxable year, each partner's share of various items of partnership income gain, loss, deduction and credit is to be determined by taking into account each partner's varying interest in the partnership during the taxable year.

Present law allows two basic methods for determining the amount of a partnership's income, gain, loss, deduction, and credit which may be allocated to a partner entering during the taxable year. The first method provides for an "interim closing" of the partnership books whenever a new partner enters the partnership. This method traces partnership income, gain, loss, deduction, and credit to the particular segment of the partnership taxable year during which it is incurred. For example, a partner admitted on December 1 to a partnership using a calendar taxable year could be allocated only his share of items incurred by the partnership during the month of December.

The second method allowed by present law provides for a proration of partnership income, gain, loss, deduction, and credit for the entire taxable year. This proration is generally based on the number of days in the partnership taxable year during which the entering partner was a member of the partnership divided by the total number of days in the partnership taxable year. The entering partner's share of each partnership item for the taxable year is determined by multiplying this fraction by the amount of partnership income, gain, loss, deduction, and credit that the partner would have been allocated had he been a partner for the entire partnership taxable year. For example, a partner admitted on December 1 to a partnership having a calendar year taxable year would be allocated 1/12 of his hypothetical share of items for the entire partnership taxable year, regardless of the point during the year at which these expenses were incurred.

To avoid undue complexity, present law generally permits use of a convention (for both the interim closing and proration method) under which partners are treated as entering on a semi-monthly basis. That is, partners
[p. 1212]

entering in the first half of a month can all be treated as entering on the first day of the month and partners entering in the last half of the month can be treated as entering on the 16th day of the month.
Techniques for avoiding retroactive allocation rules

Tiered arrangements

Some taxpayers have attempted to avoid the retroactive allocation rules by use of tiered partnership arrangements combined with the interim closing method of allocations. For example, assume that Parent partnership owns a 90 percent interest in Subsidiary partnership and that both Parent and Subsidiary use calendar year taxable year. Assume further that Subsidiary has a $10,000 loss for the calendar year 1983, and that Parent's distributive share is $9,000. If Partner A buys an 80-percent interest in Parent at the close of business on December 31, 1983, Parent may make an interim closing of its books on December 30, 1983, in order to determine A's distributive share of partnership items. Parent may take the position that, for tax purposes, it incurs its entire $9,000 portion of Subsidiary's loss on December 31, 1983, i.e., at the close of Subsidiary's taxable year, regardless of when the loss was actually incurred by subsidiary. Partner A will, therefore, claim a $7,200 loss on his 1983 return (Parent's $9,000 loss multiplied by his 80-percent interest in the partnership on December 31, 1983) rather than the $19.73 that he would be entitled to under a proportioned share computation (i.e., $9,000 X 80% X 1/365 days).

The Internal Revenue Service has taken the position that, in the situation above, losses are sustained by the parent partnership in this case at the same time they are sustained by the subsidiary partnership and that the limitation against retroactive allocations is equally applicable in this situation. Rev. Rul. 77-311, 1977-2 C.B. 218. However, taxpayers may continue to take a contrary position on their returns.
Cash basis partnerships

In addition to tiered arrangements, partnerships may attempt to avoid the retroactive allocation rules by using the cash method of accounting and deferring actual payment of deductible items until near the close of the partnership's taxable year. For example, if a partnership defers the payment of an expense (e.g., interest) until December 31, and the partnership uses the interim closing method of allocations, a partner admitted on December 31 may be allowed a deduction for a full portion of the expense. This may be the case although the expense has economically accrued at an equal rate throughout the taxable year.
Reasons for Change

The 1976 rules were enacted to clarify that the law required the inclusion of income and loss according to a partner's varying interests during the taxable year. Legislative history indicates that Congress, in adding these rules, intended to prevent partners investing in a partnership toward the close of the taxable year from deducting expenses which were incurred prior to their entry into the
[p. 1213]

partnership.4 In adding these rules, Congress rejected the argument that retroactive allocations were proper because the funds invested by the new partners served to reimburse the original partners for their expenditures so that, as an economic matter, the new partners had incurred the costs for which they were claiming deductions. This argument was found unpersuasive when the new partner was compared with an investor directly purchasing property which had generated tax losses earlier in the taxable year; that investor would clearly not be entitled to deduct the losses incurred prior to his ownership of the property.
4H. Rep. 94-658, accompanying H.R. 10612, 94th Cong., 1st Sess., P. 124 (November 12, 1975); S. Rep. 94-938, 94th Cong., 2d Sess. p. 97 (June 10, 1976).

The committee believes that the policy of the 1976 act prohibiting retroactive allocations and the rationale for that policy remain equally applicable today. Taxpayers should not be able to attempt to avoid the 1976 rules through the use of tiered or other arrangements.

The committee recognizes that the use of cash method partnerships raises issues distinct from tiered arrangements and that the cash method may be appropriate for partnerships in certain circumstances. However, the committee believes that the cash method should not be used to create deductions for late-entering partners. Accordingly, the bill requires that cash basis items generally be prorated over those days during the year to which they are economically attributable and that each partner take into account only that portion of each item attributable to that portion of the year for which he is a partner. This rule will prevent abuses associated with retroactive allocations without causing undue hardship or administrative burdens to cash basis partnership. To prevent undue burdens, the bill provides that Treasury regulations may provide reasonable procedures for complying with the daily proration rule.
Explanation of Provision
General rule

The bill provides a general rule comparable to the present rule that if any partner's interest in a partnership changes at any time during the partnership's taxable year, each partner's share of any item of partnership income, gain, loss, deduction, or credit is to be determined by using any method prescribed by Treasury regulations which takes into account the varying interests of the partners in the partnership during the taxable year. It is anticipated that these regulations will apply the law in a manner consistent with the policies of the Tax Reform Act of 1976 and of the new provisions.
Cash basis partnership

With respect to partnerships using the cash method of accounting, the bill provides new rules for the allocation of items among partners when there is a change in partnership interests. First, for specified cash basis items, the bill requires that the item be assigned to each day in the period to which it is attributable. The
[p. 1214]

amounts so assigned are then apportioned among the partners in proportion to their interest in the partnership at the close of each day. These rules (which apply except when regulations otherwise provide) effectively require, for purposes of determining the partners' varying interests in a partnership taxable year, that certain items be allocated under the accrual method. The items to which the provision applies are (1) interest, (2) taxes, (3) payment for services or for the use of property, and (4) any other item of a kind specified in Treasury regulations as an item with respect to which the rule is necessary to avoid retroactive allocations to the partners.

For example, if a new partner joins a calendar-year partnership on December 1, and if the partnership on December 1 pays an interest expense which has accrued over the course of the entire year, the partner would be entitled to 1/12 of his otherwise allocable share of deduction for that item. If the expense were attributable only to the final 6 months of the year, he would receive 1/6 of his otherwise allocable share of that item. The committee intends that the determination of the period to which an expense is attributable will be made in accordance with economic accrual principles.

The bill provides that when application of the economic accrual principles described above would result in allocating an item to periods before or after the current taxable year, those items are to be allocated entirely to the first in the case of items allocable to prior years and entirely to the last day of the year in the case of items allocable to future periods. This rule does not make any substantive change to the timing of any deduction under present law; rather, it merely describes the treatment of amounts that are currently deductible even though allocable to a past or future year in economic terms. For example if a cash method partnership failed to pay for services provided to it in year 1 until the middle of year 2, the amount of the year 2 deduction would be allocated to the first day of year 2. Similarly, if the partnership was required to pay property taxes in year 1 for the last half of year 1 and the first half of year 2, the amount allocable to year 2 would be treated as paid on the last day of year 1. Of course, this latter rule will have limited application due to the limitations on the deductibility of prepaid expenses.
Tiered partnerships

The bill provides that, if a parent partnership holds an interest in a subsidiary partnership, then (except to the extent provided by regulations) the parent, partnerships share of any item of income, gain, loss, deduction, or credit of the subsidiary partnership is to be prorated equally over that portion of the taxable year during which the parent partnership had an interest in the subsidiary. For example, if a new partner who has a 25-percent interest in all partnership items enters a parent partnership that is on a calendar taxable year on December 1, and the parent has had a 50-percent interest in a calendar year subsidiary partnership for the subsidiary's entire year, then that partner would be allocated 1/96th of the subsidiary's items for the taxable year (regardless of when each item was actually incurred). (That is his 1/4th share of 1/12th of
[p. 1215]

the parent's 1/2 of the items of an entire year.) If the parent had an interest in the subsidiary beginning July 1, the partner would be allocated 1/192nd of each of the subsidiary's items. (That is his 1/4 share of 1/12th of parent's 1/2 of the items for 1/2 of the year.) These rules are intended to prevent the use of tiered partnership to avoid the retroactive allocation rules.
Other rules

The bill provides that the daily apportionment rule will apply except to the extent provided by Treasury regulations. In this connection, the committee recognizes that most partnerships do not account for the admission of new partners on a daily basis and that daily apportionment of partnership income and expenses would thus result in an undue administrative burden. Accordingly, to prevent undue complexity, it is anticipated that the regulations will provide, in part, that a partnership has complied with the daily proration of the statute even though it operates under the semi-monthly convention described under present law, above.

The committee does not intend that any inference be drawn regarding the present law treatment of either the tiered partnership or cash methods arrangement for allowing retroactive allocations.
Effective Dates

The rule regarding tiered partnerships is effective for amounts paid or accrued after March 31, 1984. The rule regarding cash basis partnerships is effective for amounts attributable to periods after March 31, 1984.
Revenue Effect

This provision will increase fiscal year budget receipts by $50 million in 1985, $75 million in 1986, $100 million in 1987, $100 million in 1988, and $100 million in 1989.
[p. 1216]
3. Payments to Partners for Property or Certain Services (sec. 73 of the bill and secs. 707 and 709 of the Code)
Present Law
General background

The contribution of property to a partnership in return for a partnership interest is generally a tax-free transaction (sec. 721). If, instead of contributing property to a partnership, the taxpayer sells property to the partnership, the taxpayer realizes income to the extent of gain on the sale and the partnership is generally required to capitalize the amount of the purchase price, which may be deductible over the useful life of the property (or any applicable accelerated recovery period). When services are provided to a partnership, the partnership may generally deduct amounts paid or incurred for such services unless such expenses are required to be capitalized) and the party providing services must include an equivalent amount in income. This rule also applies to services provided by a partner acting in a capacity other than that of a member of the partnership.

When a partnership allocates income from partnership operations among its partners, the partners generally include these amounts in income in the year taxable to the partnership. This is distinct from a distribution of partnership assets, which is generally tax-free to the extent that the amount distributed does not exceed the recipient partner's basis for his partnership interest. This tax-free treatment is based, in part, on the theory that a partner is entitled to withdraw his investment in a partnership before recognizing gain on the investment.

Although amounts allocated to a partner are not deductible by the partnership, an allocation of taxable income to one partner may have the effect of a deduction for the remaining partners by reducing the amount of taxable income allocated to them.
Avoidance of capitalization requirement for payments for property or services

A partnership, like any taxpayer, is generally required to capitalize (rather than currently deduct) expenditures which relate to the improvement of property or which create an asset the useful life of which extends substantially beyond the end of the taxable year. Present law (sec. 709) provides specifically that a partnership may not currently deduct amounts paid or incurred to organize the partnership. Instead, the partnership is permitted an election to deduct these amounts ratably over a 5-year period. Alternatively, the partnership may capitalize these expenses. The denial of current deductions for organizational expenses was made explicit by the Tax Reform Act of 1976. In addition, neither the partnership
[p. 1217]

nor any partner is ever permitted to deduct partnerships syndication expenses.

If the organizer or syndicator of a partnership is also a general partner of the partnership, allocations of partnership gross or net income to the organizer and related distributions to him in payment for his services, if recognized, could have the effect of a current deduction for organizational and syndication fees despite the rules above. This results because the allocation, which in this case when coupled with an equivalent distribution is economically indistinguishable from a direct payment, reduces the taxable income allocated to the remaining partners in the year of the allocation. The capitalization requirement for other types of capital expenditures can also be avoided by this type of arrangement.

Present law (sec. 707) provides that, if amounts are paid or payable to a partner when he engages in a transaction with the partnership in a capacity other than as a member of the partnership, or if guaranteed payments are made to a partner for services or use of capital capitalization is required to the same extent as with comparable payments to a non-partner. This rule prevents the use of partnership allocations to pay for goods and services under certain conditions. The courts, however, have held that payments based on partnership gross income generally are not to be regarded as guaranteed payments for purposes of this provision. Pratt v. Commissioner, 64 T.C. 203 (1975), aff'd, 550 F.2d 1023 (5th Cir. 1977).
Disguised sales

Gain or loss is generally not recognized on the contribution of property to a partnership in return for a partnership interest (sec. 721). Additionally, distributions of money from a partnership to a partner are generally tax-free to the extent of the adjusted basis of the recipient partner's interest in the partnership (sec. 731). However, the partner is required to reduce the basis of his partnership interest by the amount of money received (thereby deferring tax until he disposes of the interest).

Treasury regulations provide that, if the transfer of property by a partner to a partnership results in the receipt by the partner of money or other consideration, including a promissory obligation fixed in amount and time for payment, the transaction will be treated as a sale or exchange rather than a contribution (Treas. Reg. sec. 1.721-1(a)). Based on these regulations, the Internal Revenue Service has argued that a contribution of cash by one partner followed by a distribution of cash to another partner should be recharacterized as a sale. These regulations state that the substance of the transaction, rather than its form, will govern in such cases. Treasury regulations also provide that if a contribution of property is made to a partnership and (1) within a short time before or after such contribution other property is distributed to the contributing partner and the contributed property is retained by the partnership, or (2) within a short time after such contribution to the partnership, contributed property is distributed to another partner, tax-free distribution treatment may not apply. These regulations further state that tax-free treatment does not apply if, a purported distribution was, in fact, made to effect an exchange of property
[p. 1218]

between two or more of the partners or between the partnership and a partner (Treas. Reg. sec. 1.731-1(c)(3)).

The rules above do not always prevent de facto sales of property to a partnership or another partner from being structured as a contribution to the partnership, followed (or preceded) by a tax-free distribution from, the partnership. For example, under the case law, partner A may contribute $50,000 in cash to a partnership and partner B may contribute property with a basis of $50,000 and a fair market value of $100,000. If the partnership then transfers $50,000 in cash to partner B, partner B may claim that this $50,000 represents a distribution not exceeding his basis in the partnership and for which he is therefore not subject to tax. (The basis for partner B's interest in the partnership would then be reduced from $50,000 to $0.) If this result is permitted, partner B has deferred or avoided tax on a transaction which closely resembles a sale of property to the partnership (or a partial sale to partner A followed by a joint contribution). Case law has permitted this result, despite the regulations described above, in cases which are economically indistinguishable from a sale of all or part of the property. See, Otey v. Commissioner, 70 T.C. 312 (1978), aff'd per curiam, 634 F.2d 1046 (1980); Communications Satellite Corp. v. United States, 223 Ct. Cl. 253 (1980); Jupiter Corp. v. United States, No. 83-842 (Ct. Cl. 1983).
Reasons for Change

The committee is concerned that partnerships have been used to effectively circumvent the requirement to capitalize certain expenses by making allocations of income corresponding distributions in place of direct payments for property or services. The committee believes that these transactions must be expressly prohibited if the integrity of the capitalization requirements of present law is to be preserved. For example, in Ellison v. Commissioner,80 T.C. 391 (1983), the Tax Court rejected use of a similar technique to convert purchase price into the equivalent of a deductible expense and concluded that a retained income interest in the seller of property was in reality a disguised purchase price.

In the case of disguised sales, the committee is concerned that individuals have deferred or avoided tax on sales of property by characterizing sales as contributions of property followed (or preceded) by a related tax-free partnership distribution. Although Treasury regulations provide that the substance of the transaction should govern, court decisions have allowed tax-free treatment in cases which are economically indistinguishable from sales of property to a partnership. The committee believes that these transactions should be treated for tax purposes in a manner consistent with their underlying economic substance.
Explanation of Provisions
Recharacterization of payments for capital expenses

If a partner performs services for, or transfers property to, a partnership, and receives a related allocation (direct or indirect) of partnership income or gain, the transaction will be treated as a transaction between the partnership and a person who is not a
[p. 1219]

partner, if a direct payment for the property or services would have been a capital expenditure by the partnership. Thus, the amount paid to the partner in consideration for the property or services will be treated as a fee for services or purchase price of property provided to the partnership (as the case may be), and the partnership will be required to capitalize these amounts. The partnership will disregard the purported allocation to the partner performing services or transferring property to the partnership in determining the partners' shares taxable income or loss under the partnership agreement and section 704(b).

For purposes of the rule, expenses required to be capitalized include syndication expenses and organization expenses. When allocations are made with respect to organization expenses the taxpayer will be considered to have foregone the right to amortize rather than capitalize such expenses.

The committee does not intend that this provision will apply in every instance in which a partner acquires an interest in a partnership and also performs services or transfers property to the partnership. In particular, the committee does not intend to repeal the general rule under which gain or loss is not recognized on a contribution of property in return for a partnership interest (sec. 721) or to apply this new provision in cases in which a partner receives an allocation (or an increased allocation) for an extended period to reflect his contribution of property or services, payment for which must be capitalized, to the partnership provided the allocation is not fixed or determinable. However, the committee does intend that the provision apply to allocations which are determined to be related to the performance of services (payments for which must be capitalized), or the transfer of property to, the partnership and which have the substantive economic effect of direct payments for such property or services.

The bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the provision. In prescribing these regulations, the Treasury should be mindful that the committee is concerned with transactions that work to avoid capitalization requirements and not with non-abusive allocations that reflect the various economic contributions of the partners. These regulations may apply the provision both to one-time transactions and to continuing arrangements which utilize purported partnership allocations and distributions in place of capital payments. These regulations may provide, where appropriate, that the service performer is not a partner of the partnership or simply not performing services in his capacity as a partner. Continuing arrangements that could be appropriately covered include annual compensation arrangements in which income allocations and property distributions are fixed in amount or reasonably determinable under all the facts and circumstances and which arise in connection with services direct payments for which must be capitalized. These allocations may be either "capped" allocations of partnership income (i.e., percentage allocations subject to an annual maximum amount where the parties could reasonably expect the cap to apply in most years) or allocations for a fixed number of years under which the income that will go to the partner is reasonably certain. In the case of continuing
[p. 1220]

arrangements, the time at which income will be allocated to the partner may be a factor indicating that an allocation is related to a properly capitalized expense. For example, an allocation close in time to the performance of services, or the transfer of property, is more likely to be related to the services or property. Also, when the income subject to allocation arises over an extended period or is removed from the services or property contributed by a partner, the differences between capitalization and use of an allocation are reduced. The committee specifically intends that the provision will apply to allocations used to pay partnership organization or syndication fees subject to the general principles above.

In the case of allocations which are only partly determined to be related to the performance of services for, or the transfer of property to, the partnership, the provision will apply to that portion of the allocated which is reasonably determined to be related to the property or services provided to the partnership. Finally, it is anticipated that Treasury regulations will provide for the coordination of this provision with the existing rules regarding payments to partners in their non-partner capacity (sec. 707(a)), guaranteed payments to partners (sec. 707(c)), sales or exchanges with respect to controlled partnerships (sec. 707(b)), certain other payments to partners (sec. 736 and related provisions), consistently with the principles above.

The committee does not intend to create any inference regarding the tax treatment of these transactions under existing law.
Disguised sales

The bill provides that, when a partner transfers money or other property to a partnership and there is a related direct or indirect transfer of money or other property to that partner or other partner, the transaction is to be treated (as appropriate) as a sale between the partners of property (including partnership interests) or as a partial sale and partial contribution of the property to the partnerships. The selling partner will be required to recognize gain (or loss) on all or part of the amount received in the transaction. This rule is intended to prevent the parties from characterizing a sale or exchange of property as a contribution to the partnership followed by a distribution from the partnership thereby deferring or avoiding tax on the transaction.

To accomplish this, the bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of this provision. In prescribing these regulations, the Treasury should be mindful that the committee is concerned with transactions that attempt to disguise a sale of property and not with non-abusive transactions that reflect the various economic contributions of the partners. Thus, it is anticipated that the regulations will apply the provision when the transfer of money or property from the partnership to the partner is related to the transfer of money or other property to the partnership in such manner that, taking into account all the facts and circumstances, the transaction substantially resembles a sale or exchange of all or part of the property including on interest in the partnership) to the or another partner or a sale or exchange of all or part of the property to the partnership. For example, when a partner contributes
[p. 1221]

appreciated property to a partnership and receives a distribution of money or property within a reasonable period before or after such contribution, that is approximately equal in value to the portion of contributed property given up, the transaction will be treated as a sale or exchange of property. This result will also apply to the extent (1) the transferor partner receives the proceeds of a loan related to the property while responsibility for repayment of which rests with the partnership or the other partners, or (2) the partner has received a loan related to the property in anticipation of the transaction and responsibility for repayment of the loan is transferred to the other partners. Although the rule applies to sales of property to the partnership, the committee does not intend to prohibit a partner from receiving a partnership interest in return for contributing property which entitles him to priorities or preferences as to distributions from operations that are not directly related to his contribution. The committee anticipates that the Treasury regulations will treat transactions to which the provision applies as a sale of property or partnership interests among the partners or as a partial sale and partial contribution of the property to the partnership, with attendant tax consequences, depending upon the underlying economic substance of the transaction. Finally, it is anticipated that the regulations will take into account the effect of liabilities which may accompany effective sales of property to a partnership or other partner.

No inference regarding the tax treatment of contribution arrangements or any similar transactions under existing law should be drawn from the committee's action.
Definition of partner

For purpose of the provisions regarding payments for capital expenses, and disguised sales, the bill provides that persons who become partners after performing services for, or transferring property to, the partnership are to be treated as partners.
Effective Dates

The provision regarding is effective for services performed or property transferred after March 1, 1984.
* * *
[p. 1225]
5. Transfers of Partnership Interests by Corporations (sec. 75 of the bill and new sec. 744 of the Code)
Present Law

The gain or loss on the sale or exchange of a partnership interest is generally a capital gain or loss. However, money or property received by a transferor partner in exchange for all or part of his partnership interest is subject to ordinary income treatment to the extent it is attributable to certain ordinary income assets of the partnership (sec. 751). For purposes of this provision, ordinary income items include the recapture of depreciation deductions previously taken on partnership property.

Also under present law, when a corporation distributes property (or sells property in the course of certain complete liquidations), income attributable to recapture property (and installment sales) is taxed to the corporation, while nonrecapture gain attributable to appreciation in value of the transferred property generally goes unrecognized.

Some taxpayers have taken the position that the present law recapture provisions do not apply to the distribution or liquidating sale by a corporation of an interest in a partnership that holds recapture property. According to this interpretation, a corporation may avoid recapture by contributing recapture property to a partnership and distributing interests in the partnership to its shareholders, or selling the interests in the course of liquidation. Since the partnership interests themselves arguably do not constitute recapture property, the corporation may claim that no gain should be recognized on the transaction.

Basis adjustment. -- Under present law (secs. 743 and 754), a partnership may elect to adjust the basis of partnership assets to offset gain or loss recognized by its partners on a sale or exchange of interests in the partnership. The election must apply to all sales or exchanges of partnership interests and may be revoked only for sufficient reason (Treas. Reg. sec. 1.754-1(c)).
Reasons for Change

The existing corporate recapture rule is intended to insure that corporate income is recognized on a distribution of recapture property to a corporations' shareholders or upon a liquidating sale of such property. Similarly, the requirement that a taxpayer recognize ordinary income on sales or exchanges of certain partnership interests prevents taxpayers from avoiding ordinary income taxation by transferring interests in partnership which hold assets that would be subject to depreciation recapture (or otherwise subject to ordinary income treatment) if the assets themselves were disposed of.
[p. 1226]

If an interest in a partnership which holds recapture property may be distributed, or sold in liquidation, without being subjected to recapture, the corporation has effectively avoided the recapture taxes. Thus, if this analysis is correct, the corporation may have benefitted from the tax advantages of depreciation (including accelerated depreciation) without being subject to recapture as would the case if the corporation distributed the recapture property directly to its shareholders. The committee believes that the Code should specifically prohibit this unintended tax benefit. To accomplish this, the bill generally requires that the distribution of the partnership interest be treated as if the corporation had made a direct distribution (or liquidating sale) of the recapture and other recognition assets.
Explanation of Provision

For purposes of determining the amount of gain recognized by a corporation on any distribution, the bill treats the distribution of a partnership interest as a distribution of the corporation's proportionate share of the recognition property of the partnership. Recognition property is defined as any property with respect to which the corporation would recognize gain if it distributed the property in a distribution (sec. 311 or 336) or sold the property in a liquidation sale (sec. 337). The corporation's proportionate share of recognition property shall be determined in accordance with the principles of section 751. In determining the amount of gain recognized on the transaction, the corporation is treated as if it had made a direct distribution (or liquidating sale or exchange) of the underlying recognition property.

The bill specifies that the amount of gain recognized by a corporation under the rules above may not be greater than the amount of gain that would have been recognized if the partnership interest had been sold directly by the corporation. This limitation would be applied separately to the various gains arising under section 751 without reduction for any separate losses. For example, if application of section 751 to a sale of the partnership interest would result in $200 of gain and $100 of loss, the limitation would be $200.

The bill provides that, in determining whether property of a partnership is recognition property, the partnership shall be treated as owning its proportionate share of the property of any other partnership in which it is a partner. This rule is intended to prevent the avoidance of the rules above by the use of tiered or multi-tiered partnership arrangements. (See item E.6. below.)

The bill further provides that, under Treasury regulations, rules similar to the rules above shall apply in the case of interests in trusts. These rules will prevent the use of interests in trusts to achieve results similar to those prevented by the statute in the case of partnership interests.

No inference should be drawn from the committee's action regarding the treatment of these transactions under present law.

Basis adjustments. -- When a partnership has an appropriate election in effect, the basis of partnership property may be adjusted following the taxable sale or exchange of interests in the partnership to reflect gain or loss on the transfer (secs. 743 and 754). The bill
[p. 1227]

clarifies that the basis of partnership property is to be adjusted to take into account amounts recognized on transfers accomplished through distributions (whether by corporations or partnerships).
Effective Date

The provision applies to distributions, sales, and exchanges made after March 1, 1984, in taxable years ending after that date.
* * *
[p. 1228]
6. Abuses Involving Tiered Partnerships (secs. 76 and 78 of the bill and secs. 734, 751, and 754 of the Code)
a. Use of tiered partnerships to alter character of income on exchanges of partnership interest
Present Law

The gain or loss on the sale or exchange of a partnership interest is generally a capital gain or loss. However, money or property received by a transferor partner in exchange for all or part of his partnership interest is subject to ordinary income treatment to the extent it is attributable to certain ordinary income assets of the partnership (sec. 751). These items include (1) certain unrealized receivables of the partnership, and (2) inventory items of the partnership which have attributed substantially in value. Generally, substantially appreciated inventory is defined as inventory having a fair market value greater than 120 percent of the partnership's adjusted basis for the property and greater than 10 percent of the fair market value of all partnership property, other than money. Unrealized receivables of a partnership include rights to payments that have not yet been taken into account under the partnership method of accounting and a variety of recapture amounts with respect to partnership property. Ordinary income treatment also applies to distributions to a partner that have the effect of causing a shifting of the various partners' interests in unrealized receivables or substantially appreciated inventory of the partnership property. These rules prevent a partner from receiving capital gain treatment for gains attributable to ordinary income property of the partnership.

Under present law, some taxpayers have argued that ordinary income treatment of unrealized receivables and substantially appreciated inventory may be avoided when the assets are held in a second partnership. When this occurs, it is not clear whether the ordinary income rules of section 751 should be applied by regarding change in interests in the first partnership as an exchange of a capital asset (the interest in the second partnership) or of ordinary income assets (the assets owned through the second partnership).
Reasons for Change

The committee believes that taxpayers should not be allowed to convert potential ordinary income into capital gains by selling their partnership interests. This policy has been reflected in the 1954 Code since the enactment. The committee knows of no reason why the use of tiered partnership arrangements should be permitted to frustrate this policy.
[p. 1229]
Explanation of Provision

Under the bill, the ordinary income rules of section 751 will be applied by regarding income rights, as section 751 does under present law, as severable from the partnership interest.5 Under this approach, a partner will be treated as disposing of such items independently of the rest of his partnership interest. The rule will apply regardless of how many tiers of partnerships exist between the transferring or distributee partner and the ordinary income assets.
5See H.R. Rep. No. 1337, 83rd Cong., 2nd Sess. pages 70, 71 (March 9, 1954).

The committee amendment also provides that this approach regarding income rights as severable is to apply to interests in trusts held by partnerships in the manner provided for in regulations.
Effective Date

The provision is effective for distributions, sales, and exchanges made after March 31, 1984, in taxable years ending after that date.
Revenue Effect

This provision has a negligible effect on fiscal year budget receipts.
b. Use of tiered partnership to achieve step-up in basis of partnership assets
Present Law

The partnership provisions of present law were generally designed to permit partners to enter and leave a partnership without recognizing gain or loss. To prevent the general rules from allowing a partner to escape tax on gain or from extinguishing a loss that a partner would otherwise be entitled to, the Code provided for a variety of rules relating to basis of the partners' interests in the partnership, and in contributed or distributed property and to the partnership's basis in partnership property. In certain transactions, a partner may experience an increase or decrease in basis that is not reflected appropriately in the basis of other assets. For example, if a partnership distributes property which it holds at a basis of $900 to a partner with an interest with a $500 basis, the Code will not permit the $900 basis to carry over but will instead require a substitution of the $500 basis. Thus, $400 of basis is potentially "lost."

Present law permits, but does not require, a partnership in such a case to elect to adjust the basis of remaining partnership assets. A similar result applies in the case of transfers of interests in the partnership (sec. 743). The election to step up (or step down) may be revoked only upon a showing of sufficient reason and applies to all distributions by a partnership and to all transfers of interests in the partnership.

Since the election may at some future date require a decrease in basis, partnerships may not make the election where it appears at first to be advantageous. Under present law, it may be possible in a
[p. 1230]

tiered partnership arrangement to manipulate the basis adjustment rules and the election to adjust basis in such a manner as to effectively distribute high basis property to a low basis partner without causing him to recognize gain when the property is sold. For example, assume that partnership AB holds two assets, asset 1 with a basis of 0 and a fair market value of $100 and asset 2 with a basis of $100 and a fair market value of $100. A distribution of asset 2 to partner A, who has a zero basis for his interest, would result in A holding the asset at a zero basis, and the basis of asset 1 will be increased to $100, assuming that the partnership has a section 754 election in effect. Thus, if asset 1 is sold, no gain or loss will be realized, but if asset 2 is sold, A will realize $100 gain. However, if asset 2 is instead contributed to a second partnership in which partnership AB has a major interest (e.g., 99 percent), its basis will remain at $100. A distribution of AB's interest in the second partnership to partner A will result in the basis of the interest being reduced to zero but (if the second partnership does not have section 754 election in effect) the basis of asset 2 will remain $100. Thus, the effect is an increase in total basis of assets so that, in this example, both asset 1 and asset 2 can subsequently be sold without recognition of gain. While the basis of A's interest in the second partnership would be reduced by $100, this would not have any effect so long as A retains his interest in the partnership. A could cause asset 1 to be sold and reinvest the proceeds through the second partnership without recognizing any gain. Taxpayers may also attempt to create more complex arrangements to achieve results similar to the results described above.
Reasons for Change

The committee believes that it is inappropriate for taxpayers to defer or avoid taxation by using inconsistent basis adjustment elections for related partnerships.
Explanation of Provision

The bill prohibits a partnership from adjusting the basis for its interest in another partnership following a distribution if the second partnership does not have a section 754 election in effect. This provision is intended to prevent taxpayers from achieving a net step-up in the basis of assets by means of inconsistent elections under section 754. This occurs because under section 743 a distribution of a partnership interest is treated as a distribution of the underlying assets (see item E.5., above).
Effective Date

This provision is effective for distributions after March 1, 1983, in taxable years ending after that date.
* * *
[1231]
7. Exchanges of Like-Kind Property (sec. 77 of the bill and sec. 1031 of the Code)
Present Law
General rules

An exchange, like a sale of property, is generally a taxable transaction. However, present law provides that no gain or loss is to be recognized if property held for productive use is the taxpayer's trade or business, or property held for investment purposes, is exchanged solely for property of a like-kind that is also to be held for productive use in a trade or business or for investment. This provision (sec. 1031) specifically does not apply to exchanges of stock in trade or other property held primarily for sale, or to stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest.6
6Special rules allow tax-free like-kind exchanges of stock of the same corporation (sec. 1035), certain insurance policies (sec. 1036), and certain U.S. obligations (sec. 1037). Additionally, the law provides for nonrecognition of gain in certain situations in which property lost or sold by the taxpayer is replaced, within a specified period, by property of a similar kind.

The nonrecognition of gain in like-kind exchange applies only to the extent that like-kind property is received in the transaction. For example, if a taxpayer holding a parcel of land having a basis of $50,000 and a fair market value of $100,000 exchanges the property for a parcel of land worth $90,000 plus $10,000 in cash, the taxpayer would recognize $10,000 of gain on the transaction. The remaining $40,000 of gain would be deferred until the taxpayer disposes of the second parcel as a taxable sale or exchange. No losses may be recognized from a qualifying like-kind exchange.

Present law does not require specifically that a like-kind exchange be completed within a specified period in order to qualify for tax-free treatment. In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the United States Court of Appeals for the Ninth Circuit held that an exchange qualified for like-kind treatment although the property to be exchanged could be designated by the transferor for up to 5 years after the transaction and although the transferor could have ultimately received cash rather than like-kind property. The case involved an exchange of real property in which the transferor eventually received like-kind property.

Installment sales. -- The Internal Revenue Code provides special rules for the reporting of income from installment sales (sec. 453). These rules allow gains from an installment sale to be spread out over the period during which installment payments are received. In general, the taxpayer reports income in each year for that proportion of the payments received during the year which is equivalent to the ratio which the gross profit from the sale bears to the total contract price. An installment sale is defined as a disposition
[p. 1232]

of property where at least one payment is received after the close of the taxable year in which the disposition occurs. For this purpose, payment includes property permitted to be received without the recognition of gain (sec. 453(f)(6)).
Exchanges of partnership interests

Present law does not state specifically whether an interest in one partnership may be exchanged for an interest in another partnership as a tax-free exchange of like-kind property. The Internal Revenue Service has ruled that the exception for interests in financial enterprises applies to partnership interests and thus they do not qualify as like-kind property that may be exchanged tax-free. Rev. Rul. 78-135, 1978-1 C.B. 256. Court decisions have held that exchanges of partnership interest may qualify for tax-free treatment as like-kind property exchanges where the underlying assets of the partnerships are substantially similar in nature. Estate of Rollin E. Meyer, Sr., 58 T.C. 311 (1972), aff'd per curiam, 503 F.2d 566 (9th Cir. 1974); Gulfstream Land and Development Co., 71 T.C. 587 (1979). However, the court in the Estate of Meyer case held that an exchange of a general partnership interest for a limited partnership interest does not satisfy the like-kind requirement.
Reasons for Change
Deferred like-kind exchanges

The committee is concerned that like-kind treatment of non-simultaneous exchanges has given rise to unintended results and administrative problems. These concerns extend to the underlying policy of the like-kind exchange rule.

The special treatment of like-kind exchanges has been justified on the grounds that a taxpayer making a like-kind exchange has received property similar to the property relinquished and therefore has not effectively "realized" a profit on the transaction. This rationale is less applicable in the case of deferred exchanges. To the extent that the taxpayer is able to defer completion of the transaction -- often retaining the right to designate the property to be received at some future point -- the transaction begins to resemble less a like-kind exchange and more a sale of one property followed, at some future point, by a purchase of a second property or properties. This is particularly true when (as was the case in the Starker v. United States) the taxpayer might have received like-kind or non-like-kind property in the future. The committee believes that like-kind exchange treatment is inappropriate in such situations and that the general rule requiring recognition of gain on sales or exchanges of property should apply to these cases.

The special treatment of like-kind exchanges has also been justified from an administrative standpoint because of the difficulty of valuing property which is exchanged solely or primarily for similar property. This rationale may also be less applicable to deferred like-kind exchanges, in particular exchanges which are "left open" until the taxpayer has selected a suitable exchange property. In such cases, the transferred property must be valued at a specific or near-specific dollar amount in order to determine the aggregate value of the properties that the taxpayer may receive in the future.
[p. 1233]
Thus, the taxpayer's gain may be measured with reasonable accuracy in the year of the original transfer.

The committee is also concerned that the like-kind exchange rules significantly expand the ability of taxpayers to avoid recognition of gain on deferred payment sales. Unlike other nonrecognition rules (e.g., the rollover of gain on replacement of a principal residence), the like-kind exchange provisions have no express statutory time limit on the availability of nonrecognition treatment. Decisions such as that in Starker v. United States suggest that there may, in fact, be no limit on the time for which like-kind exchanges may be kept open. If this is the case, taxpayers, by combining the installment sale rules and the like-kind exchange provisions, may defer taxation on dispositions of property for an indefinite period of time, even if a right to receive cash instead of property is retained. If cash is ultimately received, the installment sale rules will achieve a deferral until the time of receipt, while if like-kind property is received, recognition will be even further delayed. By exercising the right to designate property shortly before death, a taxpayer may conceivably avoid any taxation on the sale. Interaction of the installment sale and like-kind exchange rules also raises serious administrative problems regarding the allocation of liabilities and basis among different properties, problems which may not be resolvable until all exchanges and payments required by the agreement have been completed. Thus the tax consequences of deferred exchanges may not be determined for many years after the transaction is initiated.
Exchanges of partnership interests

It is questionable whether the like-kind exchange provisions were originally intended to apply to exchanges of partnership interests. The statute by its own terms does not apply to exchanges of stock, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest (sec. 1031). These exclusions prevent taxpayers from trading investment interests so as to take advantage of like-kind treatment on dispositions of appreciated property. The committee believes that, at least under current conditions, partnership interests typically represent investment interest similar to those items already excluded from like-kind treatment and should therefore be excluded from such treatment.

In reaching the decision above, the committee is particularly concerned by the use of the like-kind exchange rules to facilitate the exchange of interests in tax shelter investments for interests in other partnerships. Under this arrangement, taxation of the gain inherent in an interest in a "burned out" tax shelter partnership -- i.e., a partnership which has taken substantial deductions for non-recourse liabilities without actually paying off such liabilities, and hence without the partners suffering real economic loss -- may be avoided if the interest is exchanged, tax-free, for an interest in another partnership. While court decisions have limited like-kind exchange treatment to partnerships holding similar underlying assets, this rule may be inadequate to reflect the actual situation of the two partnerships and may therefore continue to allow abuses of the type above. The committee believes that such abuses are best
[p. 1234]

prevented by specifically excluding partnership interests from the like-kind rule.
Explanation of Provisions
Deferred like-kind exchanges

The bill provides that, for purposes of the like-kind exchange provision, any property received by the taxpayer more than 180 days (but not later than the due date of the taxpayer's tax return) after the date on which the taxpayer relinquishes property is not to be treated as like-kind property. Thus, tax-free treatment will be unavailable for exchanges not completed within this time period.
Exchanges of partnership interests

The bill specifies that the like-kind exchange rules do not apply to any exchange of interests in different partnerships. This rule is not intended to apply to an exchange of interests in the same partnership.

No inference should be drawn from the committee's action regarding the proper treatment of these transactions under present law.
Effective Date

The provision relating to partnership exchanges is effective for transfers of property after March 31, 1984 other than exchanges made pursuant to binding contracts entered into on or before March 1, 1984. The provision relating to deferred like-kind exchanges is effective for transfers after the date of enactment. For transfers on or before date of enactment, any property received after December 31, 1986, will not be treated as like-kind property.
Worksheet 7
Excerpts from Senate Explanation of Provisions Approved by the Finance Committee on March 2, 1984 [Deficit Reduction Act of 1984]; S. Rep. No. 169, 98th Cong., 2d Sess. (1984).
[p. 217]
2. Retroactive Allocations (sec. 56 of the bill and sec. 706 of the Code)
Present Law
General rules

The Tax Reform Act of 1976 amended the partnership provisions to preclude a partner who acquires his interest late in the taxable year from deducting partnership expenses incurred prior to his entry into the partnership (so-called "retroactive allocations" of partnership losses). The 1976 Act provided that when partners' interests change during the taxable year, each partner's share of various items of partnership income gain, loss, deduction and credit is to be determined by taking into account each partner's varying interest in the partnership during the taxable year.

Present law allows two basic methods for determining the amount of a partnership's income, gain, loss, deduction, and credit which may be allocated to a partner entering during the taxable year. The first method provides for an "interim closing" of the partnership books whenever a new partner enters the partnership. This method traces partnership income, gain, loss, deduction, and credit to the particular segment of the partnership taxable year during which it is incurred. For example, a partner admitted on December 1 to a partnership using a calendar taxable year could be allocated only his share of items incurred by the partnership during the month of December.

The second allocation method allowed by present law provides for a proration of partnership income, gain, loss, deduction, and credit for the entire taxable year. This proration generally is based on the number of days in the partnership taxable year during which the entering partner is a member of the partnership divided by the total number of days in the partnership taxable year. The entering partner's share of each partnership item for the taxable year is determined by multiplying this fraction by the amount of partnership income, gain, loss, deduction, and credit that the partner would have been allocated had he been a partner for the entire partnership taxable year. For example, a partner admitted on December 1 to a partnership having a calendar year taxable year would be allocated 1/12 of his hypothetical share of items for the entire partnership taxable year, regardless of the point during the year at which these expenses were incurred.

The legislative history of the 1976 Act provides that to avoid undue complexity, a partnership may use a convention (for both the interim closing and proration methods) under which partners are treated as entering on a semi-monthly basis. That is, partners entering in the first half of a month can all be treated as entering on the first day of the month and partners entering in the last half
[p. 218]

of the month can be treated as entering on the 16th day of the month.
Techniques for avoiding retroactive allocation rules

Tiered arrangements

Some taxpayers have attempted to avoid the retroactive allocation rules by use of tiered partnership arrangements combined with the interim closing method of allocations. For example, assume that Parent partnership owns a 90-percent interest in Subsidiary partnership and that both the Parent and the Subsidiary use a calendar year taxable year. Assume further that Subsidiary will have a $10,000 loss for the calendar year, and that Parent's distributive share will be $9,000. If Partner A makes a contribution to the partnership in exchange for an 80-percent interest in Parent at the close of business on December 30, Parent may make an interim closing of its books on December 30 to determine A's distributive share of partnership items. Parent may take the position that, for tax purposes, it incurs its entire $9,000 portion of Subsidiary's loss on December 31, i.e., at the close of Subsidiary's taxable year, regardless of when the loss was actually incurred by subsidiary. Partner A will, therefore, claim a $7,200 loss on his return (Parent's $9,000 loss multiplied by his 80-percent interest in the partnership on December 31) rather than the $19.73 that he would be entitled to under a proportioned share computation (i.e., $9,000 X 80% X 1/365 days).

The Internal Revenue Service has taken the position that, in the situation above, losses are sustained by the parent partnership at the same time they are sustained by the subsidiary partnership and that the limitation against retroactive allocations is equally applicable. Rev. Rul. 77-311, 1977-2 C.B. 218. However, taxpayers may continue to take a contrary position on their returns.

Cash basis partnerships

In addition to tiered arrangements, partnerships may attempt to avoid the retroactive allocation rules by using the cash method of accounting and deferring actual payment of deductible items until near the close of the partnership's taxable year. For example, if a partnership defers the payment of an expense (e.g., interest) until December 31, and the partnership uses the interim closing method of allocations, a partner admitted on December 30 may be allowed a deduction for a full portion of the expense. This may be the case although the expense has economically accrued at an equal rate throughout the taxable year.
Reasons for Change

The 1976 rules were enacted to clarify that the law required the inclusion of income and loss according to a partner's varying interests during the taxable year. Legislative history indicates that Congress, in adding these rules, intended to prevent partners investing in a partnership toward the close of the taxable year from deducting expenses which were incurred prior to their entry into the
[p. 219]

partnership.3 In adding these rules, Congress rejected the argument that retroactive allocations were proper because the funds invested by the new partners served to reimburse the original partners for their expenditures so that, as an economic matter, the new partners had incurred the costs for which they were claiming deductions. This argument was found unpersuasive when the new partner was compared with an investor directly purchasing property which had generated tax losses earlier in the taxable year; that investor would clearly not be entitled to deduct the losses incurred prior to his ownership of the property.
3H. Rep. 94-658, accompanying H.R. 10612, 94th Cong. 1st Sess, P. 124 (November 12, 1975); S. Rep. 94-938, 94th Cong., 2d Sess. p. 97 (June 10, 1976).

The committee believes that the policy of the 1976 act prohibiting retroactive allocations and the rationale for that policy remain equally applicable today. Taxpayers should not be able to attempt to avoid the 1976 rules through the use of tiered partnership or other arrangements.

The committee recognizes that the use of cash method partnerships raises issues distinct from tiered arrangements and that the cash method may be appropriate for partnerships in certain circumstances. However, the committee believes that the cash method should not be used to create deductions for late-entering partners. Accordingly, the bill requires that cash basis items generally be prorated over those days during the year to which they are economically attributable and that each partner take into account only that portion of each item attributable to that portion of the year for which he is a partner. This rule will prevent abuses associated with retroactive allocations without causing undue hardship or administrative burdens to cash basis partnership. To prevent undue burdens, the bill provides that any member entering the partnership during a month may be treated as a member for the entire month.
Explanation of Provision
General rule

The bill provides a general rule comparable to the present law rule that if any partner's interest in a partnership changes at any time during the partnership's taxable year, each partner's share of any item of partnership income, gain, loss, deduction, or credit is to be determined by using any method prescribed by Treasury regulations which takes into account the varying interests of the partners in the partnership during the taxable year. It is anticipated that these regulations will apply the law in a manner consistent with the policies of the Tax Reform Act of 1976 and of the new provisions. The committee wishes to make clear that the varying interests rule is not intended to override the longstanding rule of section 761(c) with respect to interest shifts among partners who are members of the partnership for the entire taxable year, provided such shifts are not, in substance, attributable to the influx of new capital from such partners. See Lipke v. Commissioner, 81 T.C. 689 (1983).
[p. 220]
Cash basis partnership

With respect to partnerships using the cash method of accounting, the bill provides new rules for the allocation of items among partners when there is a change in partnership interests. First, for specified cash basis items, the bill requires that the item be assigned to each day in the period to which it is attributable. The amounts so assigned are then apportioned among the partners in proportion to their interest in the partnership at the close of each day. These rules (which apply except when regulations otherwise provide) effectively require, for purposes of determining the partners' varying interests in a partnership taxable year, that certain items be allocated under the accrual method. The items to which the provision applies are (1) interest, (2) taxes, (3) payment for services or for the use of property, and (4) any other item of a kind specified in Treasury regulations with respect to which the rule is necessary to avoid retroactive allocations to the partners.

For example, if a new partner joins a calendar-year partnership on December 1, and if the partnership on December 31 pays an interest expense which has accrued over the course of the entire year, the partner would be entitled to 1/12 of his otherwise allocable share of deduction for that item. If the expense were attributable only to the final 6 months of the year, he would receive 1/6 of his otherwise allocable share of that item. The committee intends that the determination of the period to which an expense is attributable will be made in accordance with economic accrual principles.

The bill provides that when application of the economic accrual principles described above would result in allocating an item to periods before or after the current taxable year, those items are to be allocated entirely to the first day of the year in the case of items allocable to prior years and entirely to the last day of the year in the case of items allocable to future periods. This rule does not make any substantive change to the timing of any deduction under present law; rather, it merely describes the treatment of amounts that are currently deductible even though allocable to a past or future year in economic terms. For example, if a cash method partnership failed to pay for services provided to it in year 1 until the middle of year 2, the amount of the year 2 deduction would be allocated to the first day of year 2. Similarly, if the partnership was required to pay property taxes in year 1 for the last half of year 1 and the first half of year 2, the amount allocable to year 2 would be treated as paid on the last day of year 1. Of course, this latter rule will have limited application because of the general limitations on the deductibility of prepaid expenses.
Tiered partnerships

The bill provides that, if a parent partnership holds an interest in a subsidiary partnership, then (except to the extent provided by regulations) the parent partnership's share of any item of income, gain, loss, deduction, or credit of the subsidiary partnership is to be prorated equally over that portion of the taxable year during which the parent partnership had an interest in the subsidiary. For example, if a new partner who has a 25-percent interest in all
[p. 221]

partnership items enters on December 1, a parent partnership that is on a calendar taxable year and the parent has had a 50-percent interest in a calendar year subsidiary partnership for the subsidiary's entire year, then that partner would be allocated 1/96th of the subsidiary's items for the taxable year. (That is his 1/4th share of 1/12th of the parent's 1/2 of the items for the entire year.) If the parent had an interest in the subsidiary beginning July 1, the partner would be allocated 1/192nd of each of the subsidiary's items. (That is his 1/4 share of 1/12th of parent's 1/2 of the items for 1/2 of the year.) It is anticipated that the regulations will permit (and may require) that when a parent and subsidiary partnership use the same taxable year, the income, gain, loss, credit, and deductions of the subsidiary must be allocated to the relevant periods of the parent's taxable year in a manner consistent with the accrual of the items during the subsidiary's taxable year. Similarly, when the parent and subsidiary have different taxable years, the regulations may provide for an interim closing of the subsidiary's taxable year (with respect to the parent) at the time the parent's taxable year closes. These rules are intended to prevent the use of tiered partnership arrangements to avoid the retroactive allocation rules and generally are consistent with Rev. Rul. 77-311, 1977-2 C.B. 218.
Other rules

The bill provides for daily apportionment; however the committee recognizes that most partnerships do not account for the admission of new partners on a daily basis and that daily apportionment of partnership income and expenses would thus result in an undue administrative burden. Accordingly, to prevent undue complexity, the bill provides, that in any case where there is a disposition of less than an entire interest in the partnership by a partner (including the entry of a new partner), the partnership may elect (on an annual basis) to determine the varying interests of the partners by using a monthly convention that treats any changes in any partner's interest in the partnership during the taxable year as occurring on the first day of the month. Pending issuance of regulations, a partnership will be deemed to have elected to use the monthly convention if it uses that convention on its books or files its return for the taxable year on that basis. If a partnership is treated as having made such an election, the monthly convention will also apply to partners entering during the entire taxable year.

The committee does not intend that any inference be drawn regarding the present law treatment of either the tiered partnership or cash methods arrangement for allowing retroactive allocations.
Effective Dates

The rule regarding tiered partnerships is effective for amounts paid or accrued after March 31, 1984. The rule regarding cash basis partnerships is effective for amounts attributable to periods after March 31, 1984.
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Revenue Effect

This provision will increase fiscal year budget receipts by $50 million in 1985, $75 million in 1986, $100 million in 1987, $100 million in 1988, and $100 million in 1989.
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3. Payments to Partners for Property or Certain Services (sec. 57 of the bill and sec. 707 of the Code)
Present Law
General background

The contribution of property to a partnership in return for a partnership interest is generally a tax-free transaction (sec. 721). If, instead of contributing property to a partnership, the taxpayer sells property to the partnership, the taxpayer realizes income to the extent of gain on the sale and the partnership is generally required to capitalize the amount of the purchase price, which may be deductible over the useful life of the property (or any applicable recovery period). When services are provided to a partnership, the partnership may generally deduct amounts paid or incurred for such services (unless such expenses are required to be capitalized) and the party providing services must include an equivalent amount in income. This rule also applies to services provided by a partner acting in a capacity other than that of a member of the partnership.

When a partnership allocates income from partnership operations among its partners, the partners generally include these amounts in income in the year taxable to the partnership. This is distinct from a distribution of partnership assets, which is generally tax-free to the extent that the amount distributed does not exceed the recipient partner's basis for his partnership interest. This tax-free treatment is based, in part, on the theory that a partner is entitled to withdraw his investment in a partnership (including partnership income on which he has paid tax) before recognizing gain on the investment.

Although amounts allocated to a partner are not deductible by the partnership, an allocation of taxable income to one partner may have the effect of a deduction for the remaining partners by reducing the amount of taxable income allocated to them.
Avoidance of capitalization and other requirements for payments for property or services

A partnership, like any taxpayer, is generally required to capitalize (rather than currently deduct) expenditures which relate to the improvement of property or which create an asset the useful life of which extends substantially beyond the end of the taxable year. Present law (sec. 709) provides specifically that a partnership may not currently deduct amounts paid or incurred to organize the partnership. Instead, the partnership is permitted an election to deduct these amounts ratably over a 5-year period. Alternatively, the partnership may capitalize these expenses. The denial of current deductions for organizational expenses was made explicit by
[p. 224]

the Tax Reform Act of 1976. In addition, neither the partnership nor any partner is ever permitted to deduct partnership syndication expenses.

If the organizer or syndicator of a partnership is also a general partner of the partnership, allocations of partnership gross or net income to the organizer and related distributions to him in payment for his services, if recognized, could have the effect of a current deduction for organizational and syndication fees despite the rules above. This results because the allocation (which in this case when coupled with an equivalent distribution is economically indistinguishable from a direct payment), reduces the taxable income allocated to the remaining partners in the year of the allocation. The capitalization requirement for other types of capital expenditures also can be avoided by this type of arrangement. Similarly, if a service-partner is allocated a portion of the partnership's capital gains in lieu of a fee, then the effect of the allocation/distribution will be to convert ordinary income (compensation for services) into capital gains.

Under present law, if amounts are paid or incurred to a partner who engages in a transaction with the partnership in a capacity other than as a member of the partnership, or if guaranteed payments are made to a partner for services or for the use of the partner's capital, capitalization is required to the same extent as with comparable payments to a non-partner. The courts, however, have held that payments to a partner based on a percentage partnership gross income generally are not to be regarded as guaranteed payments. Pratt v. Commissioner, 64 T.C. 203 (1975), aff'd, 550 F.2d 1023 (5th Cir. 1977).
Disguised sales

Gain or loss generally is not recognized on the contribution of property to a partnership in return for a partnership interest (sec. 721). Additionally, distributions of money from a partnership to a partner are generally tax-free to the extent of the adjusted basis of the recipient partner's interest in the partnership (sec. 731). However, the partner is required to reduce the basis of his partnership interest by the amount of money received (thereby deferring tax until he disposes of the interest).

Treasury regulations provide that, if the transfer of property by a partner to a partnership results in the receipt by the partner of money or other consideration, including a promissory obligation fixed in amount and time for payment, the transaction will be treated as a sale or exchange rather than a contribution (Treas. Reg. sec. 1.721-1(a)). These regulations state that the substance of the transaction, rather than its form, will govern in such cases. Treasury regulations also provide that if a contribution of property is made to a partnership and (1) within a short time before or after such contribution other property is distributed to the contributing partner and the contributed property is retained by the partnership, or (2) within a short time after such contribution to the partnership, contributed property is distributed to another partner, tax-free distribution treatment may not apply. These regulations further state that tax-free treatment does not apply if a purported distribution was, in fact, made to effect an exchange of property
[p. 225]

between two or more of the partners or between the partnership and a partner (Treas. Reg. sec. 1.731-1(c)(3)). In addition, based on these regulations, the Internal Revenue Service has argued that a contribution of cash by one partner followed by a distribution of cash to another partner should be recharacterized as a sale of an interest in the partnership.

The rules above may not always prevent de facto sales of property to a partnership or another partner from being structured as a contribution to the partnership, followed (or preceded) by a tax-free distribution from, the partnership. For example, under the case law, partner A may contribute $50,000 in cash to a partnership and partner B may contribute property with a basis of $50,000 and a fair market value of $100,000 to the partnership as an equal partner. If the partnership then transfers $50,000 in cash to partner B, based on the case law, it would not be unreasonable for partner B to claim that this $50,000 represents a distribution not exceeding his basis in the partnership and for which he is therefore not subject to tax. (The basis for partner B's interest in the partnership would then be reduced from $50,000 to $0.) If this result is permitted, partner B has deferred or avoided tax on a transaction which closely resembles a sale of property to the partnership (or a partial sale to partner A followed by a joint contribution). Case law has permitted this result, despite the regulations described above, in cases which are economically indistinguishable from a sale of all or part of the property. See Otey v. Commissioner, 70 T.C. 312 (1978), aff'd per curiam, 634 F.2d 1046 (1980); Communications Satellite Corp. v. United States, 223 Ct. Cl. 253 (1980); Jupiter Corp. v. United States, No. 83-842 (Ct. Cl. 1983).
Reason for Change

The committee is concerned that partnerships have been used to effectively circumvent the requirement to capitalize certain expenses and other rules and restrictions concerning various expenses by making allocations of income and corresponding distributions in place of direct payments for property or services. The committee believes that these transactions must be expressly prohibited if the integrity of the capitalization requirements of present law is to be preserved. For example, in Ellison v. Commissioner, 80 T.C. 391 (1983), the Tax Court rejected use of a similar technique to convert purchase price into the equivalent of a deductible expense and concluded that a retained income interest in the seller of property was in reality a disguised purchase price.

In the case of disguised sales, the committee is concerned that taxpayers have deferred or avoided tax on sales of property (including partnership interests) by characterizing sales as contributions of property (including money) followed (or preceded) by a related partnership distribution. Although Treasury regulations provide that the substance of the transaction should govern, court decisions have allowed tax-free treatment in cases which are economically indistinguishable from sales of property to a partnership or another partner. The committee believes that these transactions should be treated for tax purposes in a manner consistent with their underlying economic substance.
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Explanation of Provisions
a. Characterization of payments for services or property

If a partner performs services for, or transfers property to, a partnership, and, in connection therewith, receives a related partnership allocation and distribution, the transaction will be treated as a transaction between the partnership and a person who is not a partner, if under all the facts and circumstances, the transaction is more properly characterized as a payment to a partner acting in his non-partner, capacity. In such a case, the amount paid to the partner in consideration for the property or services will be treated as a payment for services or property provided to the partnership (as the case may be), and, where appropriate, the partnership will be required to capitalize these amounts (or otherwise treat such amounts in a manner consistent with the recharacterization). The partnership will treat the purported allocation to the partner performing services or transferring property to the partnership as a payment to a non-partner in determining the partners' shares of taxable income or loss.

The committee does not intend that this provision will apply in every instance in which a partner acquires an interest in a partnership and also performs services or transfers property to the partnership. In particular, the committee does not intend to repeal the general rule under which gain or loss is not recognized on a contribution of property in return for a partnership interest (sec. 721)4 or to apply this new provision in cases in which a partner receives an allocation (or an increased allocation) for an extended period to reflect his contribution of property or services to the partnership provided the facts and circumstances indicate that the partner is receiving the allocation in his capacity as a partner. However, the committee does intend that the provision apply to allocations which are determined to be related to the performance of services for, or the transfer of property to, the partnership and which, when viewed together with distributions, have the substantive economic effect of direct payments for such property or services under the facts and circumstances of the case.
4Of course, if a partner received an interest in a partnership in exchange for services, he may recognize income upon that receipt. See sections 61 and 83, and Diamond v. Commissioner, 492 F.2d 286 (7th Cir.1974).

The bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the provision. In prescribing these regulations, the Treasury should be mindful that the committee is concerned with transactions that work to avoid capitalization requirements or other rules and restrictions governing direct payments and not with non-abusive allocations that reflect the various economic contributions of the partners. These regulations may apply the provision both to one-time transactions and to continuing arrangements which utilize purported partnership allocations and distributions in place of direct payments. The committee specifically intends that the provision will apply to allocations used to pay partnership organization or syndication fees subject to the general principles above.
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These regulations will provide, when appropriate, that the purported partner performing services or transferring property is not a partner at all. Once it is determined that the service performer or property transferor is actually a partner, the committee believes the factors described below should be considered in determining whether the partner is receiving the putative allocation and distribution in his capacity as a partner.

The first, and generally the most important, factor is whether the payment is subject to an appreciable risk as to amount. Partners extract the profits of the partnership with reference to the business success of the venture while third parties generally receive payments which are not subject to this risk. An allocation and distribution provided for a service partner under the partnership agreement which subjects the partner to significant entrepreneurial risk as to both the amount and the fact of payment generally should be recognized as a distributive share and a partnership distribution, while an allocation and distribution provided for a service partner under the partnership agreement which involves limited risk as to amount and payment should generally be treated as a fee under sec. 707(a). For example, allocations that limit a partner's risk may be either "capped" allocations of partnership income (i.e., percentage or fixed dollar amount allocations subject to an annual maximum amount when the parties could reasonably expect the cap to apply in most years) or allocations for a fixed number of years under which the income that will go to the partner is reasonably certain. Similarly, continuing arrangements in which purported allocations and distributions (under a formula or otherwise) are fixed in amount or reasonably determinable under all the facts and circumstances and which arise in connection with services also shield the purported partner from entrepreneurial risk. Although short-lived gross income allocations are particularly suspect in this regard, gross income allocations may, in very limited instances, represent an entrepreneurial return, classifiable as a distributive share under sec. 704. Similarly, while net income allocations generally appear to constitute distributive shares, some net income allocations may be fixed as to amount and probability of payment and if coupled with a distribution or payment from the partnership, should be characterized as fees.

The second factor is whether the partner status of the recipient is transitory. Transitory partner status suggests that a payment is a fee or is in return for property. The fact that the partner status is continuing, however, is of no particular relevance.

The third factor is whether the distribution and allocation that are made to the partner are close in time to the partner's performance of services for or transfers of property to the partnership. In the case of continuing arrangements, the time at which income will be allocated to the partner may be a factor indicating that an allocation is, in fact, a disguised payment. For example, an allocation close in time to the performance of services, or the transfer of property, is more likely to be related to the services or property. Also, when the income subject to allocation arises over an extended period or is remote in time from the services or property contributed by a partner, the risk of not receiving payment (the first factor described above) may increase.
[p. 228]

The fourth factor is whether, under all the facts and circumstances, it appears that the recipient became a partner primarily to obtain tax benefits for himself or the partnership which would not have been available if he had rendered services to the partnership in a third party capacity. The fact that a partner has significant non-tax motivations in becoming a partner is of no particular relevance.

The fifth factor, which relates to purported allocations/distributions for services, is whether the value of the recipient's interest in general and continuing partnership profits is small in relation to the allocation in question. This is especially significant if the allocation for services is for a limited period of time. The fact that the recipient's interest in general and continuing partnership profits is substantial does not, however, suggest that the purported partnership allocation/distribution arrangement should be recognized.

The sixth factor, which relates to purported allocations/distributions for property, is whether the requirement that capital accounts be respected under section 704(b) (and the proposed regulations thereunder) makes income allocations which are disguised payments for capital economically unfeasible and therefore unlikely to occur. This generally will be the case unless (i) the valuation of the property contributed by the partner to the partnership is below the fair market value of such property (thus improperly understating the amount in such partner's capital account), or (ii) the property is sold by the partner to the partnership at a stated price below the fair market value of such property, or (iii) the capital account will be respected at such a distant point in the future that its present value is small and there is to be no meaningful return on the capital account in the intervening period.

The committee anticipates that the Secretary may describe other factors that are relevant in evaluating whether a purported allocation and distribution should be respected. In applying these various factors, the Treasury and courts should be careful not to be misled by possibly self-serving assertions in the partnership agreement as to the duties of a partner in his partner capacity but should instead seek the substance of the transaction.

In the case of allocations which are only partly determined to be related to the performance of services for, or the transfer of property to, the partnership, the provision will apply to that portion of the allocation which is reasonably determined to be related to the property or services provided to the partnership. Finally, it is anticipated that Treasury regulations will provide for the coordination of this provision with the existing rules of section 707 and other provisions of subchapter K such as section 736.

The committee does not intend to create any inference regarding the tax treatment of the transactions described above under existing law.

The principles of this provision can be illustrated by the following examples.

Example 1

A commercial office building constructed by a partnership is projected to generate gross income of at least $100,000 per year indefinitely. Its architect, whose normal fee for such services is $40,000,
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contributes cash for a 25-percent interest in the partnership and receives both a 25-percent distributive share of net income for the life of the partnership, and an allocation of $20,000 of partnership gross income for the first two years partnership operations after leaseup. The partnership is expected to have sufficient cash available to distribute $20,000 to the architect in each of the first two years, and the agreement requires such a distribution. The purported gross income allocation and partnership distribution should be treated as a fee under sec. 707(a), rather than as a distributive share. Factors which contribute to this conclusion are (1) the special allocation to the architect is fixed in amount and there is a substantial probability that the partnership will have sufficient gross income and cash to satisfy the allocation/distribution; (2) the value of his interest in general and continuing partnership profits is relatively small in relation to the allocation in question; (3) the distribution relating to the allocation is fairly close in time to the rendering of the services; and (4) it is not unreasonable to conclude from all the facts and circumstances that the architect became a partner primarily for tax motivated reasons. If, on the other hand, the agreement allocates to the architect 20 percent of gross income for the first two years following construction of the building a question arises as to how likely it is that the architect will receive substantially more or less than his imputed fee of $40,000. If the building is pre-leased to a high credit tenant under a lease requiring the lessee to pay $100,000 per year of rent, or if there is low vacancy rate in the area for comparable space, it is likely that the architect will receive approximately $20,000 per year for the first two years of operations. Therefore, he assumes limited risk as to the amount or payment of the allocation and, as a consequence, the allocation/distribution should be treated as a disguised fee. If, on the other hand, the project is a "spec building," and the architect assumes significant entrepreneurial risk that the partnership will be unable to lease the building, the special allocation might (even though a gross income allocation), depending on all the facts and circumstances, properly be treated as a distributive share and partnership distribution.

Example 2

There may be instances in which allocation/distribution arrangements that are contingent in amount may nevertheless be recharacterized as fees. Generally, these situations should arise only when (1) the partner in question normally performs, has previously performed, or is capable of performing similar services for third parties; and (2) the partnership agreement provides for an allocation and distribution to such partner that effectively compensates him in a manner substantially similar to the manner in which the partner's compensation from third parties normally would be computed.

For example, suppose that a partnership is formed to invest in stock. The partnership admits a stock broker as a partner. The broker agrees to effect trades for the partnership without the normal brokerage commission. In exchange for his partnership interest, the broker contributes 51 percent of partnership capital and receives a 51 percent interest in residual partnership profits and
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losses. In addition, he receives an allocation of gross income that is computed in a manner which approximates his foregone commissions. It is expected that the partnership will have sufficient gross income to make this allocation. The agreement provides that the broker will receive a priority distribution of cash from operations up to the amount of the gross income allocation. In this case, even though the broker/partner's special allocation appears contingent and not substantially fixed as to amount, it is computed by means of a formula like a normal brokerage fee and effectively varies with the value and amount of services rendered rather than with the income of the partnership. Thus, this contingent gross income allocation along with the equivalent priority distribution should be treated as a fee under sec. 707(a), rather than as a distributive share and partnership distribution.

In addition to these examples, the committee intends that the provision will lead to the conclusions contained in Revenue Ruling 81-300, 1981-2 C.B. 143, and Revenue Ruling 81-301, 1981-2 C.B. 144, except that the transaction described in Revenue Ruling 81-300 would be treated as a transaction described in section 707(a).
b. Disguised sales

The bill provides that when a partner transfers money or other property to a partnership which when viewed in connection with a related direct or indirect transfer of money or other property to that partner or another partner is properly characterized as a sale of property, the transaction is to be treated (as appropriate) as a sale between the partners of property (including partnership interests) or as a partial sale and partial contribution of the property to the partnership. The selling partner will be required to recognize gain (or loss) on the amount of the sales proceeds treated as received in the transaction. This rule is intended to prevent the parties from characterizing a sale or exchange of property as a contribution to the partnership followed by a distribution from the partnership to defer or avoid tax on the transaction.

To accomplish this, the bill authorizes the Treasury Department to prescribe such regulations as may be necessary or appropriate to carry out the purposes of this provision. In prescribing these regulations, the Treasury should be mindful that the committee is concerned with transactions that attempt to disguise a sale of property and not with non-abusive transactions that reflect the various economic contributions of the partners. Similarly, the committee does not intend to change the general rules concerning the tax treatment of the partners under sections 721, 731, and 752 to the extent (1) contributed property is encumbered by liabilities not incurred in anticipation of the contribution, or (2) contributions to a partnership which, because of liabilities of the partnership incurred other than in anticipation of the contribution result in a deemed distribution under sec. 752(b).

It is anticipated that the regulations will apply the provision when the transfer of money or property from the partnership to the partner is related to the transfer of money or other property to the partnership in such manner that, taking into account all the facts and circumstances, the transaction substantially resembles a sale or exchange of all or part of the property (including an
[p. 231]

interest in the partnership). For example, when a partner contributes appreciated property to a partnership and receives a distribution of money or property within a reasonable period before or after such contribution, that is approximately equal in value to the portion of contributed property that is in effect given up to the other partner(s) the transaction will be subject to this provision. However, the distribution would not be so subject if there is a corresponding partnership allocation of income or gain, but that arrangement may instead be subject to the new provision relating to partnership payments for property or services described above. The disguised sale provision also will apply to the extent (1) the transferor partner receives the proceeds of a loan related to the property to the extent responsibility for the repayment of the loan rests, directly or indirectly, with the partnership (or its assets) or the other partners, or (2) the partner has received a loan related to the property in anticipation of the transaction and responsibility for repayment of the loan is transferred, directly or indirectly, to the partnership (or its assets) or the other partners.

Although the rule applies to sales of property to the partnership, the committee does not intend to prohibit a partner from receiving a partnership interest in return for contributing property which entitles him to priorities or preferences as to distributions, but is not in substance a disguised sale. Similarly, the committee generally does not intend this provision to adversely affect distributions that create deficit capital accounts (maintained in a manner consistent with Treasury regulations under section 704(b)) for which the distributee is liable, regardless of the timing of the distribution, unless such deficit capital account is improperly understated or not expected to be made up until such a distant point in the future that its present value is small. However, if this deficit creating distribution is coupled with an allocation of income or gain, the distribution/ allocation arrangement may be subject to the new provision relating to partnership payments for services or property. Similarly, the contribution of encumbered property to a partnership would not suggest a disguised sale to the extent responsibility for the debt is not shifted, directly or indirectly, to the partnership (or its assets) or to the non-contributing partners. The committee anticipates that the Treasury regulations will treat transactions to which the provision applies as a sale of property or partnership interests among the partners or as a partial sale and partial contribution of the property to the partnership, with attendant tax consequences, depending upon the underlying economic substance of the transaction. These regulations may provide for a period, such as three years, during which contributions by and distributions to the same or another partner normally will be presumed related. Finally, it is anticipated that the regulations will take into account the effect of liabilities which may accompany effective sales of property to a partnership or another partner.

No inference regarding the tax treatment of contribution arrangements or any similar transactions under existing law should be drawn from the committee's action.
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c. Definition of partner

For purpose of these provisions, the regulations will provide that persons who become partners after performing services for, or transferring property to, the partnership are to be treated as partners.
Effective Dates

The provision with respect to services performed for, or property transferred to, a partnership when there is a related allocation and distribution is effective for services performed on property transferral after February 29, 1984. Generally, the disguised sale rules apply to property transferred after March 31, 1984. The bill provides a transitional rule for the disguised sale provision under which prior law will apply to a contribution of property before December 31, 1984, if (1) there was a written private placement offering memorandum in existence on February 29, 1984, (2) the partners had expended $250,000 in connection with the offering of February 29, 1984, (3) the partner contributing encumbered property is the sole general partner, and (4) all of the encumbrances incurred in anticipation of the contribution are without recourse.
Revenue Effect

This provision will increase fiscal year budget receipts by $20 million in 1985, $51 million in 1986, $60 million in 1987, $69 million in 1988, and $78 million in 1989.
* * *
[p. 239]
6. Use of Tiered Partnerships to Alter Character of Income on Exchanges of Partnership Interest (sec. 60 of the bill and sec. 751 of the Code)
Present Law

The gain or loss on the sale or exchange of a partnership interest is generally a capital gain or loss. However, money or property received by a transferor partner in exchange for all or part of his partnership interest is subject to ordinary income treatment to the extent it is attributable to certain ordinary income assets of the partnership (sec. 751). These items include (1) certain unrealized receivables of the partnership, and (2) inventory items of the partnership which have appreciated substantially in value. Generally, substantially appreciated inventory is defined as inventory having a fair market value greater than 120 percent of the partnership's adjusted basis for the property and greater than 10 percent of the fair market value of all partnership property, other than money. Unrealized receivables of a partnership include rights to payments that have not yet been taken into account under the partnership method of accounting and a variety of recapture amounts with respect to partnership property. Ordinary income treatment also applies to distributions to a partner that have the effect of causing a shifting of the various partners' interests in unrealized receivables or substantially appreciated inventory of the partnership. These rules prevent a partner from receiving capital gain treatment for gains attributable to ordinary income property of the partnership.

Under present law, some taxpayers have argued that ordinary income treatment of unrealized receivables and substantially appreciated inventory may be avoided when the assets are held in a second partnership. When assets are held in a second partnership, it is not clear whether the ordinary income rules of section 751 should be applied by regarding change in interests in the first partnership as an exchange of a capital asset (the interest in the second partnership) or of ordinary income assets (the assets owned through the second partnership).
Reasons for Change

The committee believes that taxpayers should not be allowed to convert potential ordinary income into capital gains by selling their partnership interests. This policy has been reflected in the 1954 Code since its enactment. The committee knows of no reason why the use of tiered partnership arrangements should be permitted to frustrate this policy.
[p. 240]
Explanation of Provision

Under the bill, the ordinary income rules of section 751 will be applied by regarding income rights, as section 751 does under present law, as severable from the partnership interest.5 Under this approach, a partner will be treated as disposing of such items independently of the rest of his partnership interest. The rule will apply regardless of how many tiers of partnerships exist between the transferring or distributee partner and the ordinary income assets.
5See H.R. Rep. No. 1337, 83rd Cong., 2nd Sess. pages 70, 71 (March 9, 1954).

The committee amendment also provides that this approach regarding income rights as severable is to apply to interests in trusts held by partnerships in the manner provided for in regulations.

The committee does not intend to create any inference regarding the tax treatment of these transactions under existing law.
Effective Date

The provision is effective for distributions, sales, and exchanges made after March 81, 1984, in taxable years ending after that date.
Revenue Effect

This provision has a negligible effect on fiscal year budget receipts.
[p. 241]
7. Exchanges of Like-Kind Property (sec. 61 of the bill and sec. 1031 of the Code)
Present Law
General rules

An exchange, like a sale of property, is generally a taxable transaction. However, present law provides that no gain or loss is to be recognized if property held for productive use is the taxpayer's trade or business, or property held for investment purposes, is exchanged solely for property of a like-kind that is also to be held for productive use in a trade or business or for investment. This provision (sec. 1031) specifically does not apply to exchanges of stock in) trade or other property held primarily for sale, or to stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest.6
6Special rules allow tax-free like-kind exchanges of stock of the same corporation (sec. 1036), certain insurance policies (sec. 1035), and certain U.S. obligations (sec. 1035). Additionally, the law provides for nonrecognition of gain in certain situations in which property lost or sold by the taxpayer is replaced, within a specified period, by property of a similar kind.

The nonrecognition of gain in like-kind exchange applies only to the extent that like-kind property is received in the transaction. For example, if a taxpayer holding a parcel of land having a basis of $50,000 and a fair market value of $100,000 exchanges the property for a parcel of land worth $90,000 plus $10,000 in cash, the taxpayer would recognize $10,000 of gain on the transaction. The remaining $40,000 of gain would be deferred until the taxpayer disposes of the second parcel as a taxable sale or exchange. No losses may be recognized from a qualifying like-kind exchange.

Present law does not require specifically that a like-kind exchange be completed within a specified period in order to qualify for tax-free treatment. In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the United States Court of Appeals for the Ninth Circuit held that an exchange qualified for like-kind treatment even though the property to be exchanged could be designated by the transferor for up to 5 years after the transaction and even though the transferor could have ultimately received cash rather than like-kind property. The case involved an exchange of real property in which the transferor eventually received like-kind property.
Installment sales

The Internal Revenue Code provides special rules for the reporting of income from installment sales (sec. 453). These rules allow gains from an installment sale to be spread out over the period during which installment payments are received. In general, the taxpayer reports income in each year for that proportion of the
[p. 242]

payments received during the year which is equivalent to the ratio which the gross profit from the sale bears to the total contract price. An installment sale is defined as a disposition of property in which at least one payment is received after the close of the taxable year in which the disposition occurs. For this purpose, payment includes property permitted to be received without the recognition of gain (sec. 453(f)(6)).
Exchanges of partnership interests

Present law does not state specifically whether an interest in one partnership may be exchanged for an interest in another partnership as a tax-free exchange of like-kind property. The Internal Revenue Service has ruled that the exception for equity interests in financial enterprises applies to partnership interests and thus they do not qualify as like-kind property that may be exchanged tax-free. Rev. Rul. 78-135, 1978-1 C.B. 256. Court decisions have held that exchanges of partnership interest may qualify for tax-free treatment as like-kind property exchanges where the underlying assets of the partnerships are substantially similar in nature. Estate of Rollin E. Meyer, Sr., 58 T.C. 311 (1972), aff'd per curiam, 503 F.2d 566 (9th Cir. 1974); Gulfstream Land and Development Co., 71 T.C. 587 (1979). However, the court in the Estate of Meyer case held that an exchange of a general partnership interest for a limited partnership interest does not satisfy the like-kind requirement.
Reasons for Change
Deferred like-kind exchanges

The committee is concerned that like-kind treatment of non-simultaneous exchanges has given rise to unintended results and administrative problems. These concerns extend to the underlying policy of the like-kind exchange rule.

The special treatment of like-kind exchanges has been justified on the grounds that a taxpayer making a like-kind exchange has received property similar to the property relinquished and therefore has not effectively "realized" a profit on the transaction. This rationale is less applicable in the case of deferred exchanges. To the extent that the taxpayer is able to defer completion of the transaction -- often retaining the right to designate the property to be received at some future point -- the transaction begins to resemble less a like-kind exchange and more a sale of one property followed, at some future point, by a purchase of a second property or properties. This is particularly true when (as was the case in Starker v. United States) the taxpayer might have received like-kind or non-like-kind property in the future. The committee believes that like-kind exchange treatment is inappropriate in such situations and that the general rule requiring recognition of gain on sales or exchanges of property should apply to these cases.

The special treatment of like-kind exchanges has also been justified from an administrative standpoint because of the difficulty of valuing property which is exchanged solely or primarily for similar property. This rationale may also be less applicable to deferred like-kind exchanges, in particular exchanges which are "left open"
[p. 243]

until the taxpayer has selected a suitable exchange property. In such cases, the transferred property must be valued at a specific or near-specific dollar amount in order to determine the aggregate value of the properties that the taxpayer may receive in the future. Thus, the taxpayer's gain may be measured with reasonable accuracy in the year of the original transfer.

The committee is also concerned that the like-kind exchange rules significantly expand the ability of taxpayers to avoid recognition of gain on deferred payment sales. Unlike other nonrecognition rules (e.g., the rollover of gain on replacement of a principal residence), the like-kind exchange provisions have no express statutory time limit on the availability of nonrecognition treatment. Decisions such as that in Starker v. United States suggest that there may, in fact, be no limit on the time for which like-kind exchanges may he kept open. If this is the case, taxpayers, by combining the installment sale rules and the like-kind exchange provisions, may defer taxation on dispositions of property for an indefinite period of time, even if a right to receive cash instead of property is retained. If cash is ultimately received, the installment sale rules will achieve a deferral until the time of receipt, while if like-kind property is received, recognition will be even further delayed. By exercising the right to designate property shortly before death, a taxpayer may conceivably avoid any taxation on the sale. Interaction of the installment sale and like-kind exchange rules also raises serious administrative problems regarding the allocation of liabilities and basis among different properties, problems which may not be resolvable until all exchanges and payments required by the agreement have been completed. Thus the tax consequences of deferred exchanges may not be determined for many years after the transaction is initiated.
Exchanges of partnership interests

It is questionable whether the like-kind exchange provisions were originally intended to apply to exchanges of partnership interests. The statute by its own terms does not apply to exchanges of stock, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest (sec. 1031). These exclusions prevent taxpayers from trading investment interests so as to take advantage of like-kind treatment on dispositions of appreciated property. The committee believes that, at least under current conditions, partnership interests typically represent investment interests similar to those items already excluded from like-kind treatment and should therefore also be excluded from such treatment.

In reaching the decision above, the committee is particularly concerned by the use of the like-kind exchange rules to facilitate the exchange of interests in tax shelter investments for interests in other partnerships. Under this arrangement, taxation of the gain inherent in an interest in a "burned out" tax shelter partnership -- i.e., a partnership which has taken substantial deductions for nonrecourse liabilities without actually paying off such liabilities, and hence without the partners suffering real economic loss -- may be able to be avoided if the interest is exchanged, tax-free, for an interest in another partnership, provided the old partnership has a section 754 election in effect and the new partnership does not.
[p. 244]
While court decisions have limited like-kind exchange treatment to partnerships holding similar underlying assets, this rule may be inadequate to deal with the burned-out tax shelter abuses and the administrative hardships. The committee believes that such abuses and hardships are best prevented by specifically excluding partnership interests from the like-kind exchange rule.
Explanation of Provisions
Deferred like-kind exchanges

The bill provides that, for purposes of the like-kind exchange provision, any property received by the taxpayer more than 180 days (but not later than the due date of the taxpayer's tax return) after the date on which the taxpayer relinquishes property is not to be treated as like-kind property. Thus, tax-free treatment will be unavailable for exchanges not completed within this time period. In addition, property which was not identified as the property to be received by the taxpayer on the date the transferred property was relinquished will not qualify as like-kind property.
Exchanges of partnership interests

The bill specifies that the like-kind exchange rules do not apply to any exchange of interests in different partnerships. This rule is not intended to apply to an exchange of interests in the same partnership.

No inference should be drawn from the committee's action regarding the proper treatment of these transactions under present law.
Effective Date

The provisions are effective for transfers of property (by the taxpayer seeking like-kind exchange treatment) made after date of enactment.
Revenue Effect

This provision will increase fiscal year budget receipts by $226 million in 1985, $630 million in 1986, $667 million in 1987, $788 million in 1988, and $842 million in 1989.
Worksheet 7A
Rev. Rul. 93-80, 1993-2 C.B. 239.
Worksheet 7A	Click Icon to View Worksheet
Worksheet 7B
Rev. Rul. 99-6, 1999-6 I.R.B. 6
Worksheet 7B	Click Icon to View Worksheet
Worksheet 8
[Reserved]

Worksheet 9
Election to Adjust Basis of Partnership Property Under Section 754 (Regs. Section 1.754-1(b)).
                                            KSS Partners                 
                                            643 Horace Harding Expressway
                                            Flushing, NY                 
                                            EIN 12-0121962               

KSS Partners hereby elects under Internal Revenue Code Section 754 to apply the provisions of Sections 734(b) and 743(b) beginning with the calendar year 19XX (to the return for which year this statement is attached). 
                                                                         
                                       /s/___________________________    
                                       [partner]                         

Worksheet 10
Request for Revocation of Section 754 Election to Adjust Basis of Partnership Property (Regs. Section 1.754-1(c)).
                                        KSS Partners                    
                                        643 Horace Harding Expressway   
                                        Flushing, NY                    
                                        EIN 12-0121962                  
                                                                        
                                        January 4, 19X5                 
                                                                        
  District Director                                                     
  Holtsville Service Center                                             
  Holtsville, NY                                                        
                                                                        
  To the District Director:                                             

KSS Partners requests IRS approval for a revocation of its Internal Revenue Code Section 754 basis adjustment election, effective for the partnership taxable year ending December 31, 19X4.

Before the tax year 19X4, KSS Partners' assets included inventory, consisting of 10,000 pairs of shoes, and bank accounts totalling $500,000. During the tax year, KSS Partners received partner contributions totalling $1,500,000 and acquired 500 acres of farmland. KSS Partners takes the position that the partner contributions and the acquisition of the farmland qualifies under Regs. Section 1.754-1(c) as a change in the nature of the partnership business, a substantial increase in partnership assets, and a change in the character of partnership assets. Accordingly, KSS Partners respectfully requests that the IRS consents to revoke the election. 
                                                                         
                                       Very truly yours,                 
                                                                         
                                       /s/_________________________      
                                       [partner]                         

BIBLIOGRAPHY
OFFICIAL
Statutes:
Sections 311, 336, 351, 357, 368, 453, 465, 469, 703, 704, 706, 707, 708, 721, 724, 731, 732, 733, 734, 735, 736, 741, 742, 743, 751, 752, 754, 761, 1011, 1012, 1031.
Treasury Regulations:
All Treasury regulations promulgated under the above-referenced Code sections.
Treasury Rulings:
Rev. Proc. 87-32, 1987-2 C.B. 396.
Rev. Rul. 57-503, 1957-2 C.B. 139.
Rev. Rul. 60-352, 1960-2 C.B. 208.
Rev. Rul. 66-264, 1966-2 C.B. 248.
Rev. Rul. 67-65, 1967-1 C.B. 168.
Rev. Rul. 68-289, 1968-1 C.B. 314.
Rev. Rul. 70-239, 1970-1 C.B. 74, revoked and superseded by Rev. Rul. 84-111, 1984-2 C.B. 88.
Rev. Rul. 70-355, 1970-2 C.B. 51.
Rev. Rul. 72-172, 1972-1 C.B. 265.
Rev. Rul. 75-154, 1975-1 C.B. 186.
Rev. Rul. 75-194, 1975-1 C.B. 80.
Rev. Rul. 75-323, 1975-2 C.B. 346.
Rev. Rul. 75-423, 1975-2 C.B. 260.
Rev. Rul. 76-189, 1976-1 C.B. 181.
Rev. Rul. 77-137, 1977-1 C.B. 178.
Rev. Rul. 77-309, 1977-2 C.B. 216.
Rev. Rul. 77-321, 1977-2 C.B. 98.
Rev. Rul. 77-458, 1977-2 C.B. 220.
Rev. Rul. 78-135, 1978-1 C.B. 256.
Rev. Rul. 79-205, 1979-2 C.B. 255.
Rev. Rul. 80-198, 1980-2 C.B. 113.
Rev. Rul. 81-38, 1981-1 C.B. 386.
Rev. Rul. 84-52, 1984-1 C.B. 157.
Rev. Rul. 84-53, 1984-1 C.B. 159.
Rev. Rul. 84-111, 1984-2 C.B. 88.
Rev. Rul. 86-73, 1986-1 C.B. 282.
Rev. Rul. 87-50, 1987-1 C.B. 157.
Rev. Rul. 87-51, 1987-1 C.B. 158.
Rev. Rul. 87-57, 1987-2 C.B. 117.
Rev. Rul. 87-110, 1987-2 C.B. 159.
Rev. Rul. 87-115, 1987-2 C.B. 163.
Rev. Rul. 87-120, 1987-2 C.B. 161.
Rev. Rul. 88-42, 1988-1 C.B. 265.
Rev. Rul. 90-17, 1990-1 C.B. 119.
Rev. Rul. 91-32, 1991-1 C.B. 107.
Cases:
Atlas v. U.S., 555 F. Supp. 110 (N.D. Ill. 1982).
Austin v. U.S., 461 F.2d 733 (10th Cir. 1972).
Baker Commodities, Inc. v. Comr., 48 T.C. 374 (1967), aff'd, 415 F.2d 579 (9th Cir. 1969), cert. denied, 397 U.S. 988 (1970).
Barran v. Comr, 334 F.2d 58 (5th Cir. 1964), aff'g, rev'g and rem'g in part 39 T.C. 515 (1962).
Carriage Square, Inc. v. Comr., 69 T.C. 119 (1977).
Chef's Choice Produce Ltd. v. Comr., 95 T.C. 388 (1990).
Citron v. Comr., 97 T.C. 200 (1991).
Colonnade Condominiums Inc. v. Comr., 91 T.C. 793 (1988).
Communications Satellite Corp. v. U.S., 625 F.2d 997 (Ct. Cl. 1980).
Cooley v. Comr., 52 T.C.M. 411 (1986).
Cooney v. Comr., 65 T.C. 101 (1975).
Cornish, U.S. v., 348 F.2d 175 (9th Cir. 1965), rev'g and rem'g 221 F. Supp. 658 (D. Ore. 1963).
Court Holding Company, Comr. v., 324 U.S. 331 (1945), rev'g 143 F.2d 823 (5th Cir. 1944), rev'g and rem'g 2 T.C. 531 (1943), nonacq., 1969-2 C.B. XXVI.
Crane v. Comr., 331 U.S. 1 (1947), aff'g 153 F.2d 504 (2d Cir. 1945), rev'g 3 T.C. 585 (1944), nonacq., 1945 C.B. 8.
Crenshaw v. U.S., 408 U.S. 923 (1972), cert. denied, 450 F.2d 472 (5th Cir. 1971), rev'g and rem'g 315 F. Supp. 814 (D. Ga. 1970).
Diedrich v. Comr., 457 U.S. 191 (1982), aff'g 643 F.2d 499 (8th Cir. 1981), rev'g T.C. Memo 1979-441.
Donoho, U.S. v., 275 F.2d 489 (8th Cir. 1960), aff'g 168 F. Supp. 679 (D. Minn. 1958).
Echols v. Comr., 935 F.2d 703 (5th Cir. 1991).
Evans v. Comr., 447 F.2d 547 (7th Cir. 1971), aff'g 54 T.C. 40 (1970), acq., 1978-2 C.B. 2.
Foxman v. Comr., 352 F.2d 466 (3d Cir. 1965), aff'g 41 T.C. 535 (1964), acq., 1966-2 C.B. 4.
Fuchs v. Comr., 80 T.C. 506 (1983).
Gannon v. Comr., 16 T.C. 1134 (1951), acq., 1951-2 C.B. 2.
General Utilities and Operating Co. v. Helvering, 296 U.S. 200 (1935), rev'g 74 F.2d 972 (4th Cir. 1935).
Ginsburg v. U.S., 396 F.2d 989 (Ct. Cl. 1968).
Gulfstream Land & Development Corp. v. Comr., 71 T.C. 587 (1979).
Haggard v. Wood, 298 F.2d 24 (9th Cir. 1961), aff'g 60-2 USTC Para.9740 (D. Ariz. 1960).
Haines v. U.S., 76-1 USTC Para.9222 (N.D.N.J. 1976).
Hale v. Comr., 24 T.C.M. 1497 (1965).
Hatch Est. v. Comr., 198 F.2d 26 (9th Cir. 1952), rev'g 14 T.C. 251 (1950).
Hempt Brothers v. U.S., 419 U.S. 826 (1974), cert. denied, 490 F.2d 1172 (3d Cir. 1974), aff'g 354 F. Supp. 1172 (D. Pa. 1973).
Hillsboro Nat'l Bank v. Comr., 460 U.S. 370 (1983), on writ on certiorari, 641 F.2d 529 (7th Cir. 1981), aff'g 73 T.C. 61 (1980).
Hoagland v. Comr., 30 T.C.M. 1326 (1971), appeal dism'd (9th Cir. 1972).
Holiday Village Shopping Center v. U.S., 5 Ct. Cl. 566 (1984), aff'd, 773 F.2d 276 (Fed. Cir. 1985).
Hutcheson v. Comr., 17 T.C. 14 (1951), acq., 1951-2 C.B. 2.
Jupiter Corp. v. U.S., 2 Cl. Ct. 58 (1983).
Kaiser v. Glenn, 216 F.2d 551 (6th Cir. 1954), rev'g and rem'g per curiam 114 F. Supp. 356 (D. Ky. 1953).
LaRue v. Comr., 90 T.C. 465 (1988).
Long v. Comr., 77 T.C. 1045 (1981).
Malat v. Riddell, 383 U.S. 569 (1966), vac'g and rem'g per curiam 347 F.2d 23 (9th Cir. 1965), aff'g 64-1 USTC Para.9432 (D. Cal. 1964).
Mason v. Comr., T.C. Memo 1988-273.
Maxwell v. Frank, 182 F. Supp. 823 (W.D. Wash. 1960).
McCauslen v. Comr, 45 T.C. 588 (1966).
Meyer Est. v. Comr., 58 T.C. 311 (1972), nonacq., 1975-1 C.B. 3, aff'd per curiam, 503 F.2d 556 (9th Cir. 1974).
Neubecker v. Comr., 65 T.C. 577 (1975).
Nieman v. Comr, T.C. Memo 1960-120, motion to correct 33 T.C. 411 (1959).
O'Brien v. Comr., 77 T.C. 113 (1981).
Rodman v. Comr., 542 F.2d 845 (2d Cir. 1976), rev'g and rem'g T.C. Memo 1973-277.
Rooney v. U.S., 305 F.2d 681 (9th Cir. 1962), aff'g 189 F. Supp. 733 (D. Cal. 1961).
Sennett v. Comr., 80 T.C. 825 (1983), aff'd per curiam, 752 F.2d 428 (9th Cir. 1985).
Seyburn v. Comr., 51 T.C. 578 (1969).
Shapiro, Comr. v., 125 F.2d 532 (6th Cir. 1942).
Siller Brothers, Inc. v. Comr., 89 T.C. 256 (1987).
Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir. 1982).
Sloan v. Comr., 42 T.C.M. 1606 (1981).
Spicker v. Comr., 26 T.C. 91 (1956).
Stilwell v. Comr., 46 T.C. 247 (1966).
Tapper v. Comr., 52 T.C.M. 1230 (1986).
Tejon Ranch Co. v. Comr., 49 T.C.M. 1357 (1985).
Tennyson v. U.S., 76-1 USTC Para.9264 (W.D. Ark. 1976).
Thornley v. Comr., 147 F.2d 416 (3d Cir. 1945), rev'g 2 T.C. 220 (1943), acq., 1949-1 C.B. 4.
Trousdale v. Comr., 219 F.2d 563 (9th Cir. 1955), aff'g 16 T.C. 1056 (1951).
Tunnell v. U.S., 259 F.2d 916 (3d Cir. 1958), aff'g 148 F. Supp. 689 (D. Del. 1957).
Tufts v. Comr., 651 F.2d 1058 (5th Cir. 1981), rev'd, 461 U.S. 300 (1983), rev'g 70 T.C. 756 (1978).
Ungar, Inc., J., v. Comr., 244 F.2d 90 (2d Cir. 1957), aff'g 26 T.C. 331 (1956).
Weiss v. Comr., 92-1 USTC Para.50,168 (11th Cir. 1992).
Winthrop, U.S. v., 417 F.2d 905 (5th Cir. 1969), rev'g 67-2 USTC Para.9651 (D. Fla. 1967).
Zeeman v. U.S., 275 F. Supp. 235 (S.D.N.Y. 1967), aff'd in part and rem'd, 395 F.2d 861 (2d Cir. 1968).
UNOFFICIAL
Text and Treatises:
McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners.
Willis, Pennell, and Postlewaite, Partnership Taxation.
Periodicals:
1980
Arland, Blade and Henderson, "Tax Court Disallows Application of Corn Products Doctrine to Sales of Partnership Interests," 58 TAXES 491.
Klein, "Optional Adjustments to Basis of Partnership Properties -- Special Problems," 38 Inst. on Fed. Tax. 10-1.
Pitts, "The Sale of a Partnership Interest with a Section 453 Election," 58 TAXES 481.
Pommier and Tallerine, "Partnership Termination Payments Affect Partnership and Rest of Partners as Well," 24 Tax. Acct. 306.
Seago and Horvitz, "Some Subtle Effects of the Partnership Constructive Distribution Rules," 58 TAXES 97.
1981
Heller and Boyed, "Changes of Ownership in a Partnership and How They Affect the Partners' Distributive Shares," 59 TAXES 639.
1982
Jones, "Can a Corporate Liquidating Distribution of a Partnership Interest Avoid Recognizing Gain?," 56 J. Tax'n 222.
Pennell, "Problems Involving the Optional Adjustment to Basis of Partnership Assets," 34 Major Tax Plan. 8-1.
Streer, "How a Taxpayer Can Avoid Ordinary Income When Disposing of a Partnership Interest," 28 Tax. Acct. 318.
1983
Butler, "Liquidation of Partnership Interest More Advantageous Than Sale to Remaining Partners," 30 Tax. Acct. 152.
Drucker and Segal, "Problems and Opportunities in Working With Collapsible Partnerships," 61 TAXES 110.
Hesch, "Planning for Tax-Free Exchanges Involving Partnerships and Incorporation of Partnerships," 41 Inst. on Fed. Tax'n 15-1.
Hirschfeld, "When is an Acquisition of a Partnership Interest a Disguised Sale by the Partners?," 58 J. Tax'n 346.
Hoeflich, "Transfers of Interests in Public Limited Partnerships and the Collapsible Partnership Rules: A Planning Pitfall," 14 Tax Adv. 742.
1984
Butler, "Accounting for the Transfer of a Partnership Interest with Suspended Losses," 62 TAXES 147.
Moore and Nagel, "Steps to Take to Minimize Ordinary Income on the Sale of a Partnership Interest," 32 Tax. Acct. 36.
Pennell, "An Analysis of the Deficit Reduction Act Provisions Affecting Partnerships: Part I." 61 J. Tax'n 332.
Pennell, "An Analysis of the Deficit Reduction Act Provisions Affecting Partnerships: Part II." J. Tax'n 378.
1985
Baader, "Jackson Reanalyzed: Preventing Tax-Free Escape upon Transfer of a Partnership Interest," 26 William & Mary L. Rev. 317.
Bogdanski, "Closely Held Corporation: Vive Les Differences: Revenue Ruling 84-111," 11 J. Corp. Tax'n 367.
Choate and Massoglia, "Many Partnership Transactions Will Result in Recapture of Investment Tax Credit," 62 J. Tax'n 220.
Cleveland and Berryman, "Tax Treatment Upon Termination of a Partnership May be Uncertain, but Planning Opportunities Exist," 2 J. Partner. Tax'n 35.
Cuff, "Tax Results of Liquidation of Corporate Partner Still Unclear Despite TRA of 1984," 62 J. Tax'n 88.
Losey, "Recent Cases and Rulings: New Ruling on Incorporation of Partnership Business," 1 J. Partner. Tax'n 340.
Seltzer, "The Effect of the Deficit Reduction Act of 1984 on Corporate Joint Ventures and Other Partnerships," 37 Tax Exec. 165.
1986
Berkeland and Postlewaite, "Constructive Termination of a Partnership -- A Fresh Look," 39 Tax Law. 701.
Braitman, "Transactions Between Partners and Partnerships," 44 Inst. on Fed. Tax'n 21-1.
Cohen and Millman, "Partnership Procedure: Tax Termination of a Continuing Partnership," 3 J. Partner. Tax'n 54.
Coleman, "Terminating Partnership Can Still Make Election to Adjust Basis of Its Assets," 37 Tax. Acct. 343.
Feldman and Hotek, "Choices Now Available For a Partnership That Wants to Incorporate its Operations," 36 Tax. Acct. 310.
Hennessee and Porter, "The Tax Consequences of Exchanging Property Encumbered By Excessive Debt for a Partnership Interest," 35 Oil and Gas Tax Q. 259.
Kramer and Kramer, "Incorporation of a Partnership: IRS's New Position Produces Planning Opportunities and Pitfalls," 64 TAXES 560.
Lynch, "Taxation of the Disposition of Partnership Interests: Time to Repeal IRC Section 736," 65 Neb. L. Rev. 450.
Manning, "Estate Planning: Sale of a Partnership Interest When a Partner Dies or Becomes Disabled," 3 J. Part. Tax'n 256.
Mathias, "How Buy-Sell Agreements Can Produce Best Tax Results for Both the Partners and the Partnership," 37 Tax. Acct. 246.
Milner and Talley, "Effect of Termination by Sale or Exchange on Construction Partnerships," 65 J. Tax'n 110.
Segal, Stretch and Bonanno, "Determining Distributive Shares of Cash-Basis Partnership When an Interest Changes," 65 J. Tax'n 164.
Williford and Standley, "Tax Effects of the Acquisition of a Partnership Interest Can Be Controlled," 37 Tax. Acct. 134.
1987
Banks and Karr, "Sale of Partnership Interests Can Produce Unexpected Tax Results Without Proper Planning," 38 Tax. Acct. 92.
James, "Partnership Basis Adjustments and Allocations Following a Section 708 Deemed Liquidation and Recontribution," 34 U.C.L.A. L. Rev. 1905.
McGownad and Alandt, "Changes in the Partnership (Essential Tax Planning Considerations)," 66 Mich. B. J. 638.
1988
McGilsky and Bolling, "Tax Implication of Partnership Mergers," 66 TAXES 606.
Resnick and Sellers, "Tax Termination of a Partnership Can Be Controlled to Meet Needs of the Partners," 41 Tax. Acct. 376.
Seago and Strobel, "Cancellation of Indebtedness in Exchange for a Partnership Interest," 19 Tax Adv. 443.
1989
Delaney, "Structuring Partner Admissions to Avoid Disguised Sale Treatment," 71 J. Tax'n 178.
Feldman and Cramer, "Partnership Terminations Can Provide Substantial Tax Savings Opportunities," 43 Tax. Acct. 286.
Nicholson, "Disguised Sales Involving Partners and Partnerships," 47 Inst. on Fed. Tax'n 27-1.
1991
Horowitz, "Partnerships Can Survive the Bankruptcy of a General Partner," 46 Tax. Acct. 330.
Smiley, "Dispositions of U.S. Partnership Interests by Nonresident Aliens," 8 J. Part. Tax'n 133.
1992
Cuff, "Allocating Partnership Liabilities," 70 TAXES 303 (May).
Diana, "Abandonment and Worthlessness of Partnership Interests After Echols and Citron," 33 Tax Mgmt. Memo. 35.
Hanna, "A Partnership's Business Purpose Taxable Year: A Deferral Provision Whose Time Has Passed," 45 Tax Law. 685 (Spring).
McBurney, "Mining-Bowl Transactions and the Partnership Disguised Sale Regulations," 70 TAXES 123 (Mar).
O'Neill, "An Alternative to the Safe-Harbor Rules Under the 704(6) Regulations," 70 TAXES 28 (Jan).
Pickron, "Final Rules on Allocation of Partnership Liabilities Still Leave Unanswered Questions," 76 J. Tax'n 272 (May).
1993
 Pusker, "Losses on Partnership Interests May Be Ordinary," 51 Tax'n for Accts. No. 2, 76.
 Reynolds, "Dispositions of Partnership Interests: Exit Strategies for Partners," 9 Tax Mgmt. Fin. Plan. J. No. 2, 43. 
____, "Ruling Examines Abandonment and Worthlessness of Partnership Interest," 34 Tax Mgmt. Memo. 389. 
1994
Boyd and O'Dell, "Resolving the Tax Issues When a Partnership Interest Is Transferred to a Corporation," 10 J. Partnership Tax'n No. 4, 322.
Lipton, "How to Avoid Capital Loss Treatment on the Abandonment of a Partnership Interest," 80 J. Tax'n No. 3, 158.
Tierney, "Reassessing Sales and Liquidations of Partnership Interests after the Omnibus Budget Reconciliation Act of 1993," 1 Fla. Tax Rev. No. 12, 681.
Williford, "New Ruling Clarifies the Tax Consequences of Abandoning a Partnership Interest," 11 J. Partnership Tax'n No. 1, 39.
1995
Bryan and Dance, "Treatment of Liquidating Payments to LLC Members: How Will Section 736 Be Applied to LLCs," 2 J. of Limited Liability Companies 51 (Fall).
Charyk, "The Partnership Corner: New Rules Regarding Deductibility of Partnership Interest Transfers," 23 J. of Real. Est. Tax'n 149.
Tousey and Wallis, "Estate Planning: Planning Opportunities Still Exist for the Liquidation of a Deceased Partner's Partnership Interest," 12 J. of Partnership Tax'n 275 (Fall).
1996
Lipton, "Partnership Deemed Terminations Will be Simpler Under New Proposed Regulations," 85 J. of Tax'n 133.
1997
Rubin & Teplinsky, "A Comprehensive Guide to Partnership Terminations, Including the Impact of the New Proposed Regulations," 24 J. of Real Est. Tax'n 115.
1998
Frankel, Metzger, and Dell, "Planning for the Termination of an Interest in a Partnership--Withdrawals, Distributions, and Other Exit Strategies," 39 Tax Mgmt. Memo. No. 26, S-381.*
2000
Walsh, " `Hypothetical Sale' Approach Makes Real Change in Partnership Regs.," 64 Prac. Tax Strat. 330.