U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Portfolio Description

Lisa Marie Starczewski, Esq.
   Valley Forge, Pennsylvania
 
 Special Consultant to Tax Management 

Lisa Marie Starczewski, Smith College, B.A.(magna cum laude, 1985); Villanova University School of Law, J.D. (summa cum laude, 1988); Editor-in-Chief, Villanova Law Review (1987-88); member of adjunct faculty, Villanova University School of Law; former associate, Morgan, Lewis &  Bockius;Schnader, Harrison, Segal &  Lewis; Author, 550 T.M., At-Risk Rules; 565 T.M., Installment Sales; 752 T.M., Corporate Alternative Minimum Tax; 587 T.M., Noncorporate Alternative Minimum Tax; 621 T.M., IRS National Office Procedures —Rulings, Closing Agreements; Co-Author, 517 T.M., Scholarships and Educational Expenses; 504 T.M., Deduction Limitations: General; 503 T.M., Deductions:Overview and Conceptual Aspects; BNA Tax and Accounting Portfolio 5100, Revenue Recognition: Fundamental Principles; BNA Tax and Accounting Portfolio 5101, Revenue Recognition:Product Sales and Services; BNA Tax and Accounting Portfolio 5114, Accounting for Leases: Fundamental Principles;BNA Tax and Accounting Portfolio 5117, Leases: Lessee Perspective;BNA Tax and Accounting Portfolio 5118, Leases: Lessee Perspective —Selected Topics; Author of several chapters in the Tax Practice Series and contributor to various tax publications;recipient of Distinguished Author award; Member, Tax Management U.S. Income Advisory Board.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Portfolio Description

Leonard L. Silverstein, Esq. 
 Advisory Board Chairman
 Technical Director
 
 Gerald H. Sherman, Esq. 
 Deputy Technical Director
 
 Patrick G. Dooher, Esq. 
 Deputy Technical Director
 for U.S. Income

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Portfolio Description

PORTFOLIO DESCRIPTION 

Tax Management Portfolio, No. 714-3rd, Partnerships —Allocation of Liabilities; Basis Rules, analyzes the tax considerations relating to the determination of a partner's adjusted basis in his partnership interest, a partner's adjusted basis in distributed property and a partnership's adjusted basis in partnership property. These basis determinations are essential to the computation of the amount and timing of each partner's taxable income or loss.

Under the general rule of § 722, a partner's initial basis in his partnership interest is equal to the amount of money contributed plus the adjusted basis of any  contributed property in the hands of the contributing partner, increased by the amount of gain, if any, recognized by the contributing partner under § 721(b). If the contributed property is subject to an encumbrance, § 752 provides rules governing the effect of such encumbrances on the partner's adjusted basis. The rules in § 752 and the regulations thereunder, governing allocation of partnership liabilities and other obligations, are discussed in detail in this portfolio.

Under § 742, the determination of the basis of a partnership interest acquired other than by contribution is generally governed by the general basis rules set forth in § § 1011, et seq.

Under § 723, the partnership's initial basis in property contributed to it is equal to the adjusted basis of the property in the hands of the contributing partner, increased by the amount of gain, if any, recognized by the contributing partner under § 721(b).

When property is distributed to a partner, basis adjustments can occur at both the partnership level, with respect to the remaining assets, and at the partner level, with respect to both the distributed property and any remaining partnership interest. The partner's basis in the distributed property depends on several factors, principally whether the distribution is in liquidation of the partner's entire partnership interest.

If the partnership has made a § 754 election or if the mandatory basis adjustment rules are applicable, § § 734 and 743 operate, through the allocation rules of § 755, to make basis adjustments to partnership property. The § § 734 and 743 basis adjustments are discussed in detail in this Portfolio.

This Portfolio may be cited as Starczewski, 714-3rd T.M., Partnerships —Allocation of Liabilities; Basis Rules.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  I. Introduction

A. Aggregate vs. Entity Approach to Partnership Taxation 

Subchapter K (§ § 701 through 761) of the Internal Revenue Code(hereinafter the “Code”)1 governs the federal income taxation of partners and partnerships.2 Subchapter K combines an “aggregate” and “entity”approach to the taxation of a partnership.  Section 701 of the Code provides that a partnership is not a taxable entity and incurs no federal income tax liability. Instead, each partner in a partnership is required to take into account gains, losses, deductions, and credits of the partnership in computing the partner's federal income tax liability with respect to the partner's allocable share of income.3 These rules reflect an aggregate approach to the taxation of a partnership, under which the individual partners are viewed as realizing their shares of partnership income or loss directly as co-owners of the underlying partnership property. There are several Code provisions, such as those relating to the flow-through of partnership items, that reflect this approach.
——————————————————————————————

1 Unless otherwise indicated, all references to the Code are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.

2 Section 7701(a)(2) of the Code states: “The term ‘partnership' includes 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, and which is not ... a trust or estate or a corporation; and the term ‘partner' includes a member in such a syndicate, group, pool, joint venture, or organization.”The characterization of an entity as a partnership is discussed in detail in 710 T.M., Partnerships — Conceptual Overview.

3 § 702; Regs. § 1.702-1.

——————————————————————————————

In contrast to the “aggregate” approach is the “entity”approach, under which the partnership is treated as existing separately from the partners and as owning the partnership property and conducting partnership business in its separate capacity. Despite the fact that a partnership is not a taxable entity, several Code provisions treat a partnership as a separate entity. For instance, the entity approach is reflected in the fact that the amount and character of partnership income, gain, loss, deduction, and credit are determined at the partnership level.4 The entity approach is also evident in the basis rules that provide that the partnership has a basis in its assets while each partner has a separate basis in the partner's partnership interest that is distinct from the partner's share of the basis of the underlying partnership assets.5
——————————————————————————————

4 § 702(b).

5 § 705(a).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  I. Introduction

B. Two Concepts of Basis 

The fact that a partnership is treated as a separate entity for some purposes and as a conduit or flow-through entity for others adds a layer of complexity to the rules governing partnership taxation. Anyone attempting to work through a partnership tax issue should keep in mind that there are two distinct concepts of basis that apply in the setting of a partnership. First, the partnership has an adjusted basis in its assets. This basis is sometimes referred to as “inside basis.” The amount of its adjusted basis in its assets is significant in a variety of situations, including in the computation of the amount of gain or loss realized by the partnership upon the sale of an asset. Secondly, each partner has an adjusted basis in the partnership interest. This basis is sometimes referred to as “outside basis.”The amount of a partner's adjusted basis in the interest is also significant in several circumstances, including the determination of the amount of gain or loss recognized by the partner upon a distribution of property by the partnership and the deductibility of partnership losses by the partner.

Although the two concepts of basis applicable to partnerships are separate and distinct, they are related in that the total amount of the partners' adjusted bases in their partnership interests generally equals the total amount of the adjusted basis of the partnership in its assets. This equality can, however, be upset by certain events that occur during the operation of the partnership. For instance, when a partner sells a partnership interest, the transferee partner has an initial basis in the partnership interest that is equal to the partner's cost. However, the transferee partner's share of the partnership's basis in its assets may or may not be adjusted to reflect the cost of the partnership interest. Absent an adjustment, there is likely to be a discrepancy between the transferee partner's basis in the partnership interest and  the partner's share of the partnership's basis in its assets.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  I. Introduction

C. Relationship Between Basis and Capital Account 

Section 704 provides that partnership allocations of income, gain, loss, or deduction are not respected unless the allocations have “substantial economic effect.”The regulations under  § 704 provide that for partnership allocations to have “substantial economic effect,” the partnership must establish and maintain “capital accounts” for the partners.6 Capital accounts are intended to keep track of the partners' contributions, distributions, and allocations. A partner's capital account is separate and distinct from  the partner's adjusted basis in the partnership interest.7 A partner's capital account does not reflect the partner's share of partnership liabilities. In addition, upon the occurrence of certain events, partnership property is accounted for at fair market value for book purposes (in the partners' capital accounts) regardless of whether fair market value differs from basis. For example, if a partner contributes unencumbered property to a partnership, the partner's adjusted basis in the partnership interest is increased by the partner's  adjusted basis in the contributed property,8 but the partner's  capital account is increased by the fair market value of the contributed property.9 Thus, the balance in a partner's capital account is often not equal to the partner's adjusted basis in the partnership.
——————————————————————————————

6 Regs. § 1.704-1(b)(2)(iv). In addition to having capital accounts in the  § 704 sense, a partnership may also maintain a separate set of books for financial accounting purposes and refer to these as “capital accounts.” However, in this Portfolio, the term “capital account” refers to the capital account established and maintained for each partner pursuant to the regulations under § 704. For further discussion of capital accounts, see 712, T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts.

7 Regs. § 1.705-1(a)(1).

8 § 722.

9 Regs. § 1.704-1(b)(2)(iv)(d)(1).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  I. Introduction

D. Subchapter K Anti-Abuse Regulations 

The subchapter K anti-abuse 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 partners' aggregate federal tax liability in a manner inconsistent with subchapter K.10 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.11 Of particular note, several of the examples in the regulations involve  § 754 elections and the allocation of basis.
——————————————————————————————

10 Regs. § 1.701-2(b).

11 Regs. § 1.701-2(e).

——————————————————————————————

The anti-abuse regulations represent the IRS's response to its perception that the partnership rules are sometimes used in a manner inconsistent with the intention 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. Although the regulations were designed to curb only abusive transactions, the rules are arguably 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 be subject to the anti-abuse regulations.

Announcement 94-87 12 was issued at the same time as the partnership anti-abuse regulations. The announcement identified the procedures that Examination personnel were required to use if they detected indications of abusive partnership activities. In 1998, the IRS issued Settlement Guidelines with respect to these regulations.13 These guidelines were intended primarily for the IRS's own use. In the Settlement Guidelines, the IRS addressed the circumstances in which the Commissioner of the Internal Revenue is authorized under the anti-abuse regulations to recast a transaction involving the use of a partnership, as well as the issue of whether adjustments made because of the partnership anti-abuse regulations are considered partnership items under § 6231(a).
——————————————————————————————

12 1994-27 I.R.B. 124.

13 ISP Settlement Guideline: Subchapter K Anti-Abuse Rule Regs.  § 1.701-2 (9/23/98).

——————————————————————————————

With respect to the first issue, the IRS offered little guidance other than to outline the examples found in the regulations and state that the Commissioner does, in fact, have the authority to recast transactions involving the use of a partnership. The settlement guidelines with respect to the circumstances under which this authority exists were apparently redacted from the version released to the public. With respect to the second issue, the IRS concluded that certain adjustments made pursuant to the partnership anti-abuse regulations are always considered partnership items while others may or may not be, depending on the facts and circumstances.

Comment: Whether or not adjustments made pursuant to the anti-abuse regulations are considered partnership items is significant because, if the partnership is subject to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (and most partnerships are), the IRS must follow certain procedural rules with respect to adjustments made to partnership items.

The anti-abuse regulations are discussed in 710 T.M., Partnerships —Conceptual Overview.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  II. Determination of Partner's Initial Basis in Partnership Interest

A. Partnership Interest Acquired by Contribution to Partnership: § § 721 and 722 

1. Contribution of Money or Property 

a. General Rule 

Section 722 of the Code provides that the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership is equal to the amount of money contributed plus the contributing partner's adjusted basis in contributed property at the time of the contribution increased by the amount (if any) of gain recognized under  § 721(b) by the contributing partner at the time of the contribution. Thus, to determine a partner's initial basis in the partnership interest, one must first determine what the partner has contributed to the partnership in exchange for that interest. If the partner has contributed services to the partnership in exchange for his interest, the general rule of  § 722 does not apply. The contribution of services in exchange for a partnership interest is discussed in further detail in II, A, 2, below.

If the partner has contributed money and/or unencumbered property to the partnership, the computation of  the partner's initial basis in the partnership interest begins with the amount of money contributed and the adjusted basis of any unencumbered property contributed. Next, one must determine whether the contribution results in the recognition of gain under § 721(b). Section 721(a) provides that no gain or loss is recognized to a partnership or to any partner in the case of a contribution of property to the partnership in exchange for an interest in the partnership.14 However,  § 721(b) provides that the general nonrecognition rule of  § 721(a) does not apply to gain realized on a transfer of property to a partnership that would be treated as an investment company (under  § 351) if the partnership were incorporated. Thus, if a partner contributes property to a partnership that qualifies as an “investment company,” the partner's basis in the partnership interest includes the adjusted basis in the contributed property plus any gain recognized upon the transfer. The contribution of property to a partnership that would qualify as an investment company if incorporated is discussed in greater detail in II, A, 3, below.
——————————————————————————————

14 Some contributions may be other than in exchange for “an interest in the partnership”and, if so, the tax-free shield of  § 721 may not apply. However, in Rev. Rul. 56-5, 1956-1 C.B. 630, the IRS concluded that a greater interest in either capital or profits should be considered an interest in the partnership within the meaning of  § 721 (e.g., when a partner contributes additional cash to an existing partnership). Whether a preference in liquidation or greater management rights should also be considered an interest in the partnership appears more questionable. See Committee Report on P.L. 94-455, at .094, which states that, in determining a partner's interest in the partnership, all of the relevant facts and circumstances are to be taken into account. Relevant factors mentioned in the report include the interests of the respective partners in profits and losses, cash flow, and their rights to distributions of capital upon liquidation. The rules regarding nonrecognition treatment under  § 721 are discussed in greater detail in 710 T.M., Partnerships — Conceptual Overview.

——————————————————————————————

Example: On Jan. 1, Year One, X and Y form an equal partnership. X contributes $50,000 in cash and Y contributes unencumbered property with a fair market value of $50,000 and an adjusted basis of $30,000. X's initial basis in his partnership interest is $50,000 (the amount of cash contributed). Y's initial basis in her partnership interest is $30,000 (her adjusted basis in the contributed property). The inherent gain in the property ($20,000) is allocated to Y pursuant to the rules in § 704(c).15

——————————————————————————————

15 Section 704(c) requires that income, gain, loss, and deduction with respect to property contributed to the partnership by a partner be allocated so as to take into account the difference between the basis of the property to the partnership and its fair market value at the time of contribution. The  § 704(c) rules are discussed in greater detail in 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts.

——————————————————————————————

b. Contribution of Property Encumbered by Recourse Liabilities 

Section 752 provides rules related to the tax treatment of partnership liabilities.  Section 752(c) provides that, for purposes of § 752, a liability to which property is subject is considered, to the extent of the fair market value of the property, a liability of the owner of the property. Therefore, if a partner contributes property encumbered by liabilities to a partnership, the partnership is treated as having assumed the liabilities to the extent that the amount of the liabilities does not exceed the fair market value of the property at the time of the contribution.16 Under § 752(b), the partnership's assumption of the contributing partner's liabilities is treated as a deemed cash distribution from the partnership to the partner, and the contributing partner's initial basis in the partnership interest is decreased by the amount of this deemed distribution.17
——————————————————————————————

16 Regs. § 1.752-1(e). The term “liabilities” for this purpose refers to liabilities described in § 752. Regulations issued in 2005 make a distinction between “Regs.  § 1.752-1 liabilities”(essentially,  § 752 liabilities)and “Regs.  § 1.752-7 liabilities”(which include obligations that are not liabilities for purposes of § 752 and other Code sections). Regs. § § 1.752-1(a)(4), -6,-7(b)(3)(i), T.D. 9207, 70 Fed. Reg. 30334 (5/26/05). For further discussion, see III, E, and IV, C, 1, below.

17 See § 733.

——————————————————————————————

In addition, under § 752(a), any increase in a partner's share of partnership liabilities is treated as a deemed cash contribution from the partner to the partnership. Thus, the contributing partner's share of the liabilities assumed by the partnership upon the contribution of property is treated as a deemed cash contribution. The contributing partner's initial basis in the partnership interest is increased by the amount of the deemed cash contribution.18
——————————————————————————————

18 § 722.

——————————————————————————————

A contribution of property encumbered by recourse debt results, therefore, in two separate, simultaneous basis adjustments: a decrease in basis equal to the amount of the liabilities assumed by the partnership and an increase in basis equal to the contributing partner's share of that amount. The two basis adjustments are netted against each other and only the net decrease or increase is treated as a deemed distribution or contribution.19
——————————————————————————————

19 Regs.  § 1.752-1(f) (clarifying that netting rule applies to merger or consolidation of partnerships under § 708(b)(2)(A)). See Rev. Rul. 87-120, 1987-2 C.B. 161; Rev. Rul. 79-205, 1979-2 C.B. 255; TAMs 199943005-199943007. See also Rev. Rul. 2003-56, 2003-23 I.R.B. 985 (if partnership enters into  § 1031 exchange of encumbered properties, liabilities are netted for purposes of  § 752 under Regs.  § 1.1031(b)-1(c) liability offsetting rule).

——————————————————————————————

Note: A typical contribution of encumbered property results in a net decrease in the contributing partner's initial basis equal to the amount of the liability allocated to the other partners under § 752.

Any net decrease, treated as a deemed distribution, cannot reduce the contributing partner's basis in the partnership interest below zero.20 The contributing partner recognizes taxable gain to the extent that the deemed cash distribution exceeds the contributing partner's basis in the partnership interest.21 The other partners' bases in their partnership interests are increased to the extent of any increase in their respective shares of partnership liabilities resulting from the partnership's assumption of the liabilities encumbering the contributed property.22
——————————————————————————————

20 See § 733.

21 See § § 731(a)(1), 741.

22 See § 752(a).

——————————————————————————————

Example: On Jan. 1, Year One, X and Y form an equal partnership. X contributes $50,000 of cash. Y contributes property with a fair market value of $60,000 and an adjusted basis of $30,000, subject to a recourse liability of $10,000. X's initial basis in his partnership interest is $55,000 ($50,000 cash contributed plus X's share (50%)of the partnership's $10,000 recourse liability). Y's initial basis in her partnership interest is $25,000 ($30,000 adjusted basis in contributed property minus $5,000 net decrease in adjusted basis ($10,000 deemed cash distribution by partnership upon assumption of $10,000 liability on contributed property minus $5,000 deemed cash contribution equal to Y's share of partnership liability after the contribution)).

Example: On Jan. 1, Year One, X and Y form an equal partnership. X contributes $50,000 of cash. Y contributes property with a fair market value of $90,000 and an adjusted basis of $10,000, subject to a recourse liability of $40,000. X's initial basis in his partnership interest is $70,000 ($50,000 cash contributed plus X's share (50%)of the partnership's $40,000 recourse liability). Y's initial basis in her partnership interest is zero ($10,000 adjusted basis in contributed property minus $10,000 of the $20,000 net decrease in adjusted basis($40,000 deemed cash distribution by partnership upon assumption of the $40,000 liability on contributed property minus $20,000 deemed cash contribution equal to Y's share of partnership liability after the contribution)). Note that the full amount of the portion of the liability allocated to Y is $20,000, but Y's adjusted basis in her partnership interest cannot be reduced below zero. The remaining $10,000 causes Y to recognize gain of $10,000. This gain is treated as gain from the sale or exchange of a newly acquired partnership interest, a capital asset, and not as gain from the sale or exchange of the contributed property.23

——————————————————————————————

23 § 731(a).

——————————————————————————————

In Rev. Rul. 84-15,24 the IRS ruled that a partner does not increase the basis of the partner's partnership interest by the amount of gain recognized under  § 731(a) upon the contribution of property encumbered by recourse liabilities in excess of basis. In addition, the partnership does not increase its basis in the contributed property to reflect the gain recognized by the contributing partner. According to the IRS, this gain arises immediately after the contribution and not at the time of the contribution. Therefore, there is no increase in basis under  § § 722 and 723.
——————————————————————————————

24 1984-1 C.B. 158.

——————————————————————————————

Comment: It may be difficult to avoid gain recognition when a partner contributes property with recourse liabilities significantly in excess of basis. Recourse liabilities are generally allocated to the partners according to the manner in which the partners share the burden of the ultimate risk of economic loss with respect to those liabilities. See § 752, discussed in greater detail in III,  below. Therefore, to avoid gain recognition, the economic arrangement between the partners would have to be altered so that the contributing partner bears a disproportionately large share of the ultimate economic risk of loss. Alternatively, a contributing partner may avoid gain recognition if the partnership has other liabilities, a portion of which are allocated to the contributing partner, as illustrated by the  example below.

Example: On Jan. 1, Year One, X and Y form an equal partnership. X contributes property with a fair market value of $50,000 and an adjusted basis of $30,000, subject to a recourse liability of $20,000. Y contributes property with a fair market value of $70,000 and an adjusted basis of $10,000, subject to a recourse liability of $40,000. X's initial basis in his partnership interest is $40,000 ($30,000 adjusted basis in contributed property plus X's share (50%) of other partnership recourse liabilities ($40,000) minus $10,000 portion of liability on contributed property allocated to Y). Y's initial basis in her partnership interest is zero ($10,000 adjusted basis in contributed property plus $10,000 allocable share of other partnership recourse liabilities minus $20,000 portion of liability on contributed property allocated to X). Y recognizes no gain on the contribution.

c. Contribution of Property Encumbered by Nonrecourse Liabilities 

If a partner contributes property that is encumbered by nonrecourse liabilities, the results are somewhat different from those described above because of the rules governing the allocation of nonrecourse liabilities.25 “Nonrecourse liability”is defined in Regs.  § 1.752-1(a)(2) as a liability for which no partner or related person bears the economic risk of loss. A contributing partner is generally allocated a portion of the nonrecourse liability at least equal to the difference between the contributing partner's adjusted basis in the contributed property and the amount of the nonrecourse liability.26 The partnership may allocate any remaining nonrecourse liability to its partners according to their shares of partnership profits or under two alternative methods set forth in the regulations.27 See III, D, 4, below.
——————————————————————————————

25 The rules governing the allocation of nonrecourse liabilities are discussed in greater detail in III, D, 4, below.

26 Regs. § 1.752-3(a)(1), (2).

27 Regs. § 1.752-3(a)(3).

——————————————————————————————

Example: On Jan. 1, Year One, X and Y form an equal partnership. X contributes $20,000 of cash. Y contributes property with a fair market value of $50,000 and an adjusted basis of $10,000, subject to a nonrecourse liability of $30,000. Assume for purposes of this example that the partnership has no other liabilities and no “minimum gain” within the meaning of Regs. § 1.704-2(d)(1). Y's share of the nonrecourse liability is $25,000 ($20,000 under the built-in gain rule of Regs.  § 1.752-3(a)(1) and (2) ($30,000 liability less $10,000 adjusted basis) plus 50% of the $10,000  § 1.752-3(a)(3) “excess”nonrecourse liability). X's share of the nonrecourse liability is$5,000 (50% of the $10,000 “excess” nonrecourse liability). X's initial basis in X's partnership interest is $25,000 ($20,000 cash contributed plus $5,000 nonrecourse liability). Y's initial basis in Y's partnership interest is $5,000 ($10,000 adjusted basis in contributed property minus $5,000 portion of nonrecourse liability allocated to X).

d. Contribution of Recapture Property 

A partner does not recognize depreciation recapture upon the contribution of recapture property to a partnership unless the partner recognizes gain under  § 731(a) on the exchange because the partner is relieved of debt (i.e., the exchange results in a deemed distribution of cash in excess of the contributed property's basis).28
——————————————————————————————

28 See § § 1245(b)(3), 1250(d)(3); Regs. § 1.1245-4(c)(1), (2)(vi), (4) Exs. 2, 3;Regs. § 1.1250-3(c)(1), (2)(vi). See also 563 T.M.,  Depreciation Recapture — Sections 1245 and 1250.

——————————————————————————————

Example: In exchange for a 50% interest in a partnership, X contributes  § 1245 property with a fair market value of $50,000, a recomputed basis of $40,000, and an adjusted basis of $20,000. X's initial basis in his partnership interest is $20,000 (adjusted basis of contributed property). The property is subject to depreciation recapture of $20,000 (recomputed basis ($40,000) minus adjusted basis ($20,000)). However, X realizes no depreciation recapture upon the contribution.

Example: The facts are the same as in the preceding example. In addition,  the contributed property is subject to a recourse liability of $45,000. X's initial basis in his partnership interest is zero($20,000 adjusted basis in contributed property minus $20,000 portion of the recourse liability allocated to other partners). X recognizes$2,250 (remainder of recourse liability allocated to other partners)of gain, under § 731(a), on the contribution. The full amount of this recognized gain is treated as ordinary income recapture under § 1245(a)(1).

Note: The contributed property continues to be subject to depreciation recapture in the hands of the partnership.29
——————————————————————————————

29 Regs. § § 1.1245-2(c)(2), 1.1250-3(c)(3).

——————————————————————————————

e. Loans to Partnership 

Bona fide loans by a partner to a partnership are not considered capital contributions and, therefore, do not increase the partner's basis in the partnership interest.30 Loans by a partner to a partnership are generally treated as loans between unrelated persons.31 The issue of whether an advance by a partner to a partnership is a loan or a capital contribution is a question of fact to be determined from all of the relevant circumstances.32
——————————————————————————————

30  See, e.g., Kingbay v. Comr., 46 T.C. 147 (1966). The loan, however,  does represent a partnership liability that may provide the partner with additional basis in the interest through application of the  § 752 liability allocation rules.

31 § 707(a);Regs. § 1.707-1(a).

32 See, e.g., Fed. Projects, Inc. v. Comr., T.C. Memo 1987-202;  Kingbay v. Comr., 46 T.C. 147, 154 (1966); Hambuechen v. Comr., 43 T.C. 90, 99 (1964).

——————————————————————————————

f. Contribution of Partner Indebtedness 

Whether the contribution of partner indebtedness qualifies as the contribution of property is unclear. If it does so qualify, the partner's basis in the contributed indebtedness is zero.33 Thus, the contribution does not increase the partner's adjusted basis in the partnership interest. The partner should be allowed to increase the basis in the partnership interest as each payment on the indebtedness is made.  No clear statutory authority, however, provides for such increases. If, on the other hand, the indebtedness does not qualify as property, the transfer of indebtedness is merely treated as an agreement to make future contributions.34
——————————————————————————————

33 See Gemini Twin Fund III v. Comr., T.C. Memo 1991-315,   aff'd in unpub. opin. (9th Cir.  10/21/93); Bussing v. Comr., 88 T.C. 449, 463-64 (1987); Oden v. Comr., T.C. Memo 1981-184, aff'd without pub. opin., 679 F.2d 885 (4th Cir.  1982); Rev. Rul. 80-235, 1980-2 C.B. 229; TAM 8702006.

34 See, e.g., Regs.  § 1.704-1(b)(2)(ii)(c) (capital account is not credited with value of nonpublicly traded partner notes).

——————————————————————————————

g. Contributions Involving Long-Term Contracts 

(1) Contributions of Long-Term Contracts 

Contributions of long-term contracts to partnerships raise special issues because a long-term contract is not completed at the time of the contribution.35 The regulations governing a  § 721 contribution of a long-term contract to a partnership in exchange for a partnership interest are part of the regulations issued under  § 460 that address mid-contract changes in taxpayers engaged in completing long-term contracts.36 The § 460 regulations divide transactions that result in mid-contract changes into “constructive completion transactions” (in which the original taxpayer recognizes income from the contract at the time of the transaction) and “step-in-the-shoes transactions” (in which the “old taxpayer's” obligation to account for the contract terminates on the date of the transaction and is assumed by the “new taxpayer”).37
——————————————————————————————

35 A 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).

36 Most of the regulations governing mid-contract changes in taxpayers engaged in completing long-term contracts were issued in 2002. See T.D. 8995, 67 Fed. Reg. 34603. Regulations specific to partnership transactions involving long-term contracts were issued in 2004. See T.D. 9137, 69 Fed. Reg. 42551, generally applicable to transactions after May 14, 2002.

37 Regs. § 1.460-4(k)(1).

——————————————————————————————

A  § 721 contribution of a long-term contract to a partnership is a step-in-the-shoes transaction.38 A partner (the old taxpayer) making a  § 721(a) contribution of a long-term contract to a partnership (the new taxpayer) must:(1) increase the basis of the partnership interest that the partner receives by the amount of gross receipts that the partner has recognized under the contract; and (2) reduce the basis of the partnership interest, but not below zero, by the amount of gross receipts that the partner has received or reasonably expects to receive under the contract (i.e., progress payments), except to the extent that those gross receipts give rise to a liability.39
——————————————————————————————

38 Regs. § 1.460-4(k)(3)(i)(I).

39 Regs. § 1.460-4(k)(3)(iv)(A)(1), (2).

——————————————————————————————

Note: To the extent that progress payments under a long-term contract give rise to a liability within the meaning of  § 752 and the regulations thereunder, § 752(b) generally requires the contributing partner to reduce the basis of the partner's interest by the amount of the liability. Therefore, the regulations governing  § 721 contributions of long-term contracts provide the exception to the basis-reduction rule mentioned above to avoid a double reduction in basis when progress payments under a contributed long-term contract give rise to a  § 752 liability.40
——————————————————————————————

40 See preamble to T.D. 9137, 69 Fed. Reg. 42551.

——————————————————————————————

The regulations under  § 460 provide for several methods of accounting for long-term contracts. For purposes of partnership transactions, the two primary methods are the “percentage of completion method” (PCM) and the “completed contract method” (CCM). A taxpayer using the PCM must include in income for a taxable year the portion of the “total contract price”(i.e., the amount that the taxpayer reasonably expects to receive under the contract) that corresponds to the percentage of the entire contract that the taxpayer has completed during that year, determined by ascertaining the “completion factor” (i.e., the ratio of (a) “allocable contract costs” (costs allocable to the contract under Regs.  § 1.460-5) that have been incurred through the end of the taxable year to (b) total allocable contract costs that the taxpayer reasonably expects to incur under the contract).41 A taxpayer using the CCM must take into account in the year in which the taxpayer completes the contract the “gross contract price” (i.e., all amounts that the taxpayer is entitled by law or contract to receive, whether or not due or paid, and certain other amounts to the extent the “all events” test is satisfied)plus all allocable contract costs incurred by that year.42 The general basis adjustment rules described above for partnership interests received in exchange for contributed long-term contracts apply regardless of whether the contributing partner uses the PCM or the CCM, but the results may differ.
——————————————————————————————

41 Regs. § 1.460-4(b).

42 Regs. § 1.460-4(d).

——————————————————————————————

Example 1: In Year One, X enters into a long-term contract. The total contract price is $1,000,000, and the estimated total allocable contract costs are $800,000. In Year One, X incurs costs of $600,000 and receives $650,000 in progress payments under the contract. In Year Two, X contributes the contract, with a $0 basis, plus $125,000 in cash, to a partnership in exchange for a one-fourth partnership interest. Before contributing the contract, X incurs costs of $10,000(and receives no progress payments) in Year Two. If X accounts for the contract under the PCM, then, for Year One, X must report receipts of $750,000 (completion factor [$600,000/$800,000] multiplied by total contract price [$1,000,000]) and costs of $600,000. For Year Two, X reports receipts of $12,500 ($610,000/$800,000 ×  $1,000,000 -$750,000 [receipts already reported]) and reports costs of $10,000. X's basis in X's partnership interest is, therefore, $237,500 (cash contributed [$125,000], plus adjusted basis in contract contributed[$0], plus gross receipts X has recognized under the contract [$762,500], minus gross receipts X has received under the contract [$650,000]).43

——————————————————————————————

43 Regs.  § 1.460-4(k)(5) Ex. 11.

——————————————————————————————

Example 2: The facts are the same as in Example 1, except that X's basis in the contract is $610,000. If X accounts for the contract under the CCM, X reports no income or costs for the contract in Years One and Two (because the contract is not completed in those years). X's basis in X's partnership interest upon contribution of the contract in Year Two is $85,000 (cash contributed [$125,000], plus adjusted basis of contract contributed [$610,000], minus gross receipts X has received under the contract [$650,000]).44

——————————————————————————————

44 Regs.  § 1.460-4(k)(5) Ex. 12.

——————————————————————————————

If the amount of gross receipts that a contributing partner received or reasonably expects to receive would, under the general rule, create a negative basis in the partnership interest received in exchange for contribution of a long-term contract, the contributing partner must, instead, recognize ordinary income in the amount by which basis would be reduced below zero.45 In addition, the partnership must reduce its total contract price (if the partner uses the PCM for the contract) or gross contract price (if the partner uses the CCM) by the amount of income the partner recognizes.46
——————————————————————————————

45 Regs. § 1.460-4(k)(3)(iv)(A)(2).

46 Regs. § 1.460-4(k)(3)(iv)(B)(1).

——————————————————————————————

Note: The regulations contain additional basis-adjustment rules applying  § § 704 and 737 to contributions of long-term contracts to partnerships. See V, K, below.

(2) Contributions of Other Property to Partnerships Holding Long-Term Contracts 

If a partnership that holds a long-term contract properly closes its books under  § 706 with respect to the contract when property other than a long-term contract is contributed to the partnership, the contribution of the other property is a step-in-the-shoes transaction in which the partnership is both the old taxpayer and the new taxpayer.47 If the partnership uses the PCM, it must recognize income from the contract by comparing allocable contract costs it has incurred through the date of the contribution of the other property with estimated total allocable contract costs. If the partnership uses the CCM, it does not recognize any revenue and may not deduct any allocable contract costs.48 If the partnership does not close its books, the partnership must compute its income or loss from the long-term contract as though no change had occurred (regardless of the partnership's method of accounting for the contract) and must allocate the income or loss using a reasonable method that complies with § 706.49
——————————————————————————————

47 Regs. § 1.460-4(k)(3)(i)(J), (v)(D).

48 Regs. § 1.460-4(k)(3)(ii), (v)(D).

49 Regs. § 1.460-4(k)(3)(v)(D).

——————————————————————————————

Note: The regulations state that the partnership is treated as the old taxpayer and new taxpayer for purposes of Regs.  § 1.460-4(k)(3)(ii) and (iii), regarding the recognition of income and loss on a mid-contract change in taxpayer.50 The partnership is not the old taxpayer and new taxpayer for purposes of Regs. § 1.460-4(k)(3)(iv), which addresses basis adjustments on contributions of long-term contracts to partnerships (as well as certain transfers in the corporate context).51
——————————————————————————————

50 Regs. § 1.460-4(k)(3)(v)(D).

51 See Regs. § 1.460-4(k)(3)(iv)(A)(1).

——————————————————————————————

2. Contribution of Services 

a. Section 721 

The general nonrecognition rule of  § 721(a) does not apply to the acquisition of a partnership interest in exchange for services. Regs.  § 1.721-1(b)(1) provides, in part:

To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services(or in satisfaction of an obligation),  section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61.

Gross income for  §  61 purposes includes the fair market value of property received as compensation for services.52 Regs.  § 1.721-1(b)(1) implies a distinction between receipt of a profits interest (an interest in the partnership's future profit) and receipt of an interest in capital(an interest in the current value of the partnership, i.e., a right to be repaid contributions). The regulations suggest that receipt of a profits interest in exchange for services is a nontaxable event whereas a receipt of a capital interest is taxable. Regs.  § 1.721-1(b)(1) also provides that if a partner recognizes taxable income upon the acquisition of an interest in partnership capital, the amount of that income is included in the partner's initial basis in the acquired interest. Thus, if the distinction between receipt of a profits interest and receipt of a capital interest is applied, the contribution of services in exchange for a profits interest results in no recognized gain and an initial basis of zero. In contrast, the contribution of services in exchange for an interest in capital  results in recognized gain to the extent of the value of such interest and an initial basis equal to that value.
——————————————————————————————

52 Regs. § 1.61-2(d).

——————————————————————————————

b. 2005 Proposed Regulations 

Regulations proposed in 2005 would significantly change the treatment of compensatory partnership interests.53 Although generally excluding the transfer of a partnership interest in connection with the performance of services from  § 721 treatment, Prop. Regs.  § 1.721-1(b)(1) would treat these transfers as transfers of property subject to  § 83 and the regulations thereunder.54 To the extent that the recipient of the partnership interest is treated as a partner under Prop. Regs. § 1.761-1(b), the recipient partner would recognize compensation income under  § 83(a) equal to the excess of the fair market value of the partnership interest received over any amount that the recipient paid for the interest.55 The proposed regulations would make no distinction between the transfer of a profits interest for services and the transfer of a capital interest for services. A service provider's receipt of either would be taxable or not depending on whether the interest is substantially vested and, if it is not, whether the service provider makes a  § 83(b) election.56
——————————————————————————————

53 Prop. Regs. § § 1.83-3(e), 1.721-1(b)(1), 1.761-1(b), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

54 For a discussion of § 83, see 384 T.M., Restricted Property — Section 83.

55 See Prop. Regs.  § 1.704-1(b)(5) Ex. 29(ii), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

56 § 83(a);Prop. Regs. § 1.761-1(b).

——————————————————————————————

By incorporating  § 83(a) principles, the proposed regulations would require service providers to ascertain the fair market value of compensatory partnership interests to determine compensation income. The IRS and Treasury, citing the Diamond, St. John, and Campbell decisions, discussed below, acknowledged in the preamble to the proposed regulations that a profits interest may only have a speculative value and, thus, may be difficult to value.57 Concluding that it is appropriate to allow partnerships and service providers to value partnership interests based on liquidation value, the IRS issued Notice 2005-43,58 which contains a proposed revenue procedure that would provide procedures for partnerships and service providers to follow in electing under Prop. Regs.  § 1.83-3(l) to treat the fair market value of compensatory partnerships interests as equal to the liquidation value of those interests. Under Prop. Regs. § 1.83-3(l), as construed in the proposed revenue procedure, the liquidation value of a partnership interest would be equal to the amount of cash that the holder of the interest would receive with respect to the interest if the partnership sold all of its assets (including goodwill, going concern value, and other intangibles associated with partnership operations)for cash at fair market value immediately after the actual transfer of the interest, and then liquidated.
——————————————————————————————

57 Preamble to REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

58 2005-24 I.R.B. 1221.

——————————————————————————————

The proposed regulations would apply to transfers of property on or after the date on which they are published as final in the Federal Register.

c. Rev. Proc. 93-27 and Rev. Proc. 2001-43 

In Rev. Proc. 93-27,59 the IRS explained its position on the tax treatment of the receipt of a profits interest in a partnership in exchange for services rendered to or for the benefit of the partnership. First, the IRS defined a “capital interest”as an interest that entitles the partner to a share of the proceeds if all of the assets of the partnership were sold at fair market value and the partnership liquidated. This determination is generally made at the time of receipt of the partnership interest.60 A “profits interest” is defined as any interest other than a capital interest. The IRS stated that generally the receipt of a profits interest in a partnership in exchange for services is not considered a taxable event for the partner or the partnership.
——————————————————————————————

59 1993-2 C.B. 343 (clarified by Rev. Proc. 2001-43, 2001-34 I.R.B. 191).

60 Rev. Proc. 93-27, § 2.01.

——————————————————————————————

Rev. Proc. 93-27 does not apply to:
1. profit interests that relate to a “substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease”;

2. profit interests disposed of by the partner within two years of receipt; and

3. profit interests in a publicly traded limited partnership as described in § 7704(b).

In Rev. Proc. 2001-43,61 the IRS clarified Rev. Proc. 93-27 regarding the treatment of substantially nonvested partnership interests. Rev. Proc. 2001-43 provides that if a partnership grants an interest in the partnership that is substantially nonvested (within the meaning of Regs.  § 1.83-3(b)) to a service provider, the service provider is treated as receiving the interest on the date of its grant, as long as the following requirements are met:
• both the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest;

•upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and

•all other relevant conditions of Rev. Proc. 93-27 are satisfied.

——————————————————————————————

61 2001-34 I.R.B. 191.

——————————————————————————————

Comment: The proposed regulations discussed above would adopt § 83 principles overtly and would eliminate the distinction between the receipt of a profits interest and the receipt of a capital interest. Whether a service provider recognizes compensation income on the receipt of a partnership interest for the services rendered would depend, not on the type of interest that the service provider receives, but on whether the interest is substantially vested on receipt.62 The approach in the proposed regulations differs markedly from that in Rev. Proc. 93-27 and in Rev. Proc. 2001-43, which generally provide for nonrecognition on the transfer of a profits interest for services. The proposed revenue procedure (discussed above)that is contained in Notice 2005-4363 would obsolete Rev. Procs. 93-27 and 2001-43, when finalized, and would set forth a safe harbor rule on the substantial vesting and valuation of compensatory partnership interests.
——————————————————————————————

62 See Prop. Regs. § 1.721-1(b)(1), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

63 2005-24 I.R.B. 1221.

——————————————————————————————

No reporting requirements are imposed upon taxpayers who dispose of their profits interests within two years of receipt, and  the Code does not extend the statute of limitations for assessment of any deficiency resulting from such disposition.

Note: If the receipt of the profits interest results in taxable income to the taxpayer that (i) exceeds 25% of the taxpayer's gross income reported on the return or (ii) exceeds 5% of the taxpayer's gross income and is attributable to an asset for which information reports are required under § 6038D (regarding foreign financial assets), § 6501(e)(1)(A) 63.1 extends the statute of limitations to six years.
——————————————————————————————

63.1 As amended by the Hiring Incentives to Restore Employment (HIRE) Act of 2010, P.L. 111-147, § 513(a), applicable to returns filed after Mar. 18, 2010, and to returns filed before that date for which the § 6501 assessment period (determined without regard to the amendment) has not expired on that date. For earlier dates, former § 6501(e)(1)(A) provided the extension to six years only for omissions of 25% or more. The 2010 HIRE also added § 6038D. P.L. 111-147, § 511(a).

——————————————————————————————

Observation: There is no guidance as to what constitutes a “disposition.”It is, therefore, unclear if a nonrecognition transaction or a conversion of a general partnership into a limited partnership (or vice versa)results in a disposition for purposes of Rev. Proc. 93-27.64
——————————————————————————————

64 See Egerton, “Rev. Proc. 93-27 Provides Limited Relief on Receipt of Profits Interest for Services,”79 J. Tax'n 132 (Sept. 1993).

——————————————————————————————

d. The Diamond Decision 

Before Rev. Proc. 93-27 was published, the Tax Court held that the receipt of a profits interest in a partnership in exchange for the performance of services was a taxable event. In Diamond v. Comr.,65 a broker arranged financing for a building owned by a partnership in return for which he received an interest in partnership profits and losses. The interest was freely transferable and was sold by the broker for $40,000 three weeks after he had acquired it. The broker treated the gain upon the sale of the interest as capital gain. The court held that receipt of the profits interest constituted compensation income taxable under  § 61 as ordinary income. The court stated that the fact that the interest was sold less than three weeks after its receipt for $40,000 meant that the interest was worth at least that amount when received. The decision in Diamond was criticized by a number of commentators66 as being in direct conflict with the language in the  § 721 regulations as well as being difficult to apply. In most cases, the value of an interest in future profits is difficult, if not impossible, to ascertain.
——————————————————————————————

65 56 T.C. 530 (1971), aff'd,  492 F.2d 286 (7th Cir. 1974). 

66 See, e.g., Lurie, “Diamond in the Rough,” 169 N.Y.L.J. 1(1973).

——————————————————————————————

Nevertheless, the Seventh Circuit found no basis on which to overturn the Tax Court's decision and, therefore, affirmed the case but urged the Commissioner to promulgate clarifying regulations.67 The affirming opinion did, however, strongly imply that the profits interest received by the broker was taxable income when received because its market value was “capable of determination” at that time.68 The court  stated that in most situations a profits interest received in exchange for services has “speculative value,” if any, implying that the receipt of such an interest under most circumstances is not a taxable event.
——————————————————————————————

67 492 F.2d 286 (7th Cir.  1974).

68 492 F.2d at 290.

——————————————————————————————

e. Post-Diamond Decisions 

(1) GCM 36346 

In General Counsel Memorandum 36346,69 the Chief Counsel suggested that the position of the IRS should be that the receipt of a profits interest as compensation does not result in taxable income if the recipient of the interest is a partner and not an employee or independent contractor and if the interest transferred gives the transferee partner no rights to existing partnership assets upon the liquidation of  the transferee's interest. The GCM advises that the receipt of an interest in future profits is analogous to an “unfunded, unsecured promise to pay deferred compensation” under Regs. § 1.83-3(e). Section 83, which governs the taxation of transfers of property in exchange for services,  defines property as including all property other than an unsecured and unfunded promise to pay money or property in the future.70 The extent to which  § 83 applies to the receipt of partnership interests traditionally has been unclear;  the 2005 proposed regulations discussed above would eliminate the confusion by subjecting the receipt of any partnership interest for services to  § 83 and the regulations thereunder.71
——————————————————————————————

69 7/25/77.

70 Regs. § 1.83-3(e).

71 See Prop. Regs. § 1.721-1(b)(1), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05). An earlier proposed regulation Prop. Regs.  § 1.721-1(b)(1) (1971), which was never adopted, also stated that transfers of capital interests would be treated as transfers of property to which  § 83 applies, and would have distinguished between a capital interest and a profits interest.

——————————————————————————————

The GCM implies that, although  § 83 does not apply directly to the transfer of a profits interest in a partnership in exchange for services, such a transfer should not be taxable because it is analogous to an unsecured, unfunded promise to pay money in the future. However, the GCM also states that such an analogy is imperfect because, normally, if a transfer is disregarded under  § 83 as an unsecured, unfunded promise to pay in the future, amounts received pursuant to such a promise are taxable as compensation. In contrast, the character of amounts received as partnership profits or as gain upon the sale of a profits interest is determined under  § § 702(b) and 741.

(2) The Liquidation Approach 

In St. John v. U.S.72 and Kenroy, Inc. v. Comr.,73 the IRS had treated the receipt of  profits interests in  partnerships as property under  § 83 but valued the interests under a liquidation method, i.e., a comparison of the value of the partnership's assets to the capital accounts of the other partners to determine if the transferee partner would receive anything upon liquidation of his interest. In each case, the court determined that the transferee partner would receive nothing upon liquidation of his interest, and, therefore, that the value of the interest and the partner's initial basis in the interest was zero.74
——————————————————————————————

72 84-1 USTC ¶  9158 (C.D. Ill. 1983).

73 T.C. Memo 1984-232. 

74 Cf. Nat'l Oil Co. v. Comr., T.C. Memo 1986-596 (IRS had agreed with  taxpayer that  receipt of  profits interest was not taxable but then attempted to prove that  taxpayer  received taxable capital interest in  partnership; court held that liquidation approach led to  conclusion that taxpayer did not receive  current economic benefit).

——————————————————————————————

(3) The Campbell Case 

In Campbell v. Comr.,75 the Tax Court ruled that the holding in Diamond applied to the receipt of a profits interest in a partnership regardless of whether  the transferee partner would receive anything in liquidation of the interest under the liquidation method of valuing a profits interest. The Eighth Circuit reversed the Tax Court's holding and held that the receipt of a profits interest in this case was not taxable because the value of the interest was too speculative.76 The court declined to conclude whether  the receipt of a profits interest is a taxable event but did provide a detailed analysis of the various theories used to argue the issue. The court listed three theories to support the proposition that receipt of a profits interest is not a taxable event: (1) a profits interest is not property under  § § 61 and 83; (2) a profit interest has no ascertainable value; and (3) the receipt of a profits interest is a nonrealization event. The taxpayer in Campbell argued that under § 707, a service partner is not taxed on the receipt of a profits interest if the partner performs the services in the partner's  capacity as partner.77 Although the court did not hold for the taxpayer on the basis of § 707, it did indicate agreement with the taxpayer's argument.
——————————————————————————————

75 T.C. Memo 1990-162,  rev'd, 943 F.2d 815 (8th Cir. 1991).

76 For a discussion of the Campbell case, see Carman &  Fortini-Campbell, “The Dark Side of the Campbell Decision: Its Potential Collateral Consequences,” 7 J. P'ship Tax'n,  324 (1991).

77 Under § 707, the transfer of a profits interest to a partner is treated as a distributive share of income if the partner acted in the capacity of partner and as compensation if the partner acted in any other capacity.

——————————————————————————————

3. Contribution to an “Investment Company” 

Before the 1976 Tax Reform Act,78 which added  § 721(b) to the Code, it was possible to use a partnership as a vehicle to pool and diversify investments tax-free.  Section 721(b) eliminated that possibility by providing that a partner recognizes gain79 upon a transfer of appreciated property to a partnership that would be treated as an investment company (within the meaning of  § 351)if the partnership were incorporated.
——————————————————————————————

78 P.L. 94-455.

79 Note that the partner does not, however, recognize a loss on the transfer of depreciated property to a partnership that would be treated as an investment company if  incorporated. The general nonrecognition rule of  § 721(a) applies to transfers of depreciated property. This is in contrast to the rules governing contributions to corporate investment companies, which result in recognition of both gain and loss. § 351(e)(1).

——————————————————————————————

A partnership is an “investment company”  if more than 80% of the value of its assets consists of the following:80
——————————————————————————————

80 § 351(e). The provisions  in the  § 351 regulations define a partnership “investment company” as well as a corporate “investment company.” See S. Rep. No. 938, 94th Cong., 2d Sess. 43 (1976). For further discussion of the definition of “investment company,” see 758 T.M., Transfers to Controlled Corporations: In General.

——————————————————————————————

• money;

• stocks and other equity interests in a corporation;

• evidences of indebtedness;

• options;

• forward or futures contracts;

•notional principal contracts and derivatives;

•foreign currency;

• interests in precious metals (unless used in an active trade or business after the contribution);

• interests in regulated investment companies, real estate investment trusts, common trust funds, or publicly traded partnerships;

• other interests in noncorporate entities that are convertible into or exchangeable for any of the listed assets;

• interests in any entity if substantially all of its assets are assets listed above;

• to the extent provided in the regulations, interests in other entities to the extent of the value of the interests that is attributable to assets listed above.

The regulations provide that a transfer of property is considered a transfer to an investment company only if  the transfer results, directly or indirectly, in diversification of the transferors' interests.81  Section 721(b) does not specifically include a diversification requirement in order for a contribution to be taxable. However, the legislative history indicates that a diversification requirement was intended.82
——————————————————————————————

81 Regs. § 1.351-1(c)(1).

82 S. Rep. No. 938, 94th Cong., 2d Sess. 43, 44 (1976).

——————————————————————————————

Under  § § 722 and 723, a partner's initial basis in the partnership interest is increased by the amount of gain recognized under § 721(b).

Example: B and C form an equal partnership. B paid $10,000 for 250 shares of common stock in company X and $20,000 for 500 shares of common stock in company Y.  X and Y are both traded on the New York Stock Exchange. X stock is currently trading at $100.00 per share, and Y stock is currently trading at $150.00 per share. B contributes X and  Y stock to the partnership. C paid $40,000 for convertible debentures in company Z that have a current value of $100,000. C contributes the convertible debentures to the partnership. Both B and C recognize gain under § 721(b), because the partnership that they formed falls within the definition of a partnership “investment company.” B recognizes $70,000 of gain ($100,000 current market value of stock contributed minus$30,000 basis in stock). C recognizes $60,000 of gain ($100,000 current value of convertible debentures minus $40,000 basis in debentures). B has an initial basis in B's initial partnership interests of $100,000($30,000 basis in contributed property plus $70,000 gain recognized under § 721(b)). C's initial basis in C's partnership interest is $100,000 ($40,000 basis in contributed property plus $60,000 of gain recognized under § 721(b)).

4. Noncompensatory Options 

In certain circumstances, a partnership may issue noncompensatory options or convertible instruments that allow the holder to acquire by purchase or conversion an equity interest in the partnership.83 In Notice 2000-2984 the IRS requested public comment with respect to the federal income tax treatment of the exercise of an option to acquire a partnership interest, the exchange of convertible debt for a partnership interest, and the exchange of a preferred interest in a partnership for a common interest in that partnership.
——————————————————————————————

83 See generally Bowers &  Lee, “Warrants and Convertible Preferred Interests for Partnerships and LLCs,”468 PLI/Tax 723 (2000).

84 2000-23 I.R.B. 1241.

——————————————————————————————

In 2003, the IRS issued proposed regulations providing that the general nonrecognition rule in  § 721 would not apply to the issuance or lapse of noncompensatory options issued by a partnership, but would apply to the exercise of those options.85 Under the proposed regulations, the general nonrecognition rule in  § 721 would not apply to the issuance of a noncompensatory option86 or the lapse of a noncompensatory option.87 However,   § 721 would apply to the option holder and the partnership upon exercise of the noncompensatory option.88 These provisions would apply only to noncompensatory options (and not to compensatory options) and would not apply to any accrued interest on convertible debt (including original issue discount).89
——————————————————————————————

85 Prop. Regs. § 1.721-2, REG-103580-02, 68 Fed. Reg. 2930 (1/22/03), proposed to apply to noncompensatory options issued on or after the date published as final in the Federal Register. Although there is little specific guidance from the IRS on the subject,  the issuance of compensatory options, presumably, should be governed by the rules related to the contribution of services to a partnership, discussed above.

86 Prop. Regs. § 1.721-2(b).

87 Prop. Regs. § 1.721-2(c). Upon the lapse of a noncompensatory option, the partnership would likely recognize income and the former option holder would likely recognize loss.

88 Prop. Regs. § 1.721-2(a).

89 Prop. Regs. § 1.721-2(d). The proposed regulations do not include any guidance with respect to  the taxation of the option holder or the partnership on accrued unpaid interest. The treatment depends on whether the interest obligation is part of the debt and, as such, should also be treated as  § 721 property or whether the partnership should recognize gain to the extent of the accrued unpaid interest. The IRS has requested comments on this issue. See preamble to REG-103580-02, 68 Fed. Reg. 2930 (1/22/03).

——————————————————————————————

The issuance of a noncompensatory option would be taxed under general federal income tax principles  (which generally treats the issuance as an open transaction90), but if the option holder purchases a noncompensatory option using appreciated or depreciated property the option holder would recognize gain or loss under the general provisions of § 1001.91 Upon the exercise of a noncompensatory option, the option holder is treated as having contributed property to the partnership in the form of the premium, the exercise price, and the option privilege in exchange for the partnership interest.92 Under the proposed regulations,  § 721 would apply to such a transaction, except to the extent that the exercise price exceeds the capital account received by the option holder.93
——————————————————————————————

90 See Rev. Rul. 78-182, 1978-1 C.B. 265.

91 See Prop. Regs. § 1.721-2(b).

92 See  preamble to REG-103580-02, 68 Fed. Reg. 2930 (1/22/03).

93 Prop. Regs. § 1.721-2(a).

——————————————————————————————

For purposes of the proposed rules, “option” would include a call option or warrant to acquire an interest in the issuing partnership, the conversion feature of convertible debt, and the conversion feature of convertible equity.94 “Convertible debt” would be defined as any indebtedness of a partnership that is convertible into an interest in that partnership,95 “convertible equity” as preferred equity in a partnership that is convertible into common equity,96 and “exercise”  as the exercise of an option or warrant or the conversion of convertible debt or convertible equity.97 The definition of “exercise price”would depend on the type of option. With respect to a call option or warrant, the exercise price  would be that of the call option or warrant; in the case of convertible equity, the exercise price would be the converting partner's capital account with respect to that convertible equity, increased by the fair market value of cash or other property contributed to the partnership in connection with the conversion;and, in the case of convertible debt, the exercise price would be the adjusted issue price of the converted debt, increased by accrued but unpaid qualified stated interest and by the fair market value of cash or other property contributed to the partnership in connection with the conversion.98
——————————————————————————————

94 Prop. Regs. § 1.721-2(e)(1).

95 Prop. Regs. § 1.721-2(e)(2).

96 Prop. Regs. § 1.721-2(e)(3).

97 Prop. Regs. § 1.721-2(e)(4).

98 Prop. Regs. § 1.721-2(e)(5).

——————————————————————————————

Example: In Year One, X and Y form an equal general partnership. Each contributes cash of $100,000. The partnership uses this cash to purchase property. Later that year, the partnership issues a noncompensatory option to  Z to purchase a one-third partnership interest at any time within the next three years. The stated exercise price is $50,000. Z purchases this option by transferring property to the partnership with a fair market value of $15,000 and an adjusted basis of $9,000. Under the proposed regulations,  § 721 would not apply to the issuance of the option. Z would recognize $6,000 of gain under § 1001. The partnership would not recognize any gain or loss upon issuance of the option and would have a $15,000 basis in the property transferred by Z. Assume that in Year Three, Z exercises the option and transfers appreciated property to the partnership.  Section 721 applies to the exercise of the option. Thus, Z would not recognize gain upon the exercise of the option, and the partnership would have a basis in the transferred property equal to Z's adjusted basis in the property before the contribution to the partnership.

The proposed regulations also would include provisions under  § 704 with respect to proper accounting for noncompensatory options. The option holder's initial capital account would equal the consideration paid to acquire the option and the fair market value of property contributed on the exercise of the option.99 The proposed regulations also would not generally characterize noncompensatory options as partnership equity.100
——————————————————————————————

99 Prop. Regs. § 1.704-1(d)(4).

100 See Prop. Regs. § 1.761-3.

——————————————————————————————

5. Obligations to Make Future Contributions 

In Oden v. Comr.,101 the Tax Court held that a contribution of a note to a partnership evidencing an obligation to make a future contribution did not increase the basis of the contributing partner's interest. According to the court, the note has a zero basis upon contribution. However, if the contributing partner's share of partnership recourse liabilities is increased for the contribution of the note, the share of partnership liabilities allocated to the contributing partner increases, as does the basis in the partnership interest.
——————————————————————————————

101 T.C. Memo  1981-184,  aff'd without pub. opin.,  679 F.2d 885 (4th Cir.  1982). See also Rev. Rul. 80-235, 1980-2 C.B. 229.

——————————————————————————————

6. Deferred Compensation: § 409A 

Section 409A, added to the Code in 2004,102 provides that amounts deferred under a nonqualified deferred compensation plan that fails at any time during a taxable year to meet certain distribution, nonacceleration, and election requirements (or is not operated in accordance with those requirements) are includible in gross income for the taxable year to the extent the amounts are not subject to a substantial risk of forfeiture and not previously included in gross income. Regulations proposed in 2005103 and finalized in 2007104 do not address the application of  §  409A to arrangements between partners and partnerships and, instead, defer to Notice 2005-1,105 which provides interim guidance on § 409A. The Notice states that  § 409A may apply to arrangements between a partnership and its partners, specifically to an arrangement between a partnership and a partner that provides for deferral of compensation under a nonqualified deferred compensation plan. The notice states that until further guidance is issued, however, taxpayers may treat the issuance of a profits interest for the performance of services that is not included in income upon issuance (under general tax principles discussed above) as also not resulting in the deferral of compensation.106
——————————————————————————————

102 P.L. 108-357, § 885(a), effective generally for amounts deferred after 2004. Note that the IRS will not issue a ruling or determination letter on whether deferred compensation under a nonqualified deferred compensation plan is included in gross income. See Rev. Proc. 2009-3, 2009-1 I.R.B. 107, § 3.01(42).

103 REG-158080-04, 70 Fed. Reg. 57930 (10/4/05).

104 T.D. 9321, 72 Fed. Reg. 19234 (4/17/07).

105 2005-2 I.R.B. 274, obsoleted in part by T.D.  9321.

106 Notice 2005-1, 2005-2 I.R.B. 274, Q& A-7. The notice also states that, until further guidance is issued, taxpayers may treat an issuance of a capital interest in a partnership in the same manner as an issuance of stock and generally may treat  § 736 payments as not subject to § 409A, but that  § 409A may apply to  § 707(a)(1) payments(i.e., payments to a partner not acting in a partner capacity) if the payments otherwise would be deferral of compensation under a nonqualified deferred compensation plan. See also preamble to T.D. 9321, 72 Fed. Reg. 19234 (4/17/07) (until further guidance is issued,  § 409A applies to  § 707(c) guaranteed payments, and rights to receive such guaranteed payments, only when guaranteed payment is for services and partner providing services does not include payment in income by 15th day of third month following end of partner's taxable year in which partner obtained legally binding right to guaranteed payment or, if later, taxable year in which right to guaranteed payment is first no longer subject to substantial risk of forfeiture); preamble to REG-158080-04, 70 Fed. Reg. 57930 (10/4/05) (same).

——————————————————————————————

Notice 2007-86106.1 § 4 states that Notice 2005-1 Q& A-7(as it may be modified by any future guidance) remains in effect even after Notice 2005-1 is obsoleted generally for taxable years beginning after 2008.
——————————————————————————————

106.1 2007-46 I.R.B. 990 (additional 2008 transition relief under § 409A), modifying Notice 2007-78, 2007-41 I.R.B. 780 (2008 transition relief and guidance on application of § 409A).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  II. Determination of Partner's Initial Basis in Partnership Interest

B. Partnership Interest Acquired Other Than by Contribution 

1. General Rule: Cost Basis 

Section 742 of the Code provides that the basis to a transferee partner of an interest in a partnership acquired other than by contribution is determined by application of the general basis rules for property provided in Part II (§ § 1011 and following), Subchapter 0, Chapter 1, of the Code.107 Under these general rules, the basis of a partnership interest acquired by purchase is equal to its cost.108 Therefore, if a transferee's partner pays cash for a partnership interest, the transferee's initial basis in the interest is the amount of cash paid.
——————————————————————————————

107 See also  Regs. § 1.742-1.

108 See § 1012.

——————————————————————————————

In Shaheen v. Comr.,109 the Tax Court considered the acquisition of a partnership interest in satisfaction of a debt of two partners to the taxpayer. The face amount of the cancelled debt exceeded the fair market value of the transferred partnership interest. The court held that the transferee partner's initial basis in his partnership interest was equal to the fair market value of the interest. The court stated,  however, that if the fair market value of the partnership interest had exceeded the amount of the discharged debt or if there had been no ascertainable fair market value, the partner's initial basis in the partnership interest would have equaled  the amount of the discharged debt. The taxpayer failed to establish the fair market value or lack of an ascertainable fair market value of his partnership interest.  Therefore, the court held,  the taxpayer's initial basis in his partnership interest was zero and the taxpayer's distributive share of partnership losses was disallowed under § 704(d).
——————————————————————————————

109 T.C. Memo 1982-445.

——————————————————————————————

2. Acquisition of Partnership Interest from a Decedent 

The initial basis of a partnership interest acquired from a decedent is generally equal to the fair market value of the interest at the date of death or at the alternate valuation date,110 or in certain circumstances, equal to the “special use” value under § 2032A111 or, to the extent of the estate tax exclusion for qualified conservation easements,  the decedent's basis in the affected land.112 The estate's or other successor's basis in the partnership interest is increased by its allocable share of partnership liabilities and decreased to the extent that the fair market value of the interest is attributable to items constituting income in respect of a decedent, such as accounts receivable.113
——————————————————————————————

110 § 1014(a)(1), (2);Regs. § 1.742-1. For a general discussion of basis in property from a decedent, see 560 T.M., Income Tax Basis: Overview and Conceptual Aspects. 

111 § 1014(a)(3).

112 § 1014(a)(4).

113 Regs. § 1.742-1.

——————————————————————————————

3. Acquisition of Partnership Interest by Gift 

Section 1015 generally provides that the initial basis of a partnership interest acquired by gift is equal to the donor's adjusted basis in the interest before the transfer. However, for purposes of determining loss realized upon the sale or other disposition of the interest, the donee's basis is limited to the fair market value of the interest at the time of the gift.114
——————————————————————————————

114 § 1015(a).

——————————————————————————————

Example: Father gives Son a partnership interest with a fair market value of $30,000 and an adjusted basis in his hands before the transfer of $40,000. Son's initial basis in the interest is $40,000, unless Son subsequently sells or disposes of his interest at a loss. For instance, if Son sells his interest for $50,000 and there have been no adjustments to his basis in his interest, Son will recognize$10,000 of gain ($50,000 amount realized minus $40,000 adjusted basis). If, on the other hand, Son sells his interest for $20,000 and there have been no adjustments to his basis in his interest, Son will recognize only $10,000 of loss ($30,000 adjusted basis minus $20,000 amount realized) because his basis is limited to the fair market value of the interest at the time of the gift ($30,000).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  II. Determination of Partner's Initial Basis in Partnership Interest

C. Alternative Rule for Determination of Partner's Basis 

Section 705(b) provides that, under circumstances prescribed by regulations, the adjusted basis of a partner's interest in a partnership may be determined by reference to the partner's proportionate share of the adjusted basis of partnership property distributable upon a termination of the partnership. Regs. § 1.705-1(b) provides that a partner may use this alternative rule for determining basis if the partner cannot practicably apply the general rule of  § 705(a) (discussed above)or if, in the opinion of the Commissioner, it is reasonable to conclude that the result produced by application of the alternative rule will not vary substantially from the result obtainable under the general rule. If the alternative rule is used, a partner's adjusted basis in the partnership interest may need to be adjusted to reflect significant discrepancies between the partner's share of the adjusted basis of partnership property and the partnership's adjusted basis in its property. These discrepancies may arise as a result of property contributions, transfers of partnership interests, or distributions of property to the partners.115
——————————————————————————————

115 Regs. § 1.705-1(b).

——————————————————————————————

Example: X, Y, and Z are equal partners in a partnership. The partnership's assets include several properties with a total adjusted basis of $50,000 and $10,000 cash. Thus, the total adjusted basis of partnership property is $60,000. Each partner's share of the adjusted basis of partnership property is $20,000 ($60,000 ×  1/3). If the alternative rule is used, each partner's basis in the partner's interest is $20,000.

Example: X, Y, and Z are equal partners in a partnership. In Year One, the partnership's assets include several properties with a total fair market value of $100,000 and a total adjusted basis of$40,000. In addition, the partnership has $20,000 of cash. In Year One, X sells X's partnership interest to W for $40,000 (1/3 of the fair market value of the partnership's assets). W's initial basis in W's partnership interest is $40,000 — the cost.116 However, W's share of the adjusted basis of partnership property is $20,000. Therefore, for purposes of the alternative rule, W has an adjustment of $20,000 for purposes of determining W's adjusted basis in the partnership interest. If, subsequent to W's purchase of the interest, the partnership earned and retained an additional$18,000 of cash, its total adjusted basis in its property would be$78,000. W's one-third share of the adjusted basis of partnership property would be $26,000. W's adjusted basis for the interest under the alternative rule would be $46,000 ($26,000 plus the “adjustment”of $20,000).

——————————————————————————————

116 § § 742, 1012.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  II. Determination of Partner's Initial Basis in Partnership Interest

D. Multiple Interests in a Single Partnership 

In Rev. Rul. 84-53,117 the IRS ruled that a partner holding more than one partnership interest in a partnership has a single, aggregate adjusted basis in those interests. This rule applies regardless of whether the partner holds general interests, limited interests, or any combination of general and limited interests.117.1 Rev. Rul. 84-53 uses four situations to illustrate the allocation of adjusted basis among the interests held by a partner upon a sale or exchange of a portion of the interests. The factual situations set forth in the ruling are illustrated in the examples below.
——————————————————————————————

117 1984-1 C.B. 159.

117.1 Note that in PLR 200909001, the IRS ruled that if the partner, an S corporation, sold any of its separately identified lots of common units of a publicly traded partnership that were held for more than the § 1374(d)(7) recognition period, the units would not be subject to the § 1374(a) built-in gains tax. To arrive at this conclusion, the IRS seems to have allowed separate tracking of the basis of each built-in gain asset contribution to the publicly traded partnership. For an analysis of whether PLR 200909001 conflicts with, or merely illustrates an exception to, Rev. Rul. 84-53, see Jackel & Crnkovich, “IRS Deviates from Single Partnership Interest Basis Approach,” 76 BNA Daily Tax Rpt. J-1 (4/23/09).

——————————————————————————————

Example: In Year One, X and Y form an equal limited partnership for the purpose of investing and trading in stock and securities. X contributes $50,000 of cash in exchange for a 50% general partnership interest. Y contributes $50,000 of cash in exchange for a 50% limited partnership interest. In Year Two, when the fair market value of the partnership's stock and securities is $80,000, Y sells one-half of Y's limited partnership interest to X for $20,000. X holds the interest as a limited partner. The fair market value of the transferred interest($20,000) is one-half of the fair market value of Y's entire interest before  the transfer ($40,000 (50% ×  80,000)). Therefore, one-half of Y's total adjusted basis in Y's partnership interest (1/2 × $50,000) is allocated to the transferred interest. Y recognizes a$5,000 loss on the transfer ($25,000 adjusted basis minus $20,000 amount realized). The adjusted basis of Y's remaining partnership interest is $25,000. X's adjusted basis in X's entire partnership interest (50% general and 25% limited) is $70,000 ($50,000 initial basis plus $20,000 cost basis in transferred portion).

Example: The facts are the same as in the preceding example. In Year Three, when the fair market value of the partnership's stock and securities is $120,000, X sells one-half of X's general partnership interest to Z for $30,000. The fair market value of the transferred interest ($30,000) is one-third of the fair market value of X's entire interest before the transfer (90,000 (75% ×  $120,000)). Therefore, one-third of the adjusted basis in X's entire partnership interest before the transfer (1/3 ×  70,000) is allocated to the transferred portion. X recognizes $6,667 of gain on the sale ($30,000 amount realized minus $23,333 adjusted basis). X's adjusted basis in X's remaining partnership interest (a 25% general partnership interest and a 25%limited partnership interest) is $46,667. The results to X would be the same if X had instead sold to Z the limited partnership interest acquired earlier from Y.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  III. Inclusion of Partnership Liabilities in Partner's Basis: Section 752

A. In General 

The  § 752 regulations provide a set of rules for determining a partner's “share”of partnership liabilities. A partner's “share” of partnership liabilities is included in the partner's adjusted basis in the partnership interest. Under § 704(d), a partner may deduct partnership losses allocated to the partner under § 704(b) only to the extent of the partner's adjusted basis. The determination of a partner's share of partnership liabilities is, therefore, important in determining if the partner has enough basis to absorb losses allocated to the partner.118
——————————————————————————————

118 The  § 704 allocation rules are related to the  § 752 liability sharing rules. The 1988 Regulations under  § 752 (T.D. 8237, 1989-1 C.B. 180) address this relationship. Former Regs. § 1.752-1T(a)(1)(iv)(as amended by T.D. 8274, 1989-2 C.B. 101) stated:
The economic risk of loss analysis employed in this section generally corresponds to, and further develops, the economic risk of loss analysis employed in the regulations under section 704(b). The coordination of these two sections reflects the fact that one of the principal purposes for including partnership liabilities in the bases of the partners' interests in the partnership is to support the deductions that will be claimed by the partners for the items attributable to those liabilities.

——————————————————————————————

The first set of regulations under § 752, promulgated in 1956 (the “1956 Regulations”), was concise but incomplete and difficult to apply in financing transactions. In 1988, Treasury promulgated a new set of proposed and temporary regulations (the “1988 Regulations”),119 applying the liability sharing rules in more detail. The 1988 Regulations were so lengthy and confusing, however, that their application to any set of facts was often unclear and even the most experienced practitioners were reluctant to wade through the provisions. The 1988 Regulations sparked widespread criticism.120 Dissatisfaction with the 1988 Regulations was not based on the substance of the regulations so much as on their complexity. Treasury's response to this criticism was a new set of regulations in 1991.121 The 1991 Regulations did not radically change the substance of the liability sharing rules but attempted to clarify and simplify the rules to make them more “user friendly.” Rules were added to the  § 752 regulations in 2005 to address the assumption by partnerships of “Regs. § 1.752-7 liabilities”(i.e., partner obligations other than “liabilities” under § 752 and the 1991 regulations) and the effect on the basis of the partner from whom a partnership assumes a “Regs.  § 1.752-7 liability.”122
——————————————————————————————

119 T.D. 8237, 53 Fed. Reg. 53140 (12/30/88), as amended by T.D. 8274, 54 Fed. Reg. 48090 (11/21/89).

120 See, e.g., Abrams, “Long-Awaited Regulations Under  Section 752 Provide Wrong Answers,”44 Tax L. Rev. 627, 640 (1989) (“Quite simply, the temporary regulations [under § 752] cannot be understood”).

121 T.D. 8385, 56 Fed. Reg. 66978 (12/27/91). For a discussion of the final regulations, see Hagen, “The Final Regulations under IRC Sections 704(b) and 752:Envisioning Economic Risk of Loss Through a Glass Darkly,” 49 Wash. &  Lee L. Rev. 487 (1992).

122 T.D. 9207, 70 Fed. Reg. 30334 (5/26/05). See III, E, and IV, B, 1, below.

——————————————————————————————

This section provides a brief overview of the 1956 Regulations and the 1988 Regulations. This section analyzes in detail the 1991 Regulations and subsequent amendments to those regulations, including the rules related to “Regs.  § 1.752-7 liabilities.” In applying the liability sharing rules to a partnership that has been in existence for a number of years, practitioners  (in very limited circumstances) may need to apply all three sets of regulations (the 1956 Regulations, the 1988 Regulations, and the 1991 Regulations) to partnership liabilities, depending on when the liabilities were incurred, assumed, or guaranteed. See III, C, 3, and III, D, 1, below, as  well as the Worksheets, for a discussion of the regulations'effective dates.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  III. Inclusion of Partnership Liabilities in Partner's Basis: Section 752

B. Prior Law —The 1956 Regulations 

1. General Rules 

The 1956 Regulations provided two rules on the computation of a partner's share of partnership liabilities. A partner's share of partnership liabilities, first, was determined in accordance with the partner's ratio for sharing losses under the partnership agreement.123 A limited partner's share of partnership liabilities, however, could not exceed the difference between the partner's actual contribution to the partnership and the total contribution that the partner was obligated to make under the agreement.124
——————————————————————————————

123 Regs.  § 1.752-1(e) (1956).

124 Regs. § 1.752-1(e) (1956).

——————————————————————————————

If none of the partners had any personal liability with respect to a partnership liability, secondly, a partner's share of partnership liabilities was determined in accordance with the partner's ratio for sharing profits.125 This rule applied to both general and limited partners.
——————————————————————————————

125 Regs. § 1.752-1(e) (1956).

——————————————————————————————

The 1956 Regulations included an example illustrating the two rules in the context of a limited partnership.126
——————————————————————————————

126 Regs.  § 1.752-1(e)(1956).

——————————————————————————————

2. Recourse and Nonrecourse Liabilities 

The 1956 Regulations did not discuss the terms “recourse”and “nonrecourse” but referred to liabilities for which none of the partners had any personal liability.127 Such liabilities were “nonrecourse”because the lender had no right to recover from any of the partners but, instead, was limited to recovering the value of the security underlying the debt. The only specific example of a nonrecourse debt included in the 1956 Regulations involved a mortgage on real estate acquired by the partnership without the assumption by the partnership or any of the partners of any liability on the mortgage.128 Any type of debt treated as nonrecourse under state law should have been treated as nonrecourse for purposes of the 1956 Regulations.
——————————————————————————————

127 Regs.  § 1.752-1(e)(1956).

128 Regs.  § 1.752-1(e) (1956).

——————————————————————————————

The language in the 1956 Regulations (“none of the partners have any personal liability”) suggested a very limited view of the types of debt arrangements that were nonrecourse. In Kingbay v. Comr.,129 the Tax Court strictly applied the regulatory definition of “nonrecourse debt” in a limited partnership in which the sole general partner was a dummy corporation with no real assets. The partnership incurred significant loans from one of the limited partners and from unrelated third-party lenders for which the sole general partner was personally liable. The limited partners argued that the partnership debt was nonrecourse because the corporate general partner had no assets with which to pay off the debt. The Tax Court held that the debt was recourse because the corporate general partners existed to limit the other partners' liability and, therefore, that the corporation could not be ignored as a partner for purposes of determining if any partner was personally liable for partnership debt. Kingbay represents a strict interpretation of the 1956 regulatory language. However, both the 1988 and the 1991 Regulations adopt the Kingbay approach in defining “recourse”and “nonrecourse.” 130
——————————————————————————————

129 46 T.C. 147 (1966).

130 Regs.  § 1.752-1T(d)(3)(ii)(D)(2) (1988);Regs. § 1.752-2(b)(6).

——————————————————————————————

The 1956 Regulations did not discuss whether debt for which a partner was personally liable in an individual non-partner capacity was considered recourse or nonrecourse debt. The capacity in which a partner is liable should not make a difference as to how debt is categorized. The courts appear to agree that no distinction should be made.131 Both the 1988 and 1991 Regulations provide that recourse debt includes debt for which a partner is liable in an individual non-partner capacity.132
——————————————————————————————

131 See, e.g., Brown v. Comr., T.C. Memo 1980-267, aff'd without pub. opin.  (9th Cir. 1982); Laney v. Comr., T.C. Memo 1979-491, aff'd, 674 F.2d 342 (5th Cir.  1982).

132 Regs. § 1.752-1T(d)(2), (d)(3) (1988); Regs. § § 1.752-1(a), -2(a).

——————————————————————————————

The 1956 Regulations also did not discuss loans made directly by partners to the partnership. In Dillingham v. U.S.,133 the court treated a nonrecourse loan from a general partner to a partnership as nonrecourse in spite of the fact that a general partner acting as lender ultimately bore the risk of loss. Both the 1988 and the 1991 Regulations specifically provide that a nonrecourse loan from a partner (or a related person) to a partnership is treated as a recourse loan for which the lending partner bears the economic risk of loss.134
——————————————————————————————

133 81-2 USTC ¶  9601 (W.D. Okla.  1981).

134 Former Regs. § 1.752-1T(d)(3)(i)(B);Regs. § 1.752-2(c)(1).

——————————————————————————————

In Raphan v. U.S.,135 the Claims Court decided the issue of whether an otherwise nonrecourse loan guaranteed by a general partner is treated as recourse or nonrecourse for purposes of the 1956 Regulations. The Claims Court held that the debt was nonrecourse. The Federal Circuit reversed the Claims Court on this issue and held that the debt should be classified as recourse. The original holding in the Raphan case motivated Congress to enact § 79 of the Deficit Reduction Act of 1984 authorizing Treasury to promulgate new liability sharing regulations.
——————————————————————————————

135 759 F.2d 879 (Fed. Cir. 1985), cert. denied, 474 U.S. 843 (1985), and rev'g on this issue 83-2 USTC ¶  9613 (Cl. Ct.  1983).

——————————————————————————————

Also unclear under the 1956 Regulations was whether and when debt could be bifurcated into partially recourse and partially nonrecourse portions. The language in the 1956 Regulations implied that if a partner had any personal liability for a partnership debt, the entire debt was treated as recourse.136 The IRS has indicated that this result was not intended and that partially recourse liabilities are treated as partially recourse and partially nonrecourse and allocated accordingly.137 However, the Tax Court has not followed the IRS's direction on this issue.138 The 1988 and 1991 Regulations provide for bifurcation of partnership liabilities into their recourse and nonrecourse components.139
——————————————————————————————

136 See Smith v. Comr., 84 T.C. 889, 903-4 (1985),  aff'd without pub. opin. (D.C. Cir. 1986) (treating partially recourse debt as entirely recourse); Long v. Comr., 77 T.C. 1045, 1074-75 (1981) (stating in dicta that partially recourse debt is treated as entirely recourse).

137 Rev. Rul. 84-118, 1984-2 C.B. 120.

138 Smith v. Comr., 84 T.C. 889 (1985), aff'd without pub. opin. (D.C. Cir.  1986). 

139 Regs.  § 1.752-1T(j)(2) (1988);Regs. § 1.752-1(i).

——————————————————————————————

3. Application of Sharing Rules to General Partnerships 

The 1956 Regulations provided that, in a general partnership, recourse liabilities (i.e., liabilities for which one or more partners are personally liable) were shared among the partners in the proportions in which they shared losses. Nonrecourse liabilities (i.e., liabilities for which no partner is personally liable) were shared in the  proportions in which the partners shared profits.

4. Application of Sharing Rules to Limited Partnerships 

The 1956 Regulations provided that, in the case of a limited partnership, a limited partner's share of partnership recourse liabilities could not exceed the difference between the limited partner's actual contribution to the partnership and the total contribution that the limited partner was obligated to make to the partnership.140 Thus, in the context of a typical limited partnership, a limited partner could not share in the recourse liabilities of the partnership.141 A limited partner shared nonrecourse partnership liabilities in the  proportions in which the limited partner shared partnership profits.142
——————————————————————————————

140 Regs.  § 1.752-1(e)(1956).

141 Regs.  § 1.752-1(e)(1956).

142 Regs.  § 1.752-1(e)(1956).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  III. Inclusion of Partnership Liabilities in Partner's Basis: Section 752

C. Prior Law —The 1988 Regulations 

1. Background: The Raphan Case and § 79 of the 1984 Deficit Reduction Act 

In Raphan v. U.S.,143 the Claims Court held that a limited partnership liability secured by partnership assets for which no partner was personally liable but which was personally guaranteed by a general partner was a nonrecourse liability under the 1956 Regulations, and could be shared by the limited partners in the partnership. Declaring the Raphan holding to be “inappropriate,”144 Congress enacted § 79(b) of the Deficit Reduction Act of 1984 (the “1984 Act”), directing Treasury to revise and update the  § 752 regulations to address liability sharing in the context of “current commercial practices and arrangements” such as guarantees.145 Section 79(a) of the 1984 Act provides that the decision in Raphan is not to be followed for purposes of § 752. The Conference Report states that the  § 79(a) provision rejecting the Raphan holding is effective March 1, 1984, but that other provisions in the regulations are effective prospectively from the date on which the regulations are proposed or a later date prescribed by Treasury.146 The Conference Report also states that Congress intended the revisions of the  § 752 regulations to be based in large part on the manner in which the partners and persons related to the partners share the economic risk of loss with respect to partnership debt.147 With respect to nonrecourse debt, Congress expected no major revisions with respect to the manner in which such liabilities are shared, but anticipated that the new regulations would provide “more certainty.”
——————————————————————————————

143 3 Cl. Ct. 457 (1983), rev'd on this issue, 759 F.2d 879 (Fed. Cir. 1985).

144 H.R. Rep. No. 432, 98th Cong., 2d Sess. 1235 (1984).

145 H.R. Rep. No. 432, 98th Cong., 2d Sess. 1235 (1984).

146 H.R. Rep. No. 861, 98th Cong., 2d Sess. 869(1984).

147 H.R. Rep. No. 861, 98th Cong., 2d Sess. 869(1984).

——————————————————————————————

2. General Overview of the 1988 Regulations 

The 1988 Regulations were published in proposed and temporary form on December 30, 1988.148 The 1988 Regulations provided a more specific framework for determining a partner's share of partnership liabilities. A partner's share of recourse liabilities generally was equal to the share of partnership recourse liabilities “for which such partner bears the economic risk of loss.”149
——————————————————————————————

148 T.D. 8237, 53 Fed. Reg. 53140 (12/30/88). The regulations were amended on Nov. 21, 1989, by T.D. 8274, 54 Fed. Reg. 48090 (11/21/89), effective retroactively to Dec. 29, 1988. For a discussion of these regulations, see Frankel &  Coffin, “New Section 752 Regulations Clarify Treatment of Partnership Liabilities,” 6 J. P'ship Tax'n 179 (1989).

149 Former Regs. § 1.752-1T(d)(1). “Economic risk of loss” is discussed in detail in III, D, 3, a, below. A partner's share of partnership recourse liabilities also includes partnership recourse liabilities for which a person related to the partner bears the economic risk of loss.  See III, D, 3, b, (2), below, for the definition of “related person.”

——————————————————————————————

For purposes of this liability sharing rule, a liability was considered recourse to the extent that one or more partners (or related persons)bore the economic risk of loss.150 The term “nonrecourse liability”was defined as any “liability of the partnership to the extent, but only to the extent that no partner bears the economic risk of loss ... for such liability.”151 A partner's share of nonrecourse liabilities was equal to the sum of the partner's share of minimum gain (i.e., the amount of gain that would be allocated to the partner under  § 704(c) —or, in the case of a revaluation, in the same manner as  § 704(c) — if the partnership disposed of all partnership property subject to one or more nonrecourse partnership liabilities in a taxable transaction in full satisfaction of such liabilities and for no other consideration)and the partner's share of excess nonrecourse liabilities of the partnership.152
——————————————————————————————

150 Former Regs. § 1.752-1T(d)(2).

151 Former Regs. § 1.752-1T(e)(2). The term nonrecourse partnership liabilities held by a partner or a related person were treated as recourse liabilities. Former Regs. § 1.752-1T(d)(3)(i)(B).

152 Former Regs. § 1.752-1T(e)(1).

——————————————————————————————

Because the 1991 Final Regulations did not alter the substance of the 1988 Regulations, this section of the portfolio does not include a discussion of the specific provisions in the 1988 Regulations. Instead, III, D, below, discusses the 1991 Final Regulations with references, when necessary, to provisions in the 1988 Regulations that differ from those in the final regulations.

3. Effective Date 

The 1988 Regulations generally applied to liabilities incurred on or after January 30, 1989, although liabilities incurred on or after January 30, 1989, pursuant to a written binding contract in effect before December 29, 1988, and at all times thereafter, were subject to the 1956 Regulations.153 Unless an election to apply the 1988 Regulations was made,154 liabilities incurred before January 30, 1989, generally remained subject to the 1956 Regulations. The 1988 Regulations, however, did apply retroactively to certain liabilities held or guaranteed by partners.155
——————————————————————————————

153 Former Regs. § 1.752-4T(a).

154 A partnership could elect to apply the 1988 Regulations to all of its liabilities to which the 1988 Regulations otherwise would not apply as of the beginning of the first taxable year of the partnership ending after Dec. 29, 1988. Former Regs. § 1.752-4T(d).

155 Former Regs. § 1.752-4T(b).

——————————————————————————————

A 1991 amendment to the 1988 Regulations provides that a termination of a partnership under  § 708(b)(1)(B) does not cause partnership liabilities incurred or assumed before the termination to be treated as incurred or assumed on the termination date.156 Thus, a partnership termination under  § 708(b)(1)(B) does not cause liabilities that would otherwise be subject to the 1956 Regulations to be subject to the 1988 Regulations by virtue of being incurred or assumed on a termination date on or after January 30, 1989.
——————————————————————————————

156 Former Regs. § 1.752-4T(f).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  III. Inclusion of Partnership Liabilities in Partner's Basis: Section 752

D. Current Law — The 1991 Regulations and Amendments 

1. Effective Date and Transition Rules 

Regs.  § § 1.752-1 through-4 generally apply to liabilities incurred or assumed by a partnership on or after December 28, 1991 (other than liabilities incurred or assumed by the partnership pursuant to a written binding contract in effect before December 28, 1991, and all times thereafter).157 There are a couple of special effective date provisions, however, that apply to certain amended sections of the regulations. First, the amendments to Regs.  § 1.752-3 issued in 2000 related to tier three allocation of partnership nonrecourse liabilities158 do not apply to any liability incurred or assumed by a partnership prior to October 31, 2000. However, a partnership may rely upon these provisions for any such liability for taxable years ending on or after October 31, 2000. In addition, the 2001 amendment to Regs.  § 1.752-1(f) related to the netting of liabilities in a partnership merger or consolidation does not apply to any liability incurred or assumed by a partnership before January 4, 2001. However, a partnership may rely upon these provisions for any such liability.
——————————————————————————————

157 Regs. § 1.752-5(a).

158 See III, D, 4, below.

——————————————————————————————

The 1991 Regulations included a provision allowing a partnership to elect to apply the 1991 Regulations to all of its liabilities, including those to which they otherwise would not apply, as of the beginning of the first taxable year of the partnership ending on or after December 28, 1991.159 If a partnership did not make this election, liabilities incurred or assumed by a partnership before December 28, 1991, or pursuant to a written binding contract in effect before December 28, 1991, were subject to either the 1988 or the 1956 Regulations.160 The effective date provisions in the 1988 Regulations governed whether such a liability was subject to the 1988 Regulations or the 1956 Regulations.161
——————————————————————————————

159 Regs. § 1.752-5(b)(1).

160 Regs. § 1.752-5(a).

161 Former Regs. § 1.752-4T.

——————————————————————————————

A termination of a partnership under  § 708(b)(1)(B) does not cause partnership liabilities incurred or assumed before the termination to be treated as incurred or assumed on the date of the termination.162 Thus, a  § 708(b)(1)(B) partnership termination does not subject liabilities that otherwise would be subject to the 1988 or 1956 Regulations to the 1991 Regulations by virtue of being incurred or assumed on a termination date on or after December 28, 1991.
——————————————————————————————

162 Regs. § 1.752-5(c).

——————————————————————————————

If a liability that is not otherwise subject to the 1991 Regulations is “materially modified,” the liability becomes subject to the regulations in effect when the modification occurs.163 For purposes of this rule, a partner or related person guarantee of a grandfathered liability is not considered a material modification.164
——————————————————————————————

163 T.D. 8380, 56 Fed. Reg. 66348 (12/23/91). “Material modification” is not defined in the context of § 752. But see FSA 200233018 (notes payable by partnership and related S corporation may be attributable to S corporation, because only S corporation pledged its preferred interest during refinancing).

164 T.D. 8380, 56 Fed. Reg. 66348 (12/23/91).

——————————————————————————————

2. Treatment of Partnership Liabilities 

a. Definition of “Liability” 

(1) Section 752 Liabilities 

The regulations under § 752, as amended in 2005, define “liability” by reference to the term “obligation.” An “obligation” is defined (in somewhat circular fashion) as “any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the ... Code.”165 Examples of “obligations”include (i) debt, environmental, tort, contract, and pension obligations,(ii) obligations under a short sale, and (iii) obligations under derivative financial instruments, such as options, forward contracts, futures contracts, and swaps.166
——————————————————————————————

165 Regs. § 1.752-1(a)(4)(ii), added by T.D. 9207, 70 Fed. Reg. 30334 (5/26/05), generally applicable to liabilities that a partnership incurs or assumes after June 23, 2003.

166 Regs. § 1.752-1(a)(4)(ii).

——————————————————————————————

An “obligation” is a “liability” for purposes of  § 752 if, when, and to the extent that incurring the obligation —

• creates or increases the basis of any of the obligor's assets, including cash;

• gives rise to an immediate deduction to the obligor; or

• gives rise to an expense that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital.167

——————————————————————————————

167 Regs. § 1.752-1(a)(4)(i). This definition is similar to the definition in former Regs. § 1.752-1T(g)of the 1988 Regulations. The 1991 regulations did not contain a definition of “liability” until T.D 9207 added Regs. § 1.752-1(a)(4).

——————————————————————————————

This definition is consistent with the IRS's rulings on the meaning of “liability” for  § 752 purposes. In Rev. Rul. 88-77,168 for instance, the IRS ruled that accrued, unpaid expenses and accounts payable of a cash method partnership were not partnership liabilities. In Rev. Rul. 73-301,169 the IRS ruled that interim payments received by a partnership for services rendered in connection with a long-term contract reported on the completed contract method were not liabilities for purposes of § 752;although the partnership received money, there was no attendant obligation to repay.170 In Rev. Rul. 95-26,171 the IRS ruled that a short sale of securities created a  § 752 partnership liability because a short sale creates an obligation on the part of the seller to return the borrowed securities, and cash received in a short sale is an asset of the partnership.172
——————————————————————————————

168 1988-2 C.B. 128.

169 1973-2 C.B. 215.

170 See also  Helmer v. Comr., T.C. Memo 1975-160 (option on property given by partnership to prospective buyer for consideration allowed reduction of purchase price by option consideration paid should option be exercised but not otherwise; option consideration partnership received did not create partnership liability); Cemco Investors, LLC v. U.S., 2007-1 USTC ¶ 50,385 (N.D. Ill. 2007) (stating that Helmer was good law before issuance of Notice 2000-44, 2000-36 I.R.B. 255 (regarding the IRS's change of position on contingent liabilities)), aff'd, 515 F.3d 749 (7th Cir. 2008) cert. denied, 129 S.Ct. 131 (2008); Jade Trading LLC v. U.S., 80 Fed. Cl. 11 (2007), aff'd in part(on economic substance issue), vacated and remanded in part, No. 2008-5045 (Fed. Cir. 3/23/10) (citing Helmer and district court opinion in Cemco). Cf. TAM 9823002 (prepaid subscription income was  § 752 partnership liability because partnership's obligation to furnish magazines to subscribers arose on receipt of subscriber payment and partnership was obligated to refund prepayments if it failed to deliver).

171 1995-1 C.B. 131. In Marriott Int'l Resorts L.P. v. U.S., No. 2009-5007 Fed. Cir. (10/28/09), aff'g 83 Fed. Cl. 291 (2008), the U.S. Court of Appeals for the Federal Circuit held that taxpayers had notice that an obligation to close a short sale might give rise to a § 752 liability, not only before the 2005 regulations were issued, but even before Rev. Rul. 95-26 was published. The court acknowledged that the IRS and Treasury intended to “change the law governing liabilities” by issuing T.D. 9207, that the new definition of “liability” departed from Helmer, and that no precedents existing at the time of the transactions at issue (1994) even addressed short sales. Nevertheless, the court concluded that Rev. Rul. 88-77 indicated that an obligation gave rise to a liability if it created or increased the partnership's basis in any of the partnership's assets, and, thus, was sufficient to give the taxpayer “indirect notice”that a short sale could give rise to a liability.

172 See also Deputy v. du Pont, 308 U.S. 488 (1940) (only provisions determining when value of obligation is included in basis of partnership assets are Subchapter K rules, specifically § § 752, 732, and 722); , Colm Producer Inc. v. U.S., 460 F. Supp.2d 713 (N.D. Tex. 2006) (citing Rev. Rul. 95-26, district court denied taxpayer's motion for summary judgment and granted government's cross-motion for summary judgment because court found that obligation to close short sale transaction was “liability”within meaning of § 752).

——————————————————————————————

Note: For a  § 752 liability to be shared by the partners, the partnership must be the obligated party. If another person or entity is the obligor, the liability is not considered a partnership liability unless there is an agent-principal relationship between the obligor and the partnership.173
——————————————————————————————

173 See Nat'l Carbide Corp. v. Comr., 336 U.S. 422 (1949 ). See also Comr. v. Bollinger, 485 U.S. 340 (1988); Ourisman v. Comr., 760 F.2d 541 (4th Cir.  1985 ); Vaughn v. U.S., 740 F.2d 941 (Fed. Cir.  1984 ); Roccaforte v. Comr., 708 F.2d 986 (5th Cir. 1983). 

——————————————————————————————

(2) Regs. § 1.752-7 Liabilities 

A “Regs.  § 1.752-7 liability”is an “obligation” (as defined above) to the extent that either: (1) the obligation is not a  § 752 liability; or (2) the “amount” of the obligation exceeds the amount taken into account in incurring the obligation.174 The “amount” of the obligation, for this purpose, is the amount of cash that a willing assignor would pay to a willing assignee to assume the obligation in an arm's-length transaction.175
——————————————————————————————

174 Regs. § 1.752-7(b)(3)(i), T.D. 9207, 70 Fed. Reg. 30334 (5/26/05). The regulations issued by T.D. 9207 generally apply to transfers and assumptions of Regs.  § 1.752-7 liabilities after June 23, 2003. A partnership may elect, however, to apply Regs.  § 1.752-7 to all assumptions of liabilities by the partnership after Oct. 18, 1999. Otherwise, Regs.  § 1.752-6 (T.D. 9207, 70 Fed. Reg. 30334 (5/26/05)) applies to assumptions of liabilities occurring after Oct. 18, 1999, and before June 24, 2003. But see Murfam Farms LLC v. U.S., No. 06-245T (Fed. Cl. 07/30/09) (Regs. § 1.752-6 is invalid, because it does not satisfy any exceptions to statutory bar on retroactive application of regulations under § 7805(b)); Sala v. U.S., 552 F.Supp.2d 1167 (D. Colo. 2008) (setting aside Regs. § 1.752-6 as “unlawful”(in that its rules, which apply to partnerships, are not comparable to rules for corporations described in § 358(h)) and holding that, even if regulation had been properly issued, Treasury lacked authority to make it retroactive under § 7805(b)(3) anti-abuse rule); Klamath Strategic Inv. Fund, LLC v. U.S., 440 F. Supp.2d 608 (E.D. Tex. 2006) (declaring Regs. § 1.752-6 ineffective as to plaintiffs because facts of transaction at issue, although arising after regulation's purported applicability date (Oct. 18, 1999), arose before release date of Notice 2000-44, 2000-36 I.R.B. 255 (Sept. 5, 2000), which court considered earliest date on which plaintiff could have been on notice of IRS's intended change in litigation position on contingent obligations).

175 Regs. § 1.752-7(b)(3)(ii).

——————————————————————————————

Example: X contributes $10,000,000 to a newly formed partnership in 2007 in exchange for a 25% interest in the partnership and the partnership's assumption of a debt obligation. The debt obligation was issued for cash, and the issue price was equal to the stated redemption price at maturity (i.e., $5,000,000). Before the partnership assumes the obligation, however, interest rates decrease. As a result, X would have had to pay a willing assignee $6,000,000 to assume the debt obligation.

The partnership's assumption of the debt obligation from X is (i)an assumption of a  § 752 liability in the amount of $5,000,000 (i.e., the portion of the total amount of the debt obligation that created basis in X's hands) and (ii) the assumption of a Regs.  § 1.752-7 liability in the amount of $1,000,000 (i.e., the excess of the amount that a willing assignee would pay to assume the obligation over the  § 752 liability).176

——————————————————————————————

176 Regs. § 1.752-7(b)(3)(iii).

——————————————————————————————

b. Definition of “Recourse Liability” 

Regs.  § 1.752-1(a)(1) provides that a partnership liability is treated as a recourse liability to the extent that any partner or related person bears the economic risk of loss for the liability. A “related person” is a person having a relationship to a partner described in Regs. § 1.752-4(b).177 The concept of “economic risk of loss” is set forth in detail in Regs. § 1.752-2, discussed in III, D, 3, a, below.
——————————————————————————————

177 Regs. § 1.752-1(a)(3). The definition of “related person”in Regs.  § 1.752-4(b) is discussed in III, D, 3, b, (2), below.

——————————————————————————————

c. Definition of “Nonrecourse Liability” 

Regs.  § 1.752-1(a)(2) provides that a partnership liability is treated as nonrecourse to the extent that no partner or related person bears the economic risk of loss for the liability.178
——————————————————————————————

178 The definition of “related person”is provided in Regs.  § 1.752-4(b) and is discussed in detail in III, D, 3, b, (2), below. The concept of “economic risk of loss” is discussed in detail in III, D, 3, a, below.

——————————————————————————————

d. Increase in Partner's Share of Partnership
  Liabilities 

Regs.  § 1.752-1(b) provides that any increase in a partner's share of partnership liabilities, or any 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.179
——————————————————————————————

179 § 752(a). The partner's basis is increased by the amount of the deemed cash contribution. § 722.

——————————————————————————————

e. Decrease in Partner's Share of Partnership
  Liabilities 

Regs.  § 1.752-1(c) provides that any decrease in a partner's share of partnership liabilities, or any decrease in a partner's individual liabilities by reason of the partnership's assumption of the partner's individual liabilities, is treated as a distribution of money by the partnership to the partner.180 The deemed distribution may result in the recognition of gain under § 731(a)181 or § 751182 if the amount of the distribution exceeds the partner's adjusted basis in the partnership interest.
——————————————————————————————

180 § 752(b). The partner's basis is decreased by the amount of the deemed cash distribution but not below zero. The partner recognizes gain to the extent of any excess of the deemed cash distribution over the partner's adjusted basis in the partnership interest. § 731(a). See FSA 200233018 (when S corporation is co-debtor with related partnership and S corporation is only party to pledge preferred interest in refinancing, partnership may be deemed to make distribution under  § 752(b) due to partners'decreased shares of liabilities).

181 See, e.g., LaRue v. Comr., 90 T.C. 465 (1988).

182 See, e.g., Rev. Rul. 84-102, 1984-2 C.B. 119. For a discussion of the ruling, see Charyk, “The Partnership Corner: New Problems With § 751(b) — A Review of Revenue Ruling 84-102,”12 J. Real Est. Tax'n 166 (1985).

——————————————————————————————

f. Assumption of Liabilities 

Regs.  § 1.752-1(d) provides that, except as  provided otherwise in Regs.  § 1.752-1(e) (relating to contributions and distributions of encumbered property183), a person is considered to assume a liability only to the extent that the assuming person is personally obligated to pay the liability. In addition, if a partner or related person assumes a partnership liability, the person to whom the liability is owed must know of the assumption and must be able to directly enforce the partner's or related person's obligation for the liability and, immediately following the assumption, no other partner or person related to another partner can bear the economic risk of loss with respect to the liability.184
——————————————————————————————

183 Regs.  § 1.752-1(e) is discussed in III, D, 2, g, below.

184 Regs. § 1.752-1(d).

——————————————————————————————

Regs.  § 1.752-1(d) and (e) also applies in determining if a “Regs.  § 1.752-7 liability”(defined above) has been assumed.185
——————————————————————————————

185 Regs. § 1.752-7(b)(1).

——————————————————————————————

g. Contributions and Distributions of Property Subject to a Liability 

If property is contributed by a partner to a partnership and the property is subject to a liability of the contributing partner, the partnership is treated as having assumed the liability to the extent that the amount of the liability does not exceed the fair market value of the property at the time of the contribution.186 Similarly, if property is distributed by a partnership to a partner and the property is subject to a liability of the partnership, the distributee partner is treated as having assumed the liability to the extent that the amount of the liability does not exceed the fair market value of the property at the time of the distribution.187
——————————————————————————————

186 Regs. § 1.752-1(e). The effect of contributions of property on a partner's adjusted basis in the partnership interest is discussed in II, A, 1, above. The partnership's basis in contributed property is discussed in VI, A, below.

187 Regs. § 1.752-1(e). A partner's basis in distributed property is discussed in V, below. The adjustment to a partnership's adjusted basis in its assets upon a distribution of partnership property to a partner is discussed in VIII, below.

——————————————————————————————

h. Netting of Increases and Decreases of Liabilities Resulting from Same Transaction 

Regs.  § 1.752-1(f) allows a partner to net increases and decreases in liabilities that result from the same transaction. Therefore, if a partner's share of individual or partnership liabilities increases and decreases as a result of a single transaction, only a net increase is treated as a contribution of money to the partnership and only a net decrease is treated as a distribution of money from the partnership.188
——————————————————————————————

188 Regs. § 1.752-1(f). See also Rev. Rul. 87-120, 1987-2 C.B. 161; Rev. Rul. 79-205, 1979-2 C.B. 255.

——————————————————————————————

Example: B contributes property with a fair market value of$10,000 and an adjusted basis of $1,000, subject to a recourse debt of $6,000, to a partnership in exchange for a 20% interest in the partnership. The contribution results in a $6,000 decrease in B's share of individual liabilities. However, the contribution also results in a $1,200 increase in B's share of partnership liabilities. The net $4,800 decrease in B's share of liabilities is treated as a deemed cash distribution from the partnership to B. As a result of this deemed distribution, B's initial basis in B's partnership interest ($1,000 adjusted basis in contributed property) is reduced to zero and B realizes$3,800 of taxable gain.

The Regs.  § 1.752-1(f) netting rule also applies to the merger or consolidation of two or more partnerships under § 708(b)(2)(A). Without application of the netting rule, the terminating partnership could contribute to the resulting partnership highly leveraged assets, triggering a deemed distribution to the terminating partnership (which would become, momentarily, a partner in the new partnership). If the deemed distribution exceeded the terminating partnership's adjusted basis in its resulting partnership interest, the terminating partnership would recognize gain, which then would be allocated to its partners. However, under Regs. § 1.752-1(f), the merger or consolidation is treated as a single transaction; a partner only recognizes gain if the net deemed distribution exceeds the partner's adjusted basis in its interest in the resulting partnership.189
——————————————————————————————

189 See Regs.  § 1.752-1(g) Ex. 2.

——————————————————————————————

Example: B owns a 70% interest in partnership T and a 20% interest in partnership S. T's sole asset is a piece of land having a $1,000 fair market value and a $600 adjusted basis, subject to a $900 recourse liability. B's basis in B's interest in T is $420. S's sole asset is a building with a $1,000 fair market value, a $200 adjusted basis, and a $100 liability. B's basis in B's interest in S is $40. T merges into S by contributing the land, with its $900 liability, to S in exchange for an interest in S. Before terminating, T distributes the interest in S to T's partners, and B holds a 25% interest in S after the merger.

Under Regs. § 1.752-1(f), B nets the increases and decreases in B's share of partnership liabilities associated with the merger. Before the merger, B's total share of liabilities between the two partnerships was $650 ($630, or .7 × $900, from T, and $20, or .2 ×  $100, from S). After the merger, B's share of S's partnership liabilities is $250 (.25 ×  ($900+ $100)), resulting in a $400 net decrease, characterized as a deemed distribution, in B's share of S's partnership liabilities. B's adjusted basis in the S partnership before the deemed distribution, however, was $460 ($420 + $40), which fully absorbs the deemed distribution and leaves B with an adjusted basis of $60 in B's interest in S.

The IRS has applied a netting rule to  § 1031 deferred like-kind exchanges of properties subject to liabilities, even when the exchange straddles two partnership taxable years. In Rev. Rul. 2003-56,190 the IRS ruled that, if a partnership transfers encumbered property in a  § 1031 exchange in one partnership taxable year and receives encumbered replacement property in the following partnership taxable year, the liabilities are netted for purposes of § 752. The IRS ruled further that any net decrease in a partner's share of partnership liability as a result of the exchange is taken into account for purposes of  § 752(b) in the first partnership taxable year, and any net increase in a partner's share of partnership liability is taken into account for purposes of  § 752(a) in the second partnership taxable year. For further discussion of the treatment of liabilities in  § 1031 exchanges, see 567 T.M., Taxfree Exchanges Under Section 1031.
——————————————————————————————

190 2003-23 I.R.B. 985. The netting rule that the IRS applied in Rev. Rul. 2003-56 was not technically the rule in Regs. § 1.752-1(f), but rather the liability offsetting rule of Regs. § 1.1031(b)-1(c).

——————————————————————————————

i. Sale or Exchange of Partnership Interest 

Regs.  § 1.752-1(h) provides that if a partnership interest is sold or exchanged, any resulting reduction in the transferor partner's share of partnership liabilities is included in amount realized.

Example: X owns a 50% partnership interest with a fair market value of $20,000. X's adjusted basis in the interest is $4,000. X sells one-half of X's partnership interest for $10,000. X's share of partnership liabilities before the sale is $5,000. X's share of partnership liabilities after the sale is $2,500. The $2,500 decrease in X's share of partnership liabilities is included in amount realized. Thus, X realizes $10,500 of taxable gain upon the sale of half of the interest ($12,500 amount realized minus $2,000 adjusted basis).

j. Bifurcation of Partnership Liabilities 

Regs.  § 1.752-1(i) provides that if one or more partners bear the economic risk of loss as to part, but not all, of a single partnership liability, that liability is treated as two or more separate liabilities for purposes of § 752. The portion of the liability as to which one or more partners bear the economic risk of loss is treated as a recourse liability and is allocated pursuant to the rules for sharing recourse liabilities set forth in Regs. § 1.752-2.191
——————————————————————————————

191 Regs. § 1.752-1(i).

——————————————————————————————

Note: If a person related to a partner, within the meaning of Regs. § 1.752-4(b), bears the economic risk of loss with respect to part of a partnership liability, the partner to whom the person is related is treated as bearing the economic risk with respect to the liability.192
——————————————————————————————

192 Regs. § 1.752-2(a), (b). The definition of “related person” is discussed in III, D, 3, b, (2), below. The concept of “economic risk of loss” is discussed in III, D, 3, a, below.

——————————————————————————————

The portion of the liability as to which no partner bears the economic risk of loss is treated as a nonrecourse liability and is allocated pursuant to the rules for sharing nonrecourse liabilities under Regs. § 1.752-3.193
——————————————————————————————

193 Regs. § 1.752-1(i).

——————————————————————————————

k. Timing of Determination 

Regs.  § 1.752-4(d) provides that a partner's share of partnership liabilities must be determined whenever necessary to compute the tax liability of the partner or any other person. The regulations include a cross reference to the rules in Regs. § 1.705-1(a), which provide generally that a partner must compute the adjusted basis in the partnership interest at the end of each partnership taxable year.194 If, however, there is a sale or exchange of all or part of a partner's interest or a liquidation of a partner's entire interest, the partner should determine the partner's adjusted basis as of the date of the sale, exchange, or liquidation.195 Upon the admission of a new partner, on the other hand, the old partners need not redetermine their adjusted bases in their partnership interests until the end of the partnership's taxable year.196
——————————————————————————————

194 Regs. § 1.705-1(a)(1).

195 Regs. § 1.705-1(a)(1).

196 See Richardson v. Comr., 76 T.C. 512 (1981).

——————————————————————————————

3. Determining Partner's Share of Recourse Liabilities 

a. Economic Risk of Loss and Constructive
  Liquidation 

The regulations describe a partnership liability as recourse to the extent that any partner or related person bears the economic risk of loss for the liability.197 A partner's share of a recourse partnership liability equals the portion of that liability for which the partner or person related to the partner bears the economic risk of loss.198 Thus, a partner shares in a recourse liability (and includes the amount of the liability in the adjusted basis in the partner's partnership interest) only to the extent that the partner or a person related to the partner bears the economic risk of loss.199 The concept of economic risk of loss is, therefore, crucial to a determination of a partner's share of partnership liabilities.
——————————————————————————————

197 Regs. § 1.752-1(a)(1).

198 Regs. § 1.752-2(a).

199 This approach is in marked contrast to the method in the 1956 Regulations, which provided that such liabilities were to be shared according to the partners'ratios for sharing losses. The concept of “economic risk of loss” was first incorporated into the liability sharing rules in the 1988 Regulations. See, e.g., PLRs 9815022 (general obligation refinancing into which partnership entered was separate obligation of partnership — and nonrecourse liability —because no partner or related person would bear risk of loss; creditors would have no claim against partners, related persons, or assets of such persons in event of default), 9815001 (same). See also CCA 200916023 (state law obligation for limited partners to make payment on recourse loan by general partner to partnership if distribution of loan proceeds causes partnership liabilities to exceed assets not recognized; only general partnership bore economic risk of loss for loan and distribution of proceeds of loan to limited partners was taxable to extent that it exceeded outside basis determined without share of general partner recourse loan).

——————————————————————————————

The regulations provide that a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person (or a contribution to the partnership) because the liability becomes due and payable and the partner or related person would not be entitled to reimbursement from another partner or a person related to another partner.200 Thus, a constructive liquidation analysis is required in the determination of whether any partner or related person bears the economic risk of loss with respect to a partnership liability. The following circumstances constitute a constructive liquidation for purposes of the  § 752 regulations:
——————————————————————————————

200 Regs. § 1.752-2(b)(1).

——————————————————————————————

(a) all of the partnership's liabilities become payable in full; 201

(b) with the exception of property contributes to secure a partnership liability202 all of the partnership's assets, including cash, have a value of zero;203

(c) the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor's right to repayment is limited solely to one or more assets of the partnership);204

(d) all items of income, gain, loss, or deduction are allocated among the partners;205 and

(e)the partnership liquidates.206

——————————————————————————————

201 Regs. § 1.752-2(b)(1)(i).

202 See Regs. §  1.752-2(h)(2).

203 Regs. §  1.752-2(b)(1(ii).

204 Regs. § 1.752-2(b)(1)(iii).

205 Regs. § 1.752-2(b)(1)(iv).

206 Regs. § 1.752-2(b)(1)(v).

——————————————————————————————

For purposes of this constructive liquidation, if a creditor's right to repayment is limited solely to one or more assets of the partnership, gain or loss is recognized in an amount equal to the difference between the amount of the liability that is extinguished by the deemed disposition described in (c) above and the tax basis in those assets. To the extent that  § 704(c) or Regs.  § 1.704-1(b)(4)(i) applies to an asset, gain or loss recognized is equal to the difference between the amount of the liability extinguished by the deemed disposition and the book value of the asset.207
——————————————————————————————

207 Regs. § 1.752-2(b)(2)(i).

——————————————————————————————

In addition, upon a constructive liquidation, a partnership recognizes a loss equal to the tax basis of all of the partnership's assets not subject to a creditor's right to repayment. To the extent that the assets are subject to  § 704(c) or Regs. § 1.704-1(b)(4)(i), the partnership recognizes a loss on their deemed disposition equal to the remaining book value of the assets.208
——————————————————————————————

208 Regs. § 1.752-2(b)(2)(ii). These losses are not actual, reported losses but are, instead, constructive losses relevant only in applying the constructive liquidation analysis.

——————————————————————————————

The following examples illustrate the constructive liquidation analysis:

Example 1: X and Y form a general partnership to which they each contribute $20,000 in cash. On Jan. 1, the partnership purchases a building for $100,000 from an unrelated seller, paying $40,000 in cash and executing a $60,000 note for the balance. The partnership agreement provides that X and Y share all partnership items equally, except that 80% of the tax losses are allocated to X. The agreement provides that capital accounts are to be maintained in accordance with the  § 704(b) regulations and that, upon liquidation, both partners are obligated to restore any deficit in their capital accounts. Upon a constructive liquidation, the partnership liability ($60,000) becomes due and payable and the partnership's asset (the building) is deemed to be worthless. There is a hypothetical sale of the building for no consideration. After the hypothetical sale, the partners' capital accounts would be adjusted as follows:
 
 	X	Y	
Initial Contribution	$20,000 	$20,000  	
Hypothetical Loss	(80,000)	(20,000)	
 	(60,000)	0	

X would be obligated to make a $60,000 contribution to the partnership, which would be used to pay off the $60,000 liability. Because X bears the economic risk of loss with respect to the entire amount of the liability, the liability is a recourse liability and is allocated entirely to X. Thus, X's adjusted basis in X's partnership interest is $80,000 ($20,000 cash contributed plus $60,000 share of partnership liabilities) and Y's adjusted basis in Y's partnership interest is$20,000 ($20,000 cash contributed plus $0 share of partnership liabilities).

The result is the same regardless of whether Y personally guaranteed repayment of the note. For purposes of the constructive liquidation test, it is assumed that X has satisfied X's deficit restoration obligation and, therefore, that Y does not have to perform the guarantee. This is generally true even if X's net worth at the time of the allocation determination is not sufficient to cover the payment obligation.209

——————————————————————————————

209 Regs. § 1.752-2(b)(6). Cf. Regs. § 1.752-2(k)(1), T.D. 9289, 71 Fed. Reg. 59669 (10/11/06) (for liabilities incurred or assumed after Oct. 10, 2006, obligation of disregarded entity is taken into account only to extent of disregarded entity's “net value”as of allocation date).

——————————————————————————————

Example 2: Partnership XY incurs a $100,000 liability secured by a mortgage on real property. The holder's only recourse is the property itself. However, in an effort to induce the lender to make the loan, partner X guarantees repayment of $10,000 of the principal amount of the loan. X is not entitled to reimbursement from any partner or the partnership with respect to the guarantee. X bears the economic risk with respect to $10,000 of the liability. Thus, $10,000 of the$100,000 liability is treated as a recourse obligation and is allocated to X. The remainder of the obligation is a nonrecourse liability allocated to the partners in accordance with the rules set forth in Regs. § 1.752-3.210

——————————————————————————————

210 See discussion in III, D, 4, below.

——————————————————————————————

b. Obligations to Make a Payment or a Contribution 

(1) In General 

As discussed above, a partner does not bear the economic risk of loss with respect to a  § 752 partnership liability unless the partner or a related person would be obligated, upon a constructive liquidation, to make a payment to any person or a contribution to the partnership.211
——————————————————————————————

211 Regs. § 1.752-2(b)(1). The 1988 Regulations divided the determination of whether a partner or related person had an obligation to make a payment into two separate sets of rules— one applicable to obligations to make net payments to creditors or other persons with respect to partnership liabilities and the other applicable to obligations to make net contributions with respect to partnership liabilities. Former Regs. § 1.752-1T(d)(3)(ii)(A),(B). The substance of the 1991 Regulations is the same in most material respects as the 1988 Regulations. The major difference is that an analysis of a payment or contribution obligation under the 1991 Regulations is a less complicated process.

——————————————————————————————

The question of whether a partner or related person is obligated to make a payment to any person (or a contribution to the partnership)is generally a facts and circumstances inquiry.212 For purposes of this inquiry, all of the following statutory and contractual obligations are taken into account:
——————————————————————————————

212 Regs. § 1.752-2(b)(3).

——————————————————————————————

(i) contractual obligations outside the partnership agreement, such as guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or to other partners or to the partnership;213

(ii) obligations to the partnership that are imposed by the partnership agreement, including the obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership;214 and

(iii)payment obligations imposed by state law, including the governing state partnership statute.215

——————————————————————————————

213 Regs. § 1.752-2(b)(3)(i).

214 Regs. § 1.752-2(b)(3)(ii).

215 Regs. § 1.752-2(b)(3)(iii). See, e.g., Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (partner remained liable for his personal guarantee of  partnership liability under Florida law despite loss of his partnership interest for failure to meet capital call and dissolution of partnership); Seay v. Comr.,  T.C. Memo  1992-254 (partner had no continuing liability for partnership debt after transfer of interest); Gardner v. Comr.,  T.C. Memo 1987-420, aff'd in unpub. opin.  (6th Cir. 1989) (under state law, partner forfeited partnership interest due to failure to make contributions and, therefore, was no longer liable for partnership debt and recognized gain under  § § 752(b) and 731); Hirsch v. Comr., T.C. Memo  1984-52 (assignment of partnership interest did not terminate liabilities to third parties to extent of assignor partner's deficit capital account).

——————————————————————————————

Thus, in order to determine the existence of a recognized obligation to make a payment to any person (or a contribution to the partnership), three things  must be analyzed — private contractual agreements(other than the partnership agreement), the partnership agreement, and applicable state law. If an obligation on the part of a partner or related person to make a payment to any person or a contribution to the partnership is not recognized as such under the  § 752 regulations, the obligation is not taken into account for purposes of determining the partner's share of partnership liabilities.216 In addition, any such unrecognized obligation is not taken into account for purposes of determining whether the liability to which the obligation relates is recourse or nonrecourse.217
——————————————————————————————

216 Regs.  § 1.752-2(b)(3) (final sentence).

217 Regs. § § 1.752-1(a)(1),-2(a), -2(b)(1), -2(b)(3).

——————————————————————————————

(2) “Related Person”Defined 

(a) In General 

The regulations provide that a person is related to a partner if the person and the partner bear a relationship to each other that is specified in either  § 267(b) or § 707(b)(1), with the following modifications:

(1) every reference to “more than 50%” is changed to “80%or more”;218

(2) a person's family is determined by excluding brothers and sisters;219 and

(3) § 267(e)(1) and (f)(1)(A) are disregarded.220

——————————————————————————————

218 Regs. § 1.752-4(b)(1)(i).

219 Regs. § 1.752-4(b)(1)(ii).

220 Regs. § 1.752-4(b)(1)(iii).

——————————————————————————————

Under the modified version of § 267(b), a person is related to a partner if the person and the partner are:

(1) members of a family (defined, for purposes of § 752, as including a spouse, ancestors, and lineal descendants);

(2) an individual and a corporation if more than 80% of the value of the outstanding stock of the corporation is owned, directly or indirectly, by or for such individual;

(3) two corporations that are members of the same “controlled group” (as defined by  § 1563(a) and without regard to § 267(f)(1)(A));

(4) a grantor and a fiduciary of any trust;

(5) a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

(6) a fiduciary of a trust and a beneficiary of such trust;

(7) a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(8) a fiduciary of a trust and a corporation if more than 80% of the value of the outstanding stock of the corporation is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;
 
(9) a person and an organization to which  § 501 applies if the organization is controlled directly or indirectly by such person or, if the person is an individual, by members of the individual's family;

(10) a corporation and a partnership if the same persons own more than 80% in value of the outstanding stock of the corporation and more than 80% of the capital interest or the profits interest in the partnership;

(11) an S corporation and another S corporation if the same persons own more than 80% in value of the outstanding stock of each corporation;

(12)an S corporation and a C corporation, if the same persons own more than 80% in value of the outstanding stock of each corporation; or

(13) except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of that estate.221

——————————————————————————————

221 Section 267 is discussed in 527 T.M., Loss Deductions.

——————————————————————————————

Under the modified version of § 707(b)(1), a person is related to a partner if the person and the partner are:
(1) a partnership and a person owning, directly or indirectly, more than 80% of the capital interest, or the profits interest, in such partnership; or

(2)two partnerships in which the same persons own, directly or indirectly, more than 80% of the capital interests or profits interests.222

——————————————————————————————

222 Section 707 is discussed in 710 T.M., Partnerships—Conceptual Overview.

——————————————————————————————

(b) Person Related to More than One Partner 

(i) In General 

If a person is related to more than one partner, for purposes of determining economic risk of loss the person is treated as related to the partner with whom there is the highest percentage of related ownership. If two or more partners have the same percentage of related ownership and no other partner has a greater percentage, the liability is allocated equally among the partners having the equal percentages of related ownership.223
——————————————————————————————

223 Regs. § 1.752-4(b)(2)(i).

——————————————————————————————

(ii) Natural Persons 

When determining the percentage of related ownership between a person and a partner, natural persons who are related by virtue of being members of the same family are treated as having a percentage relationship of 100% with respect to each other.224
——————————————————————————————

224 Regs. § 1.752-4(b)(2)(ii).

——————————————————————————————

(iii) Related Partner Exception 

Persons owning interests directly or indirectly in the same partnership are not treated as related persons for purposes of determining the extent to which they bear the economic risk of loss with respect to partnership liabilities.225 However, this exception does not apply when determining a partner's interest under the de minimis rules under Regs.  § 1.752-2(d) and (e).226
——————————————————————————————

225 Regs. § 1.752-4(b)(2)(iii). See e.g., IPO II v. Comr., 122 T.C. 295 (2004)  (none of limited liability company's recourse loan was allocable to corporate member because (1) other, individual, member guaranteed loan, (2)operating agreement and state law provided that no member would be liable for another member's debts, and (3) related party exception severed relationship between individual member and corporate member, of which individual was 100% owner).

226 Regs. § 1.752-4(b)(2)(iii).

——————————————————————————————

(iv) Special Rules Where Entity Structured to Avoid
  Related Person Status 

The regulations contain a special rule that applies if: (1) a partnership liability is held or guaranteed by another entity that is a partnership, an S corporation, a C corporation, or a trust; (2) a partner or related person owns (directly or indirectly) a 20% or more ownership interest in the other entity; and (3) a principal purpose of having the other entity act as lender or guarantor of the liability is to avoid the determination that the partner that owns the interest bears the economic risk of loss for all or part of the liability. If all three of these conditions are met, the partner is treated as holding the other entity's interest as a creditor or guarantor to the extent of the partner's or related person's ownership interest in the entity.227 A partner's or related person's ownership interest in the other entity is determined under the following rules:
——————————————————————————————

227 Regs. § 1.752-4(b)(2)(iv)(A).

——————————————————————————————

(A) a person's ownership interest in a partnership equals the partner's highest percentage interest in any item of partnership loss or deduction for any taxable year;228

(B) a person's ownership interest in an S corporation equals the percentage of the outstanding stock in the S corporation owned by the shareholder;229

(C) a person's ownership interest in a C corporation equals the percentage of the fair market value of the issued and outstanding stock owned by the shareholder;230 and

(D)a person's ownership interest in a trust equals the percentage of the actuarial interests owned by the beneficial owner of the trust.231

——————————————————————————————

228 Regs. § 1.752-4(b)(2)(iv)(B)(1).

229 Regs. § 1.752-4(b)(2)(iv)(B)(2).

230 Regs. § 1.752-4(b)(2)(iv)(B)(3).

231 Regs. § 1.752-4(b)(2)(iv)(B)(4).

——————————————————————————————

Example: X, Y, and Z form an equal general partnership to which each contributes $10,000. X and Y want to loan money to the partnership and have the loan treated as nonrecourse so that Z can share in the liability. X and Y also form an S corporation to which each contributes$20,000. The partnership borrows $40,000 from the S corporation secured by the mortgage on the property purchased by the partnership. For purposes of § 752, the $40,000 liability is treated as held by X and Y to the extent of their ownership interests in the S Corporation. Thus, 50% of the liability is treated as the recourse obligation of X and 50% of the liability is treated as the recourse obligation of Y.

(3) Contingent Obligations 

For purposes of determining if a partner or related person is obligated to make a payment with respect to a  § 752 partnership liability, obligations subject to contingencies that make it unlikely that the obligation will ever be discharged are disregarded.232 The determination of whether a payment obligation is subject to such a contingency is made by taking into account all the facts and circumstances. In addition, if a partner or related person is obligated to make a payment upon the happening of an event in the future and the timing of that event is not determinable with reasonable certainty, the obligation is disregarded until the event occurs.233
——————————————————————————————

232 Regs. § 1.752-2(b)(4).

233 Regs. § 1.752-2(b)(4).

——————————————————————————————

Example: X and Y form an equal partnership. X and Y agree to share partnership profits and losses equally. X and Y each contribute$10,000 to the partnership. The partnership purchases a building for$10,000 cash and a $50,000 nonrecourse loan secured by a mortgage on the building. The loan agreement provides that if there is a decrease in the value of the building due to the partnership's failure to adequately maintain the property, the partnership will be liable for the outstanding balance of the loan on a recourse basis to the extent of any such decrease. Thus, the partners have an obligation to repay the loan or a portion thereof contingent upon the partnership's failing to maintain the property. However, it is not possible to determine with reasonable certainty when or if the obligation will arise, and, therefore, the obligation is disregarded for purposes of the liability sharing rules. The liability, consequently, is nonrecourse because no partner bears the economic risk of loss. The liability is allocated according to the rules set forth in Regs. § 1.752-3. In this example, X and Y share the liability equally because they share partnership profits and losses equally.234

——————————————————————————————

234 Regs.  § 1.752-2(f) Ex. 8.

——————————————————————————————

A “Regs.  § 1.752-7 liability,”on the other hand, may affect the basis of the partner from whom the Regs. § 1.752-7 liability was assumed. See III, E, below. As discussed in III, D, 2, a, above, contingent obligations may be Regs.  § 1.752-7 liabilities.

(4) Reimbursement Rights 

A partner's or related person's obligation to make a payment or contribution with respect to a partnership liability upon a constructive liquidation of the partnership is reduced to the extent that the partner or related person is entitled to reimbursement from another partner or a person related to another partner. The concept of reimbursement does not extend to rights of reimbursement from unrelated third parties.235
——————————————————————————————

235 Regs. § 1.752-2(b)(5).

——————————————————————————————

(5) Assumption of Full Performance 

For purposes of determining if a partner or related person has an obligation to make a payment or contribution with respect to a partnership liability, it is assumed that all partners and related persons who have such obligations will actually make the obligatory payment or contribution, regardless of their actual net worth.236 This rule applies regardless of the partner's or related person's actual net worth. This rule does not apply, however, if the facts and circumstances indicate a plan to circumvent or avoid the obligation.237
——————————————————————————————

236 Regs. § 1.752-2(b)(6).

237 Regs. § 1.752-2(b)(6). See the anti-abuse rule of Regs.§ 1.752-2(j), discussed in III, D, 3, h, below.

——————————————————————————————

(6) Obligations of Disregarded Entities 

Regs. § 1.752-2(k), proposed in 2004238 and finalized in 2006,239 provides rules related to the effect of a disregarded entity on the allocation of partnership recourse liabilities.240 Payment or contribution obligations of a partner that is a disregarded entity raise special issues; the owner of the disregarded entity is treated as the partner for federal tax purposes but, because of statutory limitations on liability (e.g., state law limitations on the liability of members of a limited liability company), may have no obligation to satisfy obligations undertaken by the disregarded entity. The regulations generally treat the owner of a disregarded entity/partner as bearing the economic risk of loss for obligations of the disregarded entity to the extent of the disregarded entity's “net value” as of the date on which the partnership determines its partners' shares of partnership liabilities under Regs. § § 1.752-4(d) and 1.705-1(a). This rule does not apply, however, to the extent that the owner of the disregarded entity is required to make a payment with respect to the obligation.241
——————————————————————————————

238 REG-128767-04, 69 Fed. Reg. 49832 (8/12/04).

239 T.D. 9289, 71 Fed. Reg. 59669 (10/11/06).

240 A disregarded entity is an entity disregarded as separate from its owner under § 856(i), § 1361(b)(3), or Regs. § § 301.7701-1 through-7.

241 Regs. § 1.752-2(k)(1).

——————————————————————————————

For purposes of determining “net value,” the following rules apply:242
——————————————————————————————

242 Regs. § 1.752-2(k)(2)(i).

——————————————————————————————

• “Net value” is generally equal to the fair market value of the disregarded entity's assets subject to creditors' claims under local law minus obligations of the disregarded entity that do not constitute Regs.  § 1.752-2(b)(1) payment obligations of the disregarded entity.

• For purposes of computing net value, the fair market value of the entity's assets does not include the entity's interest in the partnership for which net value is being determined and  does not include the net fair market value of property pledged to secure a liability of that partnership.

• For purposes of computing net value, the fair market value of the entity's assets includes the entity's enforceable rights to contributions from its owner and  includes the entity's interest in any partnership other than the partnership for which net value is being determined.

• For purposes of computing net value, a subsequent reduction in net value is taken into account (retroactively) if, at the time net value is being determined, the subsequent reduction is anticipated and the reduction is part of a plan that has as one of its principal purposes “creating the appearance” that a partner actually bears the risk of loss for a partnership liability.243

——————————————————————————————

243 Regs. § 1.752-2(k)(4).

——————————————————————————————

The regulations describe several “valuation events”  that may trigger the need to determine the net value of a disregarded entity.244 The regulations also contain rules governing the timing of the net value determination.245 The regulations impose upon the owner of the disregarded entity an obligation to provide necessary information to the partnership, including tax classification of the entity and the net value of the entity.246
——————————————————————————————

244 See Regs. § 1.752-2(k)(2)(ii)-(iii).

245 See Regs. § 1.752-2(k)(2)(iv).

246 See Regs. § 1.752-2(k)(5).

——————————————————————————————

Example 1: In Year One, X forms a wholly owned limited liability company (LLC), which, along with B and C, forms a limited partnership. The LLC contributes $250,000 to the limited partnership in exchange for a general partnership interest. B and C each contribute $250,000 in exchange for limited partnership interests. Only the LLC is required to make up any deficit in its partnership capital account. In Year Two, the limited partnership uses the $750,000 of contributed cash, along with borrowed funds of $500,000, to purchase property. The $500,000 loan is a general obligation of the partnership, secured by the property. The LLC has no assets other than its interest in the limited partnership on the date on which the partnership determines its partners' shares of the $300,000 debt. Because the LLC is a disregarded entity under Regs. § 301.7701-3(b)(1)(ii), X is treated as a partner of the limited partnership for federal tax purposes. Under Regs. § 1.752-2(b)(1), however, only the LLC would have an obligation to make a payment on account of the $500,000 debt upon a constructive liquidation of the limited partnership. The regulations treat X as bearing the economic risk of loss for the partnership's $500,000 debt only to the extent of the LLC's “net value.” Applying the rules in the regulations for computing net value, the net value of the LLC is $0 (because net value does not include the value of the limited partnership interest). Thus, X does not bear the economic risk of loss for any of the debt, and the debt is characterized as nonrecourse under Regs. § 1.752-1(a).247

——————————————————————————————

247 Regs.  § 1.752-2(k)(6) Ex. 1.

——————————————————————————————

Example 2: The facts are the same as in Example 1, except that, in Year Three, X makes a  $150,000 contribution to the LLC, which uses the cash and $100,000 of borrowed funds to purchase land. Both X's contribution to the LLC (which is considered a “more than de minimis” contribution) and the LLC's incurrence of debt are “valuation events” under the regulations. The LLC's net value must, therefore, be redetermined as of the end of Year Three. Assuming that the land continues to be worth $250,000 at the end of Year Three, the net value of the LLC at that time is $150,000 ($250,000 land minus $100,000 debt). Therefore, at the end of Year Three, $150,000 of the limited partnership's $500,000 liability is recourse and allocated to X. The remaining $350,000 is nonrecourse and allocated accordingly.248

——————————————————————————————

248 See Regs.  § 1.752-2(k)(6) Ex. 2.

——————————————————————————————

The  § 1.752-2(k) regulations apply to liabilities incurred or assumed by a partnership on or after October 11, 2006, other than liabilities incurred or assumed by a partnership pursuant to a written binding contract in effect prior to that date.249
——————————————————————————————

249 Regs. § 1.752-2(l).

——————————————————————————————

c. Partner or Related Person as Lender 

(1) In General 

Regs.  § 1.752-2(c)(1) provides that an otherwise nonrecourse partnership liability is treated as a recourse liability to the extent that a partner or a related person holds an interest in the liability.250 If a partner or a person related to a partner holds a partnership liability, this provision allocates the economic risk of loss for the partnership liability to the partner who holds the liability or to whom the holder is related to the extent that the economic risk of loss is not borne by another partner.251 This rule only applies to otherwise nonrecourse liabilities owed by the partnership.
——————————————————————————————

250 Nonrecourse partnership liabilities  held or guaranteed by a partner or related person are referred to as “partner nonrecourse debt” in the regulations under § 704(b). See Regs. § 1.704-2(b)(4).

251 Regs. § 1.752-2(c)(1). This rule is subject to a de minimis exception discussed below.

——————————————————————————————

Comment: It is possible for a partner holding a partnership liability to strip the right to the interest payments and sell the strip to an unrelated third party.  No provision in the regulations directly applies to this situation. However, the most consistent approach appears to be a bifurcation of the liability into two liabilities —one recourse liability held by the partner equal to the stated principal amount of the loan and one liability (either recourse or nonrecourse, depending on the facts) equal to the present value of the projected stream of interest payments.252
——————————————————————————————

252 This approach is consistent with § 1286, relating to the tax treatment of stripped bonds.  Section 1286 is discussed in detail in 535 T.M., Time Value of Money: OID and Imputed Interest.

——————————————————————————————

(2) Wrapped Debt 

For purposes of the  § 752 regulations, wrapped debt is partnership debt held by a partner or related person that includes (i.e., is “wrapped” around) underlying debt owed by the partner or related person to an unrelated lender. If the underlying debt, i.e., the “wrapped” debt, is a nonrecourse obligation that encumbers partnership property, the partnership liability is bifurcated into two separate liabilities — one liability owed to the partner or related person and one liability (equal to the underlying, “wrapped” debt) owed to an unrelated lender.253
——————————————————————————————

253 Regs. § 1.752-2(c)(2).

——————————————————————————————

Example: X owns property that is subject to a $100,000 nonrecourse liability held by an unrelated lender. X sells the property for $140,000 to a partnership in which X is a general partner. In exchange for the property, the partnership gives X $20,000 cash and a $120,000 nonrecourse note for which neither the partnership nor any partner has personal liability. The $120,000 note held by X “wraps”the $100,000 nonrecourse liability owed by X to the unrelated third party. Thus, the $120,000 partnership liability is treated as a $20,000 recourse liability for which X bears the economic risk of loss and a $100,000 nonrecourse liability owed by the partnership to the unrelated lender.

d. Guarantee of Interest on Partnership Nonrecourse Liability 

(1) In General 

Regs.  § 1.752-2(e) provides a special rule for partnership liabilities that are nonrecourse as to principal and wholly or partly recourse as to interest. The rule applies if one or more partners or related persons guarantee the payment of greater than 25% of the total interest that will accrue on a partnership nonrecourse liability over its remaining term, and it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if the partnership fails to do so.254 If the rule applies, the partnership liability is treated as two separate liabilities —one recourse liability for which the partner or related person who has guaranteed the payment bears the economic loss equal to the present value of the guaranteed future interest payments and one nonrecourse liability equal to the remainder of the stated principal amount of the liability.255 Note that this rule does not require the creation of a second partnership liability equal to the present value of the guaranteed interest payments. Instead, the original principal amount of the partnership nonrecourse liability is bifurcated into the separate portions, one equal to the present value of the guaranteed interest payments and one equal to the remaining stated principal amount of the obligation.
——————————————————————————————

254 Regs. § 1.752-2(e)(1).

255 Regs. § 1.752-2(e)(1).

——————————————————————————————

Regs.  § 1.752-2(e)(1) provides that, for purposes of this rule, it is reasonable to expect that the guarantor will be required to pay substantially all of the guaranteed future interest if, upon a default by the partnership, the lender can enforce the interest guaranty without foreclosing on the property. Once applicable, the guarantee-of-interest rule requiring bifurcation of an otherwise nonrecourse partnership liability continues to apply until all guaranteed interest is paid, even if the amount of guaranteed interest that will accrue is less than 25% of the total interest that will accrue on the liability.256
——————————————————————————————

256 Regs. § 1.752-2(e)(1).

——————————————————————————————

(2) Computation of Present Value 

For purposes of the guarantee-of-interest rule, the present value of the guaranteed future interest payments is computed by application of a discount rate equal to the interest rate stated in the loan documents or, if interest is computed under either  § 483 or § 1274, the applicable federal rate, compounded semi-annually.257 The computation of present value is made with respect to payments of interest that will accrue economically258 after the date of the guarantee.259 If the loan documents provide for a variable rate of interest that is based on current values of an objective interest index,260 present value is computed by assuming that the interest determined under the objective interest index on the date of the computation will remain constant over the term of the loan.
——————————————————————————————

257 Regs. § 1.752-2(e)(2).

258 The determination of when the interest payments will accrue economically is made in accordance with  § 446 and the regulations thereunder. Regs. § 1.752-2(e)(2). Section 446 is discussed in detail in 570 T.M., Accounting Methods —General Principles.

259 Regs. § 1.752-2(e)(2).

260 For purposes of this provision, the term “objective interest index” has the same meaning as it has for purposes of  § 1275 and the regulations thereunder. Examples of objective interest indices include the prime rate of a designated financial institution, the London Interbank Offered Rate (LIBOR), and the applicable federal rate under § 1274(d). Regs. § 1.752-2(e)(2).

——————————————————————————————

Example 1: On Jan. 1, Year One, a partnership obtains a $4,000,000 nonrecourse loan secured by property owned by the partnership. Interest accrues at a 15% annual rate and is payable on Dec. 31 of each year. The principal is payable in a lump sum on Dec. 31, Year Nine. Partner X guarantees payment of 50% of each interest payment. The guarantee can be enforced without first foreclosing on the property. The present value of the future interest payments on the date the loan is incurred is $3,508,422 (discounted at 15%, compounded annually). If tested on that date, the loan is treated as a partnership recourse liability of $1,754,211 ($3,508,422 ×  50%), for which  X bears the economic risk of loss, and a partnership nonrecourse liability of $2,245,789($4,000,000 - $1,754,211). The recourse liability is allocated entirely to X and is added to X's adjusted basis in X's partnership interest. The nonrecourse liability is allocated pursuant to the rules set forth in Regs. § 1.752-3, discussed in III, D, 4, below.

Example 2: The facts are the same as in Example 1, except that X guarantees only 25% of the partnership nonrecourse liability. The guarantee-of-interest rule does not apply to guarantees of equal to or less than 25% of the interest that will become due on an obligation. Thus, the entire $4,000,000 liability is a partnership nonrecourse liability.261

——————————————————————————————

261 If the 1988 Regulations applied to the liability, the guarantee of interest rule would apply because the threshold for application of the rule in the 1988 Regulations was a guarantee of greater than 20% of the interest that would become due on an obligation. Former Regs. § 1.752-1T(d)(3)(v)(A).

——————————————————————————————

(3) Safe Harbor 

Under a safe harbor provided in the regulations, the guarantee-of-interest rule does not apply to a partnership nonrecourse liability if the guarantee of interest by the partner or related person is for the lesser of five years or one-third of the term of the obligation.262
——————————————————————————————

262 Regs. § 1.752-2(e)(3).

——————————————————————————————

(4) De Minimis Exception 

In addition to the safe harbor described above,  a de minimis exception applies to the guarantee-of-interest rule. The exception applies if: (1) the partner or related person guaranteeing the interest payments owns an interest in each item of partnership income, gain, loss, deduction, or credit for every taxable year for which the partner is a partner in the partnership that is equal to or less than 10%; and (2) the liability for which the partner or related person guarantees interest constitutes “qualified nonrecourse financing” within the meaning of § 465(b)(6).263 For purposes of the de minimis exception,  § 465(b)(6) is applied without regard to the type of activity financed. For purposes of the 10% or less rule, an allocation of interest paid by the guarantor is not treated as a partnership item.264
——————————————————————————————

263 Regs. § 1.752-2(e)(4).

264 Regs. § 1.752-2(e)(4).

——————————————————————————————

e. Partner Providing Property as Security for Partnership Liability 

(1) Direct Pledge 

If a partner or related person pledges separate property, other than a direct or indirect interest in the partnership, as security for a partnership liability, the partner is treated as bearing the economic risk of loss for the partnership liability to the extent of the “value”of that pledged property.265 For liabilities incurred or assumed by a partnership after October 10, 2006 (other than in the case of liabilities incurred or assumed pursuant to a binding, written contract in effect before that date), the extent to which a partner is treated as bearing the economic risk of loss for a partnership liability as a result of a direct (or indirect) pledge of property is limited to the “net fair market value” at the time of the pledge or contribution.266 For purposes of determining net fair market value, any obligations to which the property is subject are taken into account; if a partner pledges additional property to the partnership, that pledge is considered a new pledge and the total net fair market value of the pledged property must be redetermined at that time.267  With respect to liabilities incurred or assumed before October 11, 2006, if a partner pledges separate property, the partner is treated as bearing the economic risk of loss to the extent of the fair market value of that property.268
——————————————————————————————

265 Regs. § 1.752-2(h)(1).

266 Regs. § 1.752-2(h)(3).

267 Regs. § 1.752-2(h)(3).

268 Former Regs. § 1.752-2.

——————————————————————————————

(2) Indirect Pledge 

If a partner contributes property to a partnership solely for the purpose of securing a partnership liability, the partner is treated as bearing the economic risk of loss for the partnership liability to the extent of the “value” of the property.269 For purposes of this rule, a partner's or related person's promissory note contributed to a partnership is disregarded unless the note is readily tradeable on an established securities market.270 Contributed property is considered contributed solely to secure a partnership liability if (i) substantially all of the items of income, gain, loss, and deduction attributable to the contributed property are allocated to the contributing partner and (ii) these allocations are generally greater than the partner's share of other significant items of partnership income, gain, loss, or deduction.271
——————————————————————————————

269 Regs. § 1.752-2(h)(2).

270 Regs. § 1.752-2(h)(4).

271 Regs. § 1.752-2(h)(2).

——————————————————————————————

For liabilities incurred or assumed by a partnership after October 10, 2006 (other than in the case of liabilities incurred or assumed pursuant to a binding, written contract in effect before that date), the extent to which a partner is treated as bearing the economic risk of loss for a partnership liability as a result of an indirect (or direct) pledge of property is limited to the “net fair market value” at the time of the pledge or contribution.272 For purposes of determining net fair market value, any obligations to which the property is subject are taken into account; if a partner pledges additional property to the partnership, that pledge is considered a new pledge and the total net fair market value of the pledged property must be redetermined at that time.273 With respect to liabilities incurred or assumed before October 11, 2006, if a partner contributes property to a partnership solely for the purpose of securing a partnership liability, the partner is treated as bearing the economic risk of loss for the partnership liability to the extent of the fair market value of the contributed property.274
——————————————————————————————

272 Regs. § 1.752-2(h)(3).

273 Regs. § 1.752-2(h)(3).

274 Former Regs. § 1.752-2.

——————————————————————————————

f. Valuation of Payment or Contribution Obligations 

The value of an obligation to make a payment with respect to a partnership liability is equal to the entire principal balance of the obligation only if one of the following two conditions is met:

(a) the payment obligation is required to be satisfied within a reasonable time after the partnership liability becomes due and payable;275 or

——————————————————————————————

275 Regs. § 1.752-2(g)(1).

——————————————————————————————

(b) the obligation bears interest equal to or greater than the applicable federal rate under  § 1274(d) at the time of valuation, beginning on the date that the partnership liability becomes due or payable.276

——————————————————————————————

276 Regs. § 1.752-2(g)(2).

——————————————————————————————

The value of an obligation to make a contribution with respect to a partnership liability is equal to the entire principal balance of the obligation only if one of the following two conditions is met:

(a) the contribution obligation is required to be satisfied before the later of the end of the year in which the partner's interest is liquidated or 90 days after the liquidation;277 or

——————————————————————————————

277 Regs. § 1.752-2(g)(1).

——————————————————————————————

(b) the obligation bears interest equal to or greater than the applicable federal rate under  § 1274(d) at the time of valuation, beginning on the date of the liquidation of the partner's interest in the partnership.278

——————————————————————————————

278 Regs. § 1.752-2(g)(2).

——————————————————————————————

If a payment or contribution obligation does not satisfy one of the conditions applicable to such an obligation set forth above, the value of the obligation is discounted to the present value of all payments due from the partner or related person.279 For purposes of computing present value, the partnership is deemed to have constructively liquidated as of the date on which the obligation is valued and the obligation is assumed to be a debt instrument issued for property on the date of valuation.280
——————————————————————————————

279 Regs. § 1.752-2(g)(2). The present value is equal to the “imputed principal amount”under § 1274(b). Section 1274 is discussed in detail in 535 T.M., Time Value of Money:OID and Imputed Interest.

280 Regs. § 1.752-2(g)(2). The debt instrument is, therefore, subject to § 1274.

——————————————————————————————

For purposes of the preceding valuation rules, a payment or contribution obligation is not considered satisfied by the transfer of a partner's or related person's promissory note unless the note is readily tradeable on an established securities market.281
——————————————————————————————

281 Regs. § 1.752-2(g)(3).

——————————————————————————————

Example: X and Y form a limited partnership in which X is a general partner and Y is a limited partner. X and Y each contribute$30,000 to the partnership. The partnership purchases property for$60,000 in cash and a $70,000 recourse note. The partnership agreement provides that X and Y share partnership profits and losses equally and that both X and Y are required to restore any deficit in their capital accounts. X is required to restore any deficit in X's account within 90 days of a liquidation of the partnership. Y is not obligated to restore the deficit in Y's capital account until two years after a partnership liquidation. If the partnership constructively liquidates, all of its assets are deemed worthless and the resulting $130,000 loss is shared equally by X and Y, resulting in a deficit of $35,000 in their respective capital accounts as follows:
 Capital Accounts	 X	 Y 	
Opening Balance	 $30,000  	 $30,000  	
Loss on Constructive Liquidation	 (65,000)	 (65,000) 	
Deficit	($35,000)	($35,000)	

The value of X's obligation to restore the $35,000 deficit in X's capital account is equal to the entire principal balance of the obligation($35,000), because the obligation must be satisfied within 90 days of liquidation. However, the value of Y's restoration obligation is equal to the present value of the obligation at the time of the constructive liquidation. (Y is not required to satisfy the obligation within 90 days, and the obligation does not bear interest.) Assuming that the applicable federal rate is 10%, compounded semiannually, the present value of Y's obligation to make a $35,000 contribution two years after the constructive liquidation is equal to $28,795. Thus, Y bears the economic risk of loss with respect to $28,795 of the $70,000 partnership liability. Y's basis in Y's partnership interest is $58,795 ($30,000(initial basis) + $28,795 (share of partnership liabilities)). X would be obligated under state law to contribute an additional $6,205 to the partnership, because the remainder of Y's restoration obligation is deemed not to exist. Thus, X bears the economic risk of loss with respect to $41,205 ($35,000 + $6,205) of the $70,000 partnership liability. X's adjusted basis in X's partnership interest is $71,205 ($30,000(initial basis) + $41,205 (share of partnership liabilities)).

For a discussion of valuing “Regs.  § 1.752-7 liabilities,”see III, D, 2, a, above.

g. Application of Recourse Liability Sharing Rules to Tiered Partnerships 

The liabilities of a lower-tier partnership are allocated to an upper-tier partnership to the extent that the upper-tier partnership and/or any of the partners in the upper-tier partnership bear the economic risk of loss with respect to the liabilities.282 For purposes of this rule, an “upper-tier partnership” is one that owns, directly or indirectly through one or more partnerships, an interest in another partnership (the “lower-tier partnership”). Generally, for purposes of applying  § 752 and the regulations thereunder to the partners of an upper-tier partnership, an upper-tier partnership's share of a lower-tier partnership's liabilities is treated as a liability of the upper-tier partnership, except in the case of lower-tier partnership liabilities owed to the upper-tier partnership.283
——————————————————————————————

282 Regs. § 1.752-2(i).

283 Regs. § 1.752-4(a).

——————————————————————————————

For a discussion of tiered partnership rules relating to “Regs. § 1.752-7 liabilities,”see III, E, below.

h. Anti-Abuse Rules 

(1) In General 

If the facts and circumstances indicate that a principal purpose of an arrangement between  parties is to eliminate a partner's economic risk of loss with respect to an obligation or create the appearance that a partner or related person bears the economic risk of loss when, in fact, the substance of the arrangement is otherwise, the obligation may be disregarded or treated as an obligation of another person for purposes of § 752.284 The regulations discuss two specific situations that indicate abuse, as discussed below. The anti-abuse rule is not, however, limited in application to the two situations specifically addressed in the regulations.285
——————————————————————————————

284 Regs. § 1.752-2(j)(1). See CCA 200246014 (guaranty by partner of partnership indebtedness is disregarded and transaction recast when it was found to be entered into for tax avoidance purposes).

285 Regs. § 1.752-2(j)(1).

——————————————————————————————

(2) Arrangements Tantamount to a Guarantee 

A partner is treated as bearing the economic risk of loss with respect to a partnership liability to the extent that:

(1) the partner or a related person enters into contractual obligations to enable the partnership to obtain a loan;

(2) the contractual obligations of the partner or related person eliminate substantially all of the risk to the lender that the partnership will not satisfy its obligations under the loan; and

(3) one of the principal purposes of entering into the contractual obligations is to attempt to permit partners (other than those who directly or indirectly bear the economic risk with respect to the loan) to include a portion of the loan in the adjusted basis of their partnership interests.286

——————————————————————————————

286 Regs. § 1.752-2(j)(2).

——————————————————————————————

This rule applies regardless of the form of the contractual obligation.287 If the rule applies, the partners are treated as bearing the economic risk of loss for the liability to the extent of their relative economic burdens for the liability pursuant to the contractual obligations. The regulations refer to a lease between a partner and a partnership that is not on commercially reasonable terms as an example of an arrangement that is tantamount to a guarantee by the partner of a partnership liability and, therefore, is subject to this anti-abuse rule.288
——————————————————————————————

287 Regs. § 1.752-2(j)(2).

288 Regs.  § 1.752-2(j)(2) (flush language).

——————————————————————————————

(3) Plan to Circumvent or Avoid the Regulations 

If the facts and circumstances surrounding a financing transaction indicate a plan to circumvent or avoid a payment or contribution obligation, the obligation is disregarded for purposes of § 752.289
——————————————————————————————

289 Regs. § 1.752-2(j)(3).

——————————————————————————————

Example: In Year One, X and Y form a general partnership to which X contributes $10,000 and Y contributes $40,000. The partnership agreement allocates losses 20% to X and 80% to Y until Y's capital account is reduced to zero, after which all losses are allocated to X. Under the partnership agreement, X is obligated to restore any deficit in X's capital account. However, X is a corporate subsidiary with capital limited to its initial contribution. Later in Year One, the partnership purchases property with a fair market value of $140,000 for $40,000 cash and a $100,000 recourse loan. Y guarantees payment of the loan to the extent that the lender is unable to recover the outstanding debt after exhausting all remedies against the partnership. Y's guarantee of the loan, together with the minimal capitalization of X indicates a plan to circumvent X's contribution obligation. Thus, for purposes of allocating the liability, X's contribution obligation is disregarded and the entire $100,000 recourse liability is allocated to Y.

4. Partner's Share of Nonrecourse Liabilities 

a. In General 

As discussed above, a nonrecourse partnership liability is, for purposes of § 752, a partnership liability for which no partner or related person bears the economic risk of loss.290 A partner's share of partnership nonrecourse liabilities includes the following:
——————————————————————————————

290 Regs. § 1.752-1(a)(2).

——————————————————————————————

(a) the partner's share of “partnership minimum gain”determined in accordance with the rules of  § 704(b) and the regulations thereunder (often referred to as the “Tier One Allocation”);291

——————————————————————————————

291 Regs. § 1.752-3(a)(1).

——————————————————————————————

(b) the amount of any taxable gain that would be allocated to the partner under  § 704(c) (or in a similar manner if partnership property is revalued292) if the partnership disposed of all partnership property subject to one or more nonrecourse partnership liabilities in a taxable transaction in full satisfaction of the liabilities and for no other consideration (often referred to as the “Tier Two Allocation”);293  and

——————————————————————————————

292 See Regs. § 1.704-1(b)(2)(iv)(f), (r).

293 Regs. § 1.752-3(a)(2).

——————————————————————————————

(c) the partner's share of “excess nonrecourse liabilities,”i.e., nonrecourse liabilities not allocated under (a) or (b) above(often referred to as the “Tier Three Allocation”).294

——————————————————————————————

294 Regs. § 1.752-3(a)(3). A partner's share of excess nonrecourse liabilities is generally determined in accordance with the partner's share of partnership profits. Alternative third-tier allocation methods are discussed below.

——————————————————————————————

“Partnership minimum gain” is defined as the gain that a partnership would realize if it disposed of all partnership property subject to nonrecourse liabilities in full satisfaction of the liabilities and for no other consideration.295 However, if partnership property subject to one or more nonrecourse liabilities is reflected on the partnership's books at a value that differs from its adjusted tax basis, the determination of minimum gain is made by reference to book value in contrast to adjusted basis.296
——————————————————————————————

295 Regs. § 1.704-2(d)(1). Partnership minimum gain is computed on a liability-by-liability basis. The separately computed gains are aggregated to determine the total amount of partnership minimum gain.

296 Regs. § 1.704-2(d)(3).

——————————————————————————————

The amount of partnership “nonrecourse deductions” for a given taxable year equals the net increase in partnership minimum gain during the year reduced (but not below zero) by the aggregate distributions made during the year of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain.297 The  § 704 regulations governing the allocation of nonrecourse deductions coordinate with the  § 752 regulations governing the sharing of nonrecourse liabilities in that a partner's share of nonrecourse liabilities (with its accompanying increase in basis)matches the partner's share of nonrecourse deductions with respect to those liabilities.298
——————————————————————————————

297 Regs. § 1.704-2(c).

298 See preamble to T.D. 8237, 53 Fed. Reg. 53140 (issuing former Regs. § 1.704-1T).

——————————————————————————————

Generally, a partner's share of partnership minimum gain at the end of a taxable year equals the sum of (a) the amount of nonrecourse deductions allocated to the partner and the partner's predecessors and (b) the aggregate amount of distributions made to the partner and the predecessors of proceeds of a nonrecourse liability allocable to an increase in partnership minimum gain, minus the sum of (i) the partner's and the predecessor's aggregate share of the net decreases in partnership minimum gain and (ii) their aggregate share of decreases in partnership minimum gain resulting from revaluations of partnership property encumbered by partnership nonrecourse liabilities.299
——————————————————————————————

299 Regs. § 1.704-2(g)(1)(i),(ii). A partner's share of partnership minimum gain is discussed in detail in 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts.

——————————————————————————————

The  § 704 regulations contemplate that a partner's share of partnership minimum gain will be determined as of the end of the partnership taxable year.300 However, it is often necessary to determine a partner's share of partnership nonrecourse liabilities during a taxable year. The 1988 Regulations under  § 752 state that if it becomes necessary to determine a partner's share of partnership nonrecourse liabilities before the end of the partnership taxable year, the partner's share of partnership minimum gain is determined as if the partnership taxable year ended immediately before the determination.301 In addition, the 1988 Regulations state that any increase in a partner's share of partnership minimum gain is deemed to occur immediately before  the event that causes the increase.302 These rules ensure that a partner's share of partnership nonrecourse liabilities will be recomputed (and, therefore, basis will be recomputed) to reflect an increase in partnership minimum gain before determination of the tax ramifications of such an increase. The 1991 Regulations do not contain these special timing rules. However, there is no indication that the drafters of the 1991 Regulations deleted these rules to alter the result. Therefore, these timing rules continue to apply to a determination of a partner's share of partnership minimum gain and partnership nonrecourse liabilities.
——————————————————————————————

300 Regs. § 1.704-2(g)(1).

301 Former Regs. § 1.752-1T(e)(3)(i).

302 Former Regs. § 1.752-1T(e)(3)(i).

——————————————————————————————

With respect to the Tier Three Allocation of excess nonrecourse liabilities, a partner's share of partnership profits generally is determined by reference to all the facts and circumstances relating to the economic arrangement between the partners.303 The partnership agreement may specifically provide for the partners' interests in profits for purposes of allocating excess nonrecourse liabilities. However, such provisions are respected only if the profits interests specified are reasonably consistent with allocations304 of some other significant item of partnership income or gain.305
——————————————————————————————

303 Regs. § 1.752-3(a)(3).

304 Such allocations must have substantial economic effect, as determined under the  § 704(b) regulations. Regs. § 1.752-3(a)(3). The concept of “substantial economic effect” is discussed in detail in 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts.

305 Regs. § 1.752-3(a)(3).

——————————————————————————————

As an alternative, a partnership may allocate excess nonrecourse liabilities in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated. In addition, a partnership is allowed to allocate excess nonrecourse liabilities to a partner that contributed built-in gain property to the extent of any excess  § 704(c) gain.306 This method is discussed in III, D, 4, d, below.
——————————————————————————————

306 Regs. § 1.752-3(a)(3).

——————————————————————————————

The IRS may approve other allocation methods by letter ruling. A partnership need not allocate excess nonrecourse liabilities under the same method each year.307
——————————————————————————————

307 Regs. § 1.752-3(a)(3).

——————————————————————————————

b. Non-contributed Property 

The following examples illustrate the allocation of liabilities in the non-contributed property context.

Example: In Year One, X and Y form an equal LLC to which each contributes $10,000 cash. The LLC agreement provides that LLC profits are shared equally. Also in Year One, the LLC purchases depreciable property for a $20,000 cash and an $80,000 nonrecourse note.  No principal payments are due on the note for three years. The LLC has no other nonrecourse liabilities. Immediately following the purchase of the property, X and Y share the nonrecourse liability as follows:
(1)Tier One Allocation: There is no LLC minimum gain because the LLC's adjusted basis in the property ($100,000) exceeds the amount of the nonrecourse debt $80,000). Therefore, there is no Tier One allocation to either member.

(2) Tier Two Allocation: There is also no Tier Two Allocation of the nonrecourse debt because, if the property were sold in full satisfaction of the debt and for no other consideration, no  § 704(c) gain would be allocated to either member.

Note: In the context of non-contributed property, Tier Two allocation is irrelevant.

(3) Tier Three Allocation: The entire nonrecourse debt is allocated under Tier Three. Assuming that no special allocation method is selected by the LLC, the debt is shared under Tier Three on the basis of each member's share of LLC profits. Thus, X and Y share the debt equally.

The $40,000 increase in each member's share of LLC liabilities is treated as a cash contribution to the LLC.308 Thus, each member's adjusted basis in the member's LLC interest is increased by $40,000.309

In Year One, Year Two, and Year Three, the LLC claims a depreciation deduction of $10,000 each year for the property. The depreciation deductions decrease the LLC's adjusted basis in the property to $70,000 as of the close of Year Three. The amount of LLC minimum gain at the end of Year Three is $10,000 ($80,000 nonrecourse liability minus$70,000 adjusted basis in the property). As of the close of Year Two, the amount of LLC minimum gain was $0 ($80,000 nonrecourse liability minus $80,000 LLC's adjusted basis in the property). Thus, LLC minimum gain increased by $10,000 in Year Three. Because of this increase in minimum gain, the $10,000 depreciation deduction in Year Three is considered a nonrecourse deduction. Absent a special allocation provision, X and Y share this nonrecourse deduction equally. Therefore, at the end of Year Three, X and Y each have a $5,000 share of LLC minimum gain. X and Y are each allocated $5,000 of the LLC nonrecourse liability under Tier One to match their $5,000 shares of LLC minimum gain. The balance of the nonrecourse liability is shared equally by X and Y.

——————————————————————————————

308 § 752(a).

309 See Regs. § 1.705-1(a)(2).

——————————————————————————————

Example — Special Allocation of Depreciation Deductions: The facts are the same as in the preceding example, except that the LLC agreement provides that all depreciation deductions are allocated to Y. The entire depreciation deduction in Year Three is a nonrecourse deduction allocated to Y. Thus, Y's share of the LLC minimum gain is $10,000. Y is allocated $10,000 of the nonrecourse liability under Tier One. The balance of the nonrecourse liability is shared equally by X and Y.

c. Contributed Property:No Ceiling Rule Problem 

Assets of a partnership may be reflected in the partners' capital accounts at book values that differ from the partnership's adjusted tax basis in such assets. This disparity can arise in two situations:a partner may contribute an asset to the partnership that has a fair market value that differs from the partner's adjusted tax basis in the asset at the time of the contribution; or, under certain circumstances, a partnership may revalue its assets and thereafter such assets are reflected in the partners' capital accounts at that restated value.

In determining whether partnership allocations will be respected for federal income tax purposes, special rules apply to allocations of partnership items with respect to property that was contributed to the partnership by a partner. Allocations of partnership items attributable to contributed property must take into account the difference between the fair market value of the property and its adjusted tax basis at the time of the contribution.310 Because allocations of tax items with respect to contributed property do not give rise to capital account adjustments, these allocations cannot by definition satisfy the capital account maintenance requirements and therefore cannot have economic effect.  Thus, special rules are provided for determining the proper method of allocating such tax items among the partners.
——————————————————————————————

310 Regs. § 1.704-3(a)(1). See also Prop. Regs. § 1.704-3(a)(1),(REG-100798-06, 73 Fed. Reg. 28765 (5/19/08)), which would provide that the IRS can recast a contribution even one described in the literal terms of one of the three allocation methods discussed below—based on the facts and circumstances. The proposed regulation would be effective for taxable years beginning after the date on which it is published as final.

——————————————————————————————

The regulations describe three methods a taxpayer may use to allocate tax items of income, gain, loss, or deduction attributable to contributed property: (1) the traditional method;311 (2) the traditional method with curative allocations;312 and (3) the remedial allocation method.313
——————————————————————————————

311 Regs. § 1.704-3(b).

312 Regs. § 1.704-3(c).

313 Regs. § 1.704-3(d).

——————————————————————————————

The traditional method requires the partnership, upon the disposition of contributed property, to allocate to the contributing partner the gain or loss attributable to the period before the contribution of the property. The partnership must also allocate any cost recovery deductions with respect to the contributed property to reduce the built-in gain or built-in loss. Generally, partnerships allocate these deductions by determining the cost recovery deductions to which the partners are economically entitled based on the property's fair market value at the time of contribution, and then allocating first to noncontributing partners the cost recovery deduction for tax purposes up to the amount of their share of the economic deductions (the deduction for book purposes). The remaining amount of tax items, if any, generally is allocated to the contributing partner. The regulations provide a “ceiling rule” under which the total amortization, depletion, depreciation, or gain or loss allocated to the partners cannot exceed the amount of the partnership's amortization, depletion, depreciation, or gain or loss.314 Thus, under the traditional method there may be insufficient partnership tax items to permit allocation to noncontributing partners of tax items equal to their share of book items.
——————————————————————————————

314 Regs. § 1.704-3(b)(1).

——————————————————————————————

To correct distortions created by the ceiling rule, a partnership using the traditional method may make reasonable curative allocations of other partnership tax items of income, gain, loss, or deduction so that equal allocations of book and tax items may be made to noncontributing partners.315 This is referred to as the “traditional method with curative allocations.” A curative allocation is an allocation for tax purposes that differs from the allocation of the items as reflected on the books of the partnership.
——————————————————————————————

315 Regs. § 1.704-3(c)(1).

——————————————————————————————

A partnership may adopt the remedial allocation method to eliminate distortions caused by the ceiling rule, by creating remedial items and allocating those items to its partners.316 To create the remedial items, the partnership first must determine the amount of its book items and the partners'distributive shares of those items. The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method. If the ceiling rule causes the book allocation of an item to a noncontributing partner to differ from the tax allocation of the same item to that partner, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner.317 The created remedial tax items do not exist independently and have no effect on capital accounts.
——————————————————————————————

316 Regs. § 1.704-3(d)(1).

317 Regs. § 1.704-3(d)(1).

——————————————————————————————

Example: X and Y form an equal partnership to which X contributes property with a fair market value of $25,000 and an adjusted basis of $20,000, subject to nonrecourse debt of $10,000. Y contributes$15,000. The book value of the contributed property is $25,000. However, the partnership's adjusted tax basis in the property is only $20,000. Thus, there is a book/tax disparity of $5,000 at the partnership level. X's initial capital account balance using book value is $15,000 ($25,000 fair market value of the property minus $10,000 liability), and X's capital account using tax basis (tax capital account) is $20,000. Assuming that the partnership has no other nonrecourse debt, the amount of partnership minimum gain when the property is first contributed is $0 (because the book value of the contributed property ($25,000)exceeds the amount of nonrecourse debt ($10,000)). Once the partnership's book depreciation deductions (which reflect the tax depreciation deductions)bring the book value of the property below $10,000, there is partnership minimum gain equal to the difference between the amount of the nonrecourse debt and the property's book value. Assume remaining tax depreciation is$4,000 per year for five years.  Under Regs. § 1.704-1(b)(2)(iv)(g)(3), because the tax depreciation is equivalent to 20% of the original basis each year, the book depreciation for each year is $5,000. Thus, at the end of the third year, book value is $10,000, and, in the absence of any other transactions with respect to the property, minimum gain increases by $5,000 in each of the next two years.

In Years One through Three, the tax depreciation deductions of $4,000 are not nonrecourse deductions because there has been no increase in partnership minimum gain. At the end of Year Four, book value is$5,000 because there is book depreciation of $5,000. There is minimum gain of $5,000 ($10,000 liability minus book value of $5,000). Thus, there is an increase in partnership minimum gain of $5,000. The $4,000 tax depreciation deduction and $1,000 of other partnership deductions are nonrecourse deductions. Of the $4,000 depreciation deduction,$1,500 is allocated to X and $2,500 is allocated to Y under  § 704(c) to prevent a book/tax disparity for Y, and the other deductions presumably are allocated equally. Thus, Y is allocated $3,000 of the nonrecourse deductions. Y's share of the partnership minimum gain is, therefore, $3,000, and X's share is $2,000. At the end of Year Four, Y's share of the liability under Tier One is $3,000 and X's is $2,000. Under Tier Two, if the partnership disposes of the property for $10,000 (the amount of the liability), there is tax gain of $6,000 ($10,000 minus adjusted basis of $4,000 ($20,000 minus four years of $4,000 depreciation)). There is book gain of $5,000 ($10,000 amount of liability minus book basis(referred to above as book value for purposes of the partnership minimum gain calculation) of $5,000), allocated equally. X's book capital account is $7,000 ($15,000 originally, minus $10,000 book depreciation(four years at $2,500 per year), minus $500 of “other”nonrecourse deductions presumably paid in cash, plus book gain of$2,500). Y's book capital account is $7,000 ($15,000 originally, minus$10,000 book depreciation (four years at $2,500 per year), minus $500 of “other” nonrecourse deductions presumably paid in cash, plus book gain of $2,500). X's tax capital account before allocation of the tax gain is $13,500 ($20,000 originally minus $6,000 tax depreciation(four years at $1,500 per year), minus $500 of “other”nonrecourse deductions presumably paid in cash). Y's tax account before allocation of the tax gain is $4,500 ($15,000 originally minus $10,000 tax depreciation (four years at $2,500 per year), minus $500 of “other”nonrecourse deductions presumably paid in cash).  Of the tax gain of $6,000, $2,500 is allocated to Y (due to the momentary $2,500 book/tax disparity), and the other $3,500 of tax gain is allocated to X. Of the $3,500 allocated to X, $1,000 is the  § 704(c) gain portion (when this $1,000 is added to the $4,000 of depreciation allocated to Y in excess of the amount allocated to X, the total is the $5,000 original built-in gain). Note that this allocation is hypothetical for  § 752 purposes and is not actually made on the partnership's return, nor are the hypothetical consequences of sale reflected in the book or tax capital accounts. Thus, under Tier Two, $1,000 of the liability is apportioned to X.  The $4,000 excess nonrecourse liability ($10,000 minus $5,000 allocated under Tier One and $1,000 allocated under Tier Two) is allocated equally.

The following table illustrates the preceding example:
Partner X and Partner Y chart of computations
The regulations under  § 752 describing Tier One Allocations simply refer to a “partner's share of partnership minimum gain determined in accordance with the rules of  § 704(b) and the regulations thereunder.”318 The regulations under  § 704(b) describe a partner's share of partnership minimum gain as the cumulative amount of partnership nonrecourse deductions (plus several other adjustments with respect to distributions not relevant to this issue) allocated to the partner.319 The regulations describe the amount of partnership nonrecourse deductions for a given taxable year as equal to the increase in partnership minimum gain(plus the amount of other distributions not relevant to this issue).320 These regulations require the use of book value, rather than tax basis in computing partnership minimum gain with respect to contributed property when there is a book/tax disparity. Thus, when determining the amount of nonrecourse deductions in a given taxable year when there is a book/tax disparity with respect to the relevant property, the computation of partnership minimum gain is based on book value. The provision specifically states that this use of book value is for purposes of “this section” of the regulations (which means Regs. § 1.704-2).321
——————————————————————————————

318 Regs. § 1.752-3(a)(1).

319 Regs. § 1.704-2.

320 Regs. § 1.704-2(c).

321 See Regs. § 1.704-2(d).

——————————————————————————————

Many, or perhaps most, practitioners relying on the use of book value to compute the amount of nonrecourse deductions concluded that the term “nonrecourse deductions” for contributed property must similarly refer to book deductions (such as book depreciation).322 This line of reasoning has led to the conclusion that the cross-reference in the  § 752 Tier One regulations to a partner's share of minimum gain, which in turn is described as the partner's share of nonrecourse deductions, refers(for contributed property)  to a partner's share of minimum gain based on the partner's share of book nonrecourse deductions.323
——————————————————————————————

322 See 2000 TNT 89-83, Unofficial Transcript of IRS Hearing on Partnership Debt Allocation Regs. (Release Date: May 3, 2000.)

323 This approach is also often based on a reference to “book” depreciation as nonrecourse in an example in the regulations that deals with a revaluation of partnership property. See Regs.  § 1.704-2(m) Ex. 3(iv). This use of book, rather than tax, is probably relevant only in the context of revaluations and not in the context of all nonrecourse debt allocations with respect to contributed property.

——————————————————————————————

However, three developments, particularly when viewed together, strongly suggest that the reference is to tax deductions, such as tax depreciation, and not book deductions. First, the discussion in Rev. Rul. 95-41324 with respect to the third method of allocating excess nonrecourse liabilities for contributed property under Tier Three specifically applies the concept of nonrecourse deductions to the tax depreciation deduction.  According to Rev. Rul. 95-41, the third method under Tier Three allows taxpayers to allocate excess nonrecourse liabilities pursuant to the “manner in which it is reasonably expected that the deductions attributable to the excess nonrecourse liabilities will be allocated.” Deductions attributable to the “excess nonrecourse liabilities” are, by definition, a subset of “nonrecourse deductions.” The ruling provides an example in which book depreciation for a given taxable year is $5,000, allocated equally between the contributing and noncontributing partners, and tax depreciation is$4,000, all of which is allocated to the noncontributing partner. The ruling concludes that the partnership would allocate all excess nonrecourse liabilities to the noncontributing partner because all of the $4,000 tax depreciation is allocated to the noncontributing partner. Thus, it is the tax depreciation deduction, and not the book depreciation deduction, that is relevant. It seems illogical and inconsistent to assume that the term “nonrecourse deduction” can have one meaning for the Tier Three Allocation and a wholly different meaning for the Tier One Allocation.
——————————————————————————————

324 1995-1 C.B. 132.

——————————————————————————————

The regulations permit taxpayers, when allocating excess nonrecourse liabilities under Tier Three, to allocate these liabilities, in an amount equal to any excess  § 704(c) gain, to the contributing partner.325 In the preamble to these regulations when proposed, the IRS stated that one of the reasons for the regulations was the fact that if a partnership held  § 704(c) property subject to the ceiling rule of Regs. § 1.704-3(b)(1), the first tier of nonrecourse liability allocation could gradually shift the allocation of liabilities away from the contributing partner to the noncontributing partner in some situations, leaving the contributing partner vulnerable to  § 731 gain.326 The reference to the ceiling rule supports the position that it is the allocation of tax deductions that is relevant. Generally, if the ceiling rule applies, the noncontributing partner is allocated a larger portion, if not all, of the tax depreciation deduction, whereas the book depreciation deduction is shared equally. It is this disproportionate sharing of the tax depreciation deduction that leads to the allocation of a greater share of nonrecourse deductions to the noncontributing partner and, therefore, of a greater portion of the liability to the noncontributing partner under Tier One.
——————————————————————————————

325 Regs. § 1.752-3(a)(3). These regulations are discussed in III, D, 4, d, below.

326 Preamble to REG-103831-99, 65 Fed. Reg. 2084 (1/13/00).

——————————————————————————————

Note: During the course of hearings on these  regulations, a tax commentator went so far as to admit that practitioners thought that the book nonrecourse deduction approach was appropriate but that Rev. Rul. 95-41 seemed to contradict that approach, and proceeded to inquire whether the newly proposed regulations were intended to refer to “tax”or “book” deductions. The hearing panel, although prevented by departmental policy from announcing legal interpretations in such an environment, replied in a way that more than implied that the correct interpretation is “tax” and not “book.”327
——————————————————————————————

327 See Unofficial Transcript of IRS Hearing on Partnership Debt Allocation Regs. (Release Date: May 3, 2000), ¶ ¶ [92] – [106].

——————————————————————————————

Although there is still some confusion as to this issue, for the reasons outlined above, the references to “nonrecourse deductions”and a “partner's share of partnership minimum gain” in the examples in III, D, 4, of this portfolio refer to a partner's share of tax deductions.

The following table illustrates application of the “book nonrecourse deduction” approach:
 
Book Nonrecourse Deduction
d. Contributed Property:Ceiling Rule Issues/Traditional Method in Effect 

The following example illustrates the allocation of liabilities subject to the ceiling rule.

Example: X and Y form an equal LLC. X contributes depreciable property subject to a nonrecourse liability of $6,000, with a basis of $4,000 and a fair market value of $10,000. Y contributes $4,000 cash. The members' shares of the nonrecourse liability are determined as follows:
(1) Tier One Allocation: There is no LLC minimum gain immediately after the contribution, because the book value of the property ($10,000) exceeds the amount of the nonrecourse debt($6,000). Thus, neither X nor Y is allocated any of the nonrecourse debt under Tier One.

(2) Tier Two Allocation:If the LLC disposed of the property in full satisfaction of the debt and for no other consideration, the LLC would recognize $2,000 of taxable gain ($6,000 nonrecourse debt minus $4,000 adjusted basis). Under § 704(c), all of this taxable gain would be allocated to X. This hypothetical sale would also generate a $4,000 book loss ($10,000 book value minus$6,000 nonrecourse debt). The book loss would be allocated equally between X and Y. Y, therefore, would receive a $2,000 book loss but no corresponding tax loss, resulting in a $2,000 book/tax disparity with respect to Y. If the LLC used the traditional method of making § 704(c) allocations,328 X would be allocated $2,000 of taxable gain from the hypothetical sale. Therefore, X would be allocated $2,000 of the nonrecourse liability under Tier Two. Another $4,000 of built-in gain ($10,000 fair market value minus $4,000 adjusted basis minus $2,000 taxable gain allocated under Tier Two) is not allocated to X.

(3) The remainder of the nonrecourse liability would be allocated under Tier Three, as discussed below.

——————————————————————————————

328 See Regs. § 1.704-3(b).

——————————————————————————————

Because of the ceiling rule, all or most of the tax depreciation with respect to contributed built-in gain property is allocated to the noncontributing partner. Some, if not all, of the depreciation deductions are nonrecourse deductions and are allocated to the noncontributing partner, thus increasing that partner's share of partnership minimum gain. As the noncontributing partner's share of partnership minimum gain increases, so does the partner's share of the nonrecourse liability under Tier One.

Assume that in each of Years One, Two, and Three, the LLC in the Example above takes $2,000 of book depreciation and $800 of tax depreciation. At the end of Year Two, the amount of LLC minimum gain is $0 ($6,000 nonrecourse debt minus $6,000 book value). At the end of Year Three, however, the amount of LLC minimum gain is $2,000 ($6,000 nonrecourse debt minus $4,000 book value). The increase in LLC minimum gain is$2,000. The $800 tax depreciation deduction, therefore, is a nonrecourse deduction, as is $1,200 of other LLC deductions. All of the tax depreciation is allocated to B, the noncontributing partner. The other $1,200 of nonrecourse deductions, presumably, is allocated equally. Thus, Y's share of LLC minimum gain in Year Three is $1,400 and X's share is$600. As of the end of Year Three, Y is allocated $1,400 of the nonrecourse liability under Tier One and X is allocated $600. Under Tier Two, if the partnership disposed of the property for $6,000, there would be tax gain of $4,400 ($6,000 liability minus adjusted basis of $1,600($4,000 minus three years of $800 depreciation)). There would be book gain of $2,000 ($6,000 liability minus book basis (referred to above as “book value” for purposes of the partnership minimum gain calculation) of $4,000), allocated equally. X's book capital account would be $1,400 ($4,000 originally, minus $3,000 book depreciation(three years at $1,000 per year), minus $600 of “other”nonrecourse deductions presumably paid in cash, plus book gain of$1,000). Y's book capital account would be $1,400 ($4,000 originally, minus $3,000 book depreciation (three years at $1,000 per year), minus$600 of “other” nonrecourse deductions presumably paid in cash, plus book gain of $1,000). X's tax capital account before the tax gain is allocated would be $3,400 ($4,000 originally, minus$0 tax depreciation, minus $600 of “other” nonrecourse deductions presumably paid in cash). Y's tax account before allocation of the tax gain would be $1,000 ($4,000 originally minus $2,400 tax depreciation (three years at $800 per year), minus $600 of “other”nonrecourse deductions presumably paid in cash). Of the tax gain of$4,400, $400 would be allocated to Y (because of the $400 momentary book/tax disparity) and $4,000 would be allocated to X. Of the $4,000 allocated to X, $3,600 is the  § 704(c) gain portion. (When this $3,600 is added to the$2,400 of depreciation allocated to Y in excess of the amount allocated to X, the total is the $6,000 original built-in gain.) This allocation is hypothetical for  § 752 purposes and is not made on the partnership's return, and the hypothetical consequences of the sale are not reflected in the book or tax capital accounts. Under Tier Two, $3,600 of the liability is apportioned to X.

As the amount allocated to the noncontributing partner increases under Tier One, the amount allocated to the contributing partner is decreased. Any decrease in the contributing partner's share of the nonrecourse liability is treated as a deemed distribution of cash by the partnership to the contributing partner.329 If other events have decreased the contributing partner's adjusted basis in the contributing partner's interest, the contributing partner may have to recognize gain with respect to the decrease in liability share.330 A contributing partner generally need only recognize built-in gain with respect to contributed property when the property is sold,331 distributed to the contributing partner,332 or distributed to another partner.333
——————————————————————————————

329 § 752(b).

330 § 731(a)(1).

331 § 704(c)(1)(A).

332 § 737.

333 § 704(c)(1)(B).

——————————————————————————————

To remedy this potential gain recognition problem,  regulations allow a partnership to allocate to the contributing partner under Tier Three the excess  § 704(c) gain inherent in the property.334 A partnership may make this allocation regardless of the method it has chosen for allocating excess nonrecourse liabilities. A partner's share of excess nonrecourse liabilities must be made in accordance with the partner's share of partnership profits, taking into account the partners' economic arrangement.335 In doing so, the partnership may specify the partners' interests in partnership profits, provided that the interests specified are reasonably consistent with allocations, or may allocate excess nonrecourse liabilities in accordance with the way in which the partnership expects to allocate deductions attributable to those liabilities. The partnership also may allocate excess nonrecourse liabilities in accordance with excess  § 704(c) gain as well as excess reverse  § 704(c) gain.336 To the extent that a partnership allocates excess  § 704(c) gain under Tier Three to the contributing partner and there is additional excess nonrecourse liability still to be allocated, the additional excess must be allocated under one of the general methods in the regulations.337 Once a partner is allocated nonrecourse debt under Tier Three based upon excess  § 704(c) gain, that excess gain cannot be considered again in determining the partners' shares of partnership profit.338
——————————————————————————————

334 Regs. § 1.752-3.

335 Regs. § 1.752-3(a)(3). See TAM 200436011 (LLC borrowed against contributed property, issued contributing member 100% of senior preferred interests, and allocated to contributing member (i) all gross income up to amount of preference and (ii) share of excess nonrecourse liabilities determined with reference to senior preferred interest allocation; National Office advised that LLC's gross income allocation did not satisfy Regs. § 1.752-3(a)(3), which directs parties to allocate excess nonrecourse liabilities in manner in which they share significant items of partnership income or gain).

336 Regs. § 1.752-3(a)(3).

337 Regs. § 1.752-3(a)(3).

338 See preamble to T.D. 8906, 65 Fed. Reg. 64888 (10/31/00).

——————————————————————————————

Immediately following the contribution of the property in the Example above, there is no Tier One Allocation of the liability and X's share of the nonrecourse liability under Tier Two (assuming the traditional method of allocation applies) is $2,000. With respect to the Tier Three Allocation, the LLC could allocate the entire amount of excess § 704(c) gain($4,000) to X under Tier Three, so that X's share of the nonrecourse liability would be $6,000, which matches the amount of built-in gain in the property ($10,000 fair market value minus $4,000 basis).

In Rev. Rul. 95-41,339 the IRS stated that  § 704(c) excess gain on the allocation of excess nonrecourse liabilities affects allocations of nonrecourse liabilities under Tier Three as follows:
——————————————————————————————

339 1995-1 C.B. 132.

——————————————————————————————

(a) If the partnership determines the partners' interests in partnership profits based on the facts and circumstances  of the partners' economic arrangement,  § 704(c) built-in gain that was not taken into account under Regs.  § 1.752-3(a)(2) is one factor, but not the only factor, considered under Regs. § 1.752-3(a)(3). If it is reasonable to expect that the partnership will have items of partnership profit over its life that will be allocated to the noncontributing partner, however, the partnership must allocate the remaining nonrecourse liabilities between the contributing and noncontributing partners in proportion to their interests in total partnership profits.

(b) If the partnership allocates excess nonrecourse liabilities consistently with allocations that have substantial economic effect of another significant item of partnership income or gain,  § 704(c) does not affect the allocation of nonrecourse liabilities under Regs.  § 1.752-3(a)(3) because § 704(c) allocations do not have substantial economic effect. In other words, if the partnership chooses this method of allocating excess nonrecourse liabilities, excess  § 704(c) gain is irrelevant.

(c) If the partnership chooses to allocate excess nonrecourse liabilities in accordance with the manner in which it is reasonably expected that the deductions attributable to the nonrecourse liabilities will be allocated, the partnership must take into account the allocations required by  § 704(c) in determining the manner in which the deductions attributable to nonrecourse liabilities will be allocated.

Note: For liabilities to which the regulations finalized in 2000 apply, the conclusion in Rev. Rul. 95-41 with respect to the effect of excess  § 704(c) gain on Tier Three Allocations is relevant only if a partnership chooses not to allocate nonrecourse debt under Tier Three based on the excess  § 704(c) gain attributable to the property that is subject to the debt.

e. Contributed Property:Ceiling Rule Issues/Curative Method in Effect 

Allocations of nonrecourse liabilities under Tier Two do not take into account curative allocations under Regs. § 1.704-3(c).340
——————————————————————————————

340 Rev. Rul. 95-41, 1995-1 C.B. 132.

——————————————————————————————

Example: X and Y form an equal LLC and agree to share all LLC items equally. X contributes depreciable property subject to a nonrecourse liability of $6,000, with an adjusted tax basis of $4,000 and a fair market value of $10,000. Y contributes $4,000 cash. The members' shares of the nonrecourse liability are determined as follows:
(1)Tier One Allocation: There is no LLC minimum gain immediately following the contribution of the property, because the book value of the property($10,000) exceeds the amount of the nonrecourse debt ($6,000). Thus, neither X nor Y is allocated any of the nonrecourse debt under Tier One.

(2) If the LLC uses the traditional method with curative allocation,341 the LLC is permitted to make reasonable curative allocations to reduce or eliminate the $2,000 book/tax disparity. However, the LLC can make these curative allocations only to the extent of the existence of other LLC items that can be allocated. Because it is not certain whether  these other LLC items will exist, curative allocations are not taken into account in making the Tier Two Allocation of a nonrecourse liability. Thus,  if the LLC adopts the traditional method with curative allocations, X is still  allocated only $2,000 of the nonrecourse liability under Tier Two.

(3)The partnership can allocate to X the $4,000 excess nonrecourse liability under Tier Three, because there is $4,000 of excess  § 704(c) gain that has not been allocated under Tier Two. If the excess nonrecourse liability is allocated under Tier Three pursuant to Rev. Rul. 95-41, discussed above, the remaining $4,000 liability will most likely be allocated to Y.

——————————————————————————————

341 See Regs. § 1.704-3(c).

——————————————————————————————

Query: Why not include curative allocations in Tier Two if it is reasonable to expect that the partnership will have sufficient LLC items to allocate to cure the book/tax disparity?  In the alternative, even if curative allocations are not taken into consideration immediately after the contribution of the property, why not take them into consideration as of the beginning of the next taxable year, when the amount of partnership items for the previous tax year is known?

f. Contributed Property:Ceiling Rule Issues/Remedial Method in Effect 

In the determination of the contributing partner's share of a nonrecourse liability, remedial allocations of gain that would be made to the contributing partner under Regs.  § 1.704-3(d) are taken into account.342
——————————————————————————————

342 Rev. Rul. 95-41, 1995-1 C.B. 132.

——————————————————————————————

Example: X and Y form an LLC and agree to share all LLC items equally. X contributes depreciable property subject to a nonrecourse liability of $6,000, with an adjusted tax basis of $4,000 and a fair market value of $10,000. Y contributes $4,000 cash. The members' shares of the nonrecourse liability are determined as follows:
(1)Tier One Allocation: There is no LLC minimum gain immediately following the contribution of the property, because the book value of the property($10,000) exceeds the amount of the nonrecourse debt ($6,000). Thus, neither X nor Y is allocated any of the nonrecourse debt under Tier One.

(2) Tier Two Allocation: If the LLC uses the remedial method of allocations,343 the LLC  must make a remedial allocation of $2,000 of tax loss to Y to eliminate the $2,000 book/tax disparity. The LLC also has to make an offsetting remedial allocation of tax gain to X of $2,000. Therefore, under the remedial method of allocation, X is allocated $4,000 of tax gain ($2,000 actual tax gain plus $2,000 remedial gain), and, under this method of allocation, X is allocated$4,000 of the nonrecourse liability under Tier Two.

(3) X is allocated the $2,000 excess nonrecourse liability under Tier Three, because there is $2,000 of excess  § 704(c) gain that has not been allocated under Tier Two. If the excess nonrecourse liability is allocated under Tier Three pursuant to Rev. Rul. 95-41, discussed above, the remaining $2,000 liability will most likely be allocated to Y.

——————————————————————————————

343 See Regs. § 1.704-3(d).

——————————————————————————————

g. Allocating a Single Nonrecourse Liability Among Multiple Partnership Properties 

If a partnership holds multiple properties that are subject to a single nonrecourse liability, the partnership must allocate the liability among the assets in order to determine the amount of  § 704(c) gain and minimum gain with respect to each piece of property.344
——————————————————————————————

344 See Regs. § 1.704-3(a)(2).

——————————————————————————————

The regulations provide that if a partnership holds multiple properties subject to a single liability, the liability may be allocated among the properties based on any reasonable method.345 A method is not considered reasonable if it allocates to any property an amount of nonrecourse liability that, combined with any other liabilities allocated to the property, exceeds the fair market value of the property at the time the liability is incurred.346 The portion of the nonrecourse liability allocated to each piece of partnership property is treated as a separate debt under Regs. § 1.752-3(a)(2). Once a liability is allocated among partnership properties, the partnership may not change the method for allocating the liability while any portion of the liability is outstanding.347 However, if one of the properties is no longer subject to the liability, the portion of the liability previously allocated to that piece of property must be reallocated among the other properties still subject to the liability so that the amount of the liability allocated to any property does not exceed the fair market value of the property at the time of reallocation.348 If the outstanding principal amount of the nonrecourse liability is reduced, the reduction must be allocated among the properties subject to the debt in the same proportion that the principal amount was originally allocated.349
——————————————————————————————

345 Regs. § 1.752-3(b)(1), effective for  § 752 liabilities incurred or assumed by a partnership on or after Oct. 31, 2000. Regs. § 1.752-5(a). However, a partnership may rely upon the regulations for any liability it incurred or assumed prior to Oct. 31, 2000, for tax years ending on or after Oct. 31, 2000.  Before these regulations were issued, the Code and regulations provided no guidance on how a single nonrecourse liability should be allocated among multiple properties. In PLR 9507023, however, the IRS permitted a limited partnership that held real estate interests to allocate nonrecourse bond debt among the properties based on the amounts that the banks issuing the debt could recover in the event of foreclosure. In PLRs 9815001 and 9815022, moreover, the IRS — after ruling that the refinancing obligations of real estate partnerships were nonrecourse liabilities — stated that a partnership could allocate such an obligation among its properties subject to the obligation in an amount not exceeding the lesser of(i) the property's fair market value and (ii) the amount of debt previously allocated to the property and repaid with proceeds of the financing.

346 Regs. § 1.752-3(b)(1). See PLR 200340024 (partnership's proposed method of allocating nonrecourse liability to its various properties was reasonable;  method allocated  liability first to properties that were acquired with, or had existing mortgages repaid by proceeds of,  liability, and remainder in accordance with fair market value of each property).

347 Regs. § 1.752-3(b)(1).

348 Regs. § 1.752-3(b)(1).

349 Regs. § 1.752-3(b)(2).

——————————————————————————————

Example — Allocation of Liability Among Multiple Properties:X and Y form an equal partnership. X contributes $70,000 of cash, and Y contributes two items of property. Property B has a fair market value and book value of $70,000 and an adjusted basis of $50,000 and is subject to a nonrecourse liability of $50,000. Property C has a fair market value and book value of $120,000 and an adjusted basis of $40,000 and is subject to a nonrecourse liability of $70,000. Immediately after the original contributions, the partnership refinances the two nonrecourse liabilities with a single $120,000 nonrecourse liability. All of the  § 704(c) gain attributable to Property B ($30,000) and Property C ($80,000) is allocable to Y.

The $120,000 nonrecourse debt is allocated as follows. With respect to Tier One, the outstanding nonrecourse debt ($120,000) does not exceed the combined book value of the properties ($190,000) and, therefore, there is no partnership minimum gain and no Tier One allocation.

Assume that the partnership chooses to allocate the $120,000 nonrecourse liabilities equally between the two properties. Thus, under Tier Two, Y is allocated $20,000 of the liability for Property B ($60,000 debt minus $40,000 adjusted basis) and $20,000 of the liability for Property C ($60,000 debt minus $40,000 adjusted basis), for a total of $40,000 allocated to Y under Tier Two.

An additional $80,000 of nonrecourse debt remains to be allocated. Assume that the partnership elects to allocate the excess nonrecourse liability to the partners up to their shares of remaining  § 704(c) gain on the properties, with any remaining amount  allocated to the partners equally, consistent with their profits interests. Y has $70,000 of remaining  § 704(c) gain ($10,000 on Property B and $60,000 on Property C). Therefore, Y is allocated $70,000 of the nonrecourse debt. The remaining $10,000 of debt is allocated equally between X and Y. Thus, Y's total Tier Three Allocation is$75,000 and X's is $5,000. The overall allocation of the $120,000 is $115,000 to Y and $5,000 to X.350

——————————————————————————————

350 See Regs. § 1.752-3(c) Ex. 3.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  III. Inclusion of Partnership Liabilities in Partner's Basis: Section 752

E. Assumptions of Regs. § 1.752-7 Liabilities 

As discussed in III, D, 2, a, above, regulations issued in 2005 provide rules for a category of obligations called “Regs. § 1.752-7 liabilities.” 351 A “Regs.  § 1.752-7 liability”is a fixed or contingent obligation that either (i) is not a  § 752 liability or (ii) is a  § 752 liability the amount of which exceeds the amount that would be taken into account in incurring the obligation.352
——————————————————————————————

351 T.D. 9207, 70 Fed. Reg. 30334 (5/26/05).

352 Regs. § 1.752-7(b)(3).

——————————————————————————————

The goal of the 2005 regulations is to prevent taxpayers from accelerating and duplicating losses when they assume obligations other than  § 752 liabilities; the regulations implement this goal generally by prohibiting a partnership that assumes a partner's Regs.  § 1.752-7 liability, and any person other than the partner from whom the Regs.  § 1.752-7 liability was assumed, from claiming a deduction, loss, or capital expense to the extent of the built-in loss associated with the obligation.353
——————————————————————————————

353 Regs. § 1.752-7(a).

——————————————————————————————

The principles of Regs.  § 1.752-1(d) and (e), governing when a person is considered to have assumed a  § 752 liability, also apply in determining if a Regs.  § 1.752-7 liability has been assumed.354 A partnership or another person is considered to have assumed a Regs.  § 1.752-7 liability, therefore, to the extent that: (1) that partnership or person becomes personally obligated to pay the Regs.  § 1.752-7 liability; and (2) if a partner or related person assumes a Regs.  § 1.752-7 liability from a partnership, the obligee knows of the assumption and can enforce the obligation and no other partner (or person related to a partner)bears the economic risk of loss immediately after the assumption.355
——————————————————————————————

354 Regs. § 1.752-7(b)(1). See III, D, 2, f, above, for a discussion of these principles.

355 Regs. § 1.752-1(d).

——————————————————————————————

The regulations contain special rules relevant to the treatment of Regs.  § 1.752-7 liabilities in tiered partnerships. If a partnership (the lower-tier partnership)assumes a Regs.  § 1.752-7 liability from another partnership (the upper-tier partnership) in a  § 721 transaction, both the upper-tier partnership and its partners are treated as “Regs. § 1.752-7 liability partners” (i.e., partners from whom a partnership assumes Regs. § 1.752-7 liabilities), and the rules for transfers and distributions in liquidation of a Regs.  § 1.752-7 liability partner's interest (discussed below) apply to a sale or liquidation of the upper-tier partnership's interest in the lower-tier partnership. If a lower-tier partnership assumes a Regs.  § 1.752-7 liability from an upper-tier partnership that previously assumed the liability from a partner, that partner continues to be the Regs.  § 1.752-7 liability partner with respect to the remaining built-in loss associated with the obligation, but the partners in the upper-tier partnership are the Regs.  § 1.752-7 liability partners with respect to any built-in loss created on the second assumption(and they share that loss according to their interests).356
——————————————————————————————

356 Regs. § 1.752-7(b)(5)(ii)(A).

——————————————————————————————

Unlike a partnership's assumption of a partner's  § 752 liability, a partnership's assumption of a Regs.  § 1.752-7 liability from a Regs.  § 1.752-7 liability partner does not reduce the partner's basis immediately. Basis is reduced later, if a “triggering event” occurs that separates the partner from the liability. The triggering events, discussed below, are (i) a transfer of the Regs.  § 1.752-7 liability partner's interest in the partnership,(ii) a distribution in liquidation of the Regs.  § 1.752-7 liability partner's interest, and (iii) another partner's assumption of the Regs.  § 1.752-7 liability that the partnership had assumed. For further discussion of the basis reduction when a triggering event occurs, see IV, C, below.

Regs.  § 1.752-7 liabilities are generally “§ 704(c) property”for purposes of Regs. § 1.704-3, which is discussed in III, D, 4, above. To the extent that the built-in loss associated with a Regs. § 1.752-7 liability exceeds the cost of satisfying the liability, the excess creates a ceiling rule limitation subject to the Regs. § 1.704-3(b), (c), and (d) allocation methods.357 For further discussion of the treatment of Regs.  § 1.752-7 liabilities as § 704(c) property, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts.
——————————————————————————————

357 Regs. § 1.704-3(a)(12).

——————————————————————————————

A partner's share of a partnership's Regs.  § 1.752-7 liability is the amount of deduction that would be allocated to the partner with respect to the liability if the partnership disposed of all its assets, satisfied all of its liabilities other than Regs.  § 1.752-7 liabilities, and paid an unrelated person to assume all of its Regs.  § 1.752-7 liabilities in a fully taxable arm's-length transaction (assuming that the payment would give rise to an immediate deduction to the partnership).358
——————————————————————————————

358 Regs. § 1.752-7(b)(3)(ii).

——————————————————————————————

Regs.  § 1.752-7 applies to partnership assumptions of Regs.  § 1.752-7 liabilities after June 23, 2003. A partnership may, however, elect to apply Regs.  § 1.752-7 to all assumptions of liabilities by the partnership occurring after October 18, 1999.359 Otherwise, Regs.  § 1.752-6 applies to assumptions between after October 19, 1999, and before June 24, 2003.360 Regs. § 1.752-6, unlike Regs. § 1.752-7, requires an immediate basis reduction when a  § 358(h)(3) liability is assumed.  Section 358(h)(3) defines “liability”for this purpose in almost exactly the same way as Regs.  § 1.752-1(a)(4)(ii) defines “obligation.” Section 358(h)(3) liabilities, therefore, include obligations that are Regs.  § 1.752-7 liabilities. Under Regs. § 1.752-6, if a partnership assumes a  § 358(h)(3) liability other than a  § 752 liability from a partner in a  § 721 transaction, then (after  § 752(a) and (b) are applied) the partner's basis in the partnership is reduced, but not below the interest's “adjusted value,” by the amount of the liability. “Adjusted value”is the interest's fair market value increased by the partner's share of partnership liabilities under Regs.  § § 1.752-1 through 1.752-5.361 The Regs.  § 1.752-6 basis reduction rule, however, does not apply if (i) the trade or business with which the liability is associated is transferred to the person assuming the liability or (ii) substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange.362
——————————————————————————————

359 Regs. § § 1.752-6(d)(2), -7(k).

360 Several courts have criticized retroactive application of Regs. § 1.752-6, to the point of holding it invalid. See Murfam Farms LLC v. U.S., No. 06-245T (Fed. Cl. 7/30/09) (retroactive regulation, Regs. § 1.752-6, requiring reduction of partner's outside basis for contingent obligations transferred to partnership is invalid, because it does not satisfy any exceptions to statutory bar on retroactive application of regulations under § 7805(b)); Sala v. U.S., 552 F.Supp.2d 1167 (D. Colo. 2008) (setting aside Regs. § 1.752-6 as “unlawful”(in that its rules, which apply to partnerships, are not comparable to rules for corporations described in § 358(h)) and holding that, even if regulation had been properly issued, Treasury lacked authority to make it retroactive under § 7805(b)(3) anti-abuse rule); Klamath Strategic Inv. Fund, LLC v. U.S., 440 F.Supp.2d 608 (E.D. Tex. 2006) (Regs. § 1.752-6 cannot apply before Sept. 5, 2000, date on which IRS released Notice 2000-44, 2000-36 I.R.B. 255, which was first date on which taxpayers could have been on notice of IRS's change in litigation position regarding contingent liabilities). The Seventh Circuit criticized Klamath in Cemco Investors, LLC v. U.S., 515 F.3d 749 (7th Cir. 2008) (cert. denied, 129 S.Ct. 131 (2008)), stating, “The district court in Klamath did not doubt that retroactivity could rest on the 2000 Act...[but] held...that when promulgating Treas. Reg. § 1.752-6 the IRS had not availed itself of that power. But if the IRS was not using that authority, why in the world does the regulation reach back to October 18, 1999?”

361 Regs. § 1.752-6(a).

362 Regs. § 1.752-6(b)(1). Exception (ii), however, does not apply if the transaction is substantially similar to transactions described in Notice 2000-44, 2000-36 I.R.B. 255 (certain transactions that purport to give taxpayers artificially high bases in partnership interests and, thus, deductible losses on disposition of the interests). Regs. § 1.752-6(b)(2).

——————————————————————————————

For a partnership to apply Regs.  § 1.752-7 instead of Regs.  § 1.752-6 to all assumptions of liabilities after October 18, 1999, the partnership must have made an election with a federal income tax return filed after September 23, 2003, and before January 1, 2006.363
——————————————————————————————

363 Regs. § 1.752-7(k)(2)(iv).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IV. Adjustments to Partner's Initial Basis

A. Annual Basis Adjustments 

1. General Rules: § § 705 and 733 

Section 705 of the Code provides that the adjusted basis of a partner's interest in a partnership is increased by the partner's distributive share of partnership taxable income (determined under § 703(a)), partnership exempt income, and the excess of depletion deductions over the basis of property subject to depletion.364 Additional contributions to the partnership also increase the adjusted basis of a partner's interest.365 A partner's adjusted basis is decreased (but not below zero) by distributions governed by § 733, the partner's distributive share of partnership losses, and expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account. 366 Examples of such expenditures include charitable contributions,367 life insurance premiums, and foreign income taxes. The adjusted basis of a partner's interest is also decreased (but not below zero) by the amount of the partner's deduction for depletion for any partnership oil and gas property to the extent that the deduction does not exceed the share of the adjusted basis of the property allocated to that partner under § 613A(c)(7)(D).368 In addition, the amount of gain or loss to a partner on a partnership's disposition of a domestic oil or gas property requires an adjustment in the partner's basis (but not below zero).369
——————————————————————————————

364 § 705(a)(1); Regs. § 1.705-1(a)(2).

365 Regs. § 1.705-1(a)(2).

366 § 705(a)(2); Regs. § 1.705-1(a)(3). Note that the court in LeBlanc v. U.S., No. 05-743T(Fed. Cl. 12/4/09), determined that while the statute dictates that the adjusted basis at any particular point cannot go “below zero,” this does not alter the way that the rest of the statute operates—it does not mean that the sum of the distributive shares of income and losses over the history of the partnership is permanently set to zero at any point that the sum becomes negative. In other words, the calculation is cumulative. For example, assume that partner A becomes a partner in the AB partnership on Jan. 1 and has an initial basis in the partnership of $1,000 (calculated under § § 722 and 752). For that year, year one, the partnership has a loss of $100,000, of which A's distributive share is $3,000. Then, in the succeeding year, year two, the partnership has income of $33,333, of which A's distributive share is $1,000. At the end of that second year, A abandons his interest in the partnership. According to the LeBlanc court, A ends up with a zero basis rather than a $1,000 basis.

367 See, e.g., Rev. Rul. 96-11, 1996-1 C.B. 140 (when partnership makes charitable contribution of property, basis of each partner's interest in partnership is decreased (but not below zero) by partner's share of partnership's basis in property contributed).

368 § 705(a)(3); Regs. § 1.705-1(a)(4).

369 Regs. § 1.705-1(a)(5).

——————————————————————————————

A partner must determine the adjusted basis in the partnership interest whenever necessary for the determination of the partner's tax liability or the tax liability of another taxpayer. If a partner holds the partnership interest throughout the partnership's entire taxable year, the determination can be made as of the end of the partnership's taxable year.370 Such a determination is necessary, for example, for computing the extent to which the partner may deduct the partner's share of partnership losses.371 If all or a portion of a partner's interest is sold or exchanged, or a partner's interest is liquidated, the adjusted basis of the partner's interest should be determined as of the date of the sale, exchange, or liquidation.372 Such a determination is necessary, for example, in determining the gain or loss from a sale or exchange.373
——————————————————————————————

370 Regs. § 1.705-1(a)(1).

371 See § 704(d).

372 Regs. § 1.705-1(a)(1). The partner whose interest is liquidated has the burden of proving the basis of the interest. See Scott v. Comr., T.C. Memo 1997-507.

373 See § 741.

——————————————————————————————

A partner's adjusted basis in a partnership interest usually differs from the amount of the partner's capital or “equity” account, because allocation of partnership liabilities to the partner is reflected in the basis of the partnership interest but not in the partner's capital account. For a discussion of the difference between adjusted basis and capital accounts, see I, C, above. A partner's adjusted basis in the partnership, moreover, may be limited to the partner's adjusted basis in contributed property, whereas the partner's capital account may be credited under the partnership agreement with the fair market value of the property.

In a distribution, other than a liquidating distribution, by a partnership to a partner, the amount of any money distributed and the basis of any property other than money distributed reduce the partner's adjusted basis in the partnership interest (but not below zero).374 The basis of property distributed by a partnership to a partner in a nonliquidating distribution generally is the adjusted basis to the partnership immediately before the distribution.375 However, the distributee partner's basis in the property cannot exceed the partner's adjusted basis in the partnership interest reduced by any money distributed in the same transaction.376 The basis of distributed property is discussed in detail in V, below.
——————————————————————————————

374 § 733;Regs. § 1.733-1. Even if gain is recognized on a distribution of marketable securities under § 731(c), § 733 is applied as if no gain were recognized. § 731(c)(5). If a partner is guaranteed an annual minimum profit participation that exceeds the partner's distributive share of partnership income in a certain year, the payment is allocated first to the partner's distributive share of partnership income, and that amount is subtracted from the partner's basis in the partnership interest. The rest of the amount paid to the partner is a guaranteed payment under § 707. See Rev. Rul. 66-95, 1966-1 C.B. 169. In some cases, however, the distinction between an overdraw by a partner of the partner's share of partnership income and a guaranteed payment is unclear. See Foster v. U.S., 329 F.2d 717 (2d Cir.  1964 ); Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970);Miller v. Comr., 52 T.C. 752 (1969);  Fahey v. Comr., T.C. Memo 1979-20.

375 § 732(a)(1); Regs. § 1.732-1(a).

376 § 732(a)(2); Regs. § 1.732-1(a).

——————————————————————————————

A partner's adjusted basis in a partnership interest is decreased by distributions before it is decreased by the partner's distributive share of partnership losses.377
——————————————————————————————

377 Rev. Rul. 66-94, 1966-1 C.B. 166.

——————————————————————————————

Example: X and Y are equal partners in a partnership. X's adjusted basis in X's partnership interest is $10,000. During the taxable year, the partnership distributes $8,000 of cash to X, and X's distributive share of partnership losses is $5,000. X's adjusted basis (i) is decreased by the amount of the cash distribution, to $2,000, and then (ii) decreased by X's distributive share of partnership losses, but only to the extent that the losses do not reduce X's basis below zero. X's adjusted basis in the partnership interest, therefore, is zero; X may only deduct$2,000 of the $5,000 distributive share of partnership losses.378

——————————————————————————————

378 See § 704(d).

——————————————————————————————

2. Section 179 Expense 

If a partnership elects to expense certain costs under § 179, a partner's adjusted basis in the partnership interest is reduced by the entire amount of the partner's distributive share of the  § 179 expense (regardless of whether the  § 179(b)(1) dollar limitation disallows any of the partner's deduction in the current year).379
——————————————————————————————

379 See Rev. Rul. 89-7, 1989-1 C.B. 178.

——————————————————————————————

3. Partnership Interest Acquired from Decedent 

The death of a partner closes the partnership's tax year with respect to the deceased partner.380 Therefore, the partnership taxable income allocable to the portion of the taxable year before the partner's death is included in the decedent's final income tax return. An estate's basis in a partnership interest is adjusted (but not below zero) by its distributive share of partnership taxable income allocable to the period after the partner's date of death.381
——————————————————————————————

380 § 706(c)(2)(A).

381 § 705(a).

——————————————————————————————

For further discussion of partnership interests acquired from decedents, see 716 T.M., Partnerships — Current and Liquidating Distributions; Death or Retirement of a Partner.

4. Discharge of Partnership Indebtedness 

Section 61(a)(12) includes income from discharge of indebtedness in gross income. At the partnership level, the discharge of partnership liabilities results in partnership taxable income, which, in turn, increases the partners' bases under § 705(a)(1)(A).382 At the same time, however, the discharge of indebtedness decreases the partners' share of partnership liabilities and, thus, decreases their bases.383
——————————————————————————————

382 The IRS has ruled privately that certain partnership obligations may be too contingent to qualify as indebtedness for  § 61(a)(12) purposes. See PLR 200523007 (partnership agreement entitled withdrawn partners to amounts equal to capital accounts plus return on such amounts if partnership completed project and determined payment would not cause hardship; sale of these partnership obligations did not give rise to debt discharge income).

383 See Schrott v. Comr., T.C. Memo 1989-346.

——————————————————————————————

Section 108(e)(8) provides that if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of indebtedness (recourse or nonrecourse) of the partnership, the partnership is treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the transferred partnership interest.384 Any debt discharge income that the partnership recognizes as a result of  § 108(e)(8) is included in the distributive shares of the taxpayers that were partners in the partnership immediately before the discharge. Under § 705(a)(1)(A), as stated above, this discharge of indebtedness income increases such partners' bases in their partnership interests.
——————————————————————————————

384 This rule was added to  § 108(e)(8) in 2004, effective for cancellations of indebtedness after Oct. 21, 2004. The 2004 amendment extended to partnerships the rule already in  § 108(e)(8) applicable to corporations that satisfy indebtedness with stock.

——————————————————————————————

Left uncertain after the 2004 amendment to § 108(e)(8) was how the fair market value of a partnership interest transferred in satisfaction of indebtedness should be determined. Under Prop. Regs. § 1.108-8,384.1 fair market value for this purpose would be the “liquidation value”of the transferred interest if (i) the debtor partnership maintained capital accounts in accordance with Regs. § 1.704-1(b)(2)(iv), (ii) the creditor, debtor partnership, and its partners treated the fair market value of the indebtedness as equal to the liquidation value of the interest in determining the tax consequences of the exchange, (iii) the exchange was an arm's-length transaction, and (iv) after the exchange, neither the partnership redeemed—nor any person related to the partnership purchased—the interest as part of a plan at the time of the exchange that had avoidance of debt discharge income as a principal purpose. Otherwise, fair market value would be determined under the facts and circumstances.
——————————————————————————————

384.1 REG-164370-05, 73 Fed. Reg. 64903 (10/31/08), proposed to apply to exchanges occurring on or after the date on which the regulation is published as final.

——————————————————————————————

Prop. Regs. § 1.108-8(b)(1) would define “liquidation value” as the amount of cash that the creditor would receive with respect to the transferred interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and other intangibles associated with its operations) for cash equal to those assets' fair market value, and then liquidated.

Under § 108(a)(1), debt discharge income is not included in gross income if it is realized in one of the following situations:

• the discharge occurs in a title 11 bankruptcy case;

• the discharge occurs when the taxpayer is insolvent, to the extent of the taxpayer's insolvency;

•the debt discharged is qualified farm indebtedness;

• in the case of a taxpayer other than a C corporation, the debt discharged is qualified real property business indebtedness (i.e., certain indebtedness incurred or assumed in connection with, and secured by, real property used in a trade or business);384.2 or

• the debt discharged is qualified principal residence indebtedness(i.e., acquisition indebtedness up to $2 million ($1 million for a married individual filing a separate return) with respect to the taxpayer's principal residence as described in § 121) that is discharged after 2006 and before 2013.384.3

——————————————————————————————

384.2 See CCA 200919035 (advising that if indebtedness was incurred by taxpayer in connection with real property used in trade or business, then it qualifies as qualified real property business indebtedness; distinction is between personal use and business use).

384.3 The 2007 Mortgage Forgiveness Debt Relief Act, P.L. 110-142, § 2, amended § 108(a)(1) by adding § 108(a)(1)(E), on “qualified principal residence indebtedness” (and adding § 108(h) to define “qualified principal residence indebtedness” and provide special rules for such debt). The Emergency Economic Stabilization Act of 2008, P.L. 110-343, Div. A, § 303(a), amended § 108(a)(1)(E) to extend applicability of the provision through the end of 2012.

——————————————————————————————

The exclusion for qualified real property business indebtedness is elective; the taxpayer may elect to apply the exclusion only to the extent that a corresponding reduction can be made in the basis of depreciable real property owned by the taxpayer as of the time of the debt discharge.385
——————————————————————————————

385 § 108(c)(2), (3).

——————————————————————————————

These exceptions apply at the partner level;386 the partnership must report separately the debt discharge income, even if the partnership is insolvent.
——————————————————————————————

386 § 108(d)(6). See alsoGershkowitz v. Comr., 88 T.C. 984 (1987) (arising under prior law but reaching result now mandated by § 108(d)(6)).

——————————————————————————————

In Rev. Rul. 92-97,387 the IRS stated that a deemed distribution (and resulting basis decrease) under  § 752(b) from partnership debt cancellation is treated as occurring at the end of the partnership taxable year as an advance or drawing against the partner's distributive share of cancellation of indebtedness income. This rule precludes recognition of gain under § 731(a), which might occur if the deemed distribution were treated as occurring before allocation of the debt discharge income caused a basis increase.388
——————————————————————————————

387 1992-2 C.B. 124.

388 Rev. Rul. 92-97 also addresses the allocation of debt discharge income under the  § 704(b) substantial economic effect rules. See 712 T.M.,  Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts. For further discussion of cancellation of partnership debt, see 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency.

——————————————————————————————

Section 108(b)(1) requires a partner or other taxpayer who excludes debt discharge income as a result of the taxpayer's bankruptcy or insolvency to reduce an equivalent amount of the tax attributes listed in § 108(b)(2), in the order in which they are listed. The taxpayer's net operating losses, credit carryovers, and capital loss carryovers generally must be reduced before the taxpayer's adjusted basis in property is reduced.389 However, the taxpayer may elect to reduce the basis of depreciable property, in lieu of other tax attribute reductions, but only to the extent of the taxpayer's total adjusted basis in depreciable property as of the beginning of the tax year following the year in which the debt was discharged.390
——————————————————————————————

389 § 108(b)(2)(A)-(E).

390 § 108(b)(5).

——————————————————————————————

The rules for reducing the basis of property by reason of the  § 108 exclusion are set forth in  § 1017 and the regulations thereunder.

For purposes of the elections to reduce the basis of depreciable property and qualified real property (discussed above), an interest of a partner in a partnership can be treated as depreciable property to the extent of the partner's proportionate interest in the partnership's depreciable property, provided there is a corresponding reduction in the partnership's depreciable property with respect to that partner.391
——————————————————————————————

391 § 1017(b)(3)(C); Regs. § 1.1017-1(g)(2).

——————————————————————————————

Regs.  § 1.1017-1(g)(2)(iv) and (v)392 correspond to the regulations under § 743. Regs  § 1.1017-1(g)(2)(iv) provides that a partner's proportionate share of the partnership's basis in depreciable property (or depreciable real property) equals the sum of: (1) the partner's  § 743(b) basis adjustments to items of partnership depreciable property (or depreciable real property); and (2) the common basis depreciation deductions (but not including remedial allocations of depreciation deductions under Regs.  § 1.704-3(d))that, under the terms of the partnership agreement effective for the taxable year in which the discharge of indebtedness occurs, are reasonably expected to be allocated to the partner over the property's remaining useful life. The assumptions that a partnership makes in determining the reasonably expected allocation of depreciation deductions must be consistent for each partner. For example, a partnership may not treat the same depreciation deductions as being reasonably expected by more than one partner.
——————————————————————————————

392 See Latta, “Cancellation of Debt and Basis Reduction: The Final Regulations Under § 108 and 1017,” 15 Tax Mgmt. Real Est. J. 31 (1999).

——————————————————————————————

Regs.  § 1.1017-1(g)(2)(v) provides that the amount of the reduction in basis of depreciable partnership property is an adjustment to the basis of partnership property with respect to the partner only. No adjustment is made to the common basis of partnership property. Thus, a basis reduction under  § 1017 is similar to a basis adjustment under § 743(b);for purposes of income, deduction, gain, loss, and distribution, the partner has a special basis for partnership properties the bases of which are adjusted under § 1017.

If a partner's actual share of depreciation from the common basis in partnership depreciable property, the basis of which has been reduced under § 1017, is less than the amount to which the partner otherwise would have been entitled, the partner recognizes income.393
——————————————————————————————

393 Regs. § 1.1017-1(g)(2)(v)(C).

——————————————————————————————

Example: X, Y, and Z are equal partners in a partnership that owns Asset 1, an item of depreciable property with a basis of $30,000. X's basis in X's partnership interest is $20,000. Under the partnership agreement, X's share of the depreciation deductions from Asset 1 over its remaining useful life will be $10,000. In Year One, the partnership decreases the basis of Asset 1 with respect to X by $10,000 under § 1017. In Year Two, the partnership amends its partnership agreement to require that items of depreciation and loss from Asset 1 be allocated equally between Y and Z. In that year, X's distributive share of the partnership's common basis depreciation deductions from Asset 1 is $0. Under Regs. § 1.743-1(j)(4)(ii)(B), the amount of the  § 1017 basis adjustment that X recovers during Year Two is $1,000. X reports $1,000 of ordinary income, because X's distributive share of the partnership's common basis depreciation deductions from Asset 1 ($0) is insufficient to offset the amount of the  § 1017 basis adjustment recovered by X during the year($1,000).

In Year Three, the partnership sells Asset 1 for $15,000 and recognizes a $12,000 loss. This loss is allocated equally between Y and Z, and X's share of the loss is $0. On the sale of Asset 1, X recovers its entire remaining  § 1017 basis adjustment ($9,000). X reports $9,000 of ordinary income.394

——————————————————————————————

394 See Regs.  § 1.1017-1(g)(2)(v)(C) Ex.

——————————————————————————————

Note: The American Recovery and Reinvestment Act of 2009 (ARRA)394.1 added § 108(i), which temporarily permits taxpayers to elect to defer debt discharge income arising from the reacquisition of certain debt instruments after 2008 and before 2011. Section 108(i) provides a schedule for ratable inclusion of the deferred income. In the case of a partnership, the deferral election—which is in lieu of the exclusions under § 108—is made at the partnership entity level.394.2 Section 108(i) deferred income is accelerated if the taxpayer liquidates or sells substantially all of its assets, ceases to do business, or is in similar circumstances.394.3 The sale or exchange or redemption of an interest in an electing (or other pass-through) entity is also an acceleration event.394.4 In the case of a partnership, any income deferred under § 108(i) is allocated to the partners immediately before the discharge of indebtedness in the manner that the amounts would have been included in the partners'distributive shares under § 704 if the income were recognized at the time of the discharge.394.5 Any decrease in a partner's share of liabilities as a result of the discharge is not taken into account for § 752 purposes at the time of the discharge to the extent the § 752 deemed distribution would cause the partner to recognize gain under § 731.394.6 Thus, the deemed distribution is deferred with respect to a partner to the extent it exceeds the partner's basis;amounts so deferred are taken into account at the same time—and to the extent remaining in the same amount—as the partner recognizes § 108(i) deferred income.394.7
——————————————————————————————

394.1 P.L. 111-5, Div. B, § 1231.

394.2 § 108(i)(5)(B)(iii). For this reason, Rev. Proc. 2009-37, 2009-36 I.R.B. __, requires a significant amount of due diligence and reporting by passthrough entities and requires such entities to provide information to their partners and shareholders, including information about the partners' and shareholders' shares of the income, deferred amounts and included amounts.

394.3 § 108(i)(5)(D)(i).

394.4 § 108(i)(5)(D)(ii).

394.5 § 108(i)(6).

394.6 § 108(i)(6).

394.7 § 108(i)(6). For further discussion of § 108(i), see 541 T.M., Tax Aspects of Restructuring Financially Troubled Businesses.

——————————————————————————————

5. Purpose of Adjustments 

The  § 705(a) basis adjustments are designed to ensure that a partner's adjusted basis in the partnership interest reflects the partner's economic investment in the partnership, so that the partner realizes an amount of gain or loss on sale or other disposition of the interest that accurately reflects the partner's economic gain or loss. The adjustments also ensure that income or loss is only taxed once.

Example: X and Y are equal partners in a partnership. Each of them contributes $50,000 of cash to the partnership in exchange for a partnership interest. In Year One, the partnership realizes$20,000 of taxable income. X and Y, therefore, each recognize $10,000 of taxable income in Year One. The partnership does not distribute the $20,000 of taxable income. Without § 705(a), neither partner would increase the basis in that partner's interest to account for the recognized income.

In Year Two, X sells X's partnership interest for $60,000. Without § 705(a), X's gain on the sale would be $10,000 ($60,000 amount realized minus $50,000 adjusted basis). X's economic gain from the investment in the partnership is also $10,000 ($60,000 received on the sale minus $50,000 cash contributed), but X would be taxed twice — first in Year One on X's $10,000 distributive share of partnership taxable income, and then in Year Two on X ’s $10,000 gain on the sale of the interest. Because of the  § 705(a) basis adjustment, however, X's adjusted basis in the interest is increased in Year One by X's $10,000 distributive share of taxable income. X recognizes no gain on the sale of the interest and, therefore, is only taxed once to reflect the true economic gain of $10,000.

6. Tax-Exempt Income 

a. General Rule 

Under § 705(a)(1)(B), a partner's adjusted basis in a partnership interest is increased by the partner's distributive share of partnership tax-exempt income. This adjustment is necessary to preserve the tax-exempt nature of the income. Examples of tax-exempt income include interest on tax-exempt government bonds and tax-exempt life insurance proceeds.395
——————————————————————————————

395 § § 103, 101(a).

——————————————————————————————

b. Tax-Deferred Income:The Helmer Case 

A partner's distributive share of partnership tax-deferred income(i.e., income that is realized but not recognized) should not result in a basis increase; such an adjustment would eliminate taxation of the income rather than merely deferring taxation of the income. In Helmer v. Comr.,396 however, the Tax Court implied that a partner's distributive share of a tax-deferred payment received by the partnership may increase the partner's basis in the partner's interest. The partnership in Helmer had granted an option to a third party to purchase one of the partnership's capital assets. In exchange for the option, the partnership received a tax-deferred option payment (the taxation of which was deferred until the option lapsed or was exercised).397 The implication in Helmer is inconsistent with the tax-deferred nature of the income; a basis increase would have the effect of treating the income as tax-exempt by permitting it to escape taxation entirely.
——————————————————————————————

396 T.C. Memo 1975-160.

397 See, e.g., Hunter v. Comr., 140 F.2d 954 (5th Cir.  1944);Dill Co. v. Comr., 33 T.C. 196 (1959), aff'd, 294 F.2d 291 (3d Cir.  1961); Virginia Iron, Coal &  Coke Co. v. Comr., 37 B.T.A. 195, aff'd, 99 F.2d 919 (4th Cir.  1938).

——————————————————————————————

7. Nondeductible Expenditures 

A partner's adjusted basis in a partnership interest is decreased by the partner's distributive share of partnership expenditures that are not deductible in computing taxable income and not properly chargeable to capital account.398 This basis decrease is necessary to ensure that a partner cannot convert a nondeductible expenditure into a recognized loss upon the sale or disposition of the interest. Examples of nondeductible expenditures include charitable contributions, political contributions, and disallowed losses under § § 267 and 707. If an expenditure is properly chargeable to capital account, there is no need for a basis adjustment because the expenditure does not decrease the fair market value or the basis of the partnership's assets.
——————————————————————————————

398 § 705(a)(2)(B).

——————————————————————————————

8. Effect of § 465 on Adjusted Basis 

Under § 465(a), losses from certain activities are allowed only to the extent of the aggregate amount with respect to which a taxpayer is at risk.399 However, even if all or a portion of a partner's share of partnership loss is disallowed under § 465, the partner's adjusted basis in the partnership interest is reduced(but not below zero) by the entire amount of the loss.400 Note, however, that losses disallowed under  § 465 are carried forward, and may be used to offset gain from the sale of the partnership interest.401
——————————————————————————————

399 The at-risk rules are discussed in detail in 550 T.M., At-Risk Rules.

400 § 705(a)(2)(A). See Prop. Regs.  § 1.465-1(e) (§ 465 and regulations thereunder are only intended to limit deduction of certain losses from covered activities;  § 465 does not apply for other purposes, such as determining adjusted basis of partner in partnership interest).

401 § 465(a)(2). See also Prop. Regs. § § 1.465-12(a), -66(a).

——————————————————————————————

9. Effect of § 469 on Adjusted Basis 

Section 469 provides that a taxpayer generally may not deduct losses from a passive activity unless the taxpayer materially participates in the activity.402 Even if all or a portion of a partner's share of partnership loss is disallowed under § 469, however, the partner's adjusted basis in the partnership interest is reduced (but not below zero) by the full amount of the loss.403 Disallowed passive losses may be carried forward and eventually used upon the taxable disposition of the partnership interest.404
——————————————————————————————

402 The  § 469 passive loss rules are discussed in detail in 549 T.M., Passive Loss Rules.

403 § 705(a)(2)(A).

404 § 469(g)(1).

——————————————————————————————

10. Effect of Gain/Loss Not Recognized Under § 707 

A partner's adjusted basis in the partnership interest is increased to the extent of any gain from the sale of partnership property that is not recognized under  § § 707(b)(1) and 267(d). In the case of a loss on the sale of partnership property that is disallowed under § 707(b)(1), each partner's basis is reduced (but not below zero) by the partner's share of the loss.405
——————————————————————————————

405 Rev. Rul. 96-10, 1996-1 C.B. 138.

——————————————————————————————

11. Effect of § 1032 on Corporate Partners 

Under § 1032, a corporation does not recognize gain or loss when it receives cash or other property in exchange for its own stock. A corporate member of a partnership, consequently, does not recognize its share of any gain or loss that the partnership realizes when it sells or exchanges stock of the corporate partner.406 A partnership allocates gain or loss to a corporate partner based on the partner's economic interest in the stock when the partnership sells or exchanges that stock, but  § 1032 prevents the corporation from recognizing any of the gain or loss. The corporate partner usually increases or decreases the basis of its partnership interest under  § 705 for the amount of the gain or loss, thus preserving the nonrecognition result of the transaction in accordance with § 1032.
——————————————————————————————

406 See Rev. Rul. 99-57, 1999-51 I.R.B. 678 (taking position that partnership should be treated as aggregate of partners for all issues concerning gain or loss from disposition of partner's stock).

——————————————————————————————

However, the IRS believes that increasing the basis of a corporate partner's interest by the full amount of unrecognized gain is inconsistent with the purposes of  § § 705 and 1032 in cases in which the corporation acquires an interest in a partnership that owns that corporation's stock, the partnership does not have a  § 754 election in effect for the year in which the corporation acquires the partnership interest, and the partnership later sells or exchanges the stock. Such an increase would permit the corporate partner to recognize a loss (or a reduced gain) when the corporate partner later sells its partnership interest, even though the corporate partner would not have incurred a corresponding economic loss or recognized an offsetting gain.407
——————————————————————————————

407 See preamble to T.D. 8986, 67 Fed. Reg. 15112 (3/29/02).

——————————————————————————————

Under regulations applicable to a partnership's disposition of a corporate partner's stock when a  § 754 election is not in effect for the year in which the corporation acquired its partnership interest, the increase (or decrease) in a corporate partner's adjusted basis in its partnership interest resulting from the partnership's sale or exchange of the stock equals the amount of gain (or loss)that the corporate partner would have recognized (without  § 1032) if the partnership had made a  § 754 election for its taxable year in which the corporation acquired its interest.408 The regulations also include anti-abuse rules to prevent taxpayers from avoiding the regulations' effect through the use of tiered partnerships or other arrangements. If, for example, a corporation acquires an indirect interest in its own stock through a chain of two or more partnerships(either because the corporation acquires a direct interest in a partnership or because one of the partnerships in a chain acquires an interest in another partnership), and the corporation is allocated gain or loss from the sale of its own stock, then the bases of the interests in the partnerships included in the chain must be adjusted to prevent double recognition of gain or loss by the issuing corporation.409
——————————————————————————————

408 Regs. § 1.705-2(b)(1).

409 Regs. § 1.705-2(c).

——————————————————————————————

If a partnership sells or exchanges a corporate partner's stock after distributing money or other property to another partner in a year for which a  § 754 election is not in effect, and the other partner recognized gain or loss on the distribution (or the basis of the property distributed to the other partner was adjusted), the increase (or decrease) in the corporate partner's adjusted basis in its partnership interest equals the amount of gain (or loss) that the corporate partner would have recognized(without  § 1032)if a  § 754 election had been in effect for the year in which the partnership made the distribution to the other partner.410 “Stock,” for this purpose, includes any position in stock to which  § 1032 applies.411
——————————————————————————————

410 Regs. § 1.705-2(b)(2).

411 Regs. § 1.705-2(d).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IV. Adjustments to Partner's Initial Basis

B. Adjustments Arising from the Operation of the § 752 Liability Rules 

1. Changes in Partner's Share of Partnership Liabilities 

If a partnership assumes a contributing partner's  § 752 liability, the partnership is deemed to distribute cash to the partner and the contributing partner's adjusted basis in the partnership interest is decreased by the amount of the deemed distribution. Under § 752(a), any increase in a partner's share of  § 752 partnership liabilities, or any increase in a partner's individual  § 752 liabilities by reason of the assumption by the partner of partnership liabilities, is treated as a contribution of money by the partner to the partnership.412 As discussed in II, A, 1, above, a partner's adjusted basis in a partnership interest is increased by the amount of money that the partner contributes to the partnership.413 Therefore, a contribution of money that is deemed to occur when a partner's share of partnership liabilities increases, or when the partner's individual liabilities increase because the partner assumes partnership liabilities, increases the partner's adjusted basis in the partnership interest in an amount equal to the deemed contribution.
——————————————————————————————

412 See Regs. § 1.752-1(b).

413 § 722;Regs. § 1.722-1.

——————————————————————————————

Example: W, X, Y, and Z form an equal partnership. On Jan. 1, Year One, the partnership has a liability of $120,000, $30,000 of which is included in each partner's basis in that partner's interest. The partnership liquidates Z's interest; leaving W, X, and Y as equal partners. Each remaining partner's share of partnership liabilities is increased to $40,000 (1/3 x $120,000). The $10,000 increase in each partner's share of partnership liabilities is treated as a cash contribution from each partner to the partnership. Each partner's adjusted basis in the partnership interest is increased by $10,000.

Under § 752(b), any decrease in a partner's share of partnership liabilities, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, is treated as a distribution of money to the partner by the partnership.414 Under § 733(1), a partner's adjusted basis in a partnership interest is decreased (but not below zero) by the amount of money that the partnership distributes to the partner (other than in liquidation of the partner's interest). Thus, the distribution of money deemed to occur when the partner's share of partnership liabilities decreases, or when the partner's individual liabilities decrease because the partnership assumes the individual liabilities, decreases the partner's adjusted basis in the partnership interest in an amount equal to the deemed distribution. The partner's adjusted basis, however, cannot be reduced below zero; any excess of the deemed distribution over the partner's adjusted basis in the partnership interest results in taxable gain to the distributee partner.415
——————————————————————————————

414 See Regs. § 1.752-1(c).

415 § 731(a)(1); Regs. § 1.731-1(a).

——————————————————————————————

Example: W, X, and Y form an equal partnership. On Jan. 1, Year One, the partnership has a liability of $120,000, $40,000 of which is included in each partner's adjusted basis in the partner's interest. However, cash distributions have reduced each partner's adjusted basis in the partnership interest to $5,000 for W, $10,000 for X, and $20,000 for Y. On June 30, Year One, W, X, and Y admit Z as a new 25% partner. As a result, the original partners' aggregate share of partnership liabilities decreases from $120,000 to $90,000;each original partner's share of partnership liabilities is decreased by $10,000. The $10,000 decrease is treated as a cash distribution from the partnership to the partner. W's adjusted basis in W's interest is decreased to zero, and W recognizes $5,000 of taxable gain. X's adjusted basis is decreased to zero, and Y's adjusted basis is decreased to $10,000. The $30,000 of partnership liabilities assumed by Z on admission to the partnership is treated as a cash contribution by Z to the partnership; Z's adjusted basis in Z's partnership interest is increased by $30,000.

In Rev. Rul. 94-4,416 the IRS ruled that a deemed distribution of money under § 752(b) resulting from a decrease in a partner's share of partnership liabilities is treated as an advance or drawing of money under Regs.  § 1.731-1(a)(1)(ii) to the extent of the partner's distributive share of income for the partnership taxable year. According to the ruling, the amount treated as an advance or drawing is taken into account at the end of the partnership taxable year.
——————————————————————————————

416 1994-1 C.B. 195.

——————————————————————————————

The admission of a new partner or the liquidation of an existing partner's interest may increase or decrease a partner's share of partnership liabilities. A general partnership's conversion into a limited partnership or a limited liability company also may change the partners' shares of partnership liabilities.417 Operation of the partnership's business may also increase or decrease partners' shares of partnership liabilities. If a partnership incurs a working capital loan, for instance, the loan results in deemed cash contributions by the partners to the partnership. If the partnership pays down a working capital loan, the payment results in deemed cash distributions by the partnership to the partners.
——————————————————————————————

417 See Rev. Rul. 84-52, 1984-1 C.B. 157, amplified by Rev. Rul. 95-37, 1995-1 C.B. 130. See also PLRs 9501033, 9452024.

——————————————————————————————

2. Distributions of Encumbered Property 

a. Current Distributions 

A partnership's current distribution418 of encumbered property to a partner results in three separate adjustments to the partner's adjusted basis in the partner's interest.
——————————————————————————————

418 Regs.   § 1.761-1(d) provides that any distribution that is not in liquidation of a partner's entire partnership interest is a current distribution.

——————————————————————————————

(1) The partner's basis is increased by the total amount of the liabilities encumbering the property.419

——————————————————————————————

419 § § 705(a), 722, 752(a), 752(c).

——————————————————————————————

(2) The partner's basis in the interest is decreased by the partner's share of the overall reduction in the amount of partnership liabilities.420 The regulations under  § 752 provide that any increases or decreases in a partner's share of partnership liabilities resulting from a single transaction are offset against each other and only the net increase or decrease(if any) is treated as a deemed cash contribution or distribution under  § 752(a) or(b).421

——————————————————————————————

420 § § 705(a), 733(1), 752(b).

421 Regs. § 1.752-1(f). See  Rev. Rul. 79-205, 1979-2 C.B. 255 (netting of simultaneous liabilities). Cf. Rev. Rul. 81-242, 1981-2 C.B. 147 (IRS refused to net liability relief with liability assumption, concluding that netting allowed by Rev. Rul. 79-205 is inappropriate when transactions are not simultaneous). See also Rev. Rul. 2003-56, 2003-23 I.R.B. 985 (if partnership enters into  § 1031 exchange of encumbered properties, liabilities are netted for purposes of  § 752 under Regs.  § 1.1031(b)-1(c) liability offsetting rule even if exchange straddles two taxable years of partnership).

——————————————————————————————

(3) The partner's basis in the interest is decreased by the partner's basis in the distributed property.422 The basis of property distributed by a partnership to a partner in a current distribution generally is equal to the partnership's adjusted basis in the property immediately before the distribution.423 However, the partner's basis in property distributed cannot exceed the partner's adjusted basis in the partnership reduced by any money distributed in the same transaction.424 This limitation applies after all of the liability adjustments to basis occurring on the distribution of the encumbered property are taken into account.425

——————————————————————————————

422 § § 705(a), 733(2).

423 § 732(a)(1); Regs. § 1.732-1(a). A partner's adjusted basis in distributed property is discussed in greater detail in V, below.

424 § 732(a)(2); Regs. § 1.732-1(a).

425 Rev. Rul. 79-205, 1979-2 C.B. 255.

——————————————————————————————

Example: X owns a 50% interest in the profits and losses of a partnership. X's adjusted basis in X's partnership interest is $7,000. On Jan. 1, Year One, X receives a current distribution of property with a fair market value to the partnership immediately before the distribution of $20,000 and an adjusted basis of $12,000, subject to a liability of $15,000. X's adjusted basis in the partnership interest after the distribution is $2,500 ($7,000 plus $15,000 (total liabilities assumed by X) minus $7,500 (X's share of the decrease ($15,000) in partnership liabilities) minus $12,000 (X's basis in the distributed property)). X's adjusted basis in the distributed property is $12,000(the adjusted basis in the hands of the partnership immediately before the distribution). Note that if the liability adjustments were not taken into account before X's basis in the distributed property is determined, X's basis in the property would be limited to $7,000 (X's predistribution adjusted basis in the partnership interest).426 If X were required to take the $7,500 deemed cash distribution (from the decrease in X's share of partnership liabilities) into account first, instead of netting the increase and decrease in X's share of partnership liabilities resulting from the distribution, X would realize $500 of taxable gain($7,500 decrease in liabilities minus $7,000 adjusted basis in partnership interest).427

——————————————————————————————

426 § 732(a)(2); Regs. § 1.732-1(a).

427 § 731(a)(1); Regs. § 1.732-1(a).

——————————————————————————————

b. Liquidating Distributions 

Because a liquidating distribution terminates the distributee partner's entire interest in the distributing partnership,428 the partner's basis in the partnership interest need not be computed after the distribution. The basis adjustments resulting from a liquidating distribution are significant, however, because the distributee partner's basis in the distributed property is equal to the partner's adjusted basis in the partnership interest reduced by any money distributed in the same transaction.429 Therefore, to determine the distributee partner's basis in the distributed property, the distributee partner's basis in the partnership interest first must be adjusted to reflect the distribution.
——————————————————————————————

428 Regs. § 1.761-1(d).

429 § 732(b);Regs. § 1.732-1(b).

——————————————————————————————

As discussed above, the order in which adjustments are made can affect the tax consequences to the distributee partner. The order of adjustments in a liquidating distribution is the same as those in a current distribution:increases and decreases in the distributee partner's share of partnership liabilities are offset against each other and only the net increase or decrease is treated as a deemed cash contribution or distribution,430 and the distributee partner's basis in the distributed property is determined after any deemed cash contribution or distribution is accounted for in the partner's adjusted basis in the interest.431
——————————————————————————————

430 Regs. § 1.752-1(f).

431 Rev. Rul. 87-120, 1987-2 C.B. 161.

——————————————————————————————

Example: X owns a one-third interest in the profits and losses of a partnership. X's adjusted basis in X's partnership interest is$100,000. The partnership has $270,000 of liabilities, $90,000 of which represents X's share. On Jan. 1, Year One, the partnership distributes property with a fair market value of $200,000, subject to a liability of $120,000, to X in liquidation of X's entire partnership interest. The distribution increases X's adjusted basis in the partnership interest by $80,000 ($120,000 (total liabilities assumed by X) minus $40,000(X's share (1/3) of the decrease ($120,000) in partnership liabilities)). Thus, X's adjusted basis in the partnership interest after the distribution —$180,000 ($100,000 predistribution basis plus $80,000 net deemed cash contribution) — is X's adjusted basis in the distributed property.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IV. Adjustments to Partner's Initial Basis

C. Adjustments Arising from the Operation of the Regs.  § 1.752-7 Liability Rules 

As discussed in III, E, above, when a partnership assumes a “Regs. § 1.752-7 liability”(as opposed to a  § 752 liability)from a partner (the “Regs.  § 1.752-7 liability partner”), the partner's basis in the partnership interest is not immediately adjusted. When a “triggering event” subsequently separates the partner from the Regs.  § 1.752-7 liability, however, the Regs.  § 1.752-7 liability partner's basis is reduced.432
——————————————————————————————

432 Regs.   § 1.752-7 generally applies to assumptions of liabilities after June 23, 2003. For assumptions of liabilities after Oct. 18, 1999, but before June 24, 2003, a different rule applies: Regs.   § 1.752-6 generally reduces the partner's basis in the partnership by the amount of the “liability”(defined by reference to  § 358(h)(3)) immediately after the partnership assumes the liability and  § 752(a) and (b) is applied. A partnership had the option of electing to apply Regs.   § 1.752-7 instead of Regs.  § 1.752-6 to all assumptions of liabilities by the partnership after Oct. 18, 1999. However, in order to do this, the partnership had to include an election with a federal income tax return filed after Sept. 23, 2003, and before Jan. 1, 2006.

——————————————————————————————

1. Triggering Events 

a. In General 

Immediately before a triggering event (i.e., a transfer or distribution in liquidation of a Regs.   § 1.752-7 liability partner's interest in the partnership, or another partner's assumption of the Regs.  § 1.752-7 liability from the partnership), the Regs.   § 1.752-7 liability partner's basis in the partnership interest generally is reduced by the “Regs.  § 1.752-7 liability reduction.” 433 The “Regs.   § 1.752-7 liability reduction”is equal to the lesser of —
——————————————————————————————

433 Regs. § 1.752-7(d)(1), (e)(1), (f)(1), (g)(2).

——————————————————————————————

• the excess of (i) the Regs.   § 1.752-7 liability partner's basis in the partnership interest over the “adjusted value” of the interest, and

• the “remaining built-in loss associated with the Regs.  § 1.752-7 liability.” 434

——————————————————————————————

434 Regs. § 1.752-7(b)(7)(i).

——————————————————————————————

The “adjusted value” of a partnership interest for this purpose is equal to the interest's fair market value increased by the partner's share of  § 752 liabilities.435 The term “remaining built-in loss associated with the Regs.   § 1.752-7 liability” refers to —
——————————————————————————————

435 Regs. § 1.752-7(b)(2).

——————————————————————————————

• the “amount” of the Regs.   § 1.752-7 liability (i.e., the amount of cash a willing assignor would pay a willing assignee to assume the obligation in an arm's-length transaction) when the partnership assumed the Regs.   § 1.752-7 liability,

• reduced by any portion of the liability that the Regs.   § 1.752-7 liability partner took into account as a partner in a partnership that itself was a Regs.  § 1.752-7 liability partner in another partnership, and

• adjusted under  § 704(c) and Regs.   § 1.704-3 for any portion of the built-in loss that the partnership has satisfied and any re-assumption by the Regs.   § 1.752-7 liability partner of the Regs.   § 1.752-7 liability.436

——————————————————————————————

436 Regs. § 1.752-7(b)(6). If the triggering event is only a partial disposition of the Regs.  § 1.752-7 liability partner's interest or only a partial assumption of the Regs.   § 1.752-7 liability by another partner, the Regs.   § 1.752-7 liability is prorated based on the portion of the interest transferred or assumed. Regs. § 1.752-7(b)(7)(ii).

——————————————————————————————

: X, Y, and Z form a partnership in Year One. X contributes an asset with a fair market value of $5,000,000 and a basis of $4,000,000 subject to a Regs.  § 1.752-7 liability of $2,000,000 in exchange for a 25% partnership interest. In Year Three, when the partnership has a  § 754 election in effect, X sells X's partnership interest to D for $3,000,000. At the time of the sale, the basis of X's partnership interest is $4,000,000, the remaining built-in loss associated with the Regs.  § 1.752-7 liability is $2,000,000, and the partnership has no  § 752 liabilities. X's basis in the interest must be reduced by the Regs.  § 1.752-7 liability reduction(the lesser of (i) the excess of X's basis over the adjusted value of the interest  [$4,000,000 – $3,000,000] and (ii) the remaining built-in loss associated with the Regs.  § 1.752-7 liability [$2,000,000]). Thus, the Regs.  § 1.752-7 liability reduction is $1,000,000 and X's basis is reduced to $3,000,000. X, therefore, realizes no gain or loss on the sale.437

——————————————————————————————

437 See Regs. § 1.752-7(e)(2) Ex. 1.

——————————————————————————————

Note: The basis reduction rule applicable upon transfers of the partnership interests of Regs.  § 1.752-7 liability partners does not apply to the transfer of a Regs.  § 1.752-7 liability partner's interest in a carryover basis transaction.438
——————————————————————————————

438 Regs. § 1.752-7(e)(3)(i).

——————————————————————————————

: X, Y, and Z form a partnership in Year One. X contributes Asset 1 with a fair market value and basis of $5,000,000 subject to a Regs.  § 1.752-7 liability of $2,000,000 in exchange for a 25% partnership interest. In Year Nine, when the partnership has a  § 754 election in effect, the partnership distributes Asset 2, with a fair market value and basis of $3,000,000, to X in liquidation of X's partnership interest. At the time of the distribution, the fair market value of X's interest is still $3,000,000, the basis of the interest is still $5,000,000, and the remaining built-in loss associated with the Regs.  § 1.752-7 liability is still $2,000,000. X's basis in the partnership interest must be reduced immediately before the distribution by the Regs.   § 1.752-7 liability reduction (the lesser of (i) the excess of X's basis over the adjusted value of the interest  [$5,000,000 – $3,000,000] and (ii) the remaining built-in loss associated with the Regs.   § 1.752-7 liability [$2,000,000]). Thus, the Regs.  § 1.752-7 liability reduction is $2,000,000 and X's basis is reduced to $3,000,000. X's basis in Asset 2 is $3,000,000, which is equal to the partnership's basis in the asset prior to distribution.439

——————————————————————————————

439 See Regs. § 1.752-7(f)(2).

——————————————————————————————

: X, Y, and Z form a partnership in Year One. X contributes Asset 1 with a fair market value and basis of $5,000,000 in exchange for a 25% partnership interest and the partnership's assumption of a Regs. § 1.752-7 liability of $2,000,000. Y contributes $3,000,000 cash for a 25% interest, and Z contributes $6,000,000 cash for a 50% interest. The partnership uses the contributed cash to purchase Asset 2. In Year Three, the partnership distributes Asset 1, subject to the Regs.   § 1.752-7 liability, to Y in liquidation of Y's partnership interest. At the time of the distribution, X's interest still has a value of $3,000,000 and a basis of $5,000,000, Y's interest still has a value and basis of $3,000,000, Asset 1 still has a value and basis of $5,000,000, Asset 2 still has a value and basis of $9,000,000, and the remaining built-in loss associated with the Regs.   § 1.752-7 liability is still $2,000,000. When Y assumes the Regs.   § 1.752-7 liability in Year Three, X's basis in the partnership interest must be reduced by the Regs.   § 1.752-7 liability reduction (the lesser of (i) the excess of X's basis over the adjusted value of  the interest [$5,000,000 – $3,000,000] and (ii) the remaining built-in loss associated with the Regs.   § 1.752-7 liability [$2,000,000]). Thus, the Regs.   § 1.752-7 liability reduction is $2,000,000 and X's basis is reduced to $3,000,000. The partnership's adjusted basis in Asset 2 is reduced by the remaining loss associated with the  § 1.752-7 liability ($2,000,000). Thus, the partnership's basis in Asset 2 is reduced to $7,000,000. Y's basis in distributed Asset 1 is $3,000,000, which is $2,000,000 less than the partnership's basis in Asset 1 prior to distribution. If a  § 754 election is in effect, there will be a $2,000,000 upward adjustment applicable to Asset 2.440

——————————————————————————————

440 See Regs. § 1.752-7(g)(5).

——————————————————————————————

b. Application of Triggering Event Rules to Tiered Partnerships 

If a transaction occurs under Regs.   § 1.752-7(e) (sale, exchange, or other disposition), (f) (distribution in liquidation), or (g) (assumption by a partner other than the Regs.   § 1.752-7 liability partner)with respect to a partnership that is itself a Regs.   § 1.752-7 liability partner with respect to another partnership, then the transaction is also a Regs. § 1.752-7(e), (f), or (g) transaction with respect to the partners of the first partnership (i.e., the upper-tier partnership), even if the upper-tier partnership did not assume the liability from any of its partners. Each partner's share of the Regs.   § 1.752-7 liability reduction is equal to that partner's share of the Regs.   § 1.752-7 liability.441
——————————————————————————————

441 Regs. § 1.752-7(j)(3).

——————————————————————————————

If, after a Regs. § 1.752-7(e), (f), or (g) transaction involving a Regs.   § 1.752-7 liability, another partnership or a corporation assumes the Regs.   § 1.752-7 liability from an upper-tier partnership in a carryover basis transaction, the upper-tier partnership must reduce its basis under Regs.   § 1.752-7(j)(4) in any corporate stock or partnership interest received by the remaining built-in loss associated with the Regs.   § 1.752-7 liability (but the upper-tier partnership's partners do not reduce their bases).

Example: X, Y, and Z form partnership UTP in Year One. X contributes Asset 1 with a fair market value and basis of $5,000,000 subject to a Regs.   § 1.752-7 liability of $2,000,000 in exchange for a 25% interest in UTP. Y contributes$3,000,000 cash for a 25% interest, and Z contributes $6,000,000 cash for a 50% interest. UTP invests the $9,000,000 cash in Asset 2. In Year Three, X sells X's interest in UTP to D for $3,000,000, at a time when the basis of X's UTP interest is $5,000,000, the remaining built-in loss associated with the Regs.   § 1.752-7 liability is$2,000,000, and UTP has no other liabilities. Under Regs. § 1.752-7(e), X's basis in UTP is reduced by the $2,000,000 Regs.  § 1.752-7 liability reduction to $3,000,000 immediately before the sale.

In Year Five, when the Regs.   § 1.752-7 liability's estimated value has increased to $3,500,000, UTP contributes Assets 1 and 2, subject to the Regs.   § 1.752-7 liability, to partnership LTP in exchange for a 50% interest in LTP. At that time, Asset 1 still has a value and basis of $5,000,000, and Asset 2 still has a value and basis of $9,000,000. Under § 722, UTP's basis in LTP is$14,000,000. UTP must reduce its basis in LTP, under Regs. § 1.752-7(j)(4), by the remaining built-in loss associated with the Regs.   § 1.752-7 liability; the partners in UTP are not required to reduce their bases. None of the UTP partners are Regs.   § 1.752-7 liability partners with respect to the $2,000,000 remaining built-in loss associated with the Regs.   § 1.752-7 liability, but, at the time of the assumption, the UTP partners are Regs.   § 1.752-7 liability partners of LTP with respect to the $1,500,000 increase that has occurred in the amount of the Regs.   § 1.752-7 liability.442

——————————————————————————————

442 Regs. § 1.752-7(j)(5).

——————————————————————————————

c. Exceptions to the Basis Reduction Rule 

The rule reducing a Regs.  § 1.752-7 liability partner's basis on a triggering event does not apply if (i) the partnership assumes the Regs.  § 1.752-7 liability as part of a contribution to the partnership of the trade or business with which the liability is associated and (ii) the partnership continues to carry on the trade or business after the contribution.443 “Trade or business,”for this purpose, means a specific group of activities conducted for the purpose of earning income or profit, or holding, dealing in, or disposing of financial instruments, if the activities in the group include every operation that is a part of the process of earning income or profit. The group of activities must fall within the  § 162(a) description of carrying on a trade or business (determined as if an individual conducted the activities).444
——————————————————————————————

443 Regs. § 1.752-7(d)(2)(i)(A).

444 Regs. § 1.752-7(b)(10).

——————————————————————————————

Example: For seven years, corporation Z engaged in the manufacture and sale of household products. Throughout that period, Z maintained a research department in connection with its manufacturing activities. Z contributes the research department to a partnership in exchange for a partnership interest and the partnership's assumption of Z's pension obligations (which are Regs.   § 1.752-7 liabilities)to the employees of the research department. The partnership continues the research activities on a contractual basis with Z.

Z's contribution of the research operations to the partnership is the contribution of a “trade or business.” In the future, therefore, if Z transfers its partnership interest or receives a distribution in liquidation of that interest, or if a partner other than Z assumes the pension obligations from the partnership, Z's basis in the partnership interest will not be reduced.445

——————————————————————————————

445 Regs.   § 1.752-7(b)(10) Ex. 3, (d)(2)(ii) Ex. 1.

——————————————————————————————

If a partnership assumes a Regs.  § 1.752-7 liability of a partner, and either another partnership assumes the same liability from the first partnership or the contributing partner transfers the partnership interest to another partnership, then the Regs.  § 1.752-7 liability is only associated with the trade or business (if any) that the partner contributed to the first partnership.446
——————————————————————————————

446 Regs. § 1.752-7(j)(2), (e)(3)(ii) Ex. 1.

——————————————————————————————

The basis reduction rule is also subject to a de minimis exception:a Regs.   § 1.752-7 liability partner's basis is not reduced on a triggering event if the amount of the remaining built-in loss with respect to all Regs.   § 1.752-7 liabilities that the partnership has assumed (other than liabilities that have associated trades or businesses) is less than 10% of the gross value of partnership assets or $1,000,000, whichever is less, immediately before the triggering event.447
——————————————————————————————

447 Regs. § 1.752-7(d)(2)(i)(B), (b)(9).

——————————————————————————————

Example: For the past five years, corporation X has engaged in Businesses 1 and 2. In Year Six, X contributes Business 1 to a partnership for a partnership interest and the partnership's assumption of X's pension obligations to the employees in Business 1. The partnership also assumes some of X's pension obligations to the employees in Business 2. The Business 1 and Business 2 pension obligations are Regs.  § 1.752-7 liabilities. At the time of the assumption, the amount of the Business 1 pension obligations is $3,000,000 and the amount of the Business 2 pensions obligations is $2,000,000. In Year Eight, X sells its partnership interest to Y for $9,000,000. At the time of the sale, the remaining built-in loss associated with the Business 1 pension obligations is$2,100,000, the remaining built-in loss associated with the Business 2 pension obligations is $900,000, and the gross value of the partnership's assets other than the pension obligations is $20,000,000. The partnership has no Regs.  § 1.752-7 liabilities other than the pension obligations.

The Business 1 pension obligations are associated with a contributed trade or business and, thus, do not reduce X's basis on the sale to Y. The remaining built-in loss associated with the Business 2 pension obligations immediately before the sale ($900,000) is less than the lesser of 10% of the gross value of the partnership's assets ($2,000,000)and $1,000,000. X's sale of its partnership interest to Y, therefore, is excluded from the basis reduction rules.448

——————————————————————————————

448 Regs.   § 1.752-7(d)(2)(ii) Ex. 2.

——————————————————————————————

The basis reduction rule applicable upon transfers of the partnership interests of Regs.  § 1.752-7 liability partners also does not apply to the transfer of a Regs.  § 1.752-7 liability partner's interest in a carryover basis transaction.449
——————————————————————————————

449 Regs. § 1.752-7(e)(3)(i).

——————————————————————————————

Example: In 2007, X contributes undeveloped land with a value and basis of $2,000,000, subject to environmental liabilities of $1,500,000, to a partnership in exchange for a 50% partnership interest. The partnership develops the land as a landfill. In 2008, X contributes its partnership interest to a corporation in a  § 351 exchange. X's contribution of the interest to the corporation is exempt from the Regs.  § 1.752-7(e)(1) basis reduction rule.450

——————————————————————————————

450 Regs.   § 1.752-7(e)(3)(ii) Ex. 2. Under  § 358 and Regs. § 1.358-7(c), however, X's basis in stock of the corporation that X receives in the  § 351 exchange may be reduced by the corporation's assumption of the environmental liabilities. Regs.   § 1.358-7(c) was added by T.D. 9207, 70 Fed. Reg. 30334 (5/26/05), and is generally effective for assumptions of liabilities by corporations after June 23, 2003.

——————————————————————————————

Nor does the basis reduction rule for transfers apply to a distribution of an interest in a lower-tier partnership that previously assumed a Regs.   § 1.752-7 liability, by an upper-tier partnership that is the Regs.   § 1.752-7 liability partner, if the upper-tier partnership's partners that were Regs.   § 1.752-7 liability partners with respect to the lower-tier partnership before the distribution continue to be Regs.   § 1.752-7 liability partners with respect to the lower-tier partnership after the distribution.451
——————————————————————————————

451 Regs. § 1.752-7(e)(3)(i).

——————————————————————————————

Example: W, X, Y, and Z form equal partnership M in 2007. W contributes real property (Real Property 1) with a value and basis of $2,000,000, and the partnership assumes $1,500,000 of W's pension obligations (Regs.   § 1.752-7 liabilities)unrelated to Real Property 1. X, Y, and Z each contribute $500,000 cash, which the partnership uses to purchase Real Property 2 for $1,500,000. In 2009, M merges into partnership N in a Regs.  § 1.708-1(c)(3) assets-over merger (with N as the surviving partnership). At the time of the merger, Real Property 1 still has a value of $2,000,000, and the remaining built-in loss with respect to the pension obligations is still $1,500,000. The value of Real Property 2, however, has declined to $500,000.

Under Regs. § 1.708-1(c)(3), the merger is treated as a contribution of M's assets and liabilities to N, followed by M's distribution of the N interests in liquidation of M. Because N assumes a Regs.   § 1.752-7 liability from M, M is a Regs.   § 1.752-7 liability partner of N. W is also a Regs.   § 1.752-7 liability partner of N to the extent of the remaining built-in loss associated with the pension obligations. M's deemed distribution of N interests is not a Regs.  § 1.752-1(e)(1) basis reducing event, because all of the partners that were Regs.   § 1.752-7 liability partners of N before the distribution continue to be Regs.   § 1.752-7 liability partners after the distribution.452

——————————————————————————————

452 Regs.   § 1.752-7(e)(3)(ii) Ex. 3.

——————————————————————————————

2. Satisfaction of Regs. § 1.752-7 Liabilities 

If a partnership satisfies a Regs.  § 1.752-7 liability after the Regs.   § 1.752-7 liability partner transfers the partner's interest or receives a distribution in liquidation of the interest, no deduction, loss, or capital expense is allowed to the partnership to the extent of the remaining built-in loss associated with the liability, and the partners' capital accounts and bases in their partnership interests are not reduced by that remaining built-in loss. However, if the partnership notifies the Regs.   § 1.752-7 liability partner that the liability has been satisfied, the Regs.   § 1.752-7 liability partner may take a loss or deduction.453
——————————————————————————————

453 Regs. § 1.752-7(e)(3)(i), (f)(1), (g)(2).

——————————————————————————————

X, Y, and Z form a partnership in Year One. X contributes an asset with a fair market value of $5,000,000 and a basis of $4,000,000 subject to a Regs.   § 1.752-7 liability of $2,000,000 in exchange for a 25% partnership interest. In Year Three, when the partnership has a  § 754 election in effect, X sells X's partnership interest to D for $3,000,000. At the time of the sale, the basis of X's partnership interest is $4,000,000, the remaining built-in loss associated with the Regs.   § 1.752-7 liability is $2,000,000, and the partnership has no  § 752 liabilities. X's basis in the interest must be reduced by the Regs.  § 1.752-7 liability reduction(the lesser of (i) the excess of X's basis  over the adjusted value of the interest [$4,000,000 – $3,000,000] and (ii) the remaining built-in loss associated with the Regs.  § 1.752-7 liability [$2,000,000]). Thus, the Regs.   § 1.752-7 liability reduction is $1,000,000 and X's basis is reduced to $3,000,000. X, therefore, realizes no gain or loss on the sale. In Year Four, the partnership satisfies the $3,000,000 Regs.  § 1.752-7 liability. Neither the partnership nor any individual partners may claim a deduction, loss, or capital expense for satisfaction of the liability to the extent of the remaining built-in loss of $2,000,000. The partnership may, however, deduct $1,000,000. In addition, if the partnership notifies X of its satisfaction of the liability, X may take an ordinary deduction of $1,000,000 (the amount of the previous Regs.   § 1.752-7 liability reduction).454

——————————————————————————————

454 See Regs.   § 1.752-7(e)(2) Ex. 1.

——————————————————————————————

For further discussion of the satisfaction of Regs.   § 1.752-7 liabilities, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

A. Distributions Other Than in Liquidation of a Partner's Interest 

Upon a distribution other than in liquidation of a partner's interest by a partnership to a partner,455 the partner's adjusted basis in the partnership interest is decreased by the amount of any money distributed and by the amount of the partner's adjusted basis in property (other than money) distributed to the partner.456 Even if a distributee partner recognizes gain on a distribution of marketable securities under § 731(c), no adjustment to the partner's basis in the partner's interest is made for that gain.457
——————————————————————————————

455 Regs.  § 1.761-1(d) defines “liquidation of a partner's interest” as the “termination of a partner's entire interest in a partnership by means of a distribution, or a series of distributions.” Thus, a distribution other than in liquidation of a partner's entire interest is a nonliquidating or current distribution.

456 § § 733, 705(a)(2). The threshold issue is whether a distribution of money or property by a partnership is a distribution to which  § 731 applies or a transaction to which  § 707 applies. Distributions that are not in settlement or liquidation of a partner's capital account and are not “draws” chargeable to a partner's capital account are not distributions governed by § 731. See, e.g., Grubb v. Comr.,  T.C. Memo 1990-425. Such distributions are either guaranteed payments governed by  § 707(c) or loans governed by § 707(a), depending on the facts and circumstances surrounding each payment.

457 § 731(c)(5).

——————————————————————————————

Generally, a partner's basis in property (other than money) distributed by a partnership to the partner in a nonliquidating distribution is equal to the partnership's adjusted basis in the property immediately preceding the distribution.458 However, a partner's basis in distributed property is limited to the partner's adjusted basis in his partnership interest immediately preceding the distribution decreased by the amount of money distributed in the same transaction.459
——————————————————————————————

458 § 732(a)(1); Regs. § 1.732-1(a). But see § 731(c)(4).

459 § 732(a)(2); Regs. § 1.732-1(a).

——————————————————————————————

Example: On Jan. 1, Year One, partner X has a $30,000 adjusted basis in his partnership interest. During Year One, the partnership distributes to X, in a nonliquidating distribution, $10,000 cash and property with a fair market value of $15,000 and an adjusted basis to the partnership of $12,000. X's adjusted basis in the distributed property is $12,000. X's adjusted basis in his partnership interest subsequent to the distribution is $8,000 ($30,000 minus $22,000 ($10,000 cash distributed + $12,000 adjusted basis in distributed property)).

Example: On Jan. 1, Year One, partner X has a $20,000 adjusted basis in his partnership interest. During Year One, the partnership distributes to X, in a nonliquidating distribution, $10,000 cash and property with a fair market value of $15,000 and an adjusted basis to the partnership of $12,000. X's adjusted basis in the distributed property is limited to $10,000 (X's adjusted basis of $20,000 reduced by the amount of cash distributed ($10,000)). X's adjusted basis in his partnership interest subsequent to the distribution is $0 ($20,000 minus $20,000 ($10,000 cash distributed + $10,000 adjusted basis in distributed property)).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

B. Distributions in Liquidation of a Partner's Interest 

If a partnership distributes property to a partner in liquidation of a partner's entire interest in the partnership, the partner's basis in the distributed property (other than money) is equal to the partner's adjusted basis in the partnership interest immediately preceding the distribution decreased by the amount of money distributed in the same transaction.460
——————————————————————————————

460 § 732(b);Regs. § 1.732-1(b).

——————————————————————————————

Example: On Jan. 1, Year One, partner X has a $30,000 adjusted basis in X's partnership interest. During Year One, the partnership distributes to X, in liquidation of X's entire partnership interest,$10,000 cash, and property with a fair market value of $30,000 and an adjusted basis of $15,000 to the partnership. X's basis in the distributed property is $20,000 ($30,000 adjusted basis in partnership minus $10,000 cash distributed).

Example —  Distribution of Encumbered Property:On Jan. 1, Year One, partner X has a $30,000 adjusted basis in the partnership interest. X's share of partnership liabilities is $20,000. During Year One, the partnership distributes to X, in liquidation of the entire interest, property with an adjusted basis to the partnership of $30,000, subject to a $10,000 liability. The net liability relief is $10,000, which is treated as a constructive cash distribution.461 X's adjusted basis in the partnership interest is reduced by the amount of the constructive cash distribution. Thus, X's adjusted basis in the distributed property is $20,000.462

——————————————————————————————

461 § 752(b). In Rev. Rul. 87-120, 1987-2 C.B. 161, the IRS stated that upon a distribution of encumbered property by a partnership in complete liquidation of a partner's interest, any resulting increases and decreases in the retiring partner's share of partnership liabilities are treated as occurring simultaneously for purposes of determining each partner's gain or loss under § 731.

462 For an example of the relationship among § § 731, 732, and 752, see Rev. Rul. 87-120, 1987-2 C.B. 161.

——————————————————————————————

Because a liquidating distribution is, by definition, a distribution in complete liquidation of a partner's interest, there is no need to determine the distributed partner's adjusted basis in the partnership interest subsequent to the distribution.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

C. Allocation of Basis Among Distributed Properties 

1. Overview and Conceptual Aspects 

As noted above, in a nonliquidating distribution, under § 732(a)(1), property distributed by a partnership generally has a carryover basis in the hands of the distributee partner. However, if the partnership's basis in the distributed assets exceeds the distributee partner's adjusted basis in the distributee's partnership interest, the general carryover rule cannot apply because the partner has insufficient basis to allocate to the distributed properties. This is referred to in this portfolio as a “basis shortfall.” This basis shortfall must be allocated among the distributed properties.

In a liquidating distribution, under  § 732(b) the distributee partner's adjusted basis in the distributed property is equal to the partner's adjusted basis in its partnership interest. If the distributee partner's adjusted basis in the partnership interest is less than the partnership's adjusted basis in the distributed property, the basis shortfall must be allocated. Alternatively, if the distributee partner's adjusted basis in the partnership interest exceeds the partnership's adjusted basis in distributed property, the “excess basis” must be allocated.

Note: In the context of a nonliquidating distribution, there is never “excess basis” to be allocated among distributed property because the distributee partner's adjusted basis in distributed property is limited to the partnership's adjusted basis in the property. If the partner's adjusted basis in the partnership interest exceeds the partnership's adjusted basis in the distributed property, the partner merely retains that excess as basis in the partnership interest.

Example: On Jan. 1, Year One, partner X has a $30,000 adjusted basis in X's partnership interest. During Year One, the partnership distributes to X, in a nonliquidating distribution, property with a fair market value of $15,000 and an adjusted basis to the partnership of $10,000. X's adjusted basis in the distributed property is $10,000. X's additional $20,000 of adjusted basis in X's partnership interest is not allocated to the distributed property. Instead, after the distribution, X's adjusted basis in X's partnership interest is $20,000 ($30,000 minus $20,000 adjusted basis in distributed property).

Section 732(c) and the regulations thereunder take fair market value into account in the allocation of a basis shortfall as well as of any excess basis.463 The distributee partner's basis in the partnership interest is allocated first to any unrealized receivables and inventory in an amount equal to the partnership's basis in such assets,  then to other distributed property to the extent of the partnership's basis in the assets, and, finally,  among the other distributed properties based on their respective amounts of unrealized appreciation (up to the extent of any unrealized appreciation) and any remaining basis to the properties in proportion to their fair market value.464 Any basis shortfall is allocated first to properties with unrealized depreciation in proportion to the respective amounts of unrealized depreciation and any additional shortfall in proportion to the adjusted bases of the properties in the hands of the partnership as previously adjusted.465
——————————————————————————————

463 These rules apply to distributions after Aug. 5, 1997. The regulations under § 732(c), issued in 1999, are effective for distributions of property from a partnership that occur on or after Dec. 15, 1999. Regs. § 1.732-1(c)(5). Before the 1997 Taxpayer Relief Act (“1997 Act”), in either a nonliquidating or liquidating distribution when there was insufficient basis in the partnership interest for a partner to take a carryover basis in all of the distributed assets, the partner's adjusted basis in the partnership interest was allocated first to any distributed unrealized receivables and inventory (“Category One assets”)in an amount equal to the adjusted basis of the property to the partnership, and then to other distributed property (“Category Two assets”)in proportion to their adjusted bases to the partnership. Pre-1997 Act § 732(c). If the distributee partner had insufficient basis in the partnership interest to take a carryover basis in distributed Category One assets, the shortfall was allocated to the Category One assets in proportion to their adjusted bases in the hands of the partnership. In the context of a liquidating distribution when the partner's adjusted basis in the partnership interest exceeded the partnership's adjusted basis in the distributed assets, the partner's adjusted basis in the partnership interest was allocated first to any distributed unrealized receivables and inventory (“Category One assets”) in an amount equal to the adjusted basis of the property to the partnership, and any remaining basis was allocated to the other distributed property in proportion to their adjusted bases to the partnership.  If no assets in the second category were distributed to absorb the excess basis, the excess was recognized as a loss.  In effect, although there were basis shortfalls and excesses, the statute and regulations did not deal with them as such. The  rules failed to take into consideration the gain or loss inherent in distributed property, thus allowing basis shifting transactions in which basis was allocated in ways that created artificially increased depreciation deductions or losses. See S. Rep. No. 33, 105th Cong., 1st Sess. 190 (1997).

464 § 732(c)(1), (2);Regs. § 1.732-1(c)(1), (2)(ii).

465 § 732(c)(3); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Note: By allocating a basis shortfall first in proportion to unrealized depreciation, potential losses with respect to distributed property are decreased. By allocating any excess basis in the context of a liquidating distribution first in proportion to unrealized appreciation, potential losses with respect to distributed property are less likely to be artificially increased.

Observation: These provisions have the effect of generally reducing the potential mismatch between basis and fair market value of the distributed property.  These rules do not, however, ensure that the distributed property will have a fair market value basis in the hands of the distributee partner.  A potential mismatch can occur because the second tier of the basis allocation provision allocates basis decreases according to the partnership's basis in the assets.

As discussed above, there are three major types of transactions to which these basis allocation rules apply: (1) nonliquidating distributions in which there is a basis shortfall; (2) liquidating distributions in which there is a basis shortfall; and (3) liquidating distributions in which there is excess basis.466
——————————————————————————————

466 The post-1997 Act law with respect to each of these types of transactions is discussed in V, C, 2, below. The pre-1997 Act law with respect to each of these types of transactions is discussed in V, C, 3, below. Pre-1997 Act law  remains relevant for partners who received distributions before Aug. 5, 1997, but who engage in a transaction with respect to the distributed property after that date under circumstances requiring determination of the person's adjusted basis in the property.  Even a donee receiving property from a partner can be affected by pre-1997 Act law.

——————————————————————————————

2. Current Law 

a. Nonliquidating Distributions —Basis Shortfall 

If a distributee partner in a nonliquidating distribution does not have sufficient basis in the partnership interest to take a carryover basis in the distributed assets, allocation of the basis shortfall depends upon the amount of the distributee partner's adjusted basis in the partnership interest and the types of assets distributed. Any of four scenarios, each of which is discussed below, may apply.

The decrease is allocated first to distributed property with unrealized depreciation in proportion to each property's respective amount of unrealized depreciation before any decrease (but only to the extent of each property's unrealized depreciation). If the required decrease exceeds the amount of unrealized depreciation in the distributed property, the remaining decrease is allocated to the distributed property in proportion to the previously adjusted bases of the distributed property(i.e., as reduced for unrealized depreciation).467
——————————————————————————————

467 Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

(1) Distribution of Only Category One Assets 

For purposes of the basis allocation rules under § 732(c), Category One assets include “unrealized receivables” and “inventory items.” The term “unrealized receivables” is defined in  § 751(c) and generally includes rights to payments for goods or services to the extent not previously included in income.468 With respect to rights to payments for goods, the rights are considered unrealized receivables only if the proceeds from payment would be treated as amounts received from the sale or exchange of property other than a capital asset.469 The term “inventory items” is defined in  § 751(d) and generally refers to assets that are not capital assets or  § 1231 property.
——————————————————————————————

468 § 751(c). See also Regs. § 1.460-4(k)(2)(iv)(E) (long-term contracts are unrealized receivables within the meaning of § 751(c)). The term unrealized receivables also includes certain other assets to the extent that their disposition would trigger recapture income. § 751(c) (flush language). However, any portion of an asset treated as an unrealized receivable under this provision, has, by definition, an adjusted basis of zero. Thus, no basis is allocated to these assets.

469 § 751(c)(1).

——————————————————————————————

If a partner receives a nonliquidating distribution of only Category One assets and has insufficient basis to take a carryover basis in those assets, the partner's basis is allocated as follows:

Step One: Determine the partnership's aggregate adjusted basis in the distributed Category One assets.

Step Two: Determine the distributee partner's adjusted basis in the distributee's partnership interest (taking into consideration any reduction in basis for cash distributed).

Step Three: Determine the amount of the basis shortfall by subtracting the amount determined in Step Two from the amount determined in Step One. This basis shortfall is referred to in the Code as a “basis decrease” that is allocated among the distributed assets.

Step Four: Determine whether any of the distributed Category One assets have unrealized depreciation (i.e., an adjusted basis in the hands of the partnership in excess of fair market value). If any of the assets have unrealized depreciation, allocate the basis decrease among those assets in proportion to the amount of unrealized depreciation in each asset.470 Do not allocate a basis decrease to any asset in excess of that asset's unrealized depreciation. If the entire basis decrease is allocated under this step, the process is finished. If not, go on to Step Five.
——————————————————————————————

470 § 732(c)(3)(A); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Five: Allocate any remaining basis decrease among all of the distributed Category One assets in proportion to the adjusted bases of the assets in the hands of the partnership, as previously adjusted under Step Four.471 (In other words, any decrease to basis made under Step Four is taken into consideration in Step Five.)
——————————————————————————————

471 § 732(c)(3)(B); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Example — Distribution of Depreciated Category One Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:472

 Asset	Partnership's AB 	Fair Market Value	
Unrealized Receivables	$10,000	$5,000	
Inventory	$25,000	$5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $35,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $30,000.

Step Four: The basis decrease of $30,000 is allocated to the depreciated Category One assets. In this case, both of the distributed Category One assets are depreciated. The decrease is allocated between the two assets in proportion to the amount of unrealized depreciation in each. However, the basis decrease allocated to each cannot exceed the amount of the unrealized depreciation. Thus, a $5,000 decrease is allocated to the unrealized receivables (the amount of unrealized depreciation) and a $20,000 decrease to the inventory (the amount of unrealized depreciation). There is an additional $5,000 decrease to allocate under the next step.

Step Five: The remaining $5,000 decrease is allocated between the two distributed assets in proportion to their adjusted bases, as adjusted under Step Four. The partnership's adjusted basis in the unrealized receivables, as adjusted, is $5,000. The partnership's adjusted basis in the inventory, as adjusted, is $5,000. Thus, $2,500 of the remaining basis decrease is allocated to the unrealized receivables, bringing X's adjusted basis in the distributed receivables to $2,500, and $2,500 of the remaining basis decrease is allocated to the inventory, bringing X's adjusted basis in the distributed inventory to $2,500.

——————————————————————————————

472 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Distribution of Appreciated Category One Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:473

 Asset	Partnership's AB 	Fair Market Value	
Unrealized Receivables 	$0	 $5,000	
Inventory	$5,000	$10,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $2,500.

Step One: The partnership's aggregate adjusted basis in the distributed property is $5,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $2,500.

Step Three: There is a basis shortfall (and, therefore, decrease) of $2,500.

Step Four: The basis decrease of $2,500 is allocated to the depreciated Category One assets. In this case, neither of the distributed Category One assets is depreciated. Thus, none of the decrease is allocated under this step.

Step Five: The $2,500 decrease is allocated between the two distributed assets in proportion to their adjusted basis. The partnership's adjusted basis in the unrealized receivables is$0. The partnership's adjusted basis in the inventory is $5,000. Thus, the entire $2,500 basis decrease is allocated to the distributed inventory, bringing X's adjusted basis in the inventory to $2,500. X's adjusted basis in the distributed unrealized receivables is $0.

——————————————————————————————

473 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example— Distribution of Both Depreciated and Appreciated Category One Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:474

Asset	Partnership's AB 	Fair Market Value	
Unrealized Receivables 	 $5,000	$10,000	
Inventory	$15,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $20,000.

Step Two: The distributee partner's adjusted basis in its partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $15,000.

Step Four: The basis decrease of $15,000 is allocated to the depreciated Category One assets. In this case, only the distributed inventory is depreciated. However, the basis decrease cannot exceed the amount of the unrealized depreciation ($10,000). Thus, a $10,000 decrease is allocated to the inventory (the amount of unrealized depreciation). There is an additional $5,000 decrease to allocate under the next step.

Step Five: The remaining $5,000 decrease is allocated between the two distributed assets in proportion to their adjusted bases, as adjusted under Step Four. The partnership's adjusted basis in the unrealized receivables is $5,000. The partnership's adjusted basis in the inventory, as adjusted, is $5,000. Thus, $2,500 of the remaining basis decrease is allocated to the unrealized receivables, bringing X's adjusted basis in the distributed receivables to $2,500, and $2,500 of the remaining basis decrease is allocated to the inventory, bringing X's adjusted basis in the distributed inventory to $2,500.

——————————————————————————————

474 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

(2) Distribution of Only Category Two Assets 

If a partner receives a nonliquidating distribution of only Category Two assets and has insufficient basis to take a carryover basis in those assets, the partner's basis is allocated as follows:

Step One: Determine the partnership's aggregate adjusted basis in the distributed Category Two assets.

Step Two: Determine the partner's adjusted basis in the partnership interest (taking into consideration any reduction in basis for cash distributed).

Step Three: Determine the amount of the basis shortfall by subtracting the amount determined in Step Two from the amount determined in Step One. This basis shortfall is referred to in the Code as a “basis decrease” that is allocated among the distributed assets.

Step Four: Determine whether any of the distributed Category Two assets have unrealized depreciation (an adjusted basis in the hands of the partnership in excess of fair market value). If any of the assets have unrealized depreciation, allocate the basis decrease among those assets in proportion to the amount of unrealized depreciation in each asset.475 Do not allocate a basis decrease to any asset in excess of that asset's unrealized depreciation. If the entire basis decrease is allocated under this step, the process is finished. If not, go on to Step Five.
——————————————————————————————

475 § 732(c)(3)(A); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Five: Allocate any remaining basis decrease among all of the distributed Category Two assets in proportion to adjusted bases of the assets in the hands of the partnership, as previously adjusted under Step Four.476 (In other words, any decrease to basis made under Step Four is taken into consideration in Step Five.)
——————————————————————————————

476 § 732(c)(3)(B); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Example — Distribution of Depreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:477

Asset	Partnership's AB 	Fair Market Value	
Capital Asset I	$10,000	$5,000	
Capital Asset II	$25,000	$5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $35,000.

Step Two: The distributee partner's adjusted basis in its partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $30,000.

Step Four: The basis decrease of $30,000 is allocated to the depreciated Category Two assets. In this case, both of the distributed Category Two assets are depreciated. The decrease is allocated between the two assets in proportion to the amount of unrealized depreciation in each. However, the basis decrease allocated to each cannot exceed the amount of the unrealized depreciation. Thus, a $5,000 decrease is allocated to Capital Asset I (the amount of unrealized depreciation in Capital Asset I) and a $20,000 decrease  to Capital Asset II (the amount of unrealized depreciation in Capital Asset II). There is an additional $5,000 decrease to allocate under the next step.

Step Five: The remaining $5,000 decrease is allocated between the two distributed assets in proportion to their adjusted bases, as adjusted as under Step Four. The partnership's adjusted basis in Capital Asset I, as adjusted, is $5,000. The partnership's adjusted basis in Capital Asset II, as adjusted, is $5,000. Thus,$2,500 of the remaining basis decrease is allocated to Capital Asset I, bringing X's adjusted basis in Capital Asset I to $2,500, and $2,500 of the remaining basis decrease is allocated to the Capital Asset II, bringing X's adjusted basis in Capital Asset II to $2,500.

——————————————————————————————

477 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Distribution of Appreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:478

Asset	Partnership's AB	Fair Market Value	
Capital Asset I	$5,000	$10,000	
Capital Asset II	$5,000	$10,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $10,000.

Step Two: The distributee partner's adjusted basis in its partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $5,000.

Step Four: The basis decrease of $5,000 is allocated to the depreciated Category Two assets. In this case, neither of the distributed Category Two assets is depreciated. Thus, none of the decrease is allocated under this step.

Step Five: The $5,000 decrease is allocated between the two distributed assets in proportion to their adjusted bases. The partnership's adjusted basis in Capital Asset I is $5,000. The partnership's adjusted basis in Capital Asset II is $5,000. Thus, one-half of the $5,000 basis decrease is allocated to Capital Asset I and one-half of the $5,000 basis decrease is allocated to Capital Asset II, bringing X's adjusted basis in capital asset I to $2,500 and X's adjusted basis in Capital Asset II to $2,500.

——————————————————————————————

478 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Distribution of Both Depreciated and Appreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:479

 Asset	Partnership's AB 	Fair Market Value	
Capital Asset I	 $5,000	$10,000	
Capital Asset II	$15,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $20,000.

Step Two: The distributee partner's adjusted basis in its partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $15,000.

Step Four: The basis decrease of $15,000 is allocated to the depreciated Category Two assets. In this case, only Capital Asset II is depreciated. However, the basis decrease cannot exceed the amount of the unrealized depreciation ($10,000). Thus, a $10,000 decrease is allocated to Capital Asset II (the amount of unrealized depreciation in Capital Asset II). There is an additional $5,000 decrease to allocate under the next step.

Step Five: The remaining $5,000 decrease is allocated between the two distributed assets in proportion to their adjusted bases, as adjusted as under Step Four. The partnership's adjusted basis in Capital Asset I is $5,000. The partnership's adjusted basis in Capital Asset II, as adjusted, is $5,000. Thus, $2,500 of the remaining basis decrease is allocated to Capital Asset I, bringing X's adjusted basis in Capital Asset I to $2,500, and $2,500 of the remaining basis decrease is allocated to Capital Asset II, bringing X's adjusted basis in Capital Asset II to $2,500.

——————————————————————————————

479 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

(3) Distribution of Both Types of Assets — Partnership's Basis in Distributed Category One Assets Exceeds Partner's Basis in Partnership Interest 

If a partner receives a nonliquidating distribution of both Category One assets and Category Two assets and has insufficient basis to take a carryover basis in the Category One assets, the partner's basis is allocated as follows:

Step One: Determine the partnership's aggregate adjusted basis in the distributed assets.

Step Two: Determine the partner's adjusted basis in the partnership interest (taking into consideration any reduction in basis for cash distributed).

Step Three: Determine the amount of the basis shortfall by subtracting the amount determined in Step Two from the amount determined in Step One. This basis shortfall is referred to in the Code as a “basis decrease” that is allocated among the distributed assets.

Step Four: Determine whether any of the distributed Category One assets have unrealized depreciation (an adjusted basis in the hands of the partnership in excess of fair market value). If any of the assets have unrealized depreciation, allocate the basis decrease among those assets in proportion to the amount of unrealized depreciation in each asset.480 Do not allocate a basis decrease to any asset in excess of that asset's unrealized depreciation. If the entire basis decrease is allocated under this step, the process is finished. If not, go on to Step Five.
——————————————————————————————

480 § 732(c)(3)(A); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Five: Allocate the basis decrease among all of the distributed Category One assets in proportion to the adjusted basis of each asset in the hands of the partnership, as previously adjusted under Step Four.481 (In other words, any decrease to basis made under Step Four is taken into consideration in Step Five.) If, after allocating the basis decrease under this step, there is no remaining basis decrease, the process is finished. If not, go to Step Six.
——————————————————————————————

481 § 732(c)(3)(B); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Six: Determine whether any of the distributed Category Two assets have unrealized depreciation (an adjusted basis in the hands of the partnership in excess of fair market value). If any of the assets have unrealized depreciation, allocate the basis decrease among those assets in proportion to the amount of unrealized depreciation in each asset.482 Do not allocate a basis decrease to any asset in excess of that asset's unrealized depreciation. If the entire remaining basis decrease is allocated under this step, the process is finished. If not, go on to Step Seven.
——————————————————————————————

482 § 732(c)(3)(A); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Seven: Allocate the remaining basis decrease among all of the distributed Category Two assets in proportion to the adjusted bases of the assets in the hands of the partnership, as previously adjusted under Step Six.483 (In other words, any decrease to basis made under Step Six is taken into consideration in Step Seven.)
——————————————————————————————

483 § 732(c)(3)(B); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Example — Depreciated Category One and Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:484

Asset	Partnership's AB 	Fair Market Value	
Unrealized Receivables	$10,000	 $5,000	
Inventory	$15,000	 $5,000	
Capital Asset I	$25,000	$20,000	
Capital Asset II	$10,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $10,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $60,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $10,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $50,000.

Step Four: The basis decrease is first allocated to the distributed Category One assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, both of the distributed Category One assets are depreciated. Thus, $5,000 of the basis decrease is allocated to the distributed unrealized receivables and $10,000 of the basis decrease is allocated to the distributed inventory under this step. The remaining $35,000 basis decrease is allocated next under Step Five.

Step Five: The remaining basis decrease is allocated next to the distributed Category One assets in proportion to their adjusted bases, as adjusted under Step Four. The partnership's adjusted basis in the distributed unrealized receivables, as adjusted under Step Four, is $5,000. The partnership's adjusted basis in the distributed inventory, as adjusted under Step Four, is also $5,000. The basis decrease cannot bring the adjusted basis of the assets below zero. Thus, $5,000 of the basis decrease is allocated to the distributed unrealized receivables (the amount of unrealized depreciation) and$5,000 of the basis decrease to the distributed inventory (the amount of unrealized depreciation), bringing X's adjusted basis in both of these assets to $0. There is an additional $25,000 basis decrease still to be allocated between the distributed Category Two assets.

Step Six: The remaining basis decrease is first allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, both of the distributed Category Two assets are depreciated. Thus, $5,000 of the basis decrease is allocated to Capital Asset I (the amount of unrealized depreciation in Capital Asset I) and $5,000 of the basis decrease is allocated to Capital Asset II (the amount of unrealized depreciation in Capital Asset II) under this step. The remaining $15,000 basis decrease is allocated under Step Seven.

Step Seven: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases, as adjusted under Step Six. The partnership's adjusted basis in Capital Asset I, as adjusted under Step Six, is $20,000. The partnership's adjusted basis in Capital Asset II, as adjusted under Step Four, is $5,000. Thus, $12,000 of the basis decrease is allocated to Capital Asset I ($15,000 basis decrease x $20,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets), and $3,000 of the basis decrease is allocated to Capital Asset II ($15,000 basis decrease x $5,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two Assets), bringing X's adjusted basis in Capital Asset I to $8,000 and X's adjusted basis in Capital Asset II to $2,000.

——————————————————————————————

484 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Appreciated Category One and Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:485

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	$10,000	
Inventory	$15,000	$30,000	
Capital Asset I	$10,000	$20,000	
Capital Asset II	$15,000	$25,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $40,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $5,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $35,000.

Step Four: The basis decrease is first allocated to the distributed Category One assets, in proportion to any unrealized depreciation. In this case, there are no distributed Category One assets with unrealized depreciation.

Step Five: The basis decrease is allocated next to the distributed Category One assets in proportion to their adjusted bases. The partnership's adjusted basis in the distributed unrealized receivables is $0. The partnership's adjusted basis in the distributed inventory is $15,000. The basis decrease cannot bring the adjusted basis of the assets below zero. Thus, $15,000 of the basis decrease is allocated to the distributed inventory, bringing X's adjusted basis in the inventory to $0. There is an additional $20,000 basis decrease still to be allocated between the distributed Category Two assets.

Step Six: The remaining basis decrease is first allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. In this case, neither of the distributed Category Two assets is depreciated.

Step Seven: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases. The partnership's adjusted basis in Capital Asset I is $10,000. The partnership's adjusted basis in Capital Asset II is $15,000. Thus, $8,000 of the basis decrease is allocated to Capital Asset I ($20,000 basis decrease x $10,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets) and $12,000 of the basis decrease is allocated to Capital Asset II ($20,000 basis decrease x $15,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $2,000 and X's adjusted basis in Capital Asset II to $3,000.

——————————————————————————————

485 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Depreciated Category One and Appreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:486

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$10,000	$5,000	
Inventory	$15,000	$10,000	
Capital Asset I	$15,000	$20,000	
Capital Asset II	$10,000	$25,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $20,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $50,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $20,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $30,000.

Step Four: The basis decrease is first allocated to the distributed Category One assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, both of the distributed Category One assets are depreciated. Thus, $5,000 of the basis decrease to the distributed unrealized receivables (the amount of unrealized depreciation) and $5,000 of the basis decrease to the distributed inventory (the amount of unrealized depreciation) under this step. The remaining $20,000 basis decrease is allocated next under Step Five.

Step Five: The remaining basis decrease is allocated next to the distributed Category One assets in proportion to their adjusted bases, as adjusted under Step Four. The partnership's adjusted basis in the distributed unrealized receivables, as adjusted under Step Four, is $5,000. The partnership's adjusted basis in the distributed inventory, as adjusted under Step Four, is also $10,000. The basis decrease cannot bring the adjusted basis of the assets below zero. Thus, $5,000 of the basis decrease is allocated to the distributed unrealized receivables and $10,000 of the basis decrease is allocated to the distributed inventory, bringing X's adjusted basis in both of these assets to $0. There is an additional $5,000 basis decrease still to be allocated between the distributed Category Two assets.

Step Six: The remaining basis decrease is first allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, neither of the distributed Category Two assets is depreciated.

Step Seven: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases. The partnership's adjusted basis in Capital Asset I is $15,000. The partnership's adjusted basis in Capital Asset II is $10,000. Thus, $3,000 of the basis decrease is allocated to Capital Asset I ($5,000 basis decrease x $15,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets)and $2,000 of the basis decrease to Capital Asset II ($5,000 basis decrease x $10,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two Assets), bringing X's adjusted basis in Capital Asset I to $12,000 and X's adjusted basis in Capital Asset II to $8,000.

——————————————————————————————

486 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Appreciated Category One and Depreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:487

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$15,000	$30,000	
Capital Asset I	$25,000	$20,000	
Capital Asset II	$10,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $10,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $50,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $10,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $40,000.

Step Four: The basis decrease is first allocated to the distributed Category One assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, neither of the distributed Category One assets is depreciated.

Step Five: The basis decrease is allocated next to the distributed Category One assets in proportion to their adjusted bases. The partnership's adjusted basis in the distributed unrealized receivables is $0. The partnership's adjusted basis in the distributed inventory is $15,000. The basis decrease cannot bring the adjusted basis of the assets below zero. Thus, $15,000 of the basis decrease is allocated to the distributed inventory, bringing X's adjusted basis in both of these assets to $0. There is an additional $25,000 basis decrease still to be allocated between the distributed Category Two assets.

Step Six: The remaining basis decrease is first allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, both of the distributed Category Two assets are depreciated. Thus, $5,000 of the basis decrease is allocated to Capital Asset I (the amount of unrealized depreciation in Capital Asset I) and $5,000 of the basis decrease  to Capital Asset II (the amount of unrealized depreciation in Capital Asset II) under this step. The remaining $15,000 basis decrease is allocated under Step Seven.

Step Seven: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases, as adjusted under Step Six. The partnership's adjusted basis in Capital Asset I, as adjusted under Step Six, is $20,000. The partnership's adjusted basis in Capital Asset II, as adjusted under Step Six, is $5,000. Thus, $12,000 of the basis decrease is allocated to Capital Asset I ($15,000 basis decrease x $20,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets) and $3,000 of the basis decrease to Capital Asset II ($15,000 basis decrease x $5,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $8,000 and X's adjusted basis in Capital Asset II to $2,000.

——————————————————————————————

487 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Mix of Category One and Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:488

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$15,000	 $5,000	
Capital Asset I	 $5,000	$20,000	
Capital Asset II	$10,000	 $7,500	

X's adjusted basis in X's partnership interest at the time of the distribution is $10,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $30,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $10,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $20,000.

Step Four: The basis decrease is first allocated to the distributed Category One assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, only the distributed inventory is depreciated. Thus, $10,000 of the basis decrease is allocated to the distributed inventory. The remaining $10,000 basis decrease is allocated next under Step Five.

Step Five: The remaining basis decrease is allocated next to the distributed Category One assets in proportion to their adjusted bases, as adjusted under Step Four. The partnership's adjusted basis in the distributed unrealized receivables is $0. The partnership's adjusted basis in the distributed inventory, as adjusted under Step Four, is $5,000. The basis decrease cannot bring the adjusted basis of the assets below zero. Thus, $5,000 of the basis decrease is allocated to the distributed inventory, bringing X's adjusted basis in both of these assets to $0. There is an additional $5,000 basis decrease still to be allocated between the distributed Category Two assets.

Step Six: The remaining basis decrease is first allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, only Capital Asset II is depreciated. Thus, $2,500 of the basis decrease is allocated to Capital Asset II (the amount of unrealized depreciation in Capital Asset II)under this step. The remaining $2,500 basis decrease is allocated under Step Seven.

Step Seven: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases, as adjusted under Step Six. The partnership's adjusted basis in Capital Asset I is $5,000. The partnership's adjusted basis in Capital Asset II, as adjusted under Step Six, is $7,500. Thus,$1,000 of the basis decrease is allocated to Capital Asset I ($2,500 basis decrease x $5,000 adjusted basis of Capital Asset I/$12,500 total adjusted bases of distributed Category Two assets) and $1,500 of the basis decrease to Capital Asset II ($2,500 basis decrease x$7,500 adjusted basis of Capital Asset I/$12,500 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $4,000 and X's adjusted basis in Capital Asset II to $6,000.

——————————————————————————————

488 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

(4) Distribution of Both Types of Assets — Partner's Basis in Partnership Interest Exceeds Partnership's Basis in Distributed Category One Assets 

If a partner receives a nonliquidating distribution of both Category One assets and Category Two assets and has sufficient basis to take a carryover basis in the Category One assets but insufficient basis to take a carryover basis in the Category Two assets, the partner's basis is allocated as follows:

Step One: Determine the partnership's aggregate adjusted basis in the distributed assets.

Step Two: Determine the partner's adjusted basis in the partnership interest (taking into consideration any reduction in basis for cash distributed).

Step Three: Determine the amount of the basis shortfall by subtracting the amount determined in Step Two from the amount determined in Step One. This basis shortfall is referred to in the Code as a “basis decrease” that is allocated among the distributed assets.

Step Four:  Allocate basis to the distributed Category One assets in an amount equal to the basis of those assets in the hands of the partnership. (i.e., give the distributee partner a carryover basis in those assets).

Step Five: Determine whether any of the distributed Category Two assets have unrealized depreciation (an adjusted basis in the hands of the partnership in excess of fair market value). If any of the assets have unrealized depreciation, allocate the basis decrease among such assets in proportion to the amount of unrealized depreciation in each asset.489 Do not allocate a basis decrease to any asset in excess of that asset's unrealized depreciation. If the entire remaining basis decrease is allocated under this step, the process is finished. If not, go on to Step Six.
——————————————————————————————

489 § 732(c)(3)(A); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Step Six:  Allocate the remaining basis decrease among all of the distributed Category Two assets in proportion to the adjusted bases of the assets in the hands of the partnership, as previously adjusted under Step Five.490 (In other words, any decrease to basis made under Step Five is taken into consideration in Step Six.)
——————————————————————————————

490 § 732(c)(3)(B); Regs. § 1.732-1(c)(2)(i).

——————————————————————————————

Example — Category One Assets and Depreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:491

 Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$10,000	$10,000	
Capital Asset I	$25,000	$20,000	
Capital Asset II	$10,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $15,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $45,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $15,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $30,000.

Step Four: The distributee partner has sufficient basis to take a carryover basis in the distributed Category One assets. Thus, X's adjusted basis in the distributed receivables is $0 and X's adjusted basis in the distributed inventory is $10,000.

Step Five: The $30,000 basis decrease is allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. However, the basis decrease cannot exceed the amount of unrealized depreciation. In this case, both of the distributed Category Two assets are depreciated. Thus, $5,000 of the basis decrease is allocated to Capital Asset I (the amount of unrealized depreciation in Capital Asset I) and $5,000 of the basis decrease to Capital Asset II (the amount of unrealized depreciation in Capital Asset II) under this step. The remaining $20,000 basis decrease is allocated under Step Six.

Step Six: The remaining basis decrease is allocated next to the distributed Category Two assets in proportion to their adjusted bases, as adjusted under Step Five. The partnership's adjusted basis in Capital Asset I, as adjusted under Step Five, is $20,000. The partnership's adjusted basis in Capital Asset II, as adjusted under Step Five, is $5,000. Thus, $16,000 of the basis decrease is allocated to Capital Asset I ($20,000 basis decrease x $20,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets) and $4,000 of the basis decrease is allocated to Capital Asset II ($20,000 basis decrease x $5,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $4,000 and X's adjusted basis in Capital Asset II to $1,000.

——————————————————————————————

491 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Category One Assets and Appreciated Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:492

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$10,000	$10,000	
Capital Asset I	$25,000	$50,000	
Capital Asset II	 $5,000	$25,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $22,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $40,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $22,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $18,000.

Step Four: The distributee partner has sufficient basis to take a carryover basis in the distributed Category One assets. Thus, X's adjusted basis in the distributed receivables is $0 and X's adjusted basis in the distributed inventory is $10,000.

Step Five: The $18,000 basis decrease is allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. In this case, neither of the distributed Category Two assets is depreciated.

Step Six: The $18,000 basis decrease is allocated entirely to the distributed Category Two assets in proportion to their adjusted bases. The partnership's adjusted basis in Capital Asset I is $25,000. The partnership's adjusted basis in Capital Asset II is $5,000. Thus, $15,000 of the basis decrease is allocated to Capital Asset I ($18,000 basis decrease x $25,000 adjusted basis of Capital Asset I/$30,000 total adjusted bases of distributed Category Two Assets) and $3,000 of the basis decrease to Capital Asset II ($18,000 basis decrease x $5,000 adjusted basis of Capital Asset I/$30,000 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $10,000 and X's adjusted basis in Capital Asset II to $2,000.

——————————————————————————————

492 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Category One Assets and Mix of Category Two Assets: On Jan. 1, XYZ Partnership makes a nonliquidating distribution of the following assets to X:493

Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$10,000	$10,000	
Capital Asset I	$25,000	$20,000	
Capital Asset II	 $5,000	$25,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $20,000.

Step One: The partnership's aggregate adjusted basis in the distributed property is $40,000.

Step Two: The distributee partner's adjusted basis in the partnership interest is $20,000.

Step Three: There is a basis shortfall (and, therefore, decrease) of $20,000.

Step Four: The distributee partner has sufficient basis to take a carryover basis in the distributed Category One assets. Thus, X's adjusted basis in the distributed receivables is $0 and X's adjusted basis in the distributed inventory is $10,000.

Step Five: The $20,000 basis decrease is allocated to the distributed Category Two assets, in proportion to any unrealized depreciation. In this case, only Capital Asset I is depreciated. Therefore,$5,000 of the basis decrease is allocated to Capital Asset I (the amount of unrealized depreciation in Capital Asset I), bringing X's adjusted basis in this asset to $20,000, under this step.

Step Six: The remaining $15,000 basis decrease is allocated to the distributed Category Two assets in proportion to their adjusted bases, as adjusted under Step Five. The partnership's adjusted basis in Capital Asset I, as adjusted under Step Five, is$20,000. The partnership's adjusted basis in Capital Asset II is $5,000. Thus, $12,000 of the basis decrease is allocated to Capital Asset I ($15,000 basis decrease x $20,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two Assets)and $3,000 of the basis decrease to Capital Asset II ($15,000 basis decrease x $5,000 adjusted basis of Capital Asset I/$25,000 total adjusted bases of distributed Category Two assets), bringing X's adjusted basis in Capital Asset I to $8,000 and X's adjusted basis in Capital Asset II to $2,000.

——————————————————————————————

493 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

b. Liquidating Distributions —Basis Shortfall 

If a distributee partner in a liquidating distribution does not have sufficient basis in the distributee's partnership interest to take a carryover basis in the distributed assets, allocation of the basis shortfall depends upon the amount of the distributee partner's adjusted basis in the partnership interest and the types of assets distributed. Any of four situations may occur; each situation, is discussed above. The analysis of each situation in a liquidating distribution is similar to the analysis in a nonliquidating distribution. It is important to note, however, that in liquidating distributions,  § 751(b) may apply to treat a portion of the transfer of property from the partnership as an exchange and the remainder as a distribution. The portion treated as a distribution is subject to the allocation rules as applied in the examples in the preceding section. In addition,  § 706(d) 494 or § 736(a)495 may apply to a liquidating distribution.
——————————————————————————————

494 Section 706(d) is discussed in detail in 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts.

495 Section 736(a) is discussed in detail in 716 T.M., Partnerships —Current and Liquidating Distributions; Death or Retirement of a Partner.

——————————————————————————————

Note: Thus, for the preceding examples to be correct in a liquidating distribution, an additional factual assumption must be made, namely, that  § 736(a) does not apply to the unrealized receivables (or to any capital asset that is goodwill) because the partner is a limited partner or capital is a material income-producing factor for the partnership.

c. Liquidating Distributions —Excess Basis 

If a distributee partner in a liquidating distribution has an adjusted basis in the distributee's interest in excess of the partnership's adjusted basis in the distributed assets, the excess basis must be allocated among the distributed assets. Allocation of the excess, referred to in the Code as a “basis increase,” depends upon the amount of the distributee partner's adjusted basis in the partnership interest and the types of assets distributed.

An increase is allocated first to distributed property (other than unrealized receivables and inventory items) with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase (but only to the extent of each property's unrealized appreciation).496 If the required increase exceeds the amount of unrealized appreciation in the distributed property, the excess is allocated to the distributed property (other than unrealized receivables or inventory items) in proportion to the fair market values of the distributed properties.497
——————————————————————————————

496 § 732(c)(2)(A); Regs. § 1.732-1(c)(2)(ii).

497 § 732(c)(2)(B); Regs. § 1.732-1(c)(2)(ii).

——————————————————————————————

If the basis to be allocated upon a distribution in liquidation of the partner's entire interest in the partnership is greater than the adjusted basis to the partnership of the unrealized receivables and inventory items distributed to the partner, and if there is no other property distributed to which the excess can be allocated, the distributee partner sustains a capital loss under  § 731(a)(2) to the extent of the unallocated basis of the partnership interest.498
——————————————————————————————

498 Regs. § 1.732-1(c)(3).

——————————————————————————————

(1) Distribution of Only Category One Assets 

If a distributee partner in a liquidating distribution has an adjusted basis in its partnership interest that exceeds the partnership's adjusted basis in the distributed property and the distributed property consists only of Category One assets, the distributee partner takes a carryover basis in the distributed assets and recognizes a capital loss to the extent of the excess basis.

Example — On Jan. 1, XYZ Partnership distributes inventory with a fair market value of $100,000 and an adjusted basis of $10,000 to X in complete liquidation of X's partnership interest. At the time of the distribution, X's adjusted basis in X's partnership interest is $40,000. Assume no application of § 706(d), and assume that either  § 751(b) does not apply or it has already been applied and the $100,000 inventory represents the portion of the transfer treated as a distribution. Assume also that goodwill is provided for in the partnership agreement. X takes a carryover basis of $10,000 in the inventory. The $30,000 excess of X's basis in X's partnership interest over X's adjusted basis in the distributed inventory is recognized by X as a capital loss.

(2) Distribution of Only Category Two Assets 

If a distributee partner in a liquidating distribution has an adjusted basis in the partnership interest that exceeds the partnership's adjusted basis in the distributed property and the distributed property consists only of Category Two assets, the distributee partner's basis is allocated among the distributed assets as follows:

Step One:  Determine the distributee partner's adjusted basis in the partnership interest on the date of the distribution(taking into consideration any reduction in basis for cash distributed).

Step Two: Determine the partnership's aggregate adjusted basis in the distributed Category Two assets.

Step Three: Determine the amount of the basis excess by subtracting the amount determined in Step Two from the amount determined in Step One. This basis excess is referred to in the Code as a “basis increase” that is allocated among the distributed assets.

Step Four: Allocate the basis increase first to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. Do not increase any asset's basis by an amount that exceeds the unrealized appreciation in that asset.499 If the entire basis increase is allocated under this step, the process is finished. If there is additional basis increase to be allocated, go to Step Five.
——————————————————————————————

499 § 732(c)(2)(A); Regs. § 1.732-1(c)(2)(ii).

——————————————————————————————

Step Five: Allocate the remaining basis increase to the distributed Category Two property in proportion to the fair market values of the distributed properties.500
——————————————————————————————

500 § 732(c)(2)(B); Regs. § 1.732-1(c)(2)(ii).

——————————————————————————————

Example — Distribution of Appreciated Category Two Assets: On Jan. 1, XYZ Partnership distributes the following assets to X in complete liquidation of X's partnership interest:

 Asset	Partnership's AB in Asset	Fair Market Value	
Capital Asset I	$10,000	$20,000	
Capital Asset II	 $5,000	$25,000	

Assume no application of  § 706(d) and assume that either  § 751(b) does not apply or, if it has already been applied, these assets represent the portion of the transfer treated as a distribution. Assume also that goodwill is provided for in the partnership agreement. X's adjusted basis in X's partnership interest at the time of the distribution is $36,000.

Step One: The distributee partner's adjusted basis in the partnership interest on the date of the distribution is $36,000.

Step Two: The partnership's aggregate adjusted basis in the distributed Category Two assets is $15,000.

Step Three: The amount of the basis excess, or basis increase, is $21,000.

Step Four: The basis increase is first allocated to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. In this case, both of the distributed Category Two assets are appreciated. Thus, $7,000 of the basis increase ($21,000 x$10,000 unrealized appreciation in Capital Asset I/$30,000 total unrealized appreciation in distributed Category Two assets) is allocated to Capital Asset I and $14,000 of the basis increase ($21,000 x $20,000 unrealized appreciation in Capital Asset II/$30,000 total unrealized appreciation in distributed Category Two assets) is allocated to Capital Asset II, bringing X's adjusted basis in Capital Asset I to $17,000 and X's adjusted basis in Capital Asset II to $19,000.

Step Five: There is no additional basis increase to allocate under Step Five.

Example — Distribution of Depreciated Category Two Assets: On Jan. 1, XYZ Partnership distributes the following assets to X in complete liquidation of X's partnership interest:

 Asset	Partnership's AB in Asset	Fair Market Value	
Capital Asset I	$20,000	$10,000	
Capital Asset II	$10,000	 $5,000	

Assume no application of  § 706(d) and assume that either  § 751(b) does not apply or, if it has already been applied, these assets represent the portion of the transfer treated as a distribution. Assume also that goodwill is provided for in the partnership agreement. X's adjusted basis in X's partnership interest at the time of the distribution is $36,000.

Step One: The distributee partner's adjusted basis in the partnership interest on the date of the distribution is $36,000.

Step Two: The partnership's aggregate adjusted basis in the distributed Category Two assets is $30,000.

Step Three: The amount of the basis excess, or basis increase, is $6,000.

Step Four: The basis increase is first allocated to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. In this case, neither of the distributed Category Two assets is appreciated.

Step Five: The entire $6,000 basis increase is allocated to the distributed Category Two properties in proportion to their fair market values. The fair market value of Capital Asset I is $10,000. The fair market value of Capital Asset II is $5,000. Thus, $4,000 of the basis increase ($6,000 x $10,000 fair market value of Capital Asset I/$15,000 total fair market value of Category Two assets)is allocated to Capital Asset I and $2,000 of the basis increase ($6,000 x$5,000 fair market value of Capital Asset II/$15,000 total fair market value of Category Two assets) is allocated to Capital Asset II, bringing X's adjusted basis in Capital Asset I to $24,000 and X's adjusted basis in Capital Asset II to $12,000.

Example — Distribution of Depreciated and Appreciated Category Two Assets: On Jan. 1, XYZ Partnership distributes the following assets to X in complete liquidation of X's partnership interest:

 Asset	Partnership's AB in Asset	Fair Market Value	
Capital Asset I	$20,000	 $5,000	
Capital Asset II	 $5,000	$20,000	

Assume no application of  § 706(d) and assume that either  § 751(b) does not apply or,  if it has already been applied, these assets represent the portion of the transfer treated as a distribution. Assume also that goodwill is provided for in the partnership agreement. X's adjusted basis in X's partnership interest at the time of the distribution is $45,000.

Step One: The distributee partner's adjusted basis in the partnership interest on the date of the distribution is $45,000.

Step Two: The partnership's aggregate adjusted basis in the distributed Category Two assets is $25,000.

Step Three: The amount of the basis excess, or basis increase, is $20,000.

Step Four: The basis increase is first allocated to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. In this case, only Capital Asset II is appreciated. Thus, $15,000 of the basis increase is allocated to Capital Asset II (the amount of unrealized appreciation), bringing X's adjusted basis in Capital Asset II to $20,000. The remaining $5,000 basis increase is allocated under Step Five.

Step Five: The remaining $5,000 basis increase is allocated to the distributed Category Two properties in proportion to their fair market values. The fair market value of Capital Asset I is $5,000. The fair market value of Capital Asset II is $20,000. Thus, $1,000 of the basis increase ($5,000 x $5,000 fair market value of Capital Asset I/$25,000 total fair market value of Category Two assets) is allocated to Capital Asset I and $4,000 of the basis increase ($5,000 x $20,000 fair market value of Capital Asset II/$25,000 total fair market value of Category Two assets) to Capital Asset II, bringing X's adjusted basis in Capital Asset I to $21,000($20,000 partnership basis plus $1,000 basis increase under Step Five)and X's adjusted basis in Capital Asset II to $24,000 ($5,000 partnership basis plus $15,000 basis increase under Step Four plus $4,000 basis increase under Step Five).

(3) Distribution of Both Types of Assets 

If a distributee partner in a liquidating distribution has an adjusted basis in the distributee's partnership interest that exceeds the partnership's adjusted basis in the distributed property and the distributed property consists of both Category One assets and Category Two assets, the distributee partner's basis is allocated among the distributed assets as follows:

Step One: Determine the distributee partner's adjusted basis in the partnership interest on the date of the distribution(taking into consideration any reduction in basis for cash distributed).

Step Two: Determine the partnership's aggregate adjusted basis in the distributed assets.

Step Three: Determine the amount of the basis excess by subtracting the amount determined in Step Two from the amount determined in Step One. This basis excess is referred to in the Code as a “basis increase” that is allocated among the distributed assets.

Step Four: Give the distributee partner a carryover basis in the distributed Category One assets.501
——————————————————————————————

501 § 732(c)(1)(A).

——————————————————————————————

Step Five: Allocate the basis increase first to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. Do not increase any asset's basis by an amount that exceeds the unrealized appreciation in that asset.502 If the entire basis increase is allocated under this step, the process is finished. If there is additional basis increase to be allocated, go to Step Six.
——————————————————————————————

502 § 732(c)(2)(A); Regs. § 1.732-1(c)(2)(ii).

——————————————————————————————

Step Six: Allocate the remaining basis increase to the distributed Category Two properties in proportion to the fair market values of the distributed properties.503
——————————————————————————————

503 § 732(c)(2)(B); Regs. § 1.732-1(c)(2)(ii).

——————————————————————————————

Example — On Jan. 1, XYZ Partnership distributes the following assets to X in complete liquidation of X's partnership interest:

 Asset	Partnership's AB in Asset	Fair Market Value	
Inventory	$10,000	$25,000	
Capital Asset I	$20,000	 $5,000	
Capital Asset II	 $5,000	$20,000	

Assume no application of  § 706(d) and assume that either  § 751(b) does not apply or, if it has already been applied, these assets represent the portion of the transfer treated as a distribution. X's adjusted basis in X's partnership interest at the time of the distribution is $65,000.

Step One: The distributee partner's adjusted basis in the partnership interest on the date of the distribution is $65,000.

Step Two: The partnership's aggregate adjusted basis in the distributed Category Two assets is $35,000.

Step Three: The amount of the basis excess, or basis increase, is $30,000.

Step Four: X takes a carryover basis in the distributed inventory. Thus, X's basis in the inventory is $10,000.

Step Five: The basis increase is first allocated to distributed Category Two assets with unrealized appreciation in proportion to the properties' respective amounts of unrealized appreciation before any increase. In this case, only Capital Asset II is appreciated. Thus, $15,000 of the basis increase is allocated to Capital Asset II (the amount of unrealized appreciation), bringing X's adjusted basis in Capital Asset II to $20,000. The remaining $15,000 basis increase is allocated under Step Five.

Step Six: The remaining $15,000 basis increase is allocated to the distributed Category Two properties in proportion to their fair market values. The fair market value of Capital Asset I is $5,000. The fair market value of Capital Asset II is $20,000. Thus, $3,000 of the basis increase ($15,000 x $5,000 fair market value of Capital Asset I/$25,000 total fair market value of Category Two assets) is allocated to Capital Asset I and $12,000 of the basis increase ($15,000 x $20,000 fair market value of Capital Asset II/$25,000 total fair market value of Category Two assets) to Capital Asset II, bringing X's adjusted basis in Capital Asset I to $23,000($20,000 partnership basis plus $3,000 basis increase under Step Five)and X's adjusted basis in Capital Asset II to $32,000 ($5,000 partnership basis plus $15,000 basis increase under Step Four plus $12,000 basis increase under Step Five).

3. Distributions Before August 5, 1997 

The following examples, reflecting the same fact patterns as the examples above under current law, illustrate not only the different approach but also the different results under the rules in effect before August 5, 1997.

Example — Nonliquidating Distribution of Depreciated Category One Assets with Basis Shortfall: On Jan. 1, 1995, XYZ Partnership makes a nonliquidating distribution of the following assets to X:504

 Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$10,000	$5,000	
Inventory	$25,000	$5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000. X's $5,000 basis is allocated between the two Category One assets in proportion to their adjusted bases in the hands of the partnership. Thus, X's adjusted basis in the unrealized receivables is $1,429 ($5,000 x $10,000 partnership adjusted basis in unrealized receivables/$35,000 partnership's aggregate adjusted basis in distributed Category One assets) and X's basis in the inventory is $3,571 ($5,000 x $25,000 partnership adjusted basis in inventory/$35,000 partnership's aggregate adjusted basis in distributed Category One assets).

——————————————————————————————

504 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Nonliquidating Distribution of Appreciated Category One Assets with Basis Shortfall: On Jan. 1, 1995, XYZ Partnership makes a nonliquidating distribution of the following assets to X:505

 Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$10,000	$20,000	
Inventory	$25,000	$30,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $5,000.  X's $5,000 basis is allocated between the two Category One assets in proportion to their adjusted bases in the hands of the partnership. Thus, X's adjusted basis in the unrealized receivables is $1,429 ($5,000 x $10,000 partnership adjusted basis in unrealized receivables/$35,000 partnership's aggregate adjusted basis in distributed Category One assets) and X's basis in the inventory is $3,571 ($5,000 x $25,000 partnership adjusted basis in inventory/$35,000 partnership's aggregate adjusted basis in distributed Category One assets).

——————————————————————————————

505 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Note: Under prior law, as illustrated by these two examples, unrealized depreciation in assets vs. unrealized appreciation in assets made no difference with respect to basis allocations among distributed assets.

Example — Nonliquidating Distribution of Both Types of Assets with Basis Shortfall (1): On Jan. 1, 1995, XYZ Partnership makes a nonliquidating distribution of the following assets to X:506

 Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$15,000	 $5,000	
Capital Asset I	 $5,000	$20,000	
Capital Asset II	$10,000	 $7,500	

X's adjusted basis in X's partnership interest at the time of the distribution is $10,000. X  allocates the $10,000 basis in X's partnership interest to the distributed Category One assets in proportion to the partnership's adjusted bases in the assets. In this case, the entire$10,000 basis is allocated to the inventory. X has a $0 basis in the remaining assets.

——————————————————————————————

506 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Nonliquidating Distribution of Both Types of Assets with Basis Shortfall (2): On Jan. 1, 1995, XYZ Partnership makes a nonliquidating distribution of the following assets to X:507

 Asset	Partnership's AB	Fair Market Value	
Unrealized Receivables	$0	 $5,000	
Inventory	$10,000	$10,000	
Capital Asset I	$25,000	$20,000	
Capital Asset II	$10,000	 $5,000	

X's adjusted basis in X's partnership interest at the time of the distribution is $20,000.  X  allocates the $20,000 basis in X's partnership interest first to the distributed Category One assets. In this case, X has sufficient basis to take a carryover basis of $10,000 adjusted basis in the distributed inventory. The additional $10,000 of basis allocated among the distributed Category Two assets in proportion to the partnership's adjusted bases in the assets. Thus, X  has a$7,143 adjusted basis in Capital Asset I ($10,000 basis to be allocated x$25,000 partnership's adjusted basis in Capital Asset I/$35,000 partnership's aggregate basis in distributed Category Two assets) and a $2,857 adjusted basis in Capital Asset II ($10,000 basis to be allocated x $10,000 partnership's adjusted basis in Capital Asset II/$35,000 partnership's aggregate basis in distributed Category Two assets).

——————————————————————————————

507 To avoid application of § 751(b), assume a similar distribution to partners Y and Z.

——————————————————————————————

Example — Liquidating Distribution with Basis Excess:On Jan. 1, 1995, XYZ Partnership distributes the following assets to X in complete liquidation of X's partnership interest:

 Asset	Partnership's AB in Asset	Fair Market Value	
Inventory	$10,000	$25,000	
Capital Asset I	$20,000	 $5,000	
Capital Asset II	 $5,000	$20,000	

Assume no application of  § 706(d) and assume that either  § 751(b) does not apply or, if it has already been applied, these assets represent the portion of the transfer treated as a distribution. X's adjusted basis in X's partnership interest at the time of the distribution is $65,000. X's$65,000 basis is first allocated to the Category One asset (inventory)in an amount equal to the partnership's adjusted basis in the inventory($10,000). The remaining $55,000 of basis is allocated to the Category Two assets in proportion to their adjusted bases in the hands of the partnership. Thus, X has a $44,000 adjusted basis in Capital Asset I ($55,000 basis to be allocated x $20,000 partnership's adjusted basis in Capital Asset I/$25,000 partnership's aggregate basis in distributed Category Two assets) and an $11,000 adjusted basis in Capital Asset II ($55,000 basis to be allocated x $5,000 partnership's adjusted basis in Capital Asset II/$25,000 partnership's aggregate basis in distributed Category Two assets).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

D. Special Basis Adjustment Available to Transferee Partner: § 732(d) 

1. In General 

Section 732(d) provides a special basis adjustment available to a partner (the “transferee partner”)who acquired all or part of a partnership interest in a “transfer”with respect to which no  § 743(b) adjustment was made (because no 754 election was in effect and the partnership was not obligated to make the adjustment because of a substantial built-in loss). A “transfer”of a partnership interest includes the acquisition of an interest by sale or exchange or upon the death of a partner.508 If partnership property (other than money)is distributed to a transferee partner within two years after the acquisition of the transferred interest (and no  § 743(b) adjustment was made), the transferee partner may elect to treat as the adjusted partnership basis of the distributed property the basis the partnership would have had in such property if it had elected to apply the  § 743(b) optional basis adjustment to the prior transfer of the partnership interest.509
——————————————————————————————

508 Regs. § 1.732-1(d)(1)(i).

509 § 732(d);Regs. § 1.732-1(d)(1)(iii). Under pre-May 9, 1997 regulations implementing § 708(b)(1)(B), the IRS indicated that  § 732(d) applied to a deemed distribution to a transferee partner who acquired an interest in a transaction that caused a  § 708(b)(1)(B) constructive termination. GCM 39502 (5/7/86). See also PLR 9232022. However, under Regs.  § 1.708-1(6)(1)(iv) as in effect after May 8, 1997, the transferee partner is not deemed to have received momentarily the assets of the terminated partnership (because they are deemed to be contributed to a new partnership by the terminated partnership), with the result that  § 732(d) cannot apply.

——————————————————————————————

If such an election is made, the amount of the adjustment is not reduced by the amount of any depletion or depreciation with respect to that portion of the basis of partnership property that is attributable to the  § 732(d) adjustment. This is because depletion or depreciation on the portion of the basis of partnership property attributable to the  § 732(d) adjustment is allowed or allowable only if the optional  § 743(b) adjustment is in effect.510
——————————————————————————————

510 Regs. § 1.732-1(d)(1)(iv).

——————————————————————————————

If a transferee partner makes a  § 732(d) election and the property distributed is not the same property that would have had a basis adjustment if a  § 754 election had been in effect at the time of the transfer of his partnership interest, the § 732(d) adjustment may apply to any like property received in the distribution.511 This rule applies as long as the transferee partner relinquishes the transferee's interest in the partnership property that otherwise would have had a basis adjustment in exchange for the distribution.
——————————————————————————————

511 Regs. § 1.732-1(d)(1)(v).

——————————————————————————————

2. Mandatory Application of the Adjustment 

A transferee partner acquiring a partnership interest in a transfer with respect to which the  § 754 election was not in effect is required to apply the  § 732(d) basis adjustment to any subsequent distribution (whether or not made within two years of the acquisition of his interest) if the following conditions, in Regs. § 1.732-1(d)(4), are met:

(i) at the time of the acquisition of the interest, the fair market value of all partnership property (other than money) exceeded 110%of its adjusted basis to the partnership;512

(ii) an allocation of basis under  § 732(c) upon a liquidating distribution immediately following the acquisition of the interest would have resulted in a shift of basis from property not subject to an allowance for depreciation, depletion, or amortization, to property subject to such an allowance;513 and

(iii)a basis adjustment under  § 743(b) would change the transferee partner's basis in the property actually distributed.514

——————————————————————————————

512 § 732(d); Regs. § 1.732-1(d)(4)(i).

513 Regs. § 1.732-1(d)(4)(ii).

514 Regs. § 1.732-1(d)(4)(iii). See TAM 9734003 (if no shift in basis occurred on deemed distribution date in deemed distribution under former Regs. § 1.708-1(b)(1)(iv), special basis adjustment rule of  § 732(d) did not apply).

——————————————————————————————

Note: The purpose of Regs.  § 1.732-1(d)(4) was to prevent distortions caused by  § 732(c) that might inflate the basis of depreciable, depletable, or amortizable property above its fair market value. When the regulations were adopted, these distortions could occur because  § 732(c) allocated basis among distributed properties based on their relative adjusted bases to the partnership. The 1997 Act's changes to  § 732(c) made the distortions less likely. Agreeing with practitioners who noted that distortions caused by  § 732(c) may still occur after the 1997 changes, Treasury retained the Regs.  § 1.732-1(d)(4) rule requiring application of the  § 732 basis adjustment in some cases.515
——————————————————————————————

515 See preamble to T.D. 8847, 64 Fed. Reg. 69903 (12/15/99).

——————————————————————————————

3. Election to Make Adjustment 

A transferee partner makes the  § 732(d) adjustment on the partner's tax return for the year in which the distribution occurs if the distribution includes any property subject to the allowance for depreciation, depletion, or amortization,516 or, if the distribution does not include such property, for any taxable year no later than the first taxable year in which the basis of any of the distributed property is relevant to the determination of the partner's income tax.517
——————————————————————————————

516 Regs. § 1.732-1(d)(2)(i).

517 Regs. § 1.732-1(d)(2)(ii).

——————————————————————————————

The election is made by attaching to the return a statement that the partner intends to make an election under  § 732(d) to adjust the basis of property received in a distribution. The statement must also set forth the computation of the adjustment and a list of the properties to which the adjustment has been allocated.518
——————————————————————————————

518 Regs. § 1.732-1(d)(3)(i), (ii). See the Worksheets for a sample election.

——————————————————————————————

4. Allocation of the Adjustment 

The  § 732(d) adjustment is allocated according to the  § 755 rules.519
——————————————————————————————

519 Regs. § 1.732-1(d)(3)(ii).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

E. Relationship Between § § 732 and 751(b) 

The rules in  § 732 governing a distributee partner's basis in distributed property do not apply to the extent that a distribution is treated as a sale or exchange under § 751(b).520 The disproportionate distribution rules in  § 751(b) apply when a partner receives (a) more than the partner's share of unrealized receivables or substantially appreciated inventory in exchange for a decrease in the partner's share of other partnership property or(b) less than the partner's share of unrealized receivables or substantially appreciated inventory in exchange for an increased share of money or other partnership property.521 Under § 751(b), the partner is treated as having received a proportionate share of each class of partnership property in a deemed distribution and then as having sold or exchanged the property deemed distributed for the property actually received.522 The  § 732 basis rules (including the  § 732(d) adjustment)apply to the partner's basis in the assets deemed distributed and subsequently sold or exchanged with the partnership.523 However, the § 732 basis rules do not apply in determining the basis of the property actually distributed; the basis of such property is its cost to the partner.524
——————————————————————————————

520 § 732(e);Regs. § § 1.732-1(e), 1.751-1(b).

521 Regs. § 1.751-1(b)(2), (3). The application of  § 751 to partnership distributions is discussed in detail in 716 T.M., Partnerships —Current and Liquidating Distributions; Death or Retirement of a Partner.

522 Regs. § 1.751-1(b).

523 Regs. § 1.732-1(e).

524 Regs. § 1.732-1(e).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

F. Relationship Between § § 732 and 751(a) 

Section 751(a) characterizes some of the gain realized on the sale or exchange of a partnership interest as ordinary income.525 For purposes of computing the amount of gain characterized as ordinary income, the transferor partner is deemed to receive a current distribution of the partner's proportionate share of  § 751 property (unrealized receivables and substantially appreciated inventory).  Section 732 (including the  § 732(d) adjustment) determines the transferor partner's basis in the assets deemed distributed.
——————————————————————————————

525 The application of  § 751(a) to the sale or exchange of a partnership interest is discussed in detail in 718 T.M., Partnerships — Dispositions of Partnerships Interests or Partnership Business; Partnership Termination.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

G. Distributions of Partner Debt 

In Rev. Rul. 93-7,526 the IRS ruled that if a partnership acquires indebtedness of a partner, and the partnership subsequently distributes (in a liquidating or nonliquidating distribution) the indebtedness to the partner so that the debt is extinguished, the rules on distribution of property determine the consequences for the partnership; the partner recognizes gain or loss to the extent that the fair market value of the indebtedness differs from the adjusted basis of the indebtedness determined under § 732. In addition, if the issue price of the indebtedness exceeds its fair market value, the partner may have cancellation of indebtedness income.
——————————————————————————————

526 1993-1 C.B. 125.

——————————————————————————————

Rev. Rul. 93-7 departs from the general nonrecognition rule for partnership distributions. Section 731(a) provides that a partner does not recognize gain or loss when the partnership distributes money or property; Rev. Rul. 93-7 provides an exception for distributions of partner debt.

The situation in Rev. Rul. 93-7 is distinguishable from the cancellation of a partnership's direct loan to a partner (which is treated as a distribution of money rather than of property).527
——————————————————————————————

527 See Regs. § 1.731-1(c)(2).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

H. Relationship Between § § 732 and 734(b) 

If the basis of partnership property has been adjusted previously under  § 734(b) (discussed in VIII, below), the  § 732 rules are applied to the distribution of the property taking into account the prior adjustments.528
——————————————————————————————

528 Regs. § 1.732-2(a).

——————————————————————————————

Example: Partnership XYZ owns a piece of property with an adjusted basis of $5,000 and a  § 734(b) adjustment of $2,000. The partnership distributes the property to X in a current distribution when X's adjusted basis in the partnership interest is$8,000. X's adjusted basis in the distributed property is $7,000. X's adjusted basis in the partnership interest after the distribution is $1,000.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

I. Relationship Between § § 732 and 743(b) 

If property is distributed to a transferee partner who acquired any part of the partnership interest in a transfer to which a  § 743(b) basis adjustment applied, the  § 732 rules are applied to the distribution taking into account the transferee partner's special basis adjustment with respect to the distributed property.529
——————————————————————————————

529 Regs. § 1.732-2(b).

——————————————————————————————

Example: When D acquired a partnership interest from a previous partner, a  § 754 election was in effect and the partnership owned a piece of property with an adjusted basis of $5,000 and a special basis adjustment of $1,000 with respect to D. If the partnership distributes this piece of property to D in a current distribution when D's adjusted basis in the partnership interest is $6,000, the partnership's basis in the property immediately preceding the distribution is $6,000 and D's adjusted basis in the property is $6,000. D's adjusted basis in the partnership interest after the distribution is zero. If, instead, the partnership distributes the property in a current distribution to a partner other than D, the partnership's basis in the property is only $5,000 and the distributee partner's basis in the property is limited to $5,000. The $1,000 special adjustment with respect to D “shifts” to another piece of “like property” owned by the partnership.530

——————————————————————————————

530 See Regs.  § § 1.732-2(b) Ex., 1.743-1(g).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

J. Distributions of Marketable Securities Under § 731(c) 

Section 731(c)(1) provides that, for purposes of  § § 731(a)(1) and 737, money includes marketable securities; the securities are taken into account at their fair market value as of the date of distribution. The distribution causes a partner to recognize gain from the disposition of the partnership interest to the extent that the value of the securities exceeds the partner's adjusted basis in the partnership interest. Thus, the partner recognizes gain in the same manner as if the partner had received cash in lieu of securities.531
——————————————————————————————

531 § 731(a)(1), (c)(1). For further discussion of § 731(c), see 716 T.M., Partnerships — Current and Liquidating Distributions; Death or Retirement of a Partner.

——————————————————————————————

The adjusted basis of the distributed marketable securities is increased by the amount of gain recognized, and the gain is allocated among the distributed marketable securities in proportion to the amounts of unrealized appreciation.532 However, the adjusted basis of the partner's partnership interest and the partnership's adjusted basis in its remaining assets are determined as if no gain were recognized under § 731(c).533
——————————————————————————————

532 § 731(c)(4).

533 § 731(c)(5).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

K. Adjustments to Contributing Partner's Basis in the Partnership Interest: § § 704(c) and 737 

Under § 704(c)(1)(A), income, gain, loss, and deduction with respect to property that a partner contributes to a partnership must be shared among the partners in a way that takes account of the variation between the property's basis to the partnership and its fair market value.

Moreover, if a partner contributes property that has a “built-in loss” (i.e., has a basis that exceeds the property's value at the time of contribution), the built-in loss is only taken into account in determining the amount of items allocated to the contributing partner. For purposes of determining the amount of items allocated to other partners, the basis of the contributed property in the partnership's hands is the property's fair market value at the time of contribution.534
——————————————————————————————

534 § 704(c)(1)(C). This rule applies to contributions that occur after Oct. 22, 2004.

——————————————————————————————

A partner contributing property with built-in gain or loss (in any year) must recognize all or a portion of that gain or loss if the property is distributed to another partner within seven years of the contribution.535 Under § 737, the contributing partner must recognize all or a portion of the built-in gain (but not loss)if the partnership distributes other property directly to the contributing partner. Regulations describe the basis adjustments to the contributing partner's partnership interest that these transactions require.536
——————————————————————————————

535 § 704(c)(1)(B).

536 For further discussion of the  § 704(c) and  § 737 regulations, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts.

——————————————————————————————

For distributions of contributed property to another partner, the contributing partner's basis in the partnership interest is increased by the amount of gain or decreased by the amount of loss that the partner recognizes under § 704(c)(1)(B).537 This increase or decrease is taken into account in determining the contributing partner's adjusted tax basis for any property distributed to the partner in a distribution that is part of the same distribution as the distribution of the contributed property (other than certain like-kind property).538 The increase or decrease is also taken into account in determining the amount of gain recognized by the contributing partner, if any, on a distribution of money or property to the contributing partner that is part of the same distribution as the distribution of the contributed property.539 The partnership's adjusted tax basis in the distributed property is increased or decreased immediately before the distribution to reflect the amount of gain or loss recognized by the contributing partner.540 This adjustment, therefore, affects the distributee partner's adjusted tax basis in the distributed property under § 732.541
——————————————————————————————

537 Regs. § 1.704-4(e)(1).

538 Regs. § 1.704-4(e)(1). See also Regs. § 1.704-4(d)(3).

539 Regs. § 1.704-4(e)(1).

540 Regs. § 1.704-4(e)(2).

541 Regs. § 1.704-4(e)(2).

——————————————————————————————

Example: On Jan. 1, Year One, X, Y, and Z form partnership XYZ as equal partners. X contributes $10,000 cash and Property P, nondepreciable real property with a fair market value of $10,000 and an adjusted tax basis of $4,000. Y and Z each contribute $20,000 cash. On Dec. 31, Year Three, Property P is distributed to Y. X recognizes a $6,000 gain on the distribution because that is the amount that would have been allocated to X under  § 704(c)(1)(A) on a sale of Property P for its fair market value at the time of the distribution ($10,000 fair market value less $4,000 adjusted basis). The adjusted basis of X's partnership interest is increased from $14,000 to $20,000 to reflect this gain. The partnership's adjusted tax basis in Property P is increased from $4,000 to $10,000 immediately before the distribution. Therefore, under § 732(a)(1), Y's adjusted tax basis in Property P is $10,000.542

——————————————————————————————

542 Regs. § 1.704-4(e)(4).

——————————————————————————————

For distributions of other property to the contributing partner, the partner's basis in the partnership interest is increased by the amount of gain recognized under  § 737 and Regs. § 1.737-3.543 Under the regulations, this amount equals the lesser of the excess distribution or the net precontribution gain.544 The “excess distribution” is the amount by which the fair market value of the distributed property (other than money) exceeds the distributee partner's adjusted basis in the partnership interest.545 For this purpose, the partner's adjusted basis includes any other basis adjustment caused by the distribution (or a distribution that is part of the same plan), such as adjustments required under § 752, except for: (1) the increase required under  § 737(c)(1) for the gain recognized by the partner; and (2) the decrease required under  § 733(2) for any property distributed to the partner other than property previously contributed by the distributee partner.546
——————————————————————————————

543 Regs. § 1.737-3(a). However, this increase is not taken into account in determining the amount of gain recognized by the partner under § 737(a)(1) or § 731(a) on a distribution of money in the same or a related distribution. Regs. § 1.737-3(a).

544 Regs. § 1.737-1(a)(1).

545 Regs. § 1.737-1(b)(1).

546 Regs. § 1.737-1(b)(3).

——————————————————————————————

Example: On Jan. 1, Year One, X, Y, and Z form partnership XYZ as equal partners. X contributes Property P, nondepreciable real property with a fair market value of $10,000 and an adjusted basis of $4,000. Y and Z each contribute $10,000 cash. The partnership purchases Property Q, nondepreciable real property with a fair market value of $9,000, subject to a $9,000 nonrecourse liability. The liability is allocated equally among the partners under § 752, increasing X's adjusted basis in the partnership interest from $4,000 to $7,000. On Dec. 31, Year Three, X receives $2,000 cash and Property Q, subject to the$9,000 liability. In the determination of the amount of the excess distribution, the adjusted basis of X's partnership interest is adjusted for the distribution of money and the shift in liabilities. X's adjusted basis is therefore increased to $11,000 ($7,000 initial adjusted basis, less $2,000 distribution of money, less $3,000 (decrease in share of partnership liabilities), plus $9,000 (increase in share of individual liabilities)). As a result of this basis adjustment, X's adjusted basis in the partnership interest ($11,000) is greater than the fair market value of the distributed property ($9,000). Therefore, there is no excess distribution.547

——————————————————————————————

547 Regs.  § 1.737-1(e) Ex. 2.

——————————————————————————————

The regulations define “net precontribution gain” as generally equal to the net gain the distributee partner would have recognized under  § 704(c)(1)(B) if, at the time of the distribution to which  § 737 applies, the partnership had actually distributed to another partner all  § 704(c) property contributed by the distributee partner.548 If a partnership has a  § 754 election in effect and also distributes money to the distributee partner in a transaction that is part of the same plan as the  § 737 distribution, the net precontribution gain is reduced by the basis adjustments required by  § 734(b)(1)(A) to any  § 704(c) property contributed by the distributee partner.549 In addition, a distributee partner's net precontribution gain is determined after taking into account any gain or loss that the partner recognized under  § 704(c)(1)(B) and Regs.  § 1.704-4 (or that the partner would have recognized  except for the like-kind exception of  § 704(c)(2) and Regs.  § 1.704-4(d)(3))on an actual distribution to another partner of  § 704(c) property contributed by the distributee partner that is part of the same plan as the distribution to the distributee partner.550
——————————————————————————————

548 Regs. § 1.737-1(c)(1).

549 Regs. § 1.737-1(c)(2)(ii).

550 Regs. § 1.737-1(c)(2)(iv).

——————————————————————————————

Example: On Jan. 1, Year One, X, Y, and Z form partnership XYZ as equal partners. X contributes Properties P and Q, nondepreciable real properties each with a fair market value of $10,000 and an adjusted basis of $6,000. Y contributes Property R, nondepreciable real property with a fair market value and adjusted basis of $20,000. Z contributes$20,000 cash. On Dec. 31, Year Three, Property R is distributed to X in complete liquidation of X's interest. As part of the same distribution, Property P is distributed to Y. X's net precontribution gain before the distribution is $8,000 ($20,000 fair market values of Properties P and Q less $12,000 the properties' adjusted bases). This gain is taken into account in determining X's excess distribution and precontribution gain. As a result, X's net precontribution gain is reduced from $8,000 to $4,000, and X's adjusted basis in the partnership interest is increased by $4,000 to $16,000. X recognizes $4,000 gain on the receipt of Property R under § 737, an amount equal to the lesser of the excess distribution of $4,000($20,000 fair market value of Property R less $16,000 adjusted basis in X's partnership interest) and X's remaining net precontribution gain of $4,000.551

——————————————————————————————

551 Regs.  § 1.737-1(e) Ex. 3.

——————————————————————————————

The distributee partner's adjusted basis in the distributed property is determined under  § 732(a) or (b), whichever applies, and the increase in the distributee partner's adjusted basis in the partnership interest for the amount of gain recognized under  § 737 is taken into account in making this determination.552
——————————————————————————————

552 Regs. § 1.737-3(b)(1).

——————————————————————————————

Example: On Jan. 1, Year One, X, Y, and Z form partnership XYZ as equal partners. X contributes Property P, nondepreciable real property with a fair market value of $10,000 and an adjusted basis of $5,000. Y contributes Property Q, nondepreciable real property with a fair market value and adjusted basis of $10,000. Z contributes$10,000 cash. On Dec. 31, Year Three, Property Q is distributed to X in complete liquidation of X's interest in the partnership. X recognizes$5,000 gain under § 737, an amount equal to the excess distribution of $5,000 ($10,000 fair market value of Property Q less $5,000 adjusted basis in X's partnership interest) and X's net precontribution gain of $5,000 ($10,000 fair market value of Property P less $5,000 adjusted basis of Property P). X's adjusted basis in the partnership interest is increased by the $5,000 recognized under § 737. This increase is taken into account in determining X's basis in the distributed property. Therefore, X's basis in Property Q is $10,000 under § 732(b).553

——————————————————————————————

553 Regs.  § 1.737-3(e) Ex. 1.

——————————————————————————————

Special rules apply the principles of  § § 704(c) and 737 to transactions involving partnerships that hold long-term contracts. As discussed in II, A, 1, g, above, the regulations governing contributions of long-term contracts are part of the regulations under  § 460 that address mid-contract changes in taxpayers engaged in completing long-term contracts.554 The  § 460 regulations divide transactions that result in mid-contract changes into “constructive completion transactions”(in which the original taxpayer recognizes income from the contract at the time of the transaction) and “step-in-the-shoes transactions”(in which the “old taxpayer's” obligation to account for the contract terminates on the date of the transaction and is assumed by the “new taxpayer”).555
——————————————————————————————

554 A 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).

555 Regs. § 1.460-4(k)(1).

——————————————————————————————

A  § 721 contribution of a long-term contract to a partnership is a step-in-the-shoes transaction.556 A partner (the old taxpayer) making the contribution to a partnership (the new taxpayer) must (i) increase the basis of the partnership interest received by the amount of the gross receipts that the partner has recognized under the contract and (ii) reduce the basis of the partnership interest (but not below zero) by the amount of gross receipts received or reasonably expected to be received under the contract.557
——————————————————————————————

556 Regs. § 1.460-4(k)(3)(i)(I).

557 Regs. § 1.460-4(k)(3)(iv)(A)(1), (2).

——————————————————————————————

The contributing partner's accounting method with respect to the contract affects the outcome of application of these rules. A taxpayer accounting for a long-term contract under the “percentage of completion method” (PCM) includes in taxable income for the taxable year a portion of the “total contract price” (i.e., the amount the taxpayer reasonably expects to receive under the contract), determined by ascertaining the “completion factor” (i.e., the ratio of (a) “allocable contract costs” (costs allocable to the contract under Regs.  § 1.460-5) incurred through the end of the taxable year to(b) allocable contract costs that the taxpayer reasonably expects to incur under the contract).558 A taxpayer using the “cost of completion method” (CCM) takes into account in the year in which the taxpayer completes the contract the “gross contract price” (i.e., all amounts that the taxpayer is entitled by law or contract to receive)plus all allocable contract costs incurred by that year.559
——————————————————————————————

558 Regs. § 1.460-4(b).

559 Regs. § 1.460-4(d).

——————————————————————————————

Example: In Year One, X enters into a long-term contract. The total contract price is $1,000,000, and the estimated total allocable contract costs are $800,000. In Year One, X incurs costs of $600,000 and receives $650,000 in payments under the contract. In Year Two, X contributes the contract, with a $0 basis, plus $125,000 in cash, to a partnership in exchange for a one-fourth partnership interest. The contract's fair market value at the time of the contribution is$160,000. Before contributing the contract, X incurs costs of $10,000(and receives no payments) in Year Two. If X accounts for the contract under the PCM, for Year 1 X reports receipts of $750,000 (completion factor multiplied by total contract price) and costs of $600,000. For Year Two, X reports receipts of $12,500 (completion factor multiplied by total contract price, minus receipts already reported) and costs of $10,000. X's basis in X's partnership interest, therefore, is $237,500(cash contributed plus adjusted basis in contract contributed, plus gross receipts X has recognized under the contract, minus gross receipts X has received under the contract).560

——————————————————————————————

560 Regs.  § 1.460-4(k)(5) Ex. 11(i)-(ii).

——————————————————————————————

When a long-term contract is contributed to a partnership, the contributing partner must determine the amount of built-in income or built-in loss attributable to the contract that is subject to  § 704(c)(1)(A) by:(1) taking into account any income or loss required under Regs.  § 1.460-4(k)(3)(ii)(A) (i.e., income based on cumulative allocable contract costs if the taxpayer uses the PCM, but no income if the taxpayer uses the CCM) for the period ending on the date of the contribution; (2) computing the income or loss the contributing partner would take into account if the contract were disposed of for fair market value in a constructive completion transaction before the contribution; and (3) reducing the result by the amount of income the partner must recognize on the contribution.561 In a constructive completion transaction under the facts of the example above, the total contract price would be $810,000 (amounts received under the contract [$650,000] plus the amount realized on the deemed sale [$160,000]), and X would report receipts of $47,500 (total contract price [$810,000] minus receipts already reported [$762,500]) and no costs, for a profit of $47,500. The amount of built-in gain subject to  § 704(c) in the example, therefore, would be $47,500.562
——————————————————————————————

561 Regs. § 1.460-4(k)(3)(v)(A)(1).

562 See Regs. § 1.460-4(k)(5) Ex. 11(iv).

——————————————————————————————

Similarly, if a partnership that holds a long-term contract revalues the contract under Regs.  § 1.704-1(b)(2)(iv)(f) (which provides rules on adjustments to capital accounts when partnership property is revalued), the amount of built-in gain or built-in loss attributable to the contract is equal of the amount of income or loss the partnership would take into account if, at the time of the revaluation, it disposed of the contract for fair market value in a constructive completion transaction.563
——————————————————————————————

563 Regs. § 1.460-4(k)(3)(v)(A)(2).

——————————————————————————————

If a partner contributing a long-term contract or a partnership revaluing a long-term contract that it holds uses the CCM, any built-in income or built-in loss under  § 704(c) is taken into account in the year in which the contract is completed;if the partner or partnership uses any other method of accounting for the contract (including the PCM), any built-in income or built-in loss must be taken into account in a manner that reasonably accounts for the  § 704(c) income or loss over the remaining term of the contract.564 Thus, in the example above, the partnership must apply  § 704(c) to the $47,500 of built-in income in a manner that reasonably accounts for that income over the remaining term of the contributed contract.565
——————————————————————————————

564 Regs. § 1.460-4(k)(3)(v)(A)(3).

565 Regs. § 1.460-4(k)(5) Ex. 11(iv) provides examples of reasonable allocations.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

L. Basis Reduction in Distributed Corporations 

The general rules for determining basis in current partnership distributions(discussed in  V, A, above) offer corporate partners an opportunity for achieving a tax-free increase in the basis of assets they receive in distributions from their partnerships. If a partnership distributes corporate stock to a corporate partner with a basis in its partnership interest that is lower than the partnership's basis in the stock, the basis of the stock in the hands of the corporate partner would be reduced to no more than the distributee partner's basis in its partnership interest before the distribution.566 However, there would be no change in the basis of the assets of the distributed corporation.
——————————————————————————————

566 § 732(a)(1), (b).

——————————————————————————————

The corporate liquidation rules would allow the corporate partner to avoid the effect of the basis reduction rules under § 732. If a partnership plans to distribute property to a corporate partner that would be required to reduce the property's basis in its hands because its own partnership interest basis is smaller, the partnership could instead contribute the property to a new corporation and distribute the stock of this new entity to its partner. If the corporate partner satisfies the control requirements of § 332(b), it might then liquidate the new corporation under  § 332 and receive the property(under  § 334(b))with the same basis that the partnership had before the transaction, effectively avoiding the rules of § 732.

Example: Corporation X is a partner in partnership XYZ, with a basis of $0 in its partnership interest. The partnership plans to distribute an asset with a basis of $100 to X. To do so, the partnership agrees to contribute the asset to a newly formed corporation (Newco)and then distribute 100% of Newco's stock to X. Under § 732, X will take the Newco stock with a basis of $0. However, because X owns 100% of Newco's stock, it can liquidate Newco tax-free under § 332. Under § 334(b), Newco's basis in the asset it distributes in liquidation would carry over to X, so that X would eliminate $100 of built-in gain from the partnership distribution. Note that if the asset were distributed to X from XYZ, X would take a $0 basis in the property under  § 732 and recognize gain on a subsequent disposition of the property.

To eliminate the possibility for the abuse illustrated by this example, § 732(f)(1) provides that the basis of property held by a corporation whose stock is distributed by a partnership to a corporate partner is reduced when the corporate partner controls the subsidiary corporation after the distribution.567
——————————————————————————————

567 Section 732(f) is effective generally for distributions made after July 14, 1999. However, in the case of a corporation that was a partner in a partnership as of July 14, 1999, the 1999 Tax Relief Extension Act, P.L. 106-170 § 538(b)(2), provides that the basis reduction rule is effective for any distribution made (or treated as made) to that partner from that partnership after June 30, 2001. For any such distribution after the date of enactment of the 1999 Act and before July 1, 2001, the rule of the preceding sentence does not apply unless the partner makes an election to have the rule apply to the distribution on the partner's federal income tax return for the taxable year in which the distribution occurs. The conference report on the Act stated that the enactment of  § 732(f) does not imply that distributions before the effective date of the new provision will achieve a particular tax result under present law, or that enactment of this provision limits the application of tax rules or principles under present or prior law.

——————————————————————————————

The amount of the reduction is the excess of (1) the partnership's adjusted basis in the stock of distributed corporation immediately before the distribution, over (2) the corporate partner's basis in that stock immediately after the distribution.568
——————————————————————————————

568 § 732(f)(1)(C).

——————————————————————————————

Example: Corporation X is a partner in partnership XYZ, which owns all of the outstanding stock of corporation B. X's basis in its partnership interest is $800 and XYZ's basis in its B stock is $1,100. If XYZ distributes the B stock to X,  the basis reduction applicable to B's assets is $300.

There are two limits on the amount of the reduction in the distributee corporation's assets. First, the amount of the basis reduction cannot exceed the amount by which (1) the sum of the aggregate adjusted bases of the property and the amount of cash of the distributed corporation exceeds (2) the corporate partner's adjusted basis in the stock of the distributed corporation.569
——————————————————————————————

569 § 732(f)(3)(A).

——————————————————————————————

Example: A distributed corporation has cash of $300 and other property with a basis of $600, and the corporate partner's basis in the stock of the distributed corporation is $400. The amount of the basis reduction cannot exceed $500 (i.e., ($300 + $600) - $400= $500).

Secondly, the amount of the basis reduction may not exceed the adjusted basis of the property of the distributed corporation. Thus, the basis of property (other than money) of the distributed corporation cannot be reduced below zero under § 732(f), even if the total amount of the basis reduction otherwise is greater.570
——————————————————————————————

570 § 732(f)(3)(B).

——————————————————————————————

Example: A distributed corporation has cash of $600 and other property with a basis of $300 (i.e., the reverse of the example above), and the corporate partner's basis in the stock of the distributed corporation is $400. The amount of the basis reduction cannot exceed$300, even though the total of two amounts still exceeds the corporate partner's basis in the distributed corporation's stock by $500.

When the amount of the basis reduction after the application of the first limit above exceeds the total bases of property (other than cash) of the distributed corporation, the corporate partner must recognize the amount of the excess as long-term capital gain. The corporate partner increases its basis in the distributed corporation's stock by the amount of gain it recognizes under this rule.571
——————————————————————————————

571 § 732(f)(4).

——————————————————————————————

Example: If the possible amount of basis reduction is $400 and the distributed corporation has cash of $200 and other property with a basis of $300, the corporate partner recognizes a $100 capital gain. The corporate partner's basis in the stock of the distributed corporation also increases by $100, and the basis of the distributed corporation's other property is reduced to zero.

Any basis reduction required under  § 732(f) is allocated among assets of the distributed corporation in accordance with the rules of § 732(c).572
——————————————————————————————

572 H. Rep. 106-478, pt. II, H (1999).

——————————————————————————————

The  § 732(f) basis reduction generally occurs with respect to a partnership distribution of stock if the corporate partner controls the distributed corporation immediately after the distribution or at any other time thereafter.573 “Control”means ownership of stock meeting the requirements of  § 1504(a)(2) (generally, an 80% vote and value requirement).574 Congress has specified that the reference to  § 332(b) in Regs.  § 1.1502-34 applies to § 732(f), so that the stock aggregation rules that qualify a corporate liquidation into a consolidated group member for tax-free treatment under  § 332 also apply to the determination of control for requiring the reduction of a distributed corporation's asset bases under § 732(f). Therefore, if a consolidated group member is also a partner and receives a partnership distribution of another corporation's stock, under Regs. § 1.1502-34 all of the distributee's stock that the consolidated group members own are aggregated to determine whether the distributee is subject to the bases reduction rules of § 732(f).575
——————————————————————————————

573 § 732(f)(1)(B).

574 § 732(f)(5).

575 § 311;Regs. § § 1.732-3, 1.1502-34.

——————————————————————————————

Section 732(f) generally reduces the basis of any property held by the distributed corporation immediately after the distribution or, if the corporate partner does not have control at that time, then at the time the corporate partner first has such control. However,  § 732(f) does not apply to any distribution if the corporate partner (1) does not have control of the distributed corporation immediately after the distribution and (2) establishes that the distribution was not part of a plan or arrangement to acquire control.576
——————————————————————————————

576 § 732(f)(2).

——————————————————————————————

If a corporation acquires stock by some other means than a distribution from a partnership and the basis of that stock is determined (because it was distributed by a partnership) in whole or in part by reference to  § 732(a)(2) or § 732(b), then the corporation is treated as receiving a distribution of stock from a partnership.577
——————————————————————————————

577 § 732(f)(6).

——————————————————————————————

Note: If a partnership distributes stock to two corporate partners, neither of which then controls the distributed corporation, and the two corporate partners merge, with the result that the survivor afterwards controls the distributed corporation, the stock that the survivor owns is treated as received in a partnership distribution, and the § 732(f) basis reduction rule applies at the time of the merger. By contrast, if a partnership distributes property other than stock (such as real estate) to a corporate partner and that corporate partner contributes that property to another corporation in a  § 351 transaction, the stock which the corporate partner receives in the  § 351 transaction is not treated as distributed by a partnership and the  § 732(f) basis reduction does not apply.

In the case of tiered corporations,  § 732(f) provides that if the property held by a distributed corporation is stock in a corporation that the distributed corporation controls, then the basis reduction applies to the property of that controlled corporation. The basis reduction is also reapplied to any property of any controlled corporation if that property is stock in a corporation that it controls.578
——————————————————————————————

578 § 732(f)(7).

——————————————————————————————

Example: A partnership distributes stock of a controlled corporation to a corporate partner and the controlled corporation has a subsidiary. The amount of the basis reduction allocable to stock of the subsidiary is applied again to reduce the basis of the assets of the subsidiary under this rule.

Section 732(f) provides for regulations to include rules to avoid double counting and to prevent the abuse of the purposes of the new provision. Further,  § 732(f) states that the regulations should prevent the avoidance of the purposes of the new basis reduction through the use of tiered partnerships.579
——————————————————————————————

579 § 732(f)(8).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

M. Basis Increases in Amortizable Intangibles 

1. Section 732(b) Basis Increases 

Section 197 allows a taxpayer to amortize intangible assets, including business goodwill and going concern value, if the taxpayer acquired the asset after August 10, 1993. Taxpayers may elect to apply  § 197 amortization to assets acquired after July 25, 1991. (The appropriate measuring date for any given taxpayer is the effective date.)  Section 197(f)(9) contains anti-churning rules to prevent taxpayers from engaging in sham sales or exchanges to qualify assets that they owned before these dates for amortization. The assets specifically covered by the anti-churning rules are any goodwill or going concern value and any other intangible that would not have been amortizable under law prior to the enactment of  § 197 (a “§ 197(f)(9) intangible”).

Section 197(f)(9)(E) provides that, in applying the anti-churning rules for basis adjustments under § § 732, 734, and 743, all anti-churning determinations are made at the partner level and each partner is treated as having owned and used that partner's proportionate share of the partnership's assets. For basis increases under § 732(b), this rule views partnership distributions as transfers of property between the partners themselves and the distributee partner is deemed to acquire the distributed intangible directly from the continuing partners of the partnership.580
——————————————————————————————

580 See preamble to T.D. 8907, 65 Fed. Reg. 69667 at “Explanation of Provisions and Summary of Contents” (11/20/00).

——————————————————————————————

When a partnership distributes a  § 197(f)(9) intangible to a partner in a nonrecognition transaction under § 731, the partner steps into the shoes of the partnership for the partner's share of the partnership's basis in the asset immediately before the transfer.581 If a partnership transfers a  § 197 intangible to a partner as all or part of a distribution in liquidation of the partner's interest in the partnership and the partner receives a basis increase in the asset under § 732(b), some or all of that increase may be treated as a separate asset that the former partner may amortize. Specifically, the former partner may amortize as much of the increase as does not exceed the total unrealized appreciation in the asset attributable to any of three sources.
——————————————————————————————

581 Regs. § 1.197-2(g)(2)(ii)(B).

——————————————————————————————

(1) Anti-churning applies to the extent the basis increase exceeds total unrealized appreciation attributable to any other partner not related to the distributee;582
——————————————————————————————

582 Regs. § 1.197-2(h)(12)(ii)(A)(1).

——————————————————————————————

Example: In 1990, X, Y, and Z each contributed $150 to form a partnership and agreed to share profits and losses equally. Between 1990 and 1992, XYZ acquired an intangible asset that was nonamortizable before the enactment of § 197. In 2007, when the intangible's fair market value was $180 and its basis $0, XYZ distributed the intangible to Z in complete liquidation of its interest in the partnership. At the time, the adjusted basis of Z's interest was $150. Z is not related to X or Y, and XYZ did not have a  § 754 election in effect.

After the distribution, under  § 732(b) Z's basis in the intangible is $150, a $150 increase over XYZ's basis. Because Z owned an interest in XYZ before Aug. 10, 1993, Z is treated as having owned and used the intangible before that date, so the  § 732(b) basis increase is subject to anti-churning to the extent that it exceeds the unrealized appreciation attributable to X and Y. Their proportionate share of the unrealized appreciation (2/3 of $180) equals $120. Therefore, Z is treated as holding two assets: (1) a nonamortizable intangible with a basis of $30; and (2); an intangible that has a basis of $120 and that Z may amortize over 15 years, beginning at the date of the distribution.

(2) If the partnership acquired the  § 197(f)(9) intangible before the effective date, anti-churning applies to the extent the basis increase exceeds total unrealized appreciation attributable to the distributee and related persons to the extent that they acquired their interests after the effective date from a prior partner (or partners) unrelated to the distributee;583
——————————————————————————————

583 Regs. § 1.197-2(h)(12)(ii)(A)(2).

——————————————————————————————

Example: In 1990, X, Y, and Z each contributed $150 to form a partnership and agreed to share profits and losses equally. Between 1990 and 1992, XYZ acquired an intangible asset that was nonamortizable before the enactment of § 197. In 2007, Z sold its partnership interest to D, an unrelated person, for $150. In 2008, when the intangible's fair market value is $180 and its basis $0, XYD distributes the intangible to D in complete liquidation of its interest in the partnership. At the time, the adjusted basis of D's interest is $150. D is not related to X or Y and XYD does not have a  § 754 election in effect.

After the distribution, D's basis in the intangible under  § 732(b) is $150, a $150 increase over XYZ's basis. D's  § 732(b) basis increase in the intangible is subject to anti-churning to the extent that it exceeds the unrealized appreciation attributable to X, Y, and D. Because  all of the unrealized appreciation of $180 is attributable to the three partners, D may amortize the entire basis increase of $150.

(3) If the partnership acquired the  § 197(f)(9) intangible after the effective date but could not itself amortize the asset, anti-churning applies to the extent the basis increase exceeds total unrealized appreciation attributable to the distributee and related persons to the extent that they acquired their interests from an unrelated prior partner (or partners) after the date on which the partnership acquired the asset.584
——————————————————————————————

584 Regs. § 1.197-2(h)(12)(ii)(A)(3).

——————————————————————————————

Thus, under this formula, the distributee may always amortize the portion of a  § 732(b) basis increase equal to the intangible's unrealized appreciation attributable to other unrelated partners and, under certain circumstances, to such unrealized appreciation attributable to the distributee, as well.

However, the portion of a  § 732(b) basis increase attributable to unrealized appreciation under (2) and (3) above is not amortizable if the intervening partner's acquisition of a partnership interest was part of a transaction (or series of related transactions) to allow a member of a partnership on the effective date to obtain amortization for a basis increase.585 The amount of unrealized appreciation attributable to a partner is the amount of taxable income that the partnership would have allocated to that partner had it sold the intangible for its fair market value immediately before the distribution.586
——————————————————————————————

585 Regs. § 1.197-2(h)(12)(ii)(A)(2)(iii), (A)(3)(iii).

586 Regs. § 1.197-2(h)(12)(ii)(D).

——————————————————————————————

When a former partner subsequently transfers an intangible that became partially amortizable because of a  § 732(b) basis increase, the intangible as a whole is still subject to anti-churning. The portion that a subsequent transferee may not amortize equals a fraction (i) the numerator of which is nonamortizable transferred basis from the partnership (determined under Regs.  § 1.197-2(g)(2)(ii)(B))and the total unrealized appreciation in the asset when distributed reduced by the amount of the basis increased not subject to anti-churning and (ii) the denominator of which is the fair market value of the intangible.587
——————————————————————————————

587 Regs. § 1.197-2(h)(12)(ii)(C).

——————————————————————————————

Example: XYZ partnership distributes a nonamortizable intangible to X in liquidation of X's interest. The partnership's basis in the intangible is $0 before the distribution and X receives an increase of $150 in the asset under § 732(b). The unrealized appreciation in the asset is $180(its fair market value at the time of the distribution), of which 2/3 ($120) is attributable to Y and Z. X holds the intangible as two assets, one that is amortizable with a basis of $120 and one that is nonamortizable with a basis of $30. For future transfers of the intangible, 1/3 of the intangible will continue to be subject to anti-churning, determined as follows: the sum of the amount of the distributed intangible's basis that is nonamortizable under Regs.  § 1.197-2(g)(2)(ii)(B) ($0)and the total unrealized appreciation inherent in the intangible reduced by the amount of the increase in the adjusted basis of the intangible under  § 732(b) to which the anti-churning rules do not apply ($180 - $120 = $60), over the fair market value of the distributed intangible ($180).

A taxpayer acquiring a partnership interest by a contribution of cash or property directly to a partnership is deemed to acquire a pro rata portion of that interest from each other person who is a partner at the time of the contribution.588
——————————————————————————————

588 Regs. § 1.197-2(h)(12)(ii)(E).

——————————————————————————————

2. Section 732(d) Basis Increases 

The anti-churning rules do not apply to a  § 732(d) basis increase in a distributed  § 197(f)(9) intangible if, had the partnership made a  § 754 election, the distributee partner would have been able to amortize the  § 734(b) basis increase of the intangible while it was still in the partnership's hands.589 For the amortization of  § 734(b) basis increases, see VIII, G, below.
——————————————————————————————

589 Regs. § 1.197-2(h)(12)(iii).

——————————————————————————————

For a detailed discussion of the anti-churning rules for  § 197 intangibles, including the definition of “related person,” see 533 T.M., Amortization of Intangibles.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  V. Partner's Basis in Distributed Property Other Than Money: § 732

N. Distributions Involving Long-Term Contracts 

As discussed above, partnership transactions that involve long-term contracts are addressed in regulations under  § 460 governing mid-contract changes in taxpayers engaged in completing long-term contracts.590 The regulations divide transactions that result in mid-contract changes into “constructive completion transactions” (in which the original taxpayer recognizes income from the contract at the time of the transaction) and “step-in-the-shoes transactions” (in which the “old taxpayer's” obligation to account for the contract terminates on the date of the transaction and is assumed by the “new taxpayer”).591
——————————————————————————————

590 A long-term contract is defined as 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).

591 Regs. § 1.460-4(k)(1).

——————————————————————————————

1. Partnership's Distribution of Long-Term Contract to Partner 

The distribution of a long-term contract by a partnership to a partner is generally treated as a constructive completion transaction in which the distributing partnership is the old taxpayer and the distributee partner is the new taxpayer.592
——————————————————————————————

592 Regs. § 1.460-4(k)(2)(iv).

——————————————————————————————

Under the general constructive completion rules, the old taxpayer is treated as completing the contract on the date of the transaction and recognizing income based on the contract price. The old taxpayer's “total contract price” or “gross contract price” is equal to the total of (i) amounts the old taxpayer has realized that are allocable to the contract plus (ii)  amounts the old taxpayer has received or reasonably expects to receive under the contract  minus(iii) any amount the old taxpayer paid to the new taxpayer, and any transaction costs, allocable to the contract.593 In the case of a long-term contract distributed by a partnership, the amounts realized for purposes of this formula are equal to the fair market value of the distributed contract.594
——————————————————————————————

593 Regs. § 1.460-4(k)(2)(ii), (iv)(B).

594 Regs. § 1.460-4(k)(2)(iv)(B). This provision is important in “cost of completion” (CCM)transactions, as illustrated in Example 2 below.

——————————————————————————————

Whether the old taxpayer's contract price is a “total contract price” or a “gross contract price” depends on whether the old taxpayer uses the “percentage of completion method”(PCM) or the “cost of completion method” (CCM) to account for the long-term contract. A taxpayer using the PCM must include in income for a taxable year the portion of the “total contract price” (i.e., the amount that the taxpayer reasonably expects to receive under the contract) that corresponds to the percentage of the entire contract that the taxpayer has completed during that year, determined by ascertaining the “completion factor”(i.e., the ratio of (a) “allocable contract costs” (costs allocable to the contract under Regs.  § 1.460-5) that have been incurred through the end of the taxable year to (b) total allocable contract costs that the taxpayer reasonably expects to incur under the contract).595 A taxpayer using the CCM must take into account in the year in which the taxpayer completes the contract the “gross contract price” (i.e., all amounts that the taxpayer is entitled by law or contract to receive, whether or not due or paid, and certain other amounts to the extent the “all events” test is satisfied) plus all allocable contract costs incurred by that year.596 The general basis adjustment rules for distributed long-term contracts apply regardless of whether the distributing partnership uses the PCM or the CCM, but the results may differ.
——————————————————————————————

595 Regs. § 1.460-4(b).

596 Regs. § 1.460-4(d).

——————————————————————————————

The distributee partner's basis in a distributed long-term contract and any  § 734 basis adjustment in undistributed partnership property are determined by reference to the contract's adjusted basis in the partnership's hands immediately before the distribution.597 The partnership's adjusted basis in the contract is equal to (i) the partnership's allocable contract costs (including transaction costs),  increased (or decreased) by (ii) the amount of taxable income(or loss) the partnership has recognized on the contract through the date of distribution, including amounts recognized as a result of the constructive completion transaction, and  decreased by (iii) amounts the partnership has received or reasonably expects to receive under the contract.598
——————————————————————————————

597 § § 732, 734(b).

598 Regs. § 1.460-4(k)(2)(iv)(D).

——————————————————————————————

Example 1: In Year One, W, X, Y, and Z each contribute $100,000 to form an equal partnership. The partnership enters into a long-term contract in the same year, and accounts for the contract under the PCM. The total contract price is $1,000,000, and the estimated total allocable contract costs are $800,000. In Year One, the partnership incurs costs of $600,000 and receives $650,000 in payments under the contract. In Year Two, the partnership distributes the contract to X. The partnership incurs no costs and receives no payments under the contract in Year Two. The fair market value of the contract is$150,000. The partnership has a  § 754 election in effect in Year Two. For Year One, the partnership reports receipts of $750,000 (completion factor [$600,000/$800,000]multiplied by total contract price [$1,000,000]) and reports costs of $600,000, for a profit of $150,000. In Year Two, the total contract price is $800,000 (amounts the partnership has realized [$150,000]plus amounts the partnership has received [$650,000]), and total allocable costs are $600,000. The partnership, therefore, reports receipts of$50,000 (total contract price [$800,000] minus receipts already reported[$750,000]), and has a profit of $50,000. X's basis in X's partnership interest immediately before the distribution is $150,000 (X's initial$100,000 contribution, plus $37,500 [X's one-fourth distributive share of the partnership's Year One income of $150,000] plus $12,500 [X's distributive share of Year Two income]). The partnership's basis in the contract immediately before the distribution is $150,000 (allocable contract costs [$600,000] plus income the partnership recognized through the date of distribution [$200,000] minus amounts the partnership has received [$650,000]). Under § 732, X's basis in the distributed contract is $150,000.599

——————————————————————————————

599 Regs.  § 1.460-4(k)(5) Ex. 9.

——————————————————————————————

Example 2: The facts are the same as in Example 1, except that the partnership accounts for the contract under the CCM. The partnership has no income from the contract in Year One. Under Regs. § 1.460-4(k)(2)(iv)(B), the amount that the partnership has realized under the contract is the contract's fair market value. In Year Two, therefore, the gross contract price is $800,000 (amounts the partnership has received under the contract [$650,000] plus the amount treated as realized [$150,000]), and total allocable contract costs are $600,000. Thus, the partnership reports profits of $200,000 in Year Two. X's basis in X's partnership interest immediately before the distribution is $150,000 ($100,000 initial contribution plus X's one-fourth distributive share of the partnership's $200,000 Year Two income). The partnership's basis in the contract immediately before the distribution is also $150,000(allocable contract costs [$600,000] plus taxable income through the date of the distribution [$200,000] minus amounts the partnership has received [$650,000]). X's basis in the distributed contract is$150,000.600

——————————————————————————————

600 Regs.  § 1.460-4(k)(5) Ex. 10.

——————————————————————————————

Long-term contracts are considered “unrealized receivables”within the meaning of § 751(c). Section 751(b) treats the disproportionate distribution to a partner of partnership property that is an unrealized receivable as a sale or exchange of other partnership property. The  § 460 regulations, however, provide that for purposes of  § 751 the amount of ordinary income or loss attributable to a long-term contract is the amount of income or loss that the partnership would take into account under the constructive completion rules if the partnership disposed of the contract for its fair market value in a constructive completion transaction (adjusted to account for income or loss allocated under  § 706 to the portion of the partnership's taxable year ending on the date of disposition).601 To avoid a circular computation, the regulations provide an ordering rule under which the partnership must apply the Regs.  § 1.460-4(k)(2)(ii) constructive completion rules before applying the rules of  § 751(b) to a distribution of a long-term contract to a partner.602
——————————————————————————————

601 Regs. § 1.460-4(k)(2)(iv)(E)(1).

602 Regs. § 1.460-4(k)(2)(iv)(E)(2).

——————————————————————————————

2. Partnership's Distribution of Interest in Lower-Tier Partnership Holding Long-Term Contract 

The constructive completion rules also 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.603
——————————————————————————————

603 Regs. § 1.460-4(k)(2)(iv)(A).

——————————————————————————————

The constructive completion rules do not apply, however, to a partnership's § 721 transfer of all of its assets and liabilities to another partnership if the transaction is followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership under Regs. § 1.708-1(b)(4) (regarding § 708(b)(1)(B) terminations)or Regs.  § 1.708-1(c)(3)(i) (regarding certain partnership mergers).604
——————————————————————————————

604 Regs. § 1.460-4(k)(2)(iv)(A).

——————————————————————————————

3. Deemed Distribution on Termination of Partnership Holding Long-Term Contract 

If a partnership holding a long-term contract terminates under  § 708(b)(1)(A) because the number of its owners is reduced to one, the entire long-term contract is treated as distributed from the partnership in a constructive completion transaction. As a result, the partnership must apply Regs.  § 1.460-4(k)(2) (the constructive completion rules) immediately before the transaction or transactions causing the termination to ascertain the partnership's income or loss and the distributee partner's basis (or partners' bases)in the contract.605
——————————————————————————————

605 Regs. § 1.460-4(k)(2)(iv)(A).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VI. Determination of Partnership's Initial Basis in Its Assets

A. Partnership's Basis in Contributed Property: § 723 

A partnership's basis in property contributed to it by a partner is equal to the contributing partner's adjusted basis in the property at the time of the contribution plus the amount of any gain recognized by the contributing partner under § 721(b).606 Thus, with the exception of contributions to partnerships that qualify as investment companies which result in the recognition of gain by the contributing partner, a partnership has a carryover basis in contributed property. The partnership's holding period for the property includes the contributing partner's holding period.607
——————————————————————————————

606 § 723; Regs. § 1.723-1.

607 Regs. § 1.723-1. See § 1223(2).

——————————————————————————————

A partnership's basis in encumbered contributed property is not increased by the amount of any gain recognized by the contributing partner as a result of a decrease in the partner's share of liabilities under § § 731(a) and 752(b). Any such gain is treated as arising after the contribution and not at the time of the contribution.608
——————————————————————————————

608 Rev. Rul. 84-15, 1984-1 C.B. 158.

——————————————————————————————

If a partner contributes non-business property to a partnership, the partnership's basis in the property is equal to the fair market value of the property at the time of the contribution, not the original cost of the property.609
——————————————————————————————

609 See Au v. Comr., 330 F.2d 1008 (9th. Cir.  1964) (non-business automobile contributed to partnership).

——————————————————————————————

In the event of a contribution of property by a terminating partnership to a new partnership, the new partnership's basis in the property is equal to the terminating partnership's adjusted basis in the property at the time of the contribution.610
——————————————————————————————

610 See Rev. Rul. 77-458, 1977-2 C.B. 220.

——————————————————————————————

It is a well-established rule that both recourse and nonrecourse liabilities incurred to purchase property are included in the purchaser's cost basis.611 However, in certain circumstances, the IRS has ruled that if a partner contributes property subject to a nonrecourse debt that substantially exceeds the fair market of the property at the time of the contributing partner's purchase of the property, the debt is disregarded for purposes of determining the contributing partner's basis in the partnership interest as well as the partnership's basis in the contributed property.612 Thus, the partnership's basis in the contributed property does not include the value of the disregarded nonrecourse debt.
——————————————————————————————

611 SeeCrane v. Comr., 331 U.S. 1, 14 (1947).

612 See Rev. Rul. 81-278, 1981-2 C.B. 159; Rev. Rul. 77-110, 1977-1 C.B. 58.

——————————————————————————————

The rulings in which the IRS has disregarded excessive nonrecourse debt involve abusive tax shelters.613 Thus, this rule should not apply to the contribution of property encumbered by legitimate nonrecourse debt even if the amount of that debt exceeds the fair market value of the contributed property.
——————————————————————————————

613 See § 1012.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VI. Determination of Partnership's Initial Basis in Its Assets

B. Partnership's Basis in Property Other Than Contributed Property 

1. In General —Cost Basis 

If a partnership acquires property from an unrelated third party, the partnership's basis in the property is determined by application of the general basis rules for property provided in Part II (§ § 1011-1023), Subchapter 0, Chapter 1 of the Code. Under the general rule of § 1012, a partnership's basis in an asset acquired by purchase is generally its cost.

2. Property Purchased from a Partner 

Generally, if a partner engages in a transaction with a partnership other than in the partner's capacity as a member of the partnership, the transaction is treated as occurring between the partnership and a non-partner.614 The regulations under  § 707(a) specifically provide that the sale of property by a partner to a partnership is a transaction governed by this general rule.615 The regulations also provide, however, that the substance of the transaction governs its tax treatment. Therefore, even though the transaction is treated as occurring between the partnership and a non-partner, if the transaction involves a partnership and a corporate partner,  § 482 may be applied if arm's-length consideration is not received.616
——————————————————————————————

614 § 707(a); Regs. § 1.707-1(a).

615 Regs. § 1.707-1(a).

616 See, e.g., Aladdin Indus. v. Comr., T.C. Memo 1981-245) (court held that sale by partnership to corporate partner could be subject to § 482); TAM 8539003 (§ 482 applied to payments between partnership and corporate partner).

——————————————————————————————

A partnership's basis in property purchased from a partner is determined as though the partnership acquired the property from a non-partner. Therefore, the general basis provisions (§ § 1011–1023) apply to the purchase. In the case of a sale of property by a partner to a controlled partnership(one in which the partner owns, directly or indirectly, more than 50% of the capital or profits interest), the  § 707(b) rules may apply to disallow some or all of the partner's loss or to recharacterize the partner's gain as ordinary income. The application of the  § 707(b) rules is discussed in 710 T.M., Partnerships — Conceptual Overview.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

A. Application of the Adjustment 

1. In General 

The general rule in  § 743(a) is that the bases of partnership assets are not adjusted when a partnership interest is transferred or when a partner dies.617 Thus, under the general rule, the transferee partner's share of the adjusted basis of a partnership's assets is the same as that of the transferor partner immediately before the transfer. However, the transferee partner's adjusted basis in the partnership interest is generally equal to the cost of the partnership interest618 and, ordinarily, is less than or greater than the sum of the partner's share of the partnership's adjusted bases in its assets. This discrepancy between “outside”619 and “inside”620 basis distorts the amount and the timing of a new partner's share of partnership income. Section 743(b) is intended to eliminate these distortions by allowing, or, in some cases, requiring, adjustments to a new partner's share of the partnership's adjusted bases in its assets.621 If an interest in a partnership is transferred by sale or exchange or on the death of a partner,  § 743(b) requires a partnership that has a “substantial built-in loss”622 or that has a  § 754 election in effect623 to:
——————————————————————————————

617 See also Regs. § 1.743-1(a).

618 See § 742.

619 The term “outside basis” as used in this section refers to a partner's adjusted basis in the partnership interest.

620 The term “inside basis” as used in this section refers to a partner's share of the partnership's bases in its assets.

621 For further discussion of the  § 743(b) adjustment see Pennell, “Problems Involving the Optional Adjustments to Basis of Partnership Assets,” 34 S. Cal. Tax Inst. ¶  800(1982).

622 § 743(d), effective for transfers after Oct. 22, 2004.

623 The  § 754 election is discussed in IX, below.

——————————————————————————————

(1) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of the partner's interest in the partnership over the partner's proportionate share of the adjusted basis of the partnership property; or

(2) decrease the adjusted basis of the partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of the partner's interest in the partnership.

Without a  § 743(b) adjustment, the sale of a partnership interest can lead to double taxation; the transferor partner is taxed on the sale of the interest,624 reflecting the built-in gain in partnership property, and the transferee partner is taxed on the transferee's share of partnership gain from the sale of a partnership asset due to the same built-in gain.
——————————————————————————————

624 See § 741.

——————————————————————————————

A partnership makes the  § 743(b) adjustment when a partnership interest is transferred by sale or exchange or upon death of a partner, if the partnership has a substantial built-in loss immediately after the transfer or has a  § 754 election in effect at the time of the transfer.625 Thus, the  § 743(b) adjustment is mandatory if the substantial built-in loss rule applies. A partnership has a “substantial built-in loss” if the partnership's adjusted basis in partnership property exceeds the property's fair market value by more than $250,000.626 There is an exception from the mandatory application of the adjustment for “electing investment partnerships.”This exception is discussed in VII, A, 2, below.
——————————————————————————————

625 § 743(b); Regs. § 1.743-1(b). See Rev. Rul. 79-92, 1979-1 C.B. 180 (partnership that sold property, realized gain, and elected installment method of reporting gain had  § 754 election in effect that gave one partner greater basis than partner's share of partnership's sale price; IRS ruled that partnership could use installment method, but partner with special basis adjustment would recognize partner's entire loss in year of sale). For further discussion, see 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

626 § 743(d), effective for transfers after Oct. 22, 2004.

——————————————————————————————

Example — Substantial Built-in Loss:627 Partnership PRS has assets with a fair market value of $4,000,000 and an adjusted basis of $4,400,000. PRS does not have a  § 754 election in effect for the taxable year. Partner P sells a 25% partnership interest in PRS to X for its fair market value of $1,000,000. PRS has a  § 743(d) substantial built-in loss because the adjusted basis of PRS property exceeds the fair market value of PRS property by more than $250,000 immediately after P's sale to X. Section 743(b), therefore, requires an adjustment to the basis of PRS property with respect to X. In a hypothetical sale by PRS of all of its assets for fair market value ($4,000,000), the amount of cash that X would receive on a liquidation of PRS — and, thus, X's interest in previously taxed capital — is $1,000,000 ($4,000,000 ÷  4). Assuming that X's share of PRS's adjusted basis in its assets is $1,100,000, the downward  § 743(b) adjustment with respect to X is $100,000 (X's $1,100,000 share of PRS's adjusted basis in its assets - X's $1,000,000 basis in the partnership interest).

——————————————————————————————

627 See Notice 2005-32, 2005-16 I.R.B. 895, § 8.A.

——————————————————————————————

As the example above illustrates, whether a partnership has a substantial built-in loss at the time of a transfer is determined at the partnership level, not by reference to the amount of loss recognized by the transferring partner or by reference to basis disparity at the partner level.

A substantial built-in loss, in fact, may require a partnership to increase its basis in its assets on the transfer of a partnership interest.

Example: PRS has assets with a fair market value of $4,000,000 and an adjusted basis of $4,400,000. Asset 1 has a value of $500,000 and a basis of $2,000,000; asset 2 has a value of $2,500,000 and a basis of $1,900,000; and asset 3 has a value of $1,000,000 and a basis of $500,000. PRS does not have a  § 754 election in effect. P sells P's 25% interest in PRS to X when the fair market value of the interest is $1,000,000 but P's basis is $500,000. P recognizes a $500,000 gain on the sale. PRS, nevertheless, has a substantial built-in loss immediately after the sale. PRS, therefore, must make a $500,000 upward adjustment to the basis of its assets with respect to X.

The  § 743(b) adjustment generally does not apply to a contribution of money or property to a partnership in exchange for a partnership interest.628
——————————————————————————————

628 A  § 721 transfer of a partnership interest to another partnership can give rise to a  § 743(b) adjustment, even if no gain is recognized. See, e.g., Regs.  § 1.755-1(b)(5)(iv) Ex. 2.

——————————————————————————————

Note: The adjustment does apply to a purported nontaxable contribution and distribution of money or property that is recharacterized as a sale of a partnership interest under  § 707(a)(2) and its regulations.

The adjustment is generally not available upon the transfer of a partnership interest as a gift, although the adjustment should be available to the extent of any gain recognized by the donor (if, for example, the donor's share of partnership liabilities exceeds the donor's adjusted basis in the partnership interest).

2. Exception to Mandatory Adjustment —Electing Investment Partnerships 

As stated above, if a partnership interest is transferred by sale or exchange or upon death of a partner and the partnership has a substantial built-in loss immediately after the transfer, the  § 743(b) adjustment is mandatory.629 There is an exception to this mandatory application of the adjustment applicable to “electing investment partnerships”(EIPs).
——————————————————————————————

629 § 743(d), effective for transfers after Oct. 22, 2004.

——————————————————————————————

In a transfer of an interest in an EIP,  § 743(e)(2) disallows the transferee partner's distributive share of losses, without regard to gains, from the sale or exchange of partnership property, except to the extent that it is established that the losses exceed the loss recognized on the transfer of the partnership interest by the transferor partner (or by a prior transferor to the extent not fully offset by a prior disallowance under § 743(e)(2)).  Section 743(e)(3) provides that losses disallowed under § 743(e)(2) do not decrease the transferee partner's basis in the transferee's partnership interest.

If an EIP allocates losses with a different character from the sale or exchange of property to a transferee partner, and  § 743(e)(2) limits the losses allocated to that partner, a proportionate amount of disallowed losses must consist of each loss of a separate character that is allocated to the transferee partner.630
——————————————————————————————

630 Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

The loss disallowance rules in  § 743(e) apply without regard to a  § 708(b)(1)(B) termination of the partnership.631
——————————————————————————————

631 § 743(e)(4).

——————————————————————————————

A partnership is an EIP if all of the following requirements are met:632
——————————————————————————————

632 § 743(e)(6).

——————————————————————————————

(1) the partnership would be an investment company under  § 3(a)(1)(A)of the Investment Company Act of 1940 but for an exemption under § 3(c)(1)or (7) of that Act;

(2) the partnership has never engaged in a trade or business;633

(3)substantially all of the assets of the partnership are held for investment;

(4) at least 95% of the assets contributed to the partnership are money;

(5) no contributed assets had an adjusted basis in excess of fair market value at the time of contribution;

(6) all of the partnership's interests are issued pursuant to a private offering within 24 months of the first capital contribution;

(7) the partnership agreement substantially restricts each partner's ability to cause a redemption of the partner's interest (although this requirement does not apply to EIPs in existence on June 4, 2004);

(8) the partnership agreement provides for a term of 15 years or less(20 years or less in the case of EIPs in existence on June 4, 2004);and

(9) the partnership makes an election, which is irrevocable except with the consent of the Secretary, to have  § 743(e) apply.634

——————————————————————————————

633 Under interim guidance on EIPs, an upper-tier partnership is not treated as engaged in the trade or business of a lower-tier partnership if, at all times during the period in which the upper-tier partnership owns an interest in the lower-tier partnership, the adjusted basis of its interest in the lower-tier partnership is less than 25% of the total capital that the upper-tier partnership's partners are required to contribute to the upper-tier partnership during its entire term. Notice 2005-32, 2005-16 I.R.B. 895.

634 See VII, E, 2, below, for further discussion of the reporting requirements applicable to electing investment partnerships.

——————————————————————————————

3. § 351/§ 721 Contributions 

The contribution of a partnership interest to a corporation or a partnership in a  § 351 or § 721 transaction can trigger the application of  § 743(b) if the partner transferring the interest has an adjusted basis in that interest that is different from the partner's share of the partnership's basis in its assets and no basis adjustment had been made when the transferor partner previously entered the partnership.

The manner of allocating the adjustment between and within classes of property differs from that applicable to purchase and death transfer transactions, as discussed in VII, C, below.

4. Distributions of Partnership Interests 

Section 761(e) provides that, for purposes of determining the applicability of § 743, the distribution of a partnership interest is treated as an exchange, except as otherwise set forth in regulations. The legislative history relevant to this provision provides that it was intended to result in an adjustment to the basis of partnership property “to reflect amounts recognized on transfers of partnership interests accomplished through distributions(whether by corporations or partnerships) as well as those accomplished by ordinary sales or exchanges.”635
——————————————————————————————

635 Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 239 (1/31/84).

——————————————————————————————

In Rev. Rul. 92-15,636 the IRS ruled that a distribution of a lower-tier partnership interest by an upper-tier partnership was an exchange for purposes of § 743(b). The distributing partnership in the ruling recognized no gain upon the distribution, but the IRS implied that the  § 743(b) adjustment was available. Although this implication may be contrary to Congress's intent in enacting § 761(e), Regs.  § 1.755-1(b)(5) provides express rules for the allocation of a  § 743(b) adjustment in such cases.
——————————————————————————————

636 1992-1 C.B. 215.

——————————————————————————————

It is uncertain if  § 761(e) provides for the application of  § 743(b) to distributions of partnership interests by estates or trusts. Regs. § 1.706-1(c)(3)(vi), Example (3), indicates that a distribution by an estate is not an exchange for purposes of § 706. In Rev. Rul. 72-352,637 the IRS stated that a distribution by a trust may be considered an exchange for  § 706 purposes.
——————————————————————————————

637 1972-2 C.B. 395.

——————————————————————————————

Note: Regs.  § 1.761-1(e) provides that the deemed distribution of interests in a new partnership by a partnership terminated under  § 708(b)(1)(B) is not a sale or exchange of an interest in the new partnership and that the deemed distribution of an interest in a new partnership by a partnership that terminates under  § 708(b)(1)(B) is treated as an exchange of the interest in the new partnership for purposes of § 743. In addition, the Senate Finance Committee's Report to the Tax Reform Act of 1986 states that the Senate intends for any regulations to exclude distributions by an estate or testamentary trust by reason of the death of a partner from application of § 761(e).638
——————————————————————————————

638 See S. Rep. No. 99-313, at 924(1986).

——————————————————————————————

5. Transfers of Partnership Property to a Foreign Corporation — § 367 

The regulations under  § 367 provide that if a partnership recognizes gain under  § 367 on the transfer of partnership property to a foreign corporation in exchange for stock in the corporation, each partner is treated as having transferred that partner's share of the transferred partnership property.639
——————————————————————————————

639 Regs. § 1.367(a)-1T(c)(3)(i)(A).

——————————————————————————————

For purposes of computing the partnership's basis in the stock of the foreign corporation, each partner is treated as having acquired a new partnership interest in exchange for an amount equal to any gain that the partner recognized on the transfer.640 Thus, if a  § 754 election is in effect, each partner has a basis adjustment equal to the amount of any gain that the partner recognizes.641 This adjustment should be applied to increase the partner's share of the partnership's basis in the stock of the foreign transferee corporation. However, if the partnership owns other appreciated capital or  § 1231 assets, the  § 755 allocation rules (discussed in VII, C, below) require the adjustment to be allocated between these other assets and the stock.
——————————————————————————————

640 Regs. § 1.367(a)-1T(c)(3)(i)(B).

641 It is not clear if the partners in a partnership that has a substantial built-in loss immediately after the transfer, but does not have a  § 754 election in effect at the time of the transfer, must make this basis adjustment.

——————————————————————————————

Observation: Although the  § 367 regulations arguably intended the adjustment to apply only to the stock, there is no authority for disregarding the general  § 755 allocation provisions in this context.

6. Partnership Interests Held as Community Property 

In Rev. Rul. 79-124,642 the IRS ruled that the  § 743(b) adjustment arising upon the death of a partner domiciled in a community property state applies to an entire partnership interest that is considered community property even if the estate of the deceased partner is admitted as a partner and the surviving spouse is not admitted as a partner. This rule applies regardless of which spouse predeceases the other.
——————————————————————————————

642 1979-1 C.B. 224.

——————————————————————————————

7. Application of the Adjustment to a Terminated Partnership 

Section 708(b)(1)(B) provides that a partnership terminates if 50% or more of the interests in partnership capital and profits are sold or exchanged within a 12-month period. If the terminating partnership has a  § 754 election in effect for the taxable year of termination(or, presumably, if it has a substantial built-in loss), the election applies to an incoming partner. Therefore, the bases of the partnership assets are adjusted pursuant to  § § 743 and 755 before the terminating partnership is deemed to contribute them to the new partnership.643
——————————————————————————————

643 Regs. § 1.708-1(b)(5).

——————————————————————————————

A  § 743 adjustment in the terminating partnership carries over to the new partnership.644
——————————————————————————————

644 Regs. § 1.743-1(h)(1).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

B. Computation of the Adjustment 

1. In General 

Section 743(b), if applicable, requires the transferee partner to increase the transferee's share of the partnership's bases in its assets “by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property”645 or to decrease the transferees' share of the partnership's bases in its assets “by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership.”646 The adjustment is allocated according to § 755, discussed in VII, C, below.
——————————————————————————————

645 § 743(b)(1).

646 § 743(b)(2).

——————————————————————————————

2. Determination of Partner's “Proportionate Share” of Partnership's Bases in Its Assets 

a. In General 

A transferee's share of the partnership's adjusted basis in partnership property is equal to the sum of the transferee's interest as a partner in the partnership's previously taxed capital, plus the transferee's share of partnership liabilities.647 The partner's share of the partnership's previously taxed capital is determined by reference to a hypothetical transaction in which (immediately after the transfer of the partnership interest)the partnership is assumed to have sold all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets.648 The partner's share of the partnership's previously taxed capital is equal to (i)the amount of cash that the transferee would receive upon liquidation of the partnership immediately following the hypothetical transaction, increased by (ii) the amount of the tax loss that would be allocated to the transferee from the hypothetical transaction, and decreased by (iii) the amount of the tax gain that would be allocated to the transferee from the hypothetical transaction.649 The increase for tax loss and decrease for tax gain are computed taking into consideration any remedial allocations under § 1.704-3(d).650 However, the regulations do not state that curative allocations are to be taken into account, perhaps because these types of allocations are dependent upon the availability and amount of offsetting items.
——————————————————————————————

647 Regs. § 1.743-1(d)(1). See also Cuff, “New Section 743/755 Regulations for Adjusting ‘Inside’Basis,” 92 J. Tax'n 281 (May 2000). Previous regulations under  § 743(b) provided that a transferee partner's proportionate share of a partnership's basis in its assets was equal to the sum of the transferee partner's interest as a partner in partnership capital and surplus, plus the transferee's share of partnership liabilities. Former Regs. § 1.743-1(b)(effective for transfers occurring before Dec. 15, 1999). The former regulations did not provide, other than by example, guidance on how to determine a transferee partner's share of the adjusted basis of partnership property. The method of allocation used by the partnership did not affect the calculation of a transferee partner's proportionate share of the partnership's basis in its assets.

648 Regs. § 1.743-1(d)(1), (2).

649 Regs. § 1.743-1(d)(1)(i)-(iii).

650 Regs. § 1.743-1(d)(1)(ii), (iii).

——————————————————————————————

b. Examples 

Example — Upward Adjustment — No Contributed Property: Assume that the XYZ Partnership has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Accts. Receivable	$30,000	$30,000	
Inventory	 30,000	 60,000	
Capital Assets	 60,000	120,000	
 	 	 	
Recourse Liabilities	 30,000	 30,000 	
Capital:	 	 	
X	 30,000	 60,000 	
Y	 30,000	 60,000 	
Z	 30,000	 60,000	

Each of the partners owns a one-third interest in partnership capital and profits and each partner's share of partnership liabilities is$10,000. Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on January 1 for $60,000. D's adjusted basis in the partnership interest is $70,000 ($60,000 cost plus $10,000 share of partnership liabilities).651 If XYZ sold all of its assets for cash equal to the fair market value of its assets ($210,000), the amount of cash that D would receive on a liquidation of XYZ would be $60,000 (($210,000 cash minus$30,000 liability) divided by 3). The amount of tax gain allocated to D would be $30,000 ($90,000 gain in partnership assets divided by 3). D's interest in previously taxed capital is, therefore, equal to $30,000 ($60,000 cash received upon hypothetical liquidation minus$30,000 hypothetical tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $40,000 ($30,000 share of previously taxed capital plus $10,000 share of liabilities). The amount of the § 743(b) upward adjustment is $30,000 (D's $70,000 basis in the partnership interest minus D's $40,000 share of the partnership's adjusted basis in its assets). The adjustment is allocated under the rules provided in § 755, discussed in VII, C, below.

——————————————————————————————

651 § § 742, 752(a).

——————————————————————————————

Example — Downward Adjustment — No Contributed Property: Assume that the XYZ Partnership has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Accts. Receivable	$30,000	$30,000	
Inventory	 30,000	 10,000	
Capital Assets	 60,000	 50,000	
 	 	 	
Recourse Liabilities	 30,000	 30,000 	
Capital:	 	 	
X	 30,000	 20,000 	
Y	 30,000	 20,000 	
Z	 30,000	 20,000	

Each of the partners owns a one-third interest in partnership capital and profits and each partner's share of partnership liabilities is$10,000. Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on January 1 for $20,000. D's adjusted basis in his partnership interest is $30,000 ($20,000 cost plus $10,000 share of partnership liabilities).652 If XYZ sold all of its assets for cash equal to the fair market value of its assets ($90,000), the amount of cash that D would receive on a liquidation of XYZ would be $20,000 (($90,000 cash minus$30,000 liability) divided by 3). The amount of tax loss allocated to D would be $10,000 ($30,000 loss in partnership assets divided by 3). D's interest in previously taxed capital is, therefore, equal to $30,000 ($20,000 cash received upon hypothetical liquidation plus$10,000 hypothetical tax loss allocated to D). D's share of the adjusted partnership's basis in its property is $40,000 ($30,000 share of previously taxed capital plus $10,000 share of liabilities). The amount of the § 743(b) downward adjustment is $10,000 (D's $40,000 share of the partnership's adjusted basis in its assets minus D's $30,000 basis in the partnership interest). The adjustment is allocated under the rules provided in § 755, discussed in VII, C, below.

——————————————————————————————

652 § § 742, 752(a).

——————————————————————————————

Example — Contributed Property/Traditional Method: In Year One individual partners X, Y, and Z form partnership XYZ in which each has an equal interest in capital and profits. X and Y each contribute$100,000 cash, and Z contributes land with a fair market value of$100,000 and an adjusted basis of $10,000. Assume that on Jan. 1, Year Three, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Land	$10,000	$100,000	
Cash	200,000	 200,000	
Capital	 	 	
X	100,000	 100,000 	
Y	100,000	 100,000 	
Z	 10,000	 100,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $100,000. D's adjusted basis in the partnership interest is $100,000.653 If XYZ sold all of its assets for cash equal to the fair market value of its assets ($300,000), the amount of cash that D would receive on a liquidation of XYZ would be $100,000. Under Regs. § 1.704-3(a)(7), the amount of tax gain allocated to D would be $90,000 (assuming that Z was not a partner from whom the partnership had assumed a Regs. § 1.752-7 liability). D's interest in previously taxed capital is, therefore, equal to $10,000($100,000 cash received upon hypothetical liquidation minus $90,000 hypothetical tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $10,000 ($10,000 share of previously taxed capital plus $0 share of liabilities). The amount of the  § 743(b) upward adjustment is $90,000 (D's $100,000 basis in the partnership interest minus D's$10,000 share of the partnership's adjusted basis in its assets).

——————————————————————————————

653 § 742.

——————————————————————————————

Assume, instead that the XYZ has the following balance sheet on Jan. 1, Year Three:

 Assets	
 Adjusted Basis	Fair Market Value	
Land	$10,000	$70,000	
Cash	200,000	200,000	
Capital	 	 	
X	100,000	 90,000 	
Y	100,000	 90,000 	
Z	 10,000	 90,000	

As reflected on the balance sheet, the contributed land has depreciated in value to $70,000. Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $90,000. D's adjusted basis in his partnership interest is $90,000.654 If XYZ sold all of its assets for cash equal to the fair market value of its assets ($270,000), the amount of cash that D would receive on a liquidation of XYZ would be $90,000. Under Regs. § 1.704-3(a)(7), the amount of tax gain allocated to D would be$60,000 (because, under the traditional method, pursuant to the ceiling rule, the amount of gain allocated to D would be limited to $60,000). D's interest in previously taxed capital is, therefore, equal to $30,000($90,000 cash received upon hypothetical liquidation minus $60,000 hypothetical tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $30,000 ($30,000 share of previously taxed capital plus $0 share of liabilities). The amount of the  § 743(b) upward adjustment is $60,000 (D's $90,000 basis in the partnership interest minus D's$30,000 share of the partnership's adjusted basis in its assets).

——————————————————————————————

654 § 742.

——————————————————————————————

Note: If the land appreciated in value to $100,000 following D's purchase of the partnership interest and the land were then sold by the partnership, all $90,000 of the tax gain would be allocated to D. The $60,000 upward adjustment would not be sufficient to eliminate all of the built-in  § 704(c) gain that must be allocated to D as the transferee of Z's interest. This is one of the disadvantages of the traditional method.

Example — Contributed Property/Remedial Method: Refer to the example above. Assume, instead, that Z's initial capital contribution consisted of publicly-traded stock and that XYZ uses the remedial method of allocations. Assume that on Jan. 1, Year Three, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Stock	$10,000	$70,000	
Cash	200,000	200,000	
Capital	 	 	
X	100,000	 90,000 	
Y	100,000	 90,000 	
Z	 10,000	 90,000	

The $30,000 decrease in the value of the stock has been reflected in each of the partner's book accounts (as permitted by Regs. § 1.704-1(b)(2)(iv)(f)(5)), so that, assuming no other adjustments, on Jan. 1, Year Three, each of the partners book and tax accounts are as follows:
 	X	 	Y	 	Z	 	
 	Book	Tax	Book	Tax	Book	Tax	
Initial
 Balance	$100,000 	$100,000 	$100,000 	$100,000 	$100,000 	$10,000	
$30,000 Loss/Value	(10,000) 	 	 (10,000) 	 	 (10,000) 	 	
Balance	90,000 	 100,000 	 90,000 	 100,000 	 90,000 	 10,000 	

There is now a $10,000 book/tax discrepancy with respect to the cash contributing partners. Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $90,000. D's adjusted basis in the partnership interest is $90,000.655 If XYZ sold all of its assets for cash equal to the fair market value of its assets ($270,000), the amount of cash that D would receive on a liquidation of XYZ would be $90,000. Under the remedial method, although the actual built-in gain is only $60,000 ($70,000 value minus $10,000 adjusted basis), there needs to be $20,000 of remedial loss to account for the $20,000 book/tax disparity applicable to the noncontributing partners. There also needs to be an additional $20,000 of remedial tax gain allocated to D to offset the remedial loss. Thus, the amount of tax gain allocated to D would be $80,000. D's interest in previously taxed capital is, therefore, equal to $10,000 ($90,000 cash received upon hypothetical liquidation minus $80,000 tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $10,000 ($10,000 share of previously taxed capital plus $0 share of liabilities). The amount of the  § 743(b) upward adjustment is $80,000 (D's $90,000 basis in the partnership interest minus D's $10,000 share of the partnership's adjusted basis in its assets).

——————————————————————————————

655 § 742.

——————————————————————————————

Note: The amount of tax gain allocated to a transferee partner pursuant to the hypothetical sale by the partnership of all of its assets may include gain other than  § 704(c) gain, such as minimum gain chargebacks.

Example — Minimum Gain Chargeback: In Year One, X, Y, and Z form an LLC to which each contributes $10,000 cash. The LLC agreement provides that LLC profits are shared equally. Also, in Year One, the LLC purchases $120,000 of depreciable property for a $30,000 cash and a $90,000 nonrecourse note. No principal payments are due on the note for three years. The LLC has no other nonrecourse liabilities. Assuming that the LLC selects no special allocation method, X, Y, and Z share the debt equally immediately following the purchase of the property. The $30,000 increase in each member's share of LLC liabilities is treated as a cash contribution to the LLC. Thus, each member's adjusted basis in the member's partnership interest is increased by $30,000 to $40,000.

In Year One, Year Two, and Year Three, the LLC claims a depreciation deduction of $12,000 each year for the property.656 The depreciation deductions decrease the LLC's adjusted basis in the property to $84,000 as of the close of Year Three. The amount of minimum gain at the end of Year Three is$6,000 ($90,000 nonrecourse liability - $84,000 adjusted basis in the property). As of the close of Year Two, the amount of minimum gain was $0 ($90,000 nonrecourse liability - $96,000 adjusted basis in the property). Thus, minimum gain increased by $6,000 in Year Three. Because of this increase in minimum gain, the $6,000 of the $12,000 depreciation deduction in Year Three is considered a nonrecourse deduction. Absent a special allocation provision, X, Y, and Z share this nonrecourse deduction equally. Therefore, at the end of Year Three, X, Y, and Z each have a Year Three share of minimum gain, and are each allocated $2,000 of the LLC nonrecourse liability under Tier One to match their $2,000 shares of LLC minimum gain. The balance of the nonrecourse liability is shared equally by X, Y, and Z. Thus, each partner's share of the nonrecourse liability is still $30,000.

Assume that the LLC has the following balance sheet on Jan. 1, Year Four:

 Assets	
 Adjusted Basis	Fair Market Value	
Depreciable Property	$84,000	$180,000	
Liabilities & 
 Capital	 	 	
Nonrecourse
 Liabilities	 90,000	  90,000 	
X	(–2,000)	  30,000 	
Y	(–2,000)	  30,000 	
Z	(–2,000)	  30,000 	

Assume that the LLC has a  § 754 election in effect and that Z sells Z's LLC interest to D on Jan. 1, Year Four, for $30,000. D's adjusted basis in the LLC interest is $60,000 ($30,000 cost + $30,000 share of nonrecourse liability).657 If the LLC sold all of its assets for cash equal to the fair market value of its assets ($180,000), the amount of cash that D would receive on a liquidation of the LLC would be $30,000 (($180,000 cash - $90,000 liability) ÷  3). The amount of tax gain allocated to D would be $32,000 ($96,000 gain on sale of property ÷ 3). D's interest in previously taxed capital is, therefore, equal to negative $2,000 ($30,000 cash received upon hypothetical liquidation -$32,000 tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $28,000 (negative $2,000 share of previously taxed capital + $30,000 share of liabilities). The amount of the  § 743(b) upward adjustment is $32,000 (D's $60,000 basis in the partnership interest -D's $28,000 share of the partnership's adjusted basis in its assets).

If, instead, the LLC agreement provides that all depreciation deductions are allocated to Z, and the partnership agreement contains all of the provisions needed for the safe harbor nonrecourse deduction provision, including a minimum gain chargeback provision, $6,000 of the depreciation deduction in Year Three is a nonrecourse deduction allocated to Z. Thus, Z's share of the LLC minimum gain is $6,000. Z is allocated$6,000 of the nonrecourse liability under Tier One. The balance of the nonrecourse liability is shared equally by X, Y, and Z. Thus, X's share of the liability is $28,000, Y's share is $28,000, and Z's share is $34,000. If the LLC has a  § 754 election in effect and Z sells Z's interest to D on Jan. 1, Year Four, for $30,000, D's adjusted basis in D's LLC interest is $64,000 ($30,000 cost + $34,000 share of nonrecourse liability).658 If the LLC sold all of its assets for cash equal to the fair market value of its assets ($180,000), the amount of cash that D would receive on a liquidation of the LLC would be $30,000 (($180,000 cash - $90,000 liability) ÷  3). The amount of tax gain allocated to D would be $36,000 ($6,000 required to be allocated under the minimum gain chargeback provision + 1/3 of the remaining $90,000 of gain). D's interest in previously taxed capital is, therefore, equal to negative $6,000 ($30,000 cash received upon hypothetical liquidation - $36,000 tax gain allocated to D). D's share of the adjusted partnership's basis in its property is $28,000 (negative$6,000 share of previously taxed capital + $34,000 share of liabilities). The amount of the  § 743(b) upward adjustment is $36,000 (D's $64,000 basis in the partnership interest -D's $28,000 share of the partnership's adjusted basis in its assets).

——————————————————————————————

656 For the sake of simplicity, assume that depreciation is straight-line over 10 years without conforming to any of the depreciation conventions.

657 § § 742, 752(a).

658 § § 742, 752(a).

——————————————————————————————

3. Computation of an Estate's § 743(b)Adjustment 

As discussed in II, B, 2, above, an estate's initial basis in its partnership interest, under  § 1014(a) and (c), is generally equal to the fair market value of the interest at the date of the partner's death or at the alternate valuation date, increased by the estate's share of partnership liabilities on that date, and decreased to the extent that such value is attributable to income in respect of a decedent (IRD).659
——————————————————————————————

659 Regs. § 1.742-1. Property acquired from a decedent dying after 2009 generally has a carryover basis unless all or a portion of the $1,300,000 “aggregate basis increase”or the $3,000,000 “aggregate spousal property basis increase”is allocated to the property. § 1022.

——————————————————————————————

If, on the death of a partner, there is a  § 754 election in effect or the partnership has a substantial built-in loss, the successor in interest receives a  § 743(b) adjustment equal to the difference between its adjusted basis in its partnership interest and its proportionate share of the partnership's bases in partnership assets. The “transfer,” for purposes of § 743(b), occurs on the date of the partner's death.660
——————————————————————————————

660 See Rev. Rul. 79-84, 1979-1 C.B. 223 (“transfer” of partnership interest held by grantor trust occurs for  § 743(b) purposes on date of grantor partner's death).

——————————————————————————————

Example: The XYZ partnership has the following balance sheet on the date of Z's death:

 Assets	
 Adjusted Basis	Fair Market Value	
Unrealized Receivables	$0	$150,000	
Land	480,000	 600,000	
Capital	 	 	
X	160,000	 250,000 	
Y	160,000	 250,000 	
Z	160,000	 250,000	

On the date of death, Z owned a 1/3 interest in partnership capital, with a fair market value of $250,000. The estate's adjusted basis in Z's partnership interest is $200,000 ($250,000 fair market value -$50,000 share of unrealized receivables, treated as IRD). The estate's share of XYZ's bases in its assets is $160,000 (the estate's share of the value of the land ($200,000) - the amount of gain that would be allocated to the estate if XYZ had sold the land ($40,000)). If XYZ has a  § 754 election in effect, the  § 743(b) adjustment is an upward adjustment of $40,000 ($200,000 (estate's adjusted basis in the XYZ interest) - $160,000 (estate's share of inside basis)). The adjustment is allocated to the land. Immediately after Z's death, therefore, the partnership's balance sheet is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Unrealized Receivables	$0	$150,000	
Land	480,000
 (+ $40,000
  adj.)	 600,000	
Capital	 	 	
X	160,000	 250,000 	
Y	160,000	 250,000 	
Estate	200,000	 250,000	

If the receivable is collected during the taxable year, after Z's death, each of the partners, including the estate, includes $50,000 in income and increases the partner's basis in the partnership by$50,000:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	$150,000	$150,000	
Land	 480,000
 (+ $40,000
  adj.)	 600,000	
Capital	 	 	
X	 210,000	 250,000 	
Y	 210,000	 250,000 	
Estate	 250,000	 250,000	

4. Computation of Adjustment When Partnership Holds Long-Term Contract 

The transfer of an interest in a partnership that holds a long-term contract raises special issues, because the contract itself is not completed at the time of the partnership transaction.661 Partnership transactions that involve long-term contracts are addressed in regulations under  § 460 governing mid-contract changes in taxpayers engaged in completing long-term contracts. The regulations divide transactions that result in mid-contract changes into “constructive completion transactions” (in which the original taxpayer recognizes income from the contract at the time of the transaction) and “step-in-the-shoes transactions”(in which the “old taxpayer's” obligation to account for the contract terminates on the date of the transaction and is assumed by the “new taxpayer”).662
——————————————————————————————

661 A long-term contract is defined as any contract for the manufacture, building, or construction of property if the contract is not completed within the taxable year in which it is entered into. § 460(f)(1).

662 Regs. § 1.460-4(k)(1).

——————————————————————————————

The transfer of an interest in a partnership that holds a long-term contract is generally a step-in-the-shoes transaction if the partnership closes its books under  § 706 with respect to the contract when the interest is transferred.663 Such a partnership that closes its books under  § 706 is both the old taxpayer and the new taxpayer for purposes of the step-in-the-shoes rules.664 The partnership, therefore, must recognize gain on the transfer if the partnership accounts for the contract under the “percentage of completion method” (PCM), but the partnership does not recognize any revenue (and may not deduct any costs) with respect to the contract if it accounts for the contract under the “cost of completion method” (CCM).665 A taxpayer using the PCM must include in income for a taxable year the portion of the “total contract price” (i.e., the amount that the taxpayer reasonably expects to receive under the contract) that corresponds to the percentage of the entire contract that the taxpayer has completed during that year, determined by ascertaining the “completion factor”(i.e., the ratio of (a) “allocable contract costs” (costs allocable to the contract under Regs.  § 1.460-5) that have been incurred through the end of the taxable year to (b) total allocable contract costs that the taxpayer reasonably expects to incur under the contract).666 A taxpayer using the CCM must take into account in the year in which the taxpayer completes the contract the “gross contract price” (i.e., all amounts that the taxpayer is entitled by law or contract to receive, whether or not due or paid, and certain other amounts to the extent the “all events” test is satisfied) plus all allocable contract costs incurred by that year.667
——————————————————————————————

663 Regs. § 1.460-4(k)(3)(i)(K), (v)(D). A transfer that terminates the partnership under  § 708(b)(1)(A) because it reduces the number of owners to one results in a deemed distribution of the long-term contract and is, therefore, a constructive completion transaction, rather than a step-in-the-shoes transaction, under Regs. § 1.460-4(k)(2)(iv). See V, N, above.

664 Regs. § 1.460-4(k)(3)(v)(D). A partnership that does not properly close its books under  § 706 must compute its income or loss from the contract as though no change in taxpayer occurred on the transfer of the interest, and must allocate the income or loss from the contract under a reasonable method complying with § 706.

665 Regs. § 1.460-4(k)(3)(ii)(A).

666 Regs. § 1.460-4(b).

667 Regs. § 1.460-4(d).

——————————————————————————————

For purposes of determining under Regs.  § 1.743-1(d) the transferee partner's share of the adjusted basis in the property of a partnership holding a long-term contract, and for purposes of allocating the basis of such a partnership among and within classes of property under Regs. § 1.755-1(b) (discussed below), the amount of ordinary income or loss attributable to the long-term contract is the amount of income or loss the partnership would take into account if, at the time the partnership interest is transferred, the partnership disposed of the contract for its fair market value in a constructive completion transaction.668 If all or part of the transferee's § 743(b) basis adjustment is allocated to a long-term contract, the basis adjustment reduces or increases the transferee's distributive share of income or loss from the contract. If the long-term contract is accounted for under the CCM, the basis adjustment is taken into account in the year in which the contract is completed; if the contract is accounted for under another long-term contract method, the partnership must determine the portion of the basis adjustment recovered in each taxable year of the partnership “in a manner that reasonably accounts for the adjustment over the remaining term of the contract.”669
——————————————————————————————

668 Regs. § 1.460-4(k)(3)(v)(B).

669 Regs. § 1.460-4(k)(3)(v)(B).

——————————————————————————————

Example: W, X, Y, and Z each contribute $100,000 to form an equal partnership in Year One. The partnership enters into a long-term contract in Year One and accounts for the contract under the PCM. The total contract price is $1,000,000, and the estimated total allocable contract costs are $800,000. In Year One, the partnership incurs costs of $600,000 and receives $650,000 in payments under the contract. In Year Two, W transfers W's interest in the partnership to T for$150,000. Also in Year Two, the partnership incurs $10,000 of costs before the transfer and $40,000 after the transfer. The partnership receives no payments in Year Two. The fair market value of the contract on the date of transfer is $160,000, and the partnership closes its books under  § 706 with respect to the contract on the date of transfer. For Year One, the partnership reports receipts of $750,000 (completion factor ($600,000 ÷ $800,000) x total contract price ($1,000,000)) and costs of$600,000, for a $150,000 profit. For the part of Year Two ending on the date of W's transfer, the partnership reports receipts of $12,500((completion factor [$610,000 ÷  $800,000] x total contract price [$1,000,000]) - receipts already reported ($750,000))and costs of $10,000, for a profit of $2,500. For the part of Year Two after the transfer, the partnership reports receipts of $134,052((completion factor [$650,000 ÷  $725,000] x total contract price [$1,000,000]) - receipts reported through the date of transfer ($762,500)) and costs of $40,000, for a profit of $94,052. W's amount realized is $150,000 (the amount for which W transferred the interest to T), and W's adjusted basis in its partnership interest is $138,125 ($100,000 originally contributed + W's distributive share($37,500) of the partnership's Year One income + W's share ($625)of the partnership's Year Two income before the transfer). W's income from the sale of W's interest, therefore, is $11,875. If the partnership had disposed of the contract in a constructive completion transaction, the total contract price would have been $810,000 (amounts received under the contract ($650,000) + the amount realized in the deemed sale ($160,000)670 and the partnership would have reported receipts and a profit of $47,500 (total contract price ($810,000) - receipts already reported ($762,500))and no costs. The amount of ordinary income attributable to the contract, therefore, is $47,500, W's share is $11,875, and all of W's share is ordinary income.671 T's adjusted basis for its partnership interest is $150,000. Under Regs. § 1.743-1(d)(2), T would be allocated income of $11,875 if the contract were disposed of for fair market value (adjusted for income from the contract for the part of the year ending on the date of transfer). T's  § 743(b) adjustment, therefore, is $11,875 under Regs. § 1.743-1(b).672

——————————————————————————————

670 See Regs.  § 1.460-4(k)(2)(iv)(B) (in distribution of long-term contract by partnership to partner (a constructive completion transaction), amount realized from transaction is fair market value of contract).

671 Under Regs. § 1.460-4(k)(2)(iv)(E), long-term contracts are unrealized receivables within the meaning of § 751(c), and the amount of ordinary income or loss attributable to a long-term contract is the amount of income or loss that the partnership would take into account under the constructive completion rules if the partnership disposed of the contract for its fair market value in a constructive completion transaction (adjusted to account for income or loss allocated under  § 706 to the portion of the partnership's taxable year ending on the date of disposition).

672 Regs.  § 1.460-4(k)(5) Ex. 13.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

C. Allocation of the Adjustment — § 755 

1. In General 

Section 743(c) provides that the  § 743(b) adjustment is to be allocated in accordance with the rules set forth in § 755.  Section 755(a) generally allocates the adjustment in a manner that reduces the difference between the fair market value and the adjusted basis of partnership properties. Alternatively, the adjustment may be allocated in any other manner permitted by regulation.673  Section 755(b) provides that in allocating the adjustment, to the extent the adjustment is attributable to property consisting of (i) capital assets and  § 1231(b) property (capital gain property) and (ii) any other property, the adjustment must be allocated to partnership property of a like character (ordinary income property). The adjustment may not reduce the basis of partnership property below zero.674 The  § 743(b) adjustment is first allocated between the two classes of partnership property (capital gain property and ordinary income property) and is then allocated among the assets in each category.675 There are special allocation rules applicable to substituted basis transactions.676
——————————————————————————————

673 § 755(a).

674 § 755(b).

675 Regs. § 1.755-1(a)(1).

676 See VII, C, 3, below.

——————————————————————————————

2. Transactions Other Than Substituted Basis Transactions — Purchase and Death Transfers 

a. Valuation of Partnership Assets 

(1) In General 

To allocate the  § 743(b) adjustment between and among the two classes of partnership property, the partnership must value each of its assets.677 The determination of the fair market value of partnership assets is integral to the allocation of the adjustment. The regulations under  § 755 provide rules relevant to this valuation.678
——————————————————————————————

677 Regs. § 1.755-1(a)(1).

678 Regs. § 1.755-1(a).

——————————————————————————————

In 1988, the IRS issued temporary regulations679 to coordinate the  § 755 allocation rules with § 1060. These temporary regulations were removed in 2003.  Section 1060 generally provides that, in the case of any “applicable asset acquisition,”the consideration received for such assets must be allocated among the assets in the manner prescribed by § 338(b)(5).680 The regulations under  § 338(b)(5) generally prescribe a “residual method” for the valuation of goodwill and going concern, pursuant to which the amount of the transferee's basis that exceeds the fair market value of the acquired tangible and intangible assets other than goodwill and going concern value is allocated to goodwill and going concern value.681
——————————————————————————————

679 T.D. 8215, 53 Fed. Reg. 27035 (7/18/88) (removed by T.D. 9059, 68 Fed. Reg. 34293 (6/9/03)).

680 § 1060(a). Generally, “applicable asset acquisition”means any direct or indirect transfer of assets that constitute a trade or business if the transferee's basis in the assets is determined wholly by reference to the consideration paid. § 1060(c). Regs.  § 1.1060-1(b)(2) provides that assets are treated as constituting a trade or business if they represent an active trade or business (as determined under  § 355) or if they are of such a nature that goodwill could conceivably accompany them. Partnership assets generally constitute active trades or businesses under § 355. In fact, even the active ownership of rental real estate constitutes an active trade or business under § 355. See Regs. § 1.355-3(b)(2)(iv)(B), (c) Ex. 12. However, the passive ownership of investment property is not considered an active trade or business. See Regs. § 1.355-3(b)(2)(iv).

681 See Regs. § 1.338-6(b); former Regs. § 1.338(b)-2T.

——————————————————————————————

Section 1060(d), added by the Technical and Miscellaneous Revenue Act of 1988,682 specifies the extent to which the rules of  § 1060 apply to partnership transactions.  Section 1060(d)(1) originally provided that the rules in § 1060(a) (and, therefore, the regulations under  § 338(b)(5)) applied to partnership distributions and transfers of partnership interests only in determining the value of “goodwill or going concern value (or similar items)”for purposes of § 755. The Omnibus Budget Reconciliation Act of 1993683 amended  § 1060(d)(1) to require application of the residual method to the valuation of “§ 197 intangibles” for purposes of § 755. Section 1060(d)(2) provides that, if  § 755 applies to a distribution or transfer, the distribution or transfer is treated as an applicable asset acquisition for purposes of  § 1060(b) (which imposes reporting requirements on both the transferor and the transferee in an applicable asset acquisition).
——————————————————————————————

682 P.L. 100-647, § 1006.

683 P.L. 103-66, § 13261. The same section of the 1993 Act added § 197, which entitles taxpayers in some circumstances to amortize certain intangibles, including goodwill and going concern value.

——————————————————————————————

Because  § 1060(d) was added, and then amended, after the temporary regulations under  § 755 became effective, certain discrepancies (discussed below) existed between  § 1060(d) and the temporary regulations. On April 5, 2000, the IRS issued proposed regulations under § 755, partly to address the inconsistencies.684 The proposed regulations were finalized, with modifications, on June 9, 2003.685 These final regulations are discussed in VII, C, 2, a, (2), below, and the former temporary regulations are discussed in VII, C, 2, a, (3), below.
——————————————————————————————

684 REG-107872-99, 65 Fed. Reg. 17829 (4/5/00).

685 T.D. 9059, 68 Fed. Reg. 34293 (6/9/03).

——————————————————————————————

(2) Final Regulations 

The final regulations apply to transfers of partnership interests and distributions of property from partnerships that occur on or after June 9, 2003.686 The regulations apply to basis adjustments under § § 732(d), 734(b), and 743(b). The most significant difference between the temporary regulations and the final regulations is that the final regulations apply the residual method of valuation to all “§ 197 intangibles” (not merely goodwill and going concern value) and only apply this method to assets that constitute a trade or business.687 This “trade or business”provision makes sense because most often a partnership with  § 197 intangibles is operating a trade or business.
——————————————————————————————

686 Regs. § 1.755-1(e)(2).

687 The 1999 proposed regulations applied the residual method to value all partnership assets and technically applied to all partnerships, which the IRS concluded was “unduly complex.” See preamble to T.D. 9059, 68 Fed. Reg. 34293.

——————————————————————————————

The final regulations prescribe the method by which a partnership assigns values to its assets if those assets constitute a trade or business. The determination of whether a partnership's assets constitute a “trade or business” is made by applying Regs. § 1.1060-1(b)(2).688 To value its assets, the partnership follows these three steps:
——————————————————————————————

688 Regs. § 1.755-1(a).

——————————————————————————————

• The partnership first determines the fair market value of each of its assets other than  § 197 intangibles, taking into consideration all relevant facts and circumstances and taking into account  § 7701(g) (which treats the fair market value of property as not less than the amount of any nonrecourse indebtedness to which the property is subject).689 For purposes of these regulatory provisions, “§ 197 intangibles”include  § 197 intangibles, as defined in § 197, as well as any goodwill or going concern value that does not qualify as a  § 197 intangible under § 197.690

• The partnership then determines the gross value of all partnership assets (“partnership gross value”).691 The regulations provide separate rules for determining partnership gross value applicable to  § 743(b) adjustments that arise in taxable transactions,  § 743(b) adjustments that arise upon the death of a partner, § 743(b) adjustments that result from a substituted basis transaction,692 and  § 734(b) adjustments.693 The regulations generally provide that, if a partnership interest is transferred in a taxable transaction, partnership gross value is equal to the amount that, if assigned to all partnership property, would result in a liquidating distribution to the transferee partner equal to that partner's basis (reduced by the amount, if any, of that basis that is attributable to partnership liabilities) in the transferred partnership interest immediately following the transfer.694 If special circumstances apply, the partnership determines partnership gross value in a different manner. For instance, the regulations provide that if the income and loss with respect to certain  § 197 intangibles are allocated differently among the partners, the partnership determines partnership gross value by assigning value, first, among  § 197 intangibles other than goodwill and going concern value in a manner that (1) is consistent with the ordering rules prescribed in Regs.  § 1.755-1(a)(5) and(2) and would cause the appropriate liquidating distribution described above.”695 If the actual fair market values of the partnership's  § 197 intangibles other than goodwill and going concern value are not sufficient to cause the appropriate liquidating distribution, then the fair market value of goodwill and going concern value is assumed to be equal to an amount that if assigned to those two intangibles would cause the appropriate liquidating distribution.696 If a partnership interest is transferred as a result of the death of a partner, then, solely for purposes of computing partnership gross value, the transferee partner's basis in the partnership interest is determined without regard to  § 1040(c) and is deemed to be adjusted for any portion of the interest that is attributable to items representing income in respect of a decedent.697

——————————————————————————————

689 Regs. § 1.755-1(a)(2), (3).

690 Regs. § 1.755-1(a)(2).

691 Regs. § 1.755-1(a)(2), (4).

692 See VII, C, 3, below.

693 See VIII, B, below.

694 Regs. § 1.755-1(a)(4)(i)(A).

695 Regs. § 1.755-1(a)(4)(i)(B).

696 Regs. § 1.755-1(a)(4)(i)(B).

697 Regs. § 1.755-1(a)(4)(i)(C).

——————————————————————————————

Finally, the partnership uses the residual method to assign values to the partnership's  § 197 intangibles.698 If the aggregate value of partnership property other than  § 197 intangibles is equal to or greater than partnership gross value, then all  § 197 intangibles are deemed to have a value of zero.699 In all other cases, the aggregate value of the partnership's  § 197 intangibles(the “residual  § 197 intangibles value”) is deemed to equal the excess of partnership gross value over the aggregate value of partnership property other than  § 197 intangibles. The residual § 197 intangibles value must be allocated, first, among  § 197 intangibles other than goodwill and going concern value, and then to goodwill and going concern value.700
——————————————————————————————

698 Regs. § 1.755-1(a)(2), (5).

699 Regs. § 1.755-1(a)(5)(i).

700 Regs. § 1.755-1(a)(5)(i).

——————————————————————————————

(3) Former Temporary Regulations 

The temporary regulations applied to any  § 743(b) adjustment made as a result of any transfer of a partnership interest after May 6, 1986 (unless the transfer was made pursuant to a binding contract that was in effect on May 6, 1986, and at all times thereafter before the transfer), and before June 9, 2003.701
——————————————————————————————

701 Former Regs. § 1.755-2T(d), T.D. 8215, 53 Fed. Reg. 27035 (7/18/88). See also Regs. § 1.755-1(e)(2), T.D. 9059, 68 Fed. Reg. 34293 (6/9/03).

——————————————————————————————

Former Regs. § 1.755-2T(b)(1) provided that the fair market value of each item of partnership property (other than goodwill or going concern value) for purposes of applying the  § 755 allocation rules was determined on the basis of all the facts and circumstances. Former Regs. § 1.755-2T(b)(2) provided that the fair market value of goodwill or going concern value was deemed to equal the amount (but not below zero) that, if assigned to such property, would result in a liquidating distribution to the transferee partner equal to the partner's basis in the partnership interest immediately after the transfer (without taking into account basis attributable to partnership liabilities). The amount of the hypothetical liquidating distribution was calculated as if all partnership property were sold immediately after the transfer for consideration equal to fair market value and the proceeds, after payment of all partnership liabilities, were distributed to the partners.702 Thus, the temporary regulations adopted the  § 1060 residual approach to the valuation of goodwill.703 The value of goodwill, under the temporary regulations, was equal to the excess of the purchase price paid for the transferred interest over the fair market value of all partnership assets other than goodwill. The rules for determining fair market value provided in the temporary regulations applied only to  § 743(b) adjustments and  § 732(d) adjustments and only if the assets of the partnership constituted a trade or business for purposes of § 1060(c).704
——————————————————————————————

702 Former Regs. § 1.755-2T(b)(2)(i). See also § 1.755-2T(b)(2)(ii).

703 The enactment of § 1060 and the temporary regulations' adoption of the residual method of valuing goodwill overruled the Ninth Circuit's decision in U.S. v. Cornish, 348 F.2d 175 (9th Cir.  1965), rev'g and remanding  221 F. Supp. 658 (D. Or. 1963). In Cornish, the transferee partner purchased a partnership interest for an amount well in excess of the fair market value of the partnership's assets(not taking into consideration goodwill and going concern value). The IRS argued that the entire excess should be allocated to goodwill or going concern value. The Ninth Circuit agreed with the IRS that the going concern value of a business does not operate to increase the market value of depreciable assets. However, the court rejected the IRS's argument that the entire excess should be allocated to going concern value, holding instead that the total amount paid by the transferee partner should be allocated to the following three classes: (A) the fair market value of the tangible assets; (B) the fair market value of going concern value as a nondepreciable intangible asset; and (C)the remainder of the purchase price, categorized as “partnership overvaluation,” prorated between the tangibles and the nondepreciable intangibles. In contrast to Cornish is Muserlian v. Comr., 932 F.2d 109 (2d Cir.  1991), aff'g 58 T.C. 100 (1989), in which the Second Circuit affirmed the Tax Court's factual determination that no portion of the purchase price paid for a partnership interest represented overvaluation and, therefore, the price was allocated first to the tangible assets, to the extent of their fair market value, and the remainder was allocated to goodwill ongoing concern value. 932 F.2d at 110. The Muserlian court did not specifically reject the Cornish approach but, instead, distinguished its facts on the grounds that in Muserlian there was less evidence of overvaluation because the sale occurred between the transferor partner and a partnership owned by the transferor partner's wife and children.

704 Former Regs. § 1.755-2T(a)(2).

——————————————————————————————

Note: As mentioned above, the temporary regulations were issued before  § 1060(d) was enacted.  Section 1060(d) does not impose a trade or business requirement upon the application of the residual method to partnership transactions. This discrepancy between  § 1060(d) and the temporary regulations under  § 755 is one of the reasons that the IRS issued the 2000 proposed regulations and the 2003 final regulations under § 755.

b. Allocation Between Classes of Partnership
  Property 

(1) In General 

The  § 743(b) adjustment is first divided between the two classes of assets described in § 755(b): capital and  § 1231 assets on the one hand(referred to in the regulations as “capital gain property”)and all other property (“ordinary income property”). Properties and potential gain treated as unrealized receivables under  § 751(c) are treated as separate assets that are ordinary income property.705 In most instances, the portion of the basis adjustment allocated to one class of partnership property may be an increase while the portion allocated to the other is a decrease. This is true even if the total amount of the basis adjustment is zero.706
——————————————————————————————

705 Regs. § 1.755-1(a).

706 Regs. § 1.755-1(b)(i).

——————————————————————————————

The allocation of the basis adjustment between the two classes of property (as well as the allocation of the adjustment within each class of property) is based on the allocations of income, gain, or loss that the transferee partner would receive if, immediately after the transfer of the partnership interest, all of the partnership property were disposed of in a fully taxable transaction for cash in an amount equal to the fair market value of partnership property.707 This calculation is made taking into consideration any remedial allocations under § 1.704-3(d).708
——————————————————————————————

707 Regs. § 1.755-1(b)(1)(ii). This hypothetical transaction is similar to the hypothetical transaction described in Regs.  § 1.743-1(d)(2) relating to the determination of a transferee partner's share of previously taxed capital.

708 Regs. § 1.755-1(b)(1)(ii).

——————————————————————————————

(2) Upward  § 743(b) Adjustment 

An upward  § 743(b) basis adjustment is allocated between the two classes of property as follows:709
——————————————————————————————

709 Regs. § 1.755-1(b)(2).

——————————————————————————————

Step One: Determine the total amount of income, gain, or loss(including remedial allocations) that would be allocated to the transferee partner from the sale of all partnership ordinary income property in a transaction in which all of those assets were sold for an amount of cash equal to their fair market value.

Step Two: If Step One generates a loss that would be allocated to the transferee partner, allocate to the ordinary income property class a downward adjustment equal to the amount of that loss, and subtract the amount of that downward adjustment (treating the amount of the adjustment as a negative number) from the amount of the  § 743(b) upward adjustment. This creates a larger upward adjustment, which is then allocated to the capital asset class as described in Step Four.

Step Three: If Step One generates income or gain that would be allocated to the transferee partner, allocate to the ordinary income property class an upward adjustment equal to the amount of that income or gain. If the amount of the upward adjustment is less than or equal to the amount of the  § 743(b) upward adjustment, then also subtract the amount of that upward adjustment from the  § 743(b) upward adjustment. This creates an upward basis adjustment, which is then allocated to the capital asset class, as described in Step Four. (Note, however, that this adjustment for the capital asset class is less than the total upward adjustment.) If the amount of the upward adjustment to the ordinary income property exceeds the amount of the  § 743(b) upward adjustment, then subtract the amount of the  § 743(b) upward adjustment from the amount of the upward adjustment allocated to the ordinary income property. This creates a downward basis adjustment that is then allocated to the capital asset class, as described in Step Five.

Step Four: Allocate the upward basis adjustment, computed under Step Two or Step Three, to the capital gain property class. The process of allocating the upward basis adjustment between the two property classes is finished.

Step Five: Allocate the downward basis adjustment, computed under Step Three to the capital gain property class.  However, if this downward adjustment exceeds the partnership's aggregate basis(or the transferee's share, if any, of remedial loss) in capital gain property, then the amount of the downward basis adjustment allocated to the capital asset class is limited to that amount of aggregate basis or share of remedial loss, and the remaining downward basis adjustment (referred to as the “excess basis decrease”)is allocated to the ordinary income class.710
——————————————————————————————

710 Regs. § 1.755-1(b)(2)(i)(B).

——————————————————————————————

Comment: The excess basis decrease to which the regulations refer is a concept that the regulations do not illustrate. The sole permutation involving an overall upward  § 743(b) basis adjustment in which there is a downward adjustment allocated to the capital asset class, as illustrated by Example (2) below, fails to generate an excess basis decrease regardless of how the numbers are changed. The generating of an excess basis decrease, when there is an upward  § 743(b) adjustment, requires that the overall gain allocated to the transferee partner on the sale of the ordinary income assets exceed the total upward adjustment by an amount that exceeds the partnership's aggregate adjusted bases in the capital assets. However, to make that happen by decreasing the partnership's capital assets as low as zero causes the total upward § 743(b) adjustment itself to increase, thus removing the prerequisite of a downward basis adjustment to the capital asset class. It is unclear whether the regulation was drafted to deal with a hypothetical situation that exists only in theory or to deal with actual transactions of which the regulation drafters had knowledge. If it were the latter case, the regulation would be expected to illustrate these real world transactions. Perhaps the concept of an excess basis decrease arises from a situation envisioned by the regulation drafters in which the overall adjustment is an arbitrarily selected number that is not synchronized with the adjusted bases and fair market values of the partnership's assets, much in the same manner in which Regs. § 1.755-1(b)(3)(iv), Example 2, makes its point through the use of an artificially generated purchase price that did not reflect fair market value.

Example (1) — Upward Adjustment — Appreciation in Ordinary Income Assets Is Less Than Adjustment: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value 	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 180,000	
 	$180,000	$420,000	
Capital	 	 	
X	 $60,000	$140,000 	
Y	  60,000	 140,000 	
Z	  60,000	 140,000	
 	$180,000	$420,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $140,000. The amount of the  § 743(b) upward adjustment is $80,000 (D's $140,000 basis in the partnership interest minus D's$60,000 share of the partnership's adjusted basis in its assets). The $80,000 upward adjustment is allocated as follows:

Step One: The total amount of gain that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $20,000 (one-third of the $60,000 gain in Ordinary Income Asset I).

Step Two: There is no loss allocated to D with respect to the ordinary income assets and, therefore, no allocation under Step Two.

Step Three: A $20,000 upward adjustment is allocated to the ordinary income property class. This amount is subtracted from the total $80,000 upward adjustment, leaving a $60,000 upward adjustment.

Step Four: The remaining $60,000 upward basis adjustment computed under Step Three is allocated to the capital gain property class.

Example (2) — Upward Adjustment — Appreciation in Ordinary Income Assets Exceeds the Adjustment: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	 360,000	
Capital Asset I	  60,000	  30,000	
Capital Asset II	  60,000	  45,000	
 	$180,000	$495,000	
Capital	 	 	
X	 $60,000	$165,000 	
Y	  60,000	 165,000 	
Z	  60,000	 165,000	
 	$180,000	$495,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $165,000. The amount of the  § 743(b) upward adjustment is $105,000 (D's $165,000 basis in the partnership interest minus D's $60,000 share of the partnership's adjusted basis in its assets). The $105,000 upward adjustment is allocated as follows:

Step One: The total amount of gain that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $120,000 (one-third of the $360,000 gain in the ordinary income assets).

Step Two: There is no loss allocated to D with respect to the ordinary income assets and, therefore, no allocation under Step Two.

Step Three: A $120,000 upward adjustment is allocated to the ordinary income property class. This amount is subtracted from the total $105,000 upward adjustment, creating a $15,000 downward basis adjustment.

Step Four: The $15,000 downward basis adjustment computed under Step Three is allocated to the capital gain property class.

Example (3) — Upward Adjustment — Depreciated Ordinary Income Assets: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 150,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 180,000	
 	$270,000	$420,000	
Capital	 	 	
X	 $90,000	$140,000 	
Y	  90,000	 140,000 	
Z	  90,000	 140,000	
 	$180,000	$420,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $140,000. The amount of the  § 743(b) upward adjustment is $50,000 (D's $140,000 basis in the partnership interest minus D's$90,000 share of the partnership's adjusted basis in its assets). The $50,000 upward adjustment is allocated as follows:

Step One: The total amount of loss that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $10,000 (one-third of the $30,000 overall loss in the ordinary income assets).

Step Two: A $10,000 downward adjustment is allocated to the ordinary income property class. The amount of this downward adjustment(treating the amount of the adjustment as a negative number) is subtracted from the amount of the  § 743(b) upward adjustment, creating a $60,000 upward adjustment (50,000 - (-$10,000)).

Step Three: There is no overall gain allocated to D with respect to the ordinary income assets and therefore, no allocation under Step Three.

Step Four: The $60,000 upward basis adjustment computed under Step Two is allocated to the capital gain property class.

(3) Downward § 743(b)Adjustment 

A downward  § 743(b) basis adjustment is allocated between the two classes of property as follows:711
——————————————————————————————

711 Regs. § 1.755-1(b)(2).

——————————————————————————————

Step One: Determine the total amount of income, gain, or loss(including remedial allocations) that would be allocated to the transferee partner from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value.

Step Two: If Step One generates income or gain that would be allocated to the transferee partner, allocate to the ordinary income property class an upward adjustment equal to the amount of that income or gain, and also subtract the amount of that upward adjustment from the amount of the  § 743(b) downward adjustment (treating the downward basis adjustment as a negative number). This creates a larger downward adjustment that is then allocated to the capital asset class as described in Step Four.

Step Three: If Step One generates a loss that would be allocated to the transferee partner, allocate to the ordinary income property class a downward adjustment equal to the amount of that loss. Subtract the amount of that downward adjustment (treating it as a negative number) from the  § 743(b) downward adjustment (also treating the downward adjustment as a negative number). In instances in which the amount of the downward adjustment allocated to the ordinary income property is less than or equal to the amount of the  § 743(b) downward adjustment, this computation creates a downward basis adjustment that is then allocated to the capital asset class, as described in Step Four. Note, however, that the amount of this adjustment for the capital asset class is less than the total  § 743(b) downward adjustment. (For example, if the amount of the overall  § 743(b) downward adjustment is -10 and the amount of the downward adjustment allocated to the ordinary income property is -4, then there is a downward adjustment of -6 to allocate to the capital gain property (-10 - (-4) =-6).) In instances in which the amount of the downward adjustment allocated to the ordinary income property exceeds the amount of the § 743(b) downward adjustment, this computation creates an upward basis adjustment that is then allocated to the capital asset class, as described in Step Five. (For example, if the amount of the downward adjustment is -10 and the amount of the downward adjustment allocated to the ordinary income property is -12, then there is an upward adjustment of 2 to allocate to the capital gain property (-10 - (-12) = 2).)

Step Four: Allocate the downward basis adjustment, computed under Step Two or Step Three, to the capital gain property class. However, if this downward adjustment exceeds the partnership's aggregate basis (or the transferee's share, if any, of remedial loss) in capital gain property, then the amount of the downward basis adjustment allocated to the capital asset class is limited to that amount of aggregate basis or share of remedial loss, and the remaining downward basis adjustment (referred to as the “excess basis decrease”)is allocated to the ordinary income class.

Step Five: Allocate the upward basis adjustment, computed under Step Three, to the capital gain property class.

Comment: As noted above, the excess basis decrease to which the regulations refer is a concept that the regulations do not illustrate. The two permutations involving an overall downward  § 743(b) basis adjustment in which there is a downward adjustment allocated to the capital asset class, as illustrated by Examples (4) and (5) below, fail to generate an excess basis decrease regardless of how the numbers are changed. In the first permutation, generating an excess basis decrease requires that the overall gain allocated to the transferee partner on the sale of the ordinary income assets be as large as possible. However, as that gain increases, the overall downward basis adjustment decreases and eventually disappears. In the second permutation, generating an excess basis decrease requires the amount of downward adjustment allocated to the capital asset to equal the overall downward basis adjustment, which is a logical impossibility because, by definition, in this permutation there is at least some portion of the overall downward adjustment allocated to the ordinary income class. Again, it is unclear whether the regulation was drafted to deal with a hypothetical situation or to deal with actual transactions of which the regulation drafters had knowledge.

Example (4) — Downward Adjustment — Appreciated Ordinary Income Assets: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	  60,000	
Capital Asset I	 180,000	  60,000	
Capital Asset II	 240,000	 120,000	
 	$480,000	$300,000	
Capital	 	 	
X	$160,000	$100,000 	
Y	 160,000	 100,000 	
Z	 160,000	 100,000	
 	$480,000	$300,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $100,000. The amount of the  § 743(b) downward adjustment is $60,000 (D's $160,000 share of the partnership's adjusted basis in its assets minus D's $100,000 basis in the partnership interest). The $60,000 downward adjustment is allocated as follows:

Step One: The total amount of gain that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $20,000 (one-third of the $60,000 gain in Ordinary Income Asset I).

Step Two: A $20,000 upward adjustment is allocated to the ordinary income property class. The $20,000 upward adjustment is subtracted from the amount of the  § 743(b) downward adjustment (treating the downward basis adjustment as a negative number, creating an $80,000 downward adjustment (-60,000 - $20,000).

Step Three: There is no overall loss allocated to D with respect to the ordinary income assets and, therefore, no allocation under Step Three.

Step Four: The $80,000 downward basis adjustment computed under Step Two is allocated to the capital gain property class.

Example (5) — Downward Adjustment — Depreciation in Ordinary Income Assets Is Less Than Adjustment: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Inventory	 150,000	 180,000	
Capital Asset I	 180,000	  60,000	
Capital Asset II	 240,000	 120,000	
 	$570,000	$300,000	
Capital	 	 	
X	$190,000	$100,000 	
Y	 190,000	 100,000 	
Z	 190,000	 100,000	
 	$570,000	$300,000	

Z sells Z's partnership interest to D on Jan. 1 for $100,000. The partnership is required to make a  § 743(b) adjustment because the partnership has a substantial built-in loss ($270,000) immediately after the sale.712 The amount of the  § 743(b) downward adjustment is $90,000 (D's $190,000 share of the partnership's adjusted basis in its assets minus D's $100,000 basis in the partnership interest). The $90,000 downward adjustment is allocated as follows:

Step One: The total amount of loss that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $10,000 (one-third of the $30,000 overall loss in Ordinary Income Asset I and inventory).

Step Two: There is no overall gain allocated to D with respect to the ordinary income assets and, therefore, no allocation under Step Two.

Step Three: A $10,000 downward adjustment is allocated to the ordinary income property class. The $10,000 downward adjustment is subtracted (treating it as a negative number) from the  § 743(b) downward adjustment(also treating the downward adjustment as a negative number), creating an $80,000 downward adjustment (-90,000 - (-$10,000)).

Step Four: The $80,000 downward basis adjustment computed under Step Three is allocated to the capital gain property class.

——————————————————————————————

712 If the date of the balance sheet and the sale in this example were prior to Oct. 22, 2004, the partnership would be required to make the downward adjustment only if it had a  § 754 election in effect.

——————————————————————————————

Example (6) — Downward Adjustment — Depreciation in Ordinary Income Assets Exceeds Adjustment: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Inventory	 210,000	  60,000	
Capital Asset I	 180,000	 210,000	
Capital Asset II	 240,000	 270,000	
 	$630,000	$600,000	
Capital	 	 	
X	$210,000	$200,000 	
Y	 210,000	 200,000 	
Z	 210,000	 200,000	
 	$630,000	$600,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $200,000. The amount of the  § 743(b) downward adjustment is $10,000 (D's $210,000 share of the partnership's adjusted basis in its assets minus D's $200,000 basis in the partnership interest). The $10,000 downward adjustment is allocated as follows:

Step One: The total amount of loss that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $30,000 (one-third of the $90,000 overall loss in Ordinary Income Asset I and inventory).

Step Two: There is no overall gain allocated to D with respect to the ordinary income assets and, therefore, no allocation under Step Two.

Step Three: A $30,000 downward adjustment is allocated to the ordinary income property class. The $30,000 downward adjustment is subtracted (treating it as a negative number) from the  § 743(b) downward adjustment(also treating the downward adjustment as a negative number), creating a $20,000 upward adjustment (-10,000 - (-$30,000)).

Step Four: The $20,000 upward basis adjustment computed under Step Three is allocated to the capital gain property class.

Observation: A rather puzzling issue arises if the ordinary income class of property has neither an overall gain nor an overall loss. Consider, for example, a partnership with unrealized receivables having an adjusted basis of $0 and a value of $60 and inventory with an adjusted basis of $120 and a value of $60. Also assume that because of appreciation in capital assets, there is an overall upward  § 743(b) basis adjustment. Literally, the regulations state that “the amount of the basis adjustment allocated to the class of ordinary income property is equal to the total amount of income, gain, or loss ... that would be allocated to the transferee ... from the sale of all ordinary income property in the hypothetical transaction.” In this example, if the partnership sold Ordinary Income Asset I and inventory for their fair market values, the total gain or loss allocated to the transferee partner would be zero. Thus, it appears that the regulations provide for no allocation to the ordinary income class. This creates a potential discrepancy because there is inherent gain in Ordinary Income Asset I and inherent loss in the inventory. Depending on the subsequent history of the partnership and the identity of property distributed to each partner, the transferee may not ultimately receive offsetting allocations of $20,000 of ordinary income and $20,000 of ordinary loss. The use of the word “the” in the regulations to modify the phrase “basis adjustment allocated to the class of ordinary income property” compels a conclusion that there is only one adjustment and not multiple adjustments adding to zero allocated to the ordinary income class. The regulations provide that if the transferee's adjusted basis in the partnership interest equals the transferee's share of the partnership's adjusted basis in its assets, there is an adjustment equal to zero (in contrast to there being no adjustment at all), which in turn can be allocated as an upward adjustment to one class and a downward adjustment to another class. The fact that the regulations do not refer to the possibility of an adjustment of zero being allocated to a class and in turn being allocated as upward and downward adjustments to individual assets within the class suggests that in the example in this observation there would be no adjustment allocated to the ordinary class and no adjustment allocated to the assets within the class. This sort of discrepancy is not unlike the inapplicability of  § 751(b) to a proportionate distribution of  § 751 assets among all of the partners, which has the result that the inherent gains or losses in those assets are not distributed proportionately. As a practical matter, this problem can be avoided by assigning to one of the assets in the class a fair market value that is a few dollars more or less than the amount that generates a net gain or loss of zero, thus changing the amount of gain or loss that would be allocated to the transferee partner so that the overall gain or loss for the category is something other than zero.

(4) Allocation of “Zero” § 743(b)Adjustment 

The regulations contemplate that even if the total amount of the  § 743(b) basis adjustment is zero, there may be a basis increase allocated to one class of partnership property and a corresponding basis decrease allocated to the other class.713 If the amount of the  § 743(b) adjustment is technically zero, but there is an overall gain or loss in one class of assets and an offsetting gain or loss in the other class of assets, the zero adjustment is allocated as follows:714
——————————————————————————————

713 Regs. § 1.755-1(b)(1).

714 Regs. § 1.755-1(b)(2).

——————————————————————————————

Step One: Determine the total amount of income, gain, or loss(including remedial allocations) that would be allocated to the transferee partner from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value.

Step Two: If Step One generates a loss that would be allocated to the transferee partner, allocate to the ordinary income property class a downward adjustment equal to the amount of that loss, and subtract the amount of the loss (treating the amount of the loss as a negative number) from the amount of the  § 743(b) adjustment. This creates an upward adjustment (equal to the downward adjustment that was allocated to the ordinary income assets) that is then allocated to the capital asset class. For example, if the amount of the loss is -$10,000, the adjustment allocated to the capital asset class is+$10,000 ($0 - (-$10,000)).

Step Three: If Step One generates income or gain that would be allocated to the transferee partner, allocate to the ordinary income property class an upward adjustment equal to the amount of that income or gain, and subtract the amount of the income or gain from the amount of the  § 743(b) adjustment. This creates a downward adjustment (equal to the upward adjustment that was allocated to the ordinary income assets) that is then allocated to the capital asset class. For example, if the amount of the income or gain is $10,000, the adjustment allocated to the capital asset class is -$10,000 ($0 - $10,000).

Example (7) — Zero Overall Adjustment — Depreciated Ordinary Income Assets: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Receivables	$0	 $60,000	
Inventory	 240,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 120,000	
 	$360,000	$360,000	
Capital	 	 	
X	$120,000	$120,000 	
Y	 120,000	 120,000 	
Z	 120,000	 120,000	
 	$360,000	$360,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $120,000. The amount of the  § 743(b) adjustment is $0(D's $120,000 basis in the partnership interest minus D's $120,000 share of the partnership's adjusted basis in its assets). The $0 adjustment is allocated as follows:

Step One: The total amount of loss that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $40,000 (one-third of the overall $120,000 loss in the ordinary income assets).

Step Two: A $40,000 downward adjustment is allocated to the ordinary income property class and subtracted from the  § 743(b) adjustment, creating a $40,000 upward adjustment ($0 - (-$40,000)) that is allocated to the capital asset class.

Example (8) — Zero Overall Adjustment — Appreciated Ordinary Income Assets: Assume that on Jan. 1, XYZ has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	 120,000	
Capital Asset I	 120,000	  60,000	
Capital Asset II	 120,000	  60,000	
 	$300,000	$300,000	
Capital	 	 	
X	$100,000	$100,000 	
Y	 100,000	 100,000 	
Z	 100,000	 100,000	
 	$300,000	$300,000	

Assume that the partnership has a  § 754 election in effect and that Z sells Z's partnership interest to D on Jan. 1 for $100,000. The amount of the  § 743(b) adjustment is $0(D's $100,000 basis in the partnership interest minus D's $100,000 share of the partnership's adjusted basis in its assets). The $0 adjustment is allocated as follows:

Step One: The total amount of income or gain that would be allocated to D from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $40,000 (one-third of the overall $120,000 gain in the ordinary income assets).

Step Two: A $40,000 upward adjustment is allocated to the ordinary income property class and subtracted from the  § 743(b) adjustment, creating a $40,000 downward adjustment ($0 - $40,000) that is allocated to the capital asset class.

Observation: A variation of the issue discussed in the observation above arises if there is an overall adjustment of zero, both the ordinary income and capital asset classes have neither an overall gain nor an overall loss, and there are appreciated and depreciated items of property in both classes. This creates a potential discrepancy because there is inherent gain in some items of property and inherent loss in other items of property. The regulations do not address this situation.

c. Allocation Within Each Class of Partnership
  Property 

Once a partnership has allocated a  § 743(b) adjustment between the two classes of partnership property, the partnership must allocate the adjustment among the assets within each category.715 The amount of the  § 743(b) adjustment allocated to the ordinary income property class is next allocated among the partnership's ordinary income assets.716 For each item of ordinary income property, follow the following steps:
——————————————————————————————

715 Regs. § 1.755-1(a)(1).

716 Regs. § 1.755-1(b)(3)(i).

——————————————————————————————

Step One: Determine the total income, gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to the transferee partner from the hypothetical sale of the ordinary income item. This amount will be referred to as “W.”Note that if there is a loss allocated to the transferee partner under this step, W will be a negative number.

Step Two: Determine the amount of any “excess basis decrease”that was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. This amount will be referred to as “X.”

Step Three: Determine the fair market value of the item of ordinary income property to the partnership (referred to as “Y”)and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”).

Step Four: Determine the amount of the adjustment allocated to the item of ordinary income property pursuant to the following formula: W – (X x (Y/Z)).

The amount of the  § 743(b) adjustment allocated to the capital asset class is allocated among the partnership's capital assets.717 For each item of property in the capital asset class:
——————————————————————————————

717 Regs. § 1.755-1(b)(3)(ii).

——————————————————————————————

Step One: Determine the total income, gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to the transferee partner from the hypothetical sale of the capital asset. This amount will be referred to as “W.”Note that if there is a loss allocated to the transferee partner under this step, W will be a negative number.

Step Two: Determine the total amount of gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to the transferee partner from the hypothetical sale of all of the partnership's capital gain property. This calculation should not, however, include any asset if the transferee partner has no interest in income, gain, loss, or deduction with respect to that asset.718 This amount will be referred to as “X.”
——————————————————————————————

718 Regs. § 1.755-1(b)(3)(iii)(A), effective for transfers of partnership interests that occur on or after June 9, 2003.

——————————————————————————————

Step Three: Determine the total amount of the adjustment allocated to the capital asset class. This amount will be referred to as “Y.”

Step Four: Determine the fair market value of the capital asset to the partnership (referred to as “Z”) and the total fair market value of all the partnership's capital gain property (referred to as “Q”). This calculation should not, however, include any asset if the transferee partner has no interest in income, gain, loss, or deduction with respect to that asset.719
——————————————————————————————

719 Regs. § 1.755-1(b)(3)(iii)(A), effective for transfers of partnership interests that occur on or after June 9, 2003.

——————————————————————————————

Step Five: If the amount of the total adjustment allocated to the capital asset class (“Y”) is positive (an upward adjustment), determine the amount of the adjustment allocated to the capital asset pursuant to the following formula: W – ((X-Y) x(Z/Q)). If the amount of the total adjustment allocated to the capital asset class (“Y”) is negative (a downward adjustment), determine the amount of the adjustment allocated to the capital asset pursuant to the following formula: W – ((X-Y) x (Z/Q)). Remember that in the second formula, “Y” is a negative number. If application of this formula results in a basis decrease to a particular capital asset, in no case may the decrease exceed the partnership's adjusted basis in that asset (or the transferee partner's share of any remedial loss under Regs.  § 1.704-3(d) under a hypothetical sale). If there is an excess decrease, it is used to reduce the remaining basis, if any, of other partnership capital gain assets pro rata in proportion to their adjusted bases (as adjusted by the  § 743(b) adjustment allocation rules).720
——————————————————————————————

720 Regs. § 1.755-1(b)(3)(iii)(B), effective for transfers of partnership interests that occur on or after June 9, 2003.

——————————————————————————————

Example (1) — Upward Adjustment — Appreciation in Ordinary Income Assets Is Less Than Adjustment:  On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 180,000	
 	$180,000	$420,000	
Capital	 	 	
B	 $60,000	$140,000 	
C	  60,000	 140,000 	
D	  60,000	 140,000	
 	$180,000	$420,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $140,000. The amount of the  § 743(b) upward adjustment is $80,000 (E's $140,000 basis in the partnership interest minus E's$60,000 share of the partnership's adjusted basis in its assets). The $80,000 upward adjustment is allocated +$20,000 to the ordinary income property class and +$60,000 to the capital asset class.721

The +$20,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 - ($0 x ($60,000/$120,000)).

The +$20,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of income, gain, or loss that would be allocated to E from the hypothetical sale of the Ordinary Income Asset II is $0. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of the Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to the Ordinary Income Asset II is $0: $0 - ($0 x ($60,000/$120,000)).

The +$60,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset I is $20,000. This amount will be referred to as “W.”

Step Two: The total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $60,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$60,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $300,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is +$20,000: $20,000 – (($60,000 - $60,000) x($120,000/$300,000)).

——————————————————————————————

721 See Example (1) in VII, C, 2, b, above.

——————————————————————————————

The +$60,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset I is $40,000. This amount will be referred to as “W.”

Step Two: The total amount of gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $60,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$60,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $180,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $300,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is +$40,000: $40,000 – (($60,000 - $60,000) x($180,000/$300,000)).

Example (2) — Upward Adjustment — Appreciation in Ordinary Income Assets Exceeds the Adjustment: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	 360,000	
Capital Asset I	  60,000	  30,000	
Capital Asset II	  60,000	  45,000	
 	$180,000	$495,000	
Capital	 	 	
B	 $60,000	$165,000 	
C	  60,000	 165,000 	
D	  60,000	 165,000	
 	$180,000	$495,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $165,000. The amount of the  § 743(b) upward adjustment is $105,000 (E's $165,000 basis in the partnership interest minus E's $60,000 share of the partnership's adjusted basis in its assets). The $105,000 upward adjustment is allocated +$120,000 to the ordinary income property class and -$15,000 to the capital asset class.722

The +$120,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $420,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$420,000)).

The +$120,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is $100,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $360,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $420,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is +$100,000: $100,000 – ($0 x ($360,000/$420,000)).

The -$15,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset I is -$10,000. This amount will be referred to as “W.”

Step Two: The total amount of gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$15,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$15,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $30,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $75,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is -$10,000: -$10,000 – ((-$15,000 – (-$15,000)) x($30,000/$75,000)).

——————————————————————————————

722 See Example (2) in VII, C, 2, b, above.

——————————————————————————————

The -$15,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset II is -$5,000. This amount will be referred to as “W.”

Step Two: The total amount of gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$15,000. This amount will be referred to as “Y.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$15,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $45,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $75,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is -$5,000: -$5,000 – ((-$15,000 – (-$15,000)) x($30,000/$75,000)).

Example (3) — Upward Adjustment — Depreciated Ordinary Income Assets: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 150,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 180,000	
 	$270,000	$420,000	
Capital	 	 	
B	 $90,000	$140,000 	
C	  90,000	 140,000 	
D	  90,000	 140,000	
 	$180,000	$420,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on January 1 for $140,000. The amount of the  § 743(b) upward adjustment is $50,000 (E's $140,000 basis in the partnership interest minus E's$90,000 share of the partnership's adjusted basis in its assets). The $50,000 upward adjustment is allocated as -$10,000 to the ordinary income property class and +60,000 to the capital asset class.723

——————————————————————————————

723 See Example (3) in VII, C, 2, b, above.

——————————————————————————————

The -$10,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$120,000)).

The -$10,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is -$30,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is -30,000: -$30,000 – ($0 x ($60,000/$120,000)).

Note that the +20,000 adjustment to Ordinary Income Asset I and the-$30,000 adjustment to Ordinary Income Asset II add to -$10,000, the amount of the adjustment allocated to the ordinary income property class.

The +$60,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset I is $20,000. This amount will be referred to as “W.”

Step Two: The total amount of gain, or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $60,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is $60,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $300,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is +$20,000: $20,000 – (($60,000 – $60,000) x($120,000/$300,000)).

The $60,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset II is $40,000. This amount will be referred to as “W.”

Step Two: The total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $15,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is $15,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $180,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $300,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is +$40,000: $40,000 – (($60,000 – $60,000) x($180,000/$300,000)).

Example (4) — Downward Adjustment — Appreciated Ordinary Income Assets: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	  60,000	
Capital Asset I	 180,000	  60,000	
Capital Asset II	 240,000	 120,000	
 	$480,000	$300,000	
Capital	 	 	
B	$160,000	$100,000 	
C	 160,000	 100,000 	
D	 160,000	 100,000	
 	$480,000	$300,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $100,000. The amount of the  § 743(b) downward adjustment is $60,000 (E's $160,000 share of the partnership's adjusted basis in its assets minus E's $100,000 basis in the partnership interest). The $60,000 downward adjustment is allocated +20,000 to the ordinary income property class and -$80,000 to the capital asset class.724

——————————————————————————————

724 See Example (4) in VII, C, 2, b, above.

——————————————————————————————

The +$20,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$120,000)).

The +$20,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of income, gain, or loss that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is $0. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is $0: $0 – ($0 x ($60,000/$120,000)).

The -$80,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset I is -$40,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$80,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$80,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $60,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $180,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is -$40,000: -$40,000 – ((-$80,000 – (-$80,000)) x($60,000/$180,000)).

The -$80,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset II is -$40,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$80,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$80,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $180,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is -$40,000: -$40,000 – ((-$80,000 – (-$80,000)) x($120,000/$180,000)).

Example (5) — Downward Adjustment — Depreciation in Ordinary Income Assets Is Less Than Adjustment: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 150,000	  60,000	
Capital Asset I	 180,000	  60,000	
Capital Asset II	 240,000	 120,000	
 	$570,000	$300,000	
Capital	 	 	
B	$190,000	$100,000 	
C	 190,000	 100,000 	
D	 190,000	 100,000	
 	$570,000	$300,000	

D sells D's partnership interest to E on Jan. 1 for $100,000. The partnership is required to make a  § 743(b) adjustment because it has a substantial built-in loss ($270,000).725 The amount of the  § 743(b) downward adjustment is $90,000 (E's $190,000 share of the partnership's adjusted basis in its assets minus E's $100,000 basis in the partnership interest). The $90,000 downward adjustment is allocated -$10,000 to the ordinary income property class and -$80,000 to the capital asset class.726

——————————————————————————————

725 If the date of the balance sheet and the sale in this example were prior to Oct. 22, 2004, the partnership would be required to make the downward adjustment only if it had a  § 754 election in effect.

726 See Example (5) in VII, C, 2, b, above.

——————————————————————————————

The -$10,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$120,000)).

The -$10,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is -$30,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is -$30,000: -$30,000 – ($0 x ($60,000/$120,000)).

Note that the +$20,000 adjustment allocated to Ordinary Income Asset I and the -$30,000 adjustment allocated to Ordinary Income Asset II add to -$10,000, the amount of the adjustment allocated to the ordinary income property class.

The -$80,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset I is -$40,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$80,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$80,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $60,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $180,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is -$40,000: -$40,000 – ((-$80,000 – (-$80,000)) x($60,000/$180,000)).

The -$80,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset II is -$40,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$80,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$80,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $180,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is -$40,000: -$40,000 – ((-$80,000 – (-$80,000)) x($120,000/$180,000)).

Example (6) — Downward Adjustment — Depreciation in Ordinary Income Assets Exceeds Adjustment: On Jan. 1, Year One, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 210,000	  60,000	
Capital Asset I	 180,000	 210,000	
Capital Asset II	 240,000	 270,000	
 	$630,000	$600,000	
Capital	 	 	
B	$210,000	$200,000 	
C	 210,000	 200,000 	
D	 210,000	 200,000	
 	$630,000	$600,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $200,000. The amount of the  § 743(b) downward adjustment is $10,000 (E's $210,000 share of the partnership's adjusted basis in its assets minus E's $200,000 basis in the partnership interest). The $10,000 downward adjustment is allocated -$30,000 to the ordinary income property class and +$20,000 to the capital asset class.727

——————————————————————————————

727 See Example (6) in VII, C, 2, b, above.

——————————————————————————————

The -$30,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$120,000)).

The -$30,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is -$50,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is -$50,000: -$50,000 – ($0 x ($60,000/$120,000)).

Note that the +$20,000 adjustment allocated to Ordinary Income Asset I and the -$50,000 adjustment allocated to Ordinary Income Asset II add to -$30,000, the amount of the adjustment allocated to the ordinary income property class.

The +$20,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset I is $10,000. This amount will be referred to as “W.”

Step Two: The total amount of gain that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $20,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$20,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $210,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $480,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is + $10,000: $10,000 – (($20,000 – $20,000) x($210,000/$480,000)).

The +$20,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset II is $10,000. This amount will be referred to as “W.”

Step Two: The total amount of gain that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $20,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$20,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $270,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $480,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is +$10,000: $10,000 – (($20,000 – $20,000) x($270,000/$480,000)).

Example (7) — Zero Overall Adjustment — Depreciated Ordinary Income Assets: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 240,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 120,000	
 	$360,000	$360,000	
Capital	 	 	
B	$120,000	$120,000 	
C	 120,000	 120,000 	
D	 120,000	 120,000	
 	$360,000	$360,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $120,000. The amount of the  § 743(b) adjustment is $0(E's $120,000 basis in the partnership interest minus E's $120,000 share of the partnership's adjusted basis in its assets). The $0 adjustment is allocated -$40,000 to the ordinary income property class and +$40,000 to the capital asset class.728

——————————————————————————————

728 See Example (7)in VII, C, 2, b, above.

——————————————————————————————

The -$40,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$120,000)).

The -$40,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is -$60,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $120,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is -$60,000: -$60,000 – ($0 x ($60,000/$120,000)).

The +$40,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset I is $20,000. This amount will be referred to as “W.”

Step Two: The total amount of gain that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $40,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$40,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $240,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is + $20,000: $20,000 – (($40,000 – $40,000) x($120,000/$240,000)).

The +$40,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Capital Asset II is $20,000. This amount will be referred to as “W.”

Step Two: The total amount of gain that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is $40,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is +$40,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $120,000, and the total fair market value of all the partnership's capital gain property(referred to as “Q”) is $240,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is +$20,000: $20,000 – (($40,000 – $40,000) x($120,000/$240,000)).

Example (8) — Zero Overall Adjustment — Appreciated Ordinary Income Assets: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	 120,000	
Capital Asset I	 120,000	  60,000	
Capital Asset II	 120,000	  60,000	
 	$300,000	$300,000	
Capital	 	 	
B	$100,000	$100,000 	
C	 100,000	 100,000 	
D	 100,000	 100,000	
 	$300,000	$300,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1 for $100,000. The amount of the  § 743(b) adjustment is $0(E's $100,000 basis in the partnership interest minus E's $100,000 share of the partnership's adjusted basis in its assets). The $0 adjustment is allocated +$40,000 to the ordinary income property class and -$40,000 to the capital asset class.729

——————————————————————————————

729 See Example (8)in VII, C, 2, b, above.

——————————————————————————————

The +$40,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset I is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset I to the partnership (referred to as “Y”) is $60,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $180,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$20,000: $20,000 – ($0 x ($60,000/$180,000)).

The +$40,000 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of gain that would be allocated to E from the hypothetical sale of Ordinary Income Asset II is $20,000. This amount will be referred to as “W.”

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes. Thus, “X” equals $0.

Step Three: The fair market value of Ordinary Income Asset II to the partnership (referred to as “Y”) is $120,000, and the total fair market value of all the partnership's items of ordinary income property (referred to as “Z”) is $180,000.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset II is -$20,000: $20,000 – ($0 x ($120,000/$180,000)).

The -$40,000 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset I is -$20,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$40,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$40,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset I to the partnership (referred to as “Z”) is $60,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $120,000.

Step Five: The amount of the adjustment allocated to Capital Asset I is $20,000: -$20,000 – ((-$40,000 – (-$40,000)) x($60,000/$120,000)).

The -$40,000 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of loss that would be allocated to E from the hypothetical sale of Capital Asset II is -$20,000. This amount will be referred to as “W.”

Step Two: The total amount of loss that would be allocated to E from the hypothetical sale of all of the partnership's capital gain property is -$40,000. This amount will be referred to as “X.”

Step Three: The total amount of the adjustment allocated to the capital asset class is -$40,000. This amount will be referred to as “Y.”

Step Four: The fair market value of Capital Asset II to the partnership (referred to as “Z”) is $60,000, and the total fair market value of all the partnership's capital gain property (referred to as “Q”) is $120,000.

Step Five: The amount of the adjustment allocated to Capital Asset II is -$20,000: -$20,000 – ((-$40,000 – (-$40,000)) x($60,000/$120,000)).

Note: In Regs. § 1.755-1(b)(3)(iv), Example 2, the drafters change the sales price and transferee's adjusted basis in his partnership interest, thereby lowering the basis adjustment. The implication of this change is that the partnership interest is sold for less than the proportionate share of the partnership's assets attributable to the partnership interest. Although it is not specifically stated, presumably this reduction reflects a nonmarketability discount. In most instances, when a partnership interest or an LLC membership interest (particularly a minority interest that cannot be readily liquidated and cannot compel the liquidation of the entity's assets) is sold to an unrelated person in an arm's-length transaction, a discount will be negotiated for the nonmarketability of the interest.

Example (9) — Nonmarketability Discount:730 On Jan. 1, partnership BC has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	 $40,000	 $45,000	
Ordinary Income
 Asset II	  10,000	   2,500	
Capital Asset I	  25,000	  75,000	
Capital Asset II	 100,000	 117,500	
 	$175,000	$240,000	

Assume that the partnership has a  § 754 election in effect. Assume that Capital Asset I was contributed to the partnership by B when it had a fair market value of $50,000 and an adjusted basis of $25,000. Assume also that B's share of the partnership's adjusted basis in its assets is $75,000. B sells B's partnership interest to T for $110,000. The amount of the  § 743(b) upward adjustment is $35,000 (T's $110,000 basis in the partnership interest minus T's $75,000 share of the partnership's adjusted basis in its assets). The $35,000 upward adjustment is allocated as follows:

Step One: The total amount of loss that would be allocated to T from the sale of all partnership ordinary income property in a transaction in which all of those assets are sold for an amount of cash equal to their fair market value is $1,250 (one-half of the$2,500 overall loss in the ordinary income class).

Step Two: A $1,250 downward adjustment is allocated to the ordinary income property class. The amount of this downward adjustment(treating the amount of the adjustment as a negative number) is subtracted from the amount of the  § 743(b) upward adjustment, creating a $36,250 upward adjustment ($35,000 –(-$1,250)) allocated to the capital gain property class.

——————————————————————————————

730 See Regs.  § 1.755-1(b)(3)(iv) Ex. 2.

——————————————————————————————

The -$1,250 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset I as follows:

Step One: The total amount of gain that would be allocated to T from the hypothetical sale of the asset is $2,500.

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes.

Step Three: The fair market value of the asset to the partnership is $45,000, and the total fair market value of all the partnership's items of ordinary income property is $47,500.

Step Four: The amount of the adjustment allocated to Ordinary Income Asset I is +$2,500: $2,500 – ($0 x ($45,000/$47,500)).

The -$1,250 adjustment allocated to the ordinary income property is allocated to Ordinary Income Asset II as follows:

Step One: The total amount of loss that would be allocated to T from the hypothetical sale of the asset is -$3,750.

Step Two: No “excess basis decrease” was allocated to the ordinary income property pursuant to the allocation of the adjustment between the classes.

Step Three: The fair market value of the asset to the partnership is $2,500, and the total fair market value of all the partnership's items of ordinary income property is $47,500.

Step Four: The amount of the adjustment allocated to the Ordinary Income Asset II is -3,750: -$3,750 – ($0 x ($2,500/$47,500)).

The +$36,250 adjustment allocated to the capital asset class is allocated to Capital Asset I as follows:

Step One: The total amount of gain that would be allocated to T from the hypothetical sale of Capital Asset I is $37,500.

Step Two: The total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to T from the hypothetical sale of all of the partnership's capital gain property is $46,250.

Step Three: The total amount of the adjustment allocated to the capital asset class is +$36,250. Note that the total gain that would be allocated to T from the sale of both capital assets exceeds the adjustment by $10,000 because of the effect of the nonmarketability discount on the amount of the adjustment.

Step Four: The fair market value of Capital Asset I to the partnership is $75,000 and the total fair market value of all the partnership's capital gain property is $192,500.

Step Five: The amount of the adjustment allocated to Capital Asset I is +$33,604: $37,500 – ($10,000 x ($75,000/$192,500)).

The +$36,250 adjustment allocated to the capital asset class is allocated to Capital Asset II as follows:

Step One: The total amount of gain that would be allocated to T from the hypothetical sale of Capital Asset II is $8,750.

Step Two: The total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to T from the hypothetical sale of all of the partnership's capital gain property is $46,250.

Step Three: The total amount of the adjustment allocated to the capital asset class is +$36,250. Note that the total gain that would be allocated to T from the sale of both capital assets exceeds the adjustment by $10,000 because of the effect of the nonmarketability discount on the amount of the adjustment.

Step Four: The fair market value of Capital Asset II to the partnership is $117,500, and the total fair market value of all the partnership's capital gain property is $192,500.

Step Five: The amount of the adjustment allocated to Capital Asset I is +$2,646: $8,750 – ($10,000) x ($117,500/$192,500)).

3. Substituted Basis Exchanges 

a. Valuation of Partnership Assets 

Regs.  § 1.755-1(a) applies to the valuing of the partnership's assets.731 The regulations provide a special rule for computing partnership gross value when a  § 743(b) adjustment arises in a substituted basis transaction (transactions in which the transferee's basis in the partnership interest is determined in whole or in part by reference to the transferor's basis in the interest or the basis of other property held by the transferee).732 In this case, partnership gross value is equal to the value of the entire partnership as a going concern increased by the amount of partnership liabilities at the time of the relevant exchange. This is the same as the computation of partnership gross value used in the context of a  § 734(b) adjustment.733
——————————————————————————————

731 See discussion in VII, C, 2, a, above.

732 Regs. § 1.755-1(a)(4)(ii).

733 See Regs. § 1.755-1(a)(4)(iii).

——————————————————————————————

b. Allocations Between Classes of Property 

If, in an exchange, the transferee's basis in the interest is determined in whole or in part by reference to the transferor's basis in the interest, special rules apply. For example, these rules apply if a partnership interest is contributed to a corporation in a transaction to which  § 351 applies or to a partnership in a transaction to which  § 721(a) applies. If the § 743(b) basis adjustment is zero (because the transferee partner's adjusted basis in the partnership equals the transferee partner's share of the partnership's aggregate adjusted basis in its assets), then no adjustment is made to the basis of partnership property.734
——————————————————————————————

734 Regs. § 1.755-1(b)(5)(i).

——————————————————————————————

Note: This is in sharp contrast to purchase and death transfers in which a zero basis adjustment can be allocated as an upward adjustment to one class of property and a downward adjustment to the other class of property.

Example: On Jan. 1, BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	 240,000	  60,000	
Capital Asset I	  60,000	 120,000	
Capital Asset II	  60,000	 120,000	
 	$360,000	$360,000	
Capital	 	 	
B	$120,000	$120,000 	
C	 120,000	 120,000 	
D	 120,000	 120,000	
 	$360,000	$360,000	

Assume that the partnership has a  § 754 election in effect and that D transfers D's partnership interest to corporation E on Jan. 1 in a  § 351 exchange for qualifying stock with a fair market value of $120,000. The amount of the  § 743(b) adjustment is $0(E's $120,000 transferred basis in the partnership interest minus E's $120,000 share of the partnership's adjusted basis in its assets). Therefore, no basis adjustments are allocated to the items of partnership property.

An upward  § 743(b) adjustment is allocated to the capital asset class or the ordinary income class, respectively, only if the total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to the transferee partner from the hypothetical sale of all the items of property in that class would generate a net gain or net income to the transferee partner.735 If an upward adjustment, accordingly, is allocated to both the capital asset class and the ordinary income class, the adjustment is allocated to the two classes in proportion to the net gain or net income that would be allocated to the transferee partner from the sale of all the items of property in each class.736
——————————————————————————————

735 Regs. § 1.755-1(b)(5)(ii).

736 Regs. § 1.755-1(b)(5)(ii).

——————————————————————————————

A downward  § 743(b) adjustment is allocated to the capital asset class or the ordinary income class, respectively, only if the total amount of gain or loss (including any remedial allocations under Regs.  § 1.704-3(d)) that would be allocated to the transferee partner from the hypothetical sale of all the items of property in that class would generate a net loss to the transferee partner.737 If a downward adjustment, accordingly, is allocated to both the capital asset class and the ordinary income class, the adjustment is allocated to the two classes in proportion to the net loss that would be allocated to the transferee partner from the sale of all the items of property in each class.738
——————————————————————————————

737 Regs. § 1.755-1(b)(5)(ii).

738 Regs. § 1.755-1(b)(5)(ii).

——————————————————————————————

Example: On Jan. 1, Year One, partnership BCD has the following balance sheet:

 Assets	
 Adjusted Basis	Fair Market Value	
Ordinary Income
 Asset I	$0	 $60,000	
Ordinary Income
 Asset II	  60,000	 360,000	
Capital Asset I	  60,000	 30,000	
Capital Asset II	  60,000	  45,000	
 	$180,000	$495,000	
Capital	 	 	
B	 $60,000	$165,000 	
C	  60,000	 165,000 	
D	  60,000	 165,000	
 	$180,000	$495,000	

Assume that no  § 754 election is in effect and that D sells D's partnership interest to E on Jan. 1, Year One, for $165,000. Assume that the partnership distributes its income as it is earned and that its assets do not change in value. On Jan. 1, Year Four, E transfers E's partnership interest to corporation F in a  § 351 exchange for qualifying stock with a fair market value of $165,000. Assume that the partnership makes a  § 754 election effective Jan. 1, Year Four. The amount of the  § 743(b) adjustment is $105,000(F's $165,000 transferred basis in the partnership interest minus F's $60,000 share of the partnership's adjusted basis in its assets). The entire $105,000 upward adjustment is allocated to the ordinary income class because, if all of the partnership assets in each class were sold in a group, only the sale of the assets in the ordinary income class as a group would generate gain.

c. Allocations Within the Classes 

If an upward adjustment is allocated to a class, it is allocated within the class as follows. First, it is allocated to properties with unrealized appreciation in proportion to the transferee partner's share of the amounts of unrealized appreciation in each item of property in that class, before  the adjustment is taken into account. However, the amount of the adjustment allocated to an item of property cannot exceed the transferee partner's share of that item of property's unrealized appreciation.739 Secondly, any remaining upward adjustment is allocated among the items of property within the class in proportion to the transferee partner's share of the amount that would be realized by the partnership upon the hypothetical sale of each item of property in the class.740
——————————————————————————————

739 Regs. § 1.755-1(b)(5)(iii)(A).

740 Regs. § 1.755-1(b)(5)(iii)(A).

——————————————————————————————

If a downward adjustment is allocated to a class, it is allocated within the class as follows. First, it is allocated to properties with unrealized depreciation in proportion to the transferee partner's share of the amounts of unrealized depreciation in each item of property in that class, before the adjustment is taken into account. However, the amount of the adjustment allocated to an item of property cannot exceed the transferee partner's share of that item of property's unrealized depreciation.741 Secondly, any remaining downward adjustment is allocated among the items of property within the class in proportion to the transferee partner's share of the partnership's adjusted basis in each item of property in the class, taking into account the adjustment allocated to the property under the first step.742
——————————————————————————————

741 Regs. § 1.755-1(b)(5)(iii)(B).

742 Regs. § 1.755-1(b)(5)(iii)(B).

——————————————————————————————

If a downward adjustment is allocable to either or both classes, and it exceeds the transferee partner's share of the partnership's adjusted basis in all depreciated assets in that class, then the transferee's downward adjustment is limited to the transferee partner's share of the partnership's adjusted basis in all depreciated assets in that class.743 If a downward basis adjustment cannot be allocated to any asset because it exceeds the transferee partner's share of the partnership's adjusted basis in all depreciated assets in a particular class, the adjustment is made when the partnership subsequently acquires property of a like character to which an adjustment can be made.744
——————————————————————————————

743 Regs. § 1.755-1(b)(5)(iii)(C).

744 Regs. § 1.755-1(b)(5)(iii)(D).

——————————————————————————————

Example: Refer to the preceding example, in which the entire$105,000 upward adjustment was allocated to the ordinary income class. The adjustment is allocated within the class as follows. An upward adjustment of $17,500 is allocated to Ordinary Income Asset I ($105,000 x$20,000 unrealized appreciation/$120,000 total unrealized appreciation in the class) and an upward adjustment of $87,500 is allocated to Ordinary Income Asset II ($105,000 x $100,000 unrealized appreciation/$120,000 total unrealized appreciation in the class).

Note: This result is in sharp contrast to how an adjustment arising from a purchase or death transaction is allocated.

d. Transfers Before December 15, 1999 

Under prior law, the amount of the  § 743(b) adjustment was first divided between the two classes of assets described in  § 755(b) —capital and  § 1231 assets on the one hand and all other property on the other — in proportion to the relative appreciation (if the adjustment was upward) or depreciation(if the adjustment was downward) of each class. Then, the portion of the adjustment allocated to each class of assets was allocated to the bases of the properties within the class in a manner that reduced the difference between the fair market value and the adjusted basis of partnership properties.745 An upward adjustment was allocated only to appreciated assets in proportion to the difference between the fair market value and basis of each such asset.746 A downward adjustment was allocated only to depreciated assets in proportion to the difference between the basis and fair market value of each such asset.747
——————————————————————————————

745 Former Regs. § 1.755-1(a)(1)(i)(in effect for transfers before Dec. 15, 1999).

746 Former Regs. § 1.755-1(a)(1)(ii)(in effect for transfers before Dec. 15, 1999).

747 Former Regs.  § 1.755-1(a)(1)(iii)(in effect for transfers before Dec. 15, 1999).

——————————————————————————————

Under prior law, a taxpayer was able to file an application for permission to allocate the adjustment within a class in an alternative manner.748 The application had to be filed within 30 days after the close of the partnership taxable year in which the proposed adjustment was to be made, and had to set forth the proposed adjustments in detail and explain why an alternative method of allocation was desired.749 Upon a satisfactory showing of the values of partnership property, the district director allowed offsetting increases and decreases to the bases of partnership property within a class. However, the net amount of all the adjustments had to equal the amount of the adjustment as computed under § 743(b).750
——————————————————————————————

748 Former Regs. § 1.755-1(a)(2) (in effect for transfers before Dec. 15, 1999).

749 Former Regs. § 1.755-1(a)(2) (in effect for transfers before Dec. 15, 1999).

750 Former Regs. § 1.755-1(a)(2) (in effect for transfers before Dec. 15, 1999).

——————————————————————————————

Example: Partnership BCD has the following balance sheet on Jan. 1, 1998:

 Assets	Adjusted
  Basis	Fair Market Value	
Accts. Receivable	$30,000	$30,000	
Inventory	 30,000	 60,000	
Capital Assets #1	 10,000	 40,000	
Capital Assets #2	 80,000	 80,000	
Recourse Liabilities	 30,000	 30,000 	
Capital:	 	 	
B	 40,000	 60,000 	
C	 40,000	 60,000 	
D	 40,000	 60,000	

Each of the partners owns a one-third interest in partnership capital and each partner's share of partnership liabilities is $10,000. Assume that the partnership has a  § 754 election in effect and that D sells D's partnership interest to E on Jan. 1, 1998, for $60,000. E's adjusted basis in E's partnership interest is $70,000 ($60,000 cost plus $10,000 share of partnership liabilities).751 E's share of inside basis is $50,000 ($40,000 (transferee partner's interest in partnership capital) plus $10,000 (transferee partner's share of partnership liabilities)). The amount of the  § 743(b) adjustment is $20,000. The net appreciation in the capital asset class is $30,000 (fair market value of the capital assets ($120,000) minus total adjusted bases of the capital assets ($90,000)). The net appreciation in the ordinary income property is $30,000 (fair market value of other property ($90,000)minus total adjusted bases in other property ($60,000)). The upward § 743(b) adjustment is allocated between the two classes in proportion to the net appreciation in each class. Thus, one-half of the adjustment ($10,000) is allocated to the capital assets and one-half of the adjustment is allocated to the ordinary income property. The adjustment allocated to each class is next allocated to the assets within each class in proportion to the net appreciation in each asset. Capital Asset #1 has net appreciation of $30,000 ($40,000 minus $10,000) and Capital Asset #2 is not appreciated at all. Therefore, the $10,000 capital asset class adjustment is allocated entirely to Capital Asset #1. In the ordinary income property class, the inventory is the only appreciated asset. Therefore, the entire$10,000 adjustment is allocated to the inventory. As a result of the § 743(b) adjustment, the adjusted bases of the partnership assets, as to E only, are as follows:

 Assets	E's Share of Fair
 Market Value	E's Share of Partnership's Adjusted Basis	E's Adjustment	E's Total Basis	
Accounts
  Receivable	10,000	10,000	0	10,000 	
Inventory	20,000	10,000	10,000	20,000	
Capital Asset #1	13,333	 3,333	10,000	13,333	
Capital Asset #2	26,666	26,666	0	26,666 	

——————————————————————————————

751 § § 742, 752(a).

——————————————————————————————

Note: The example above involves an upward  § 743(b) adjustment in a partnership with no depreciated assets. The previous regulations under § 755 worked to reflect economic reality in cases in which either the adjustment was upward and there were no depreciated assets or the adjustment was downward and there were no appreciated assets. However, in the more complex case of a partnership that holds both appreciated and depreciated assets, application of the previous regulations under § 755 often produced results that did not reflect economic reality.

Example: Partnership BCD has the following balance sheet on Jan. 1, 1998:

 Assets	
 Adjusted Basis	Fair Market Value	
Inventory	$60,000	$12,000 	
Land	 18,000	 72,000 	
Equipment	 33,000	 18,000 	
Goodwill	0	 27,000 	
Recourse Liabilities	0	0 	
Capital:	 	 	
B	 37,000	 43,000 	
C	 37,000	 43,000 	
D	 37,000	 43,000	

Assume that the partnership has a  § 754 election in effect and that D sells D's one-third interest in the partnership to E on Jan. 1, 1998, for $43,000. The amount of the  § 743(b) adjustment is $6,000 (E's adjusted basis in E's partnership interest ($43,000)minus E's proportionate share of inside basis ($37,000)). The class of partnership property consisting of capital and  § 1231(b) assets (land, equipment, goodwill) has net appreciation of $66,000 ($117,000 total fair market value minus $51,000 total adjusted bases). The class consisting of ordinary income property (inventory) has net depreciation of $48,000($60,000 adjusted basis minus $12,000 fair market value). Thus, the entire adjustment is allocated to the class of capital and  § 1231(b) assets. Within that class, absent special permission granted by the district director, the adjustment is allocated only to appreciated assets in proportion to the net appreciation in each asset. The equipment is depreciated and, therefore, none of the adjustment is allocated to the equipment. The land has net appreciation of $54,000, and the goodwill has net appreciation of $27,000. Thus, E's share of the partnership's adjusted basis in the land is increased by $4,000 ($54,000/$81,000 x$6,000) and E's share of the partnership's adjusted basis in the goodwill is increased by $2,000 ($27,000/$81,000 x $6,000). After the adjustments are made, E's share of the partnership's adjusted bases in its assets is as follows:
 Assets	 E's Share of Fair Market Value	E's Share of Partnership's Adjusted Basis	E's Adjustment	E's Total Basis	
Inventory	$4,000	$20,000	$0	$20,000	
Land	24,000	  6,000	4,000	 10,000	
Equipment	 6,000	 11,000	    0	 11,000 	
Goodwill	 9,000	     0	2,000	  2,000 	

None of the assets has a cost basis with respect to E. Upon the sale of any of these assets, without changes in fair market value, E will incur loss or gain that is not a true reflection of E's actual economic loss or gain. For example, when the inventory is sold, the partnership will recognize $48,000 of ordinary loss, $16,000 of which will be allocated to E as a one-third partner.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

D. Effect of § 743(b) Adjustment on Calculation of Income, Gain, or Loss and on Transferee Partner's Distributive Share of Partnership Items 

The basis adjustment that results from the sale or exchange of a partnership interest or the death of a partner, like any other basis amount, is a reference used to calculate income, gain, loss, and deduction. However, the basis adjustment is an adjustment with respect to the transferee only.752 No adjustment is made to the common basis of partnership property (i.e., the partnership's adjusted basis in its assets). For purposes of income, deduction, gain, loss, and distribution, the transferee will have a special basis for those partnership properties that are adjusted as a result of the  § 743(b) basis adjustment. Thus, the basis adjustment does not affect the partnership's computation of any item of income, gain, or loss and does not have any effect on the partners' capital accounts.753
——————————————————————————————

752 Regs. § 1.743-1(j)(1).

753 Regs. § 1.743-1(j)(1).

——————————————————————————————

To determine a transferee partner's distributive share of partnership items, a partnership first computes its items of income, deduction, gain, or loss at the partnership level and allocates each of the items to the partners in accordance with  § 704(b) and the partnership agreement.754 All of the partners'capital accounts are adjusted to take into account these allocations. The partnership then adjusts the transferee partner's distributive share of partnership items to reflect any basis adjustments relevant to that partner. These adjustments must be reflected on Schedules K and K-1 of the partnership's tax return, but they are not reflected in the transferee partner's capital account.755
——————————————————————————————

754 Regs. § 1.743-1(j)(2).

755 Regs. § 1.743-1(j)(2).

——————————————————————————————

The amount of a transferee's income, gain, or loss from the sale or exchange of a partnership asset in which the transferee has a basis adjustment is equal to the transferee's share of the partnership's gain or loss from the sale of the asset (including any remedial allocations under Regs. § 1.704-3(d)), minus the amount of the transferee's positive basis adjustment for the partnership asset (determined by taking into account the recovery of the basis adjustment under Regs. § 1.743-1(j)(4)(i)(B)756) or plus the amount of the transferee's negative basis adjustment for the partnership asset (determined by taking into the account the recovery of the basis adjustment under Regs. § 1.743-1(j)(4)(ii)(B)).757
——————————————————————————————

756 See VII, K, below.

757 See VII, K, below.

——————————————————————————————

Example: B and C form an equal partnership. B contributes nondepreciable property with a fair market value of $50,000 and an adjusted tax basis of $100,000. The partnership uses the traditional allocation method under Regs. § 1.704-3(b). C contributes $50,000 cash. B sells B's interest to D for $50,000. Assume that the partnership has an election in effect to adjust the basis of partnership property under § 754. D receives a negative $50,000 basis adjustment under  § 743(b) that, under § 755, is allocated to the nondepreciable property. The partnership then sells the property for $60,000. The partnership recognizes a book gain of $10,000 (allocated equally between C and D) and a tax loss of $40,000. D will receive an allocation of $40,000 of tax loss under the principles of § 704(c). However, because D has a negative $50,000 basis adjustment in the nondepreciable property, D recognizes a $10,000 gain from the partnership's sale of the property.

Example: B and C form an equal partnership, which will make allocations under  § 704(c) using the remedial allocation method described in Regs. § 1.704-3(d). B contributes nondepreciable property with a fair market value of $100,000 and an adjusted tax basis of $150,000. C contributes $100,000 cash. B sells B's partnership interest to D for $100,000. The partnership has an election in effect to adjust the basis of partnership property under § 754. D receives a negative$50,000 basis adjustment under  § 743(b) that, under § 755, is allocated to the nondepreciable property. The partnership then sells the property for $120,000. The partnership recognizes a $20,000 book gain and a $30,000 tax loss. The book gain will be allocated equally between C and D. The entire $30,000 tax loss will be allocated to D under the principles of § 704(c). To match its $10,000 share of book gain, C will be allocated $10,000 of remedial gain, and D will be allocated an offsetting $10,000 of remedial loss. D was, therefore, allocated a total of $40,000 of tax loss with respect to the property. However, because D has a negative $50,000 basis adjustment to the property, D recognizes a $10,000 gain from the partnership's sale of the property.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

E. Reporting and Returns 

1. In General 

The regulations provide that partnerships (rather than partners) are required to make and report the  § 743(b) basis adjustments.758 Partnerships are required to adjust the transferee's distributive share of partnership tax items so that the information reported on the transferee's Schedule K-1 reflects the adjustments to the transferee's distributive share of the partnership items affected by the basis adjustment. The partnership must attach a statement to the partnership return for the year of the transfer that sets forth the name and taxpayer identification number of the transferee as well as the computation of the adjustment and the partnership properties to which the adjustment has been allocated.759
——————————————————————————————

758 Under prior law, transferees were required to report the basis adjustments. Transferees accomplished this by attaching statements to their returns that showed how the basis adjustment was determined and how the adjustment was allocated among the various partnership properties. No guidance existed with respect to when (i.e., before or after the Schedule K-1) the effect of the basis adjustment to specific partnership items was to be determined or who was required to make and report the adjustments to the partnership items.

759 Regs. § 1.743-1(k)(1)(i).

——————————————————————————————

In Notice 2005-32,760 the IRS indicated that Treasury and the IRS intend to amend the regulations under  § 743 to require partnerships and partners to provide statements similar to those described in the current regulations following transfers that trigger mandatory basis adjustments under § 743. Notice 2005-32 states that, until further guidance is provided, partnerships with substantial built-in losses when interests are transferred must comply with Regs. § 1.743-1(k)(1) as if a  § 754 election were in effect at the time of the transfer. The notice also states that the transferee of the partnership interest in such a situation must comply with Regs.  § 1.743-1(k)(2) as if a  § 754 election were in effect, and partnerships in that situation may rely on, and must comply with, Regs. § 1.743-1(k)(3), (4), and (5) as if a  § 754 election were in effect.
——————————————————————————————

760 2005-16 I.R.B. 895. The notice also provides interim reporting requirements for electing investment partnerships. See VII, E, 2, below.

——————————————————————————————

The regulations provide a special rule for a partnership that holds oil and gas property that is depleted at the partner level under § 613A(c)(7)(D). The transferee partner must attach a statement to the transferee's return for the year of the transfer setting forth the computation of the  § 743 basis adjustment allocable to oil and gas properties and the specific properties to which the adjustment has been allocated.761
——————————————————————————————

761 Regs. § 1.743-1(k)(1)(ii).

——————————————————————————————

Example: A partnership owns a single piece of  § 613A(c)(7)(D) domestic oil and gas property, as well as other nondepletable assets. B, a partner in the partnership, has an adjusted tax basis in the property of $100,000 (excluding any prior  § 743 basis adjustments). B sells B's partnership interest to E for $800,000 cash. B's adjusted basis of $100,000 in the property carries over to C, another partner.762 The partnership determines that the property accounts for 50% of the fair market value of all partnership assets. The remaining 50% of E's purchase price ($400,000) is attributable to nondepletable assets. The partnership must provide a statement to E stating the portion of E's adjusted basis attributable to nondepletable assets ($400,000). The partnership must report  § 743 basis adjustments with respect to nondepletable assets. E must attach a statement to E's return for the year of the transfer that sets forth the computation of the  § 743 basis adjustment allocable to the depletable property.

——————————————————————————————

762 See Regs. § 1.613A-3(e)(6)(iv).

——————————————————————————————

A transferee that acquires, by sale or exchange, an interest in a partnership that has a  § 754 election in effect at the time of the transfer or that has a substantial built-in loss immediately after the transfer must notify the partnership in writing within 30 days of the sale or exchange.763 The written notice to the partnership must be signed under penalties of perjury and must include the following information:764
——————————————————————————————

763 Regs § 1.743-1(k)(2)(i). See also Notice 2005-32, 2005-16 I.R.B. 895.

764 Regs § 1.743-1(k)(2)(i). See also Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

• the names and addresses of the transferee and (if ascertainable) of the transferor;

•the taxpayer identification numbers of the transferee and (if ascertainable)of the transferor;

• the relationship(if any) between the transferee and the transferor;

• the date of the transfer;

• the amount of any liabilities assumed or taken subject to by the transferee;

• the amount of any money and the fair market value of any other property delivered or to be delivered for the transferred interest in the partnership;and

• any other information necessary for the partnership to compute the transferee's basis.

A transferee that acquires, on the death of a partner, an interest in a partnership that has a  § 754 election in effect at the time of the transfer or that has a substantial built-in loss immediately after the transfer must notify the partnership in writing within one year of the death of the deceased partner.765 The written notice to the partnership must be signed under penalties of perjury and must include all of the following:766
——————————————————————————————

765 Regs. § 1.743-1(k)(2)(ii). See also Notice 2005-32, 2005-16 I.R.B. 895.

766 Regs. § 1.743-1(k)(2)(ii). See also Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

• the names and addresses of the deceased partner and the transferee;

• the taxpayer identification numbers of the deceased partner and the transferee;

• the relationship (if any) between the transferee and the transferor;

• the deceased partner's date of death;

•the date on which the transferee became the owner of the partnership interest;

• the fair market value of the partnership interest on the applicable date of valuation set forth in § 1014;and
  
• the manner in which the fair market value of the partnership interest was determined.

If a partnership interest is transferred to a nominee that is required to furnish the statement under  § 6031(c)(1) to the partnership, the nominee may satisfy the notice requirement by providing the statement required under Regs. § 1.6031(c)-1T, as long as the statement satisfies the requirements of that regulation as well as the general notice requirement, described above, of the § 743 regulations.767
——————————————————————————————

767 Regs. § 1.743-1(k)(2)(iii). See also Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

To accommodate partnership concerns about the reliability of the information provided by transferees, partnerships are entitled to rely on the written representations of transferees concerning either the amount paid for the partnership interest or the transferee's basis in the partnership interest acquired from a decedent. For purposes of computing any basis adjustments under  § 743(b) as well as for purposes of any statements or returns with respect to those adjustments, a partnership may generally rely on the written notice provided by a transferee partner.768 This rule does not apply, however, if any partner who has responsibility for federal income tax reporting by the partnership has knowledge of facts indicating that the statement from the transferee partner is clearly erroneous.769 A partnership is not required to make or report  § 743(b) basis adjustments with respect to any transfer until either it has received written notice from the transferee or any partner who has responsibility for federal income tax reporting has knowledge that there has been a transfer of a partnership interest.770
——————————————————————————————

768 Regs. § 1.743-1(k)(3). See also Notice 2005-32, 2005-16 I.R.B. 895.

769 Regs. § 1.743-1(k)(3). See also Notice 2005-32, 2005-16 I.R.B. 895.

770 Regs. § 1.743-1(k)(4). See also Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

If a transferee partner fails to provide the partnership with the required written notice, the partnership must attach a statement to its return in the year in which the partnership is otherwise notified of the transfer setting forth the name and taxpayer identification number (if ascertainable) of the transferee.771 The following statement must be prominently displayed in capital letters on the first page of the partnership's return for the year and on the first page of any schedule or information statement relating to such transferee's share of income, credits, deductions, etc.: “RETURN FILED PURSUANT TO § 1.743-1(k)(5).”If the transferee partner provides no notice, the partnership is entitled to report the transferee's share of partnership items without reflecting the transferee's basis adjustment in partnership property. If the transferee partner later provides the required written notice to the partnership, the partnership must make such adjustments as are necessary to adjust the basis of partnership property (as of the date of the transfer) in any amended return otherwise to be filed by the partnership or in the next annual partnership income tax return to be regularly filed by the partnership. At that time, the partnership must also provide the transferee with any information necessary for the transferee to amend its prior returns properly to reflect the adjustment under § 743(b).772
——————————————————————————————

771 Regs. § 1.743-1(k)(5). See also Notice 2005-32, 2005-16 I.R.B. 895.

772 Regs. § 1.743-1(k)(5). See also Notice 2005-32, 2005-16 I.R.B. 895.

——————————————————————————————

Note: The partnership is not required to amend its prior income tax return if it is not otherwise filing an amended return.

2. Special Reporting Requirements Applicable to Electing Investment Partnerships 

An “electing investment partnership” (EIP) is not treated as having a substantial built-in loss in connection with any transfer that occurs while the partnership's election to be an EIP is in effect.773 A partnership-level disallowance rule, instead of the substantial built-in loss rule, applies to losses in an EIP.
——————————————————————————————

773 § 743(e), effective for transfers after Oct. 22, 2004. See VII, A, 2, above, for further discussion.

——————————————————————————————

Notice 2005-32,774 which provides interim guidance on EIPs, states that a partnership makes an election to be treated as an EIP by attaching a statement to an original or amended return for the taxable year for which the election is effective, (i) setting forth the partnership's name, address, and tax identification number, (ii) representing that the partnership is eligible to make the election, and (iii) declaring that the partnership elects to be treated as an EIP.775
——————————————————————————————

774 2005-16 I.R.B. 895.

775 If a partnership filed a return for a taxable year that includes Oct. 22, 2004, and wishes to be treated as an EIP for transfers after that date but did not attach to the return a statement with the information described above, the partnership should file an amended return with a statement meeting the Notice 2005-32 requirements.

——————————————————————————————

The partnership must file the original or amended return to which the election statement is attached no later than six months after the Regs.  § 1.6031(a)-1(e) due date (excluding extensions) for the return for the taxable year for which the election is to be effective. The election is in effect for all succeeding taxable years, unless it is terminated or revoked.776
——————————————————————————————

776 If a partnership filed an election for the partnership's taxable year that includes Oct. 22, 2004, the election is effective for all transfers occurring after Oct. 22, 2004. In all other cases, the election is effective for transfers during the partnership's taxable year for which the election is effective.

——————————————————————————————

A partnership that has a  § 754 election in effect cannot make an election to be treated as an EIP. In fact, Notice 2005-32 allows an EIP to terminate its EIP election simply by filing a  § 754 election. An EIP election also terminates if the partnership fails to meet the definition of an EIP. Otherwise, a partnership can only revoke its election to be treated as an EIP with IRS consent, sought in a letter ruling request.

Notice 2005-32 provides that if a partnership's EIP election terminates because the partnership fails to meet the definition of an EIP or because the partnership makes a  § 754 election, the partnership becomes subject to the mandatory (i.e., substantial built-in loss) basis adjustment rules with respect to the first transfer after the partnership ceases to meet the definition or after the effective date of the  § 754 election. If an election to be treated as an EIP terminates, any losses that are subsequently allocated to a partner to whom a partnership interest was transferred while the EIP election was in effect remain subject to the  § 743(e)(2) disallowance rules.

Section 6031(f) 777 requires an EIP to furnish information necessary to enable its partners to compute their losses disallowed by  § 743(e)(2) (in addition to the information described in § 6031(b)). Notice 2005-32, however, shifts this burden to the transferor partner by stating that when an interest in an EIP is transferred in a sale or exchange or on the death of a partner, the transferor (or the deceased partner's executor, personal representative, or other successor in interest) 778 must notify the transferee and the EIP, in writing and signed under penalties of perjury, within 30 days after the transferor (or successor in interest) receives Schedule K-1 from the EIP for the partnership's taxable year in which the transfer occurred. The purpose of this transfer notice (which must contain information specified in Notice 2005-32) is to enable the transferee to compute the amount of loss disallowed under § 743(e)(2).779 Notice 2005-32 states that the transferee and the EIP “shall retain the notice ...as long as the contents thereof may become material in the administration of any internal revenue law.”
——————————————————————————————

777 Effective for transfers after Oct. 22, 2004.

778 If the transferor is a nominee within the meaning of Regs. § 1.6031(c)-1T, the nominee rather than the beneficial owner of the transferred interest must supply the information to the transferee and to the EIP.

779 If an EIP is not required to file a partnership return, the transferee of a partnership interest may be required to give the IRS similar information regarding the partner's distributive share of gains and losses of the EIP. See Regs. § 1.6031(a)-1(b)(4).

——————————————————————————————

If the transferor partner (or the partner's successor in interest)fails to provide the transfer notice, the transferee partner must treat all losses allocated from the EIP as disallowed under  § 743(e)(2) unless the transferee obtains information necessary to determine the true amount of disallowed losses. If the transferee has enough information to determine the maximum amount of losses that could be disallowed (but cannot determine the true amount of disallowed losses), the transferee may treat that maximum amount as the amount of disallowed losses.780 Notice 2005-32 states, however, that if the transferor partner or the EIP later provides the required information, the transferee must file an amended return for the year of the loss allocation.
——————————————————————————————

780 Notice 2005-32 provides an example in which the transferee can ascertain the adjusted basis that a prior transferor had in that transferor's interest in the partnership, but cannot ascertain that transferor's amount realized; the transferee may assume that the sales price in the prior transfer was zero.

——————————————————————————————

Because the amount of losses disallowed under  § 743(e)(2) is determined without regard to gains, Notice 2005-32 requires an EIP to state separately on Schedules K and K-1 all allocations of losses to all of its partners, including losses that could be netted against gains at the partnership level but for § 743(e).781 If a partnership's EIP election terminates, the partnership must continue to state such gains and losses separately in future returns relating to any period during which the partnership has one or more transferee partners subject to § 743(e)(2).
——————————————————————————————

781 If an EIP filed a return for a taxable year that includes Oct. 22, 2004, in which the partnership did not separately state gains and losses, the EIP must file an amended return separately stating gains and losses before the time for making an EIP election for that year expires.

——————————————————————————————

The EIP itself must provide annual notice of its EIP election to partners by attaching language set out in Notice 2005-32 to every statement provided to a partner or nominee under  § 6031(b) that the partnership issues with respect to any taxable year for which an EIP election is in effect (whether the election is in effect for all, or only part, of the year).782
——————————————————————————————

782 If a partnership provided  § 6031(b) statements with respect to a taxable year that includes Oct. 22, 2004, and elects to be treated as an EIP for that year but did not include the language required in Notice 2005-32, the partnership must provide amended  § 6031(b) statements with the required language before the time for making an EIP election for that year expires.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

F. Application of § 743(b)Adjustment to Tiered Partnerships 

In Rev. Rul. 87-115,783 the IRS ruled that if a partner in an upper-tier partnership transfers an interest in the partnership, the  § 743(b) adjustment is applicable with respect to the assets of both the upper-tier and the lower-tier partnership if both partnerships have a  § 754 election in effect. If, on the other hand, only the upper-tier partnership has a  § 754 election in effect, the adjustment applies only to the basis of the upper-tier partnership's assets.784 If only the lower-tier partnership has a  § 754 election in effect, the adjustment is not available to adjust the basis of either partnerships' assets.785
——————————————————————————————

783 1987-2 C.B. 163. See also Rev. Rul. 78-2, 1978-1 C.B. 202.

784 Rev. Rul. 87-115, 1987-2 C.B. 163.

785 Rev. Rul. 87-115. The IRS has yet to clarify the application of the tiered-partnership rules when either the upper- or lower-tier partnership is subject to the mandatory § 743(b) basis adjustment. See VII, A, above, for a discussion of the mandatory § 743(b) basis adjustment.

——————————————————————————————

Application of the  § 743(b) adjustment to a tiered partnership is particularly complex in the situation in which there is a difference between outside and inside basis in the lower-tier partnership.

Example: Assume that E purchases a 25% interest in an upper-tier partnership (“UTP”) that owns assets that have appreciated by $80,000. One of UTP's assets is a one-third interest in a lower-tier partnership (“LTP”). UTP purchased its interest in LTP for $80,000 at a time when the selling partner's share of LTP's adjusted bases in its assets was $110,000. However, at the time of UTP's purchase, LTP did not have a  § 754 election in effect. There is, therefore, a $30,000 discrepancy between UTP's adjusted basis in its interest in LTP and UTP's share of LTP's adjusted bases in its assets. At the time of E's purchase of the UTP interest, the fair market value of UTP's interest in LTP is $120,000. At the time of E's purchase, both UTP and LTP have a  § 754 election in effect. With respect to UTP's assets, E is entitled to a $20,000  § 743(b) adjustment, $10,000 of which is allocated to UTP's interest in LTP. Upon the sale of the UTP interest to E, there is a deemed sale of 25% of UTP's interest in LTP. With respect to LTP's assets, E's  § 743(b) adjustment is limited to $2,500: E's share of UTP's adjusted basis in the LTP interest ($30,000(25% of $80,000 plus $10,000 adjustment)) minus E's share of LTP's adjusted bases in its assets ($27,400 (25% of $110,000)). Note that if the discrepancy between UTP's inside and outside basis in LTP did not exist, E's  § 743(b) adjustment with respect to LTP's assets would be $10,000: $30,000 (25% of $80,000 plus $10,000 adjustment)) minus E's share of LTP's adjusted bases in its assets ($20,000 (25% of $80,000)).786

——————————————————————————————

786 This example is based on the illustrations in Rev. Rul. 87-115, 1987-2 C.B. 163.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

G. Effect of § 743(b) Adjustment on Subsequent Distributions of Partnership Property 

1. Current Distributions of Special Basis Property to a Transferee Partner 

If a partnership distributes special basis property (property subject to a  § 743(b) adjustment)to the partner to whom the adjustment applies (the transferee partner), the basis adjustment is taken into account in determining the partnership's adjusted basis in the property for purposes of calculating the distributee partner's basis in the property under § 732.787
——————————————————————————————

787 Regs. § 1.743-1(g)(1)(i).

——————————————————————————————

Example: B and C are equal partners in a partnership that owns several assets, one of which is a depreciable asset with a common partnership basis of $2,000 and a special upward basis adjustment to C of $500. If the partnership makes a current distribution of this asset to C, the partnership's adjusted basis in the asset with respect to C is $2,500. Thus, assuming the  § 732(a)(2) limitation does not apply, C's adjusted basis in the distributed asset is $2,500.

2. Current Distributions of Special Basis Property to a Non-transferee Partner 

If a partnership distributes special basis property (property subject to a  § 743(b) adjustment)to a partner to whom the  § 743(b) adjustment does not apply, the distributee partner does not take the adjustment into account for purposes of determining the partnership's adjusted basis in the property.788 The partner to whom the  § 743(b) adjustment is applicable reallocates it, pursuant to the rules in Regs. § 1.755-1(c), to remaining partnership property of a like kind.789
——————————————————————————————

788 Regs. § 1.743-1(g)(2)(i).

789 Regs. § 1.743-1(g)(2)(ii).

——————————————————————————————

Example: B and C are equal partners in a partnership that owns several assets, two of which are depreciable assets. Depreciable asset X has a common basis to the partnership of $800 and a special upward basis adjustment to C of $200. Depreciable asset Y has a common basis to the partnership of $1,000 and a special upward basis adjustment to C of $300. The partnership makes a current distribution of X to B and Y to C. The partnership's adjusted basis in X with respect to B is $800. Therefore, assuming the limitation of  § 732(a)(2) does not apply, B's adjusted basis in X is $800. The partnership's adjusted basis in Y with respect to C is $1,500 ($1,000 common basis plus $300 special basis adjustment allocable to Y plus $200 basis adjustment originally allocated to X and reallocated to Y). Thus, assuming the limitation of  § 732(a)(2) does not apply, C's adjusted basis in Y is $1,500.

Note: If C had not received a distribution of property, the$200 basis adjustment originally allocated to X would still have been reallocated to Y (assuming that Y is the partnership's only other depreciable asset).

If the partnership owns no property of the character required to be adjusted, the adjustment is made when the partnership subsequently acquires property of a like character to which an adjustment can be made.790
——————————————————————————————

790 Regs. § 1.755-1(c)(4).

——————————————————————————————

3. Liquidating Distributions to a Transferee Partner 

If a transferee partner receives a distribution in liquidation of the transferee's entire partnership interest, the partner is considered to have relinquished the partner's interest in any remaining partnership properties. If, pursuant to a liquidating distribution, a transferee partner receives a distribution of partnership property, the adjusted basis to the partnership immediately preceding the distribution includes the transferee's basis adjustment, if any, for the property in which the partner relinquished an interest.791 Note that this reallocation rule does not increase the partner's adjusted basis in the distributed property because, under § 732(b), in a liquidating distribution the distributee partner's basis in the distributed property is equal to the partner's adjusted basis in the partnership interest minus the amount of any money distributed. However, the reallocation rule is relevant for purposes of allocating the partner's basis among the distributed assets. If, upon a liquidating distribution, a distributee partner is unable to use the entire amount of his  § 743(b) adjustment, the unused portion is added to the common basis of the remaining partnership assets.792
——————————————————————————————

791 Regs. § 1.743-1(g)(3).

792 Regs. § 1.743-1(g)(3).

——————————————————————————————

Example: B, C, and D are equal partners in a partnership. Each partner originally contributed $10,000 in cash, and the partnership used the contributions to purchase five nondepreciable assets. The partnership has no liabilities. Assume that the partnership's balance sheet, after five years, is as follows:
Assets	 	Adjusted Basis	Fair Market Value	
Asset 1	 	$10,000	$10,000	
Asset 2	 	  4,000	  6,000	
Asset 3	 	  6,000	  6,000	
Asset 4	 	  7,000	  4,000	
Asset 5	 	 10,000	 13,000	
Capital	B	$10,000	$13,000 	
 	C	 10,000	 13,000 	
 	D	 10,000	 13,000	

Assume that B sells B's partnership interest to E for $13,000. Assume also that the partnership has a  § 754 election in effect at the time of the sale. E has a $3,000 upward basis adjustment, allocated under  § 755 to the assets as follows:
Assets	 	Value 	As to E 	
Asset 1	$10,000	$10,000	$0.00	
Asset 2	4,000	6,000	666.67	
Asset 3	6,000	6,000	0.00	
Asset 4	7,000	4,000	(1,000.00)	
Asset 5	3,000	13,000	3,333.00	

Assume that the partnership distributed Asset 5 to E in complete liquidation of E's interest in the partnership. Immediately before the distribution, the partnership's adjusted basis in Asset 5 is $6,000 ($3,000 common basis plus $3,333 (amount of E's basis adjustment with respect to Asset 5) minus $333.33 (sum of E's basis adjustment with respect to Asset 2 ($666.67) and Asset 4 (negative $1,000))). For purposes of § § 732 and 734, the partnership is treated as having an adjusted basis of $6,000 in the distributed asset.793

——————————————————————————————

793 See Regs.  § 1.743-1(g)(5) Ex.(v).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

H. Effect of § 743(b) Adjustment on Subsequent Transfers of Partnership Interests 

Upon the subsequent transfer of a partnership interest that was previously entitled to a  § 743(b) adjustment, the amount of the last transferee's adjustment, if any, is determined by reference to the partnership common basis for its property without regard to any prior transferee's adjustment.794
——————————————————————————————

794 Regs. § 1.743-1(f).

——————————————————————————————

Example: D purchases a one-third interest in a partnership on Jan. 1, Year One. At the time of the transfer, the partnership has a  § 754 election in effect. After the transfer, the adjusted bases of partnership assets with respect to D are as follows:
Assets	D's Share of Fair Market Value 	D's Share of Partnership's Adjusted Basis	D's Adjustment	D's Total Basis	
Cash	$10,000	$10,000	-0-	$10,000 	
Inventory	 20,000	 10,000	10,000	 20,000 	
Capital Asset	 30,000	 10,000	20,000	 30,000 	

Two years later, on Jan. 1, Year Three, D sells his entire interest to E for $100,000. At the time of the sale the adjusted bases of partnership assets with respect to D are as follows:

Assets	D's Share of Fair Market Value	D's Share of Partnership's Adjusted Basis	D's Adjustment	D's Total Basis	
Cash	$10,000	$10,000	-0-	$10,000 	
Inventory	 40,000	 20,000	10,000	 30,000 	
Capital Asset	 50,000	 20,000	20,000	 40,000 	

The amount of E's  § 743(b) adjustment is calculated without regard to D's special basis adjustment. Thus, the amount of E's adjustment is $50,000 ($100,000 adjusted basis in partnership interest minus $50,000 proportionate share of partnership's common basis).

In the case of a gift of an interest in a partnership, the donor is treated as transferring, and the donee as receiving, that portion of the basis adjustment attributable to the gifted partnership interest.795
——————————————————————————————

795 Regs. § 1.743-1(f).

——————————————————————————————

Example: B, C, and D form a partnership in which each partner has an equal interest in capital and profits. B and C each contribute$50,000 cash, and D contributes property with an adjusted basis and fair market value of $50,000. After the land has appreciated in value to $80,000, B transfers its partnership interest to E for $60,000(one-third of the $180,000 value of partnership property). Assume that the partnership has a  § 754 election in effect at the time of the sale. E has a $10,000 upward  § 743(b) basis adjustment. During the following year, E gifts 50% of the partnership interest to F. E is treated as having transferred $5,000 of the upward  § 743(b) basis adjustment to F.796

——————————————————————————————

796 See Regs.  § 1.743-1(f) Ex.(iii).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

I. Effect of § 743(b) Adjustment on Subsequent Contributions of Partnership Interests 

1. Contributions of Property by an Upper-Tier Partnership to a Lower-Tier Partnership Under § 721 

The regulations provide that if, in a transaction to which  § 721(a) applies, a partnership(referred to as the “upper-tier partnership” or UTP) contributes to another partnership (referred to as the “lower-tier partnership”or LTP) property with respect to which a basis adjustment has been made, the basis adjustment is treated as contributed to the LTP, regardless of whether the LTP makes a  § 754 election.797 The LTP's basis in the contributed assets and the UTP's basis in the partnership interest received in the transaction are determined taking into consideration the basis adjustment. However, that portion of the basis of the UTP's interest in the LTP attributable to the basis adjustment must be segregated and allocated solely to the transferee partner for whom the basis adjustment was made. Similarly, that portion of the LTP's basis in its assets attributable to the basis adjustment must be segregated and allocated solely to the UTP and the transferee partner from whom the adjustment was made.798
——————————————————————————————

797 Regs. § 1.743-1(h)(1).

798 Regs. § 1.743-1(h)(1).

——————————————————————————————

2. Effect of Termination on  § 743(b) Adjustment 

A partner with a  § 743(b) basis adjustment in property held by a partnership that terminates under § 708(b)(1)(B) will continue to have the same basis adjustment with respect to property deemed contributed by the terminated partnership to the new partnership under Regs. § 1.708-1(b)(1)(iv), regardless of whether the new partnership makes a  § 754 election.799
——————————————————————————————

799 Regs. § 1.743-1(h)(1). The termination of a partnership under  § 708(b)(1)(B) due to the sale of a 50% or greater interest in partnership capital and profits is treated as a contribution of the terminated partnership's property to a new partnership, followed by a distribution of the interests in the new partnership to the post-termination partners.

——————————————————————————————

Observation: An interesting issue arises in the context of a termination under  § 708(b)(1)(B) when there is  § 704(c) property involved.  Section 704(c) property deemed contributed to the new partnership continues to be treated as  § 704(c) property in the hands of the new partnership. However, the new partnership is not bound by the terminated partnership's choice of allocation method. As discussed below, the manner in which a basis adjustment allocated to  § 704(c) property is recovered depends in part upon the allocation method chosen by the partnership. What happens if an adjustment with respect to a piece of  § 704(c) property is partially recovered before termination, using, for instance, the traditional method, and, after termination, the new partnership makes allocations with respect to that piece of  § 704(c) property using the remedial method? The regulations do not address this question.

3. Contributions of Property by a Partnership to a Corporation Under § 351 

A corporation's adjusted tax basis in property transferred to the corporation by a partnership in a transaction to which  § 351 applies is determined taking into consideration any  § 743(b) basis adjustments to the contributed partnership property (other than any basis adjustment that reduces a partner's gain, as described in Regs. § 1.743-1(h)(2)(ii)).800 The amount of gain, if any, recognized by the partnership on a  § 351 exchange of property by the partnership to a corporation is determined without taking into consideration any  § 743(b) basis adjustment to the transferred property.801 The amount of gain, if any, recognized by the partnership on the transfer that is allocated to a partner with a basis adjustment in the transferred property is adjusted to reflect the partner's basis adjustment in the transferred property.802
——————————————————————————————

800 Regs. § 1.743-1(h)(2)(i).

801 Regs. § 1.743-1(h)(2)(ii).

802 Regs. § 1.743-1(h)(2)(ii).

——————————————————————————————

The partnership's adjusted tax basis in stock received from a corporation in a  § 351 exchange is determined without taking into consideration the  § 743(b) basis adjustment in property transferred to the corporation in the exchange.803 A partner with a basis adjustment in property transferred to the corporation, however, has a basis adjustment in the stock received by the partnership in the exchange in an amount equal to the partner's basis adjustment in the transferred property, reduced by any basis adjustment that reduced the partner's gain under Regs. § 1.743-1(h)(2)(ii).804
——————————————————————————————

803 Regs. § 1.743-1(h)(2)(iii).

804 Regs. § 1.743-1(h)(2)(iii).

——————————————————————————————

Example: B, C, and D are equal partners in partnership P. P's only asset, Asset 1, has an adjusted tax basis of $60,000 and a fair market value of $120,000. Asset 1 is a nondepreciable capital asset and is not  § 704(c) property. B has a basis in B's partnership interest of $40,000, and a positive § 743(b) adjustment of $20,000 in Asset 1. In a transaction to which  § 351 applies, P contributes Asset 1 to X, a corporation, in exchange for $15,000 in cash and X stock with a fair market value of $105,000. Under Regs. § 1.743-1(h)(2)(iii), P realizes $60,000 of gain on the transfer of Asset 1 to X ($120,000 amount realized minus $60,000 adjusted basis), but recognizes only$15,000 of that gain (the amount of boot (cash) received) under § 351(b)(1). Of this amount, $5,000 is allocated to each partner. B must use $5,000 of B's basis adjustment in Asset 1 to offset B's share of P's gain. Under Regs. § 1.743-1(h)(2)(iii), P's basis in the stock received from X is $60,000. However, B has a basis adjustment in the stock received by P equal to $15,000 (its basis adjustment in Asset 1, $20,000, reduced by the portion of the adjustment that reduced B's gain, $5,000). Under Regs. § 1.743-1(h)(2)(i), X's basis in Asset 1 is $75,000 (P's common basis in the asset of$60,000 plus B's basis adjustment under  § 743(b) of $20,000 less the portion of the adjustment which reduced B's gain, $5,000).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

J. Effect of § 743(b) Adjustment on Depletion 

If an adjustment under  § 743(b) is made to the basis of partnership property subject to depletion, each partner must compute depletion separately, based on that partner's interest in the property.805 Each partner may use either percentage depletion or cost depletion, depending upon which method produces a greater allowance.806 For partnerships that hold oil and gas properties that are depleted at the partner level under § 613A(c)(7)(D), the transferee partner (and not the partnership) must make the basis adjustments, if any, required under  § 743(b) with respect to such properties.807
——————————————————————————————

805 Regs. § 1.743-1(j)(5). See Regs. § 1.702-1(a)(8).

806 See Regs. § 1.743-1(j)(6) Ex.

807 See Regs. § 1.613A-3(e)(6)(iv).

——————————————————————————————

Example: B, C, and D each contribute $5,000 cash to form a partnership, which purchases a coal property for $15,000. B, C, and D each have equal interests in capital and profits. D subsequently sells D's partnership interest to E for $100,000 when an election under  § 754 is in effect. E has a basis adjustment under  § 743(b) for the coal property of $95,000 (the difference between E's basis, $100,000, and E's share of the basis of partnership property, $5,000). Assume that the depletion allowance computed under the percentage method would be $21,000 for the taxable year so that each partner would be entitled to $7,000 as its share of the deduction for depletion. However, under the cost depletion method, at an assumed rate of 10%, the allowance with respect to E's one-third interest, which has a basis to E of $100,000 ($5,000, plus its basis adjustment of $95,000), is $10,000, although the cost depletion allowance with respect to the one-third interest of B and C in the coal property, each of which has a basis of $5,000, is only$500. For partners B and C, the percentage depletion is greater than cost depletion and each will deduct $7,000 based on the percentage depletion method. However, as to E, the transferee partner, the cost depletion method results in a greater allowance and E will, therefore, deduct $10,000 based on cost depletion.808

——————————————————————————————

808 See Regs. § 1.743-1(j)(6) Ex. See also § 613(a).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

K. Effect of § 743(b) Adjustment on Depreciation 

1. Upward Adjustments 

If a partnership increases the adjusted basis of any property with respect to a transferee partner because of a  § 743(b) basis adjustment, the amount of the increase is treated as separate newly purchased recovery property.809 The deemed separate property is treated as placed in service on the date of the transfer for which the basis adjustment is made. Any applicable recovery period and method may be used to determine the recovery allowance with respect to the increased portion of the basis.810 The transferee partner with respect to whom the adjustment is held adds the depreciation with respect to the adjustment to the distributee's distributive share of partnership depreciation or amortization deductions.811
——————————————————————————————

809 Regs. § 1.743-1(j)(4)(i)(B)(1).

810 Regs. § 1.743-1(j)(4)(i)(B)(1). These rules apply to transfers of partnership interests on or after Dec. 15, 1999. Regs. § 1.734-1(e)(3). In transfers before Dec. 16, 1999, if a partnership owned property that did not qualify for the MACRS depreciation system, any portion of the basis adjustment allocated to that property also did not qualify for MACRS. See Prop. Regs.  § 1.168-4(d)(8) (interpreting ACRS). If  § 743(b) resulted in an upward adjustment to partnership property that the partnership was depreciating under the pre-1981 rules in § 167, the transferee partner was not allowed to use MACRS or the ACRS system with respect to basis attributable to the adjustment. See Prop. Regs. § 1.168-4(d)(8), (e) Ex. (9) (1984). The methods of depreciation available with respect to the basis increase were limited to the methods applicable to “used property”under § 167, even if the partnership was depreciating the asset under an accelerated method provided in § 167(b). Regs. § 1.167(c)-1(a)(6). See also Rev. Rul. 57-352, 1957-2 C.B. 150.

811 Regs. § 1.743-1(j)(4)(i)(A).

——————————————————————————————

Note: The recovery period and method in effect for the partnership's basis in the property other than the basis adjustment is unaffected.812
——————————————————————————————

812 Regs. § 1.743-1(j)(4)(i)(B)(1).

——————————————————————————————

Comment: These rules allowing a partnership to use any applicable recovery period and method with respect to an adjustment absolve from the anti-churning rules adjustments with respect to partnership pre-1987 property as to which ACRS is less generous than MACRS. The rules may have been issued because, as a practical matter, MACRS is usually less generous than ACRS. Nonetheless, there are situations in which a partnership can now apply MACRS to an adjustment amount attributable to pre-1987 partnership even if MACRS is more generous.

If  § 743(b) resulted in a downward basis adjustment, the transferee partner was required to include in gross income an amount equal to the portion of the previous depreciation on deduction attributable to the basis decrease.813
——————————————————————————————

813 Regs. § 1.167(c)-1(a)(6).

——————————————————————————————

Example 1: Partnership P is a calendar year partnership with three equal partners, B, C, and D. Assume P paid $100,000 to acquire 5-year MACRS property on July 1, Year One, and had properly computed MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducted $35,000 in Year One, $26,000 in Year Two, and $15,600 in Year Three. On Jan. 1, Year Four, B sold B's partnership interest to E. P appropriately made a  § 743(b) upward adjustment, of which $10,000 was properly allocated to the 5-year MACRS property and was held with respect to E. For Year Four, P deducts $11,010 with respect to the original $100,000 basis in the property, continuing with the percentages set forth in the MACRS Table applicable to the property. Absent special allocations,$3,670 of the $11,010 is allocated to E. With respect to the $10,000 adjustment held with respect to E, P computes MACRS depreciation as though it were a newly acquired asset. It remains 5-year property. Assume P chooses to use the general depreciation system and accelerated method, i.e., forgoes any election to use the straight-line method. For Year Four, the MACRS depreciation deduction with respect to the$10,000 is $3,500 ($10,000 x .35). The 35% is the percentage for the first year in the recovery period for the $10,000 adjustment. P does not use the 11.01% amount that it uses for the $100,000 original basis because the 11.01% is the percentage for the fourth year of the recovery period for the $100,000. E's total depreciation deductions for Year Four with respect to the 5-year MACRS property is $7,170.

Example 2: The facts are the same as in Example 1, except that the transfer generating the basis adjustment occurs on Dec. 31, Year Four. P acquires no other property during Year Four. Presumably, the mid-quarter convention must be used with respect to the $10,000 because more than 40% of P's basis in property acquired during Year Four was acquired in the fourth quarter. This conclusion is a logical consequence of treating the adjustment as though it were separate MACRS property. Accordingly, the MACRS depreciation deduction with respect to the$10,000 adjustment would be $5,000 and not $35,000. Because this deduction is computed with respect to E, it is allocated to E.

Observation: Even though the $5,000 reflects application of a mid-quarter convention that treats the adjustment as having been placed in service on November 15, Year Four, thus including 45 days of depreciation in the example above, the  § 706(d) ratable portion rules should not override the MACRS convention simply because E has been a partner for only one day; the MACRS Table in effect has computed a $5,000 MACRS depreciation deduction for the single day of December 31.

If the remedial method of making allocations with respect to contributed property has been adopted by the partnership for the property to which the basis increase is attributable, the portion of the basis increase attributable to built-in gain in the contributed property is recovered over the remaining recovery period for the partnership's excess book basis in the property, and the remaining portion of the basis increase is subject to the general principles.814
——————————————————————————————

814 Regs. § 1.743-1(j)(4)(i)(B)(2).

——————————————————————————————

Note: The regulations cryptically cite Regs.  § 1.704-3(d)(2) in incorporating the recovery period, but do not specify how the amount is allocated over the recovery period. Using the approach taken for the allocation of a decrease adjustment over a remaining period, it appears that the amount recovered over the remaining recovery period is computed for each remaining year of the recovery period by multiplying the amount by a fraction, the numerator of which is the portion of the adjusted basis in the property recovered by the partnership in that year, and the denominator of which is the adjusted basis of the property on the date of the transfer generating the adjustment, before taking any adjustments into account.815
——————————————————————————————

815 See Regs. § 1.743-1(j)(4)(i)(B)(2).

——————————————————————————————

Example — Traditional Method: B, C, and D form partnership P on Jan. 1, Year One. B and C each contribute $100,000. D contributes property with a fair market value of $100,000 and an adjusted basis of $10,000. The property was not depreciable in D's hands. The property is five-year MACRS property. Each year, P's expenses other than MACRS depreciation on the property equal its gross income.

For Year One, P properly computes MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducts $3,500 in Year One. P chooses to use the traditional method of allocating the MACRS depreciation. Therefore, the $3,500 is allocated equally between B and C.

For Year Two, P properly computes MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducts $2,600 in Year Two. The$2,600 is allocated equally between B and C.

On Jan. 1, Year Three, D sells D's partnership interest to E. Because the property has increased in value to $160,000, E pays D $120,000 for the partnership interest. (The partnership has cash of $200,000 and a $160,000 property.) Because the  § 754 election is in effect, P has an upward  § 743(b) adjustment with respect to E. E's previously taxed capital is $10,000, which is the$120,000 value of E's interest in P's property, reduced by the gain of $110,000 that would be allocated to E if P sold the five-year MACRS property for $160,000. The $110,000 is the disparity between E's book account of $120,000 (reflecting one-third of the book gain on the hypothetical sale of the property for $160,000) and the tax capital account of $10,000 which E inherits from D under Regs. § 1.704-1(b)(2)(iv)(m). The adjustment equals the excess of E's $120,000 adjusted basis in the partnership interest over the sum of the previously taxed capital of $10,000 plus E's zero share of ABC liabilities. The adjustment, therefore, is $110,000. It is allocated entirely to the five-year MACRS property because there are no other assets aside from cash.

With respect to the $110,000 adjustment held with respect to E, P computes MACRS depreciation as though it were a newly acquired asset. It remains five-year property. Assume P chooses to use the general depreciation system and accelerated method, i.e., to forgo any election to use the straight-line method. For Year Three, the MACRS depreciation deduction with respect to the $110,000 is $38,500 ($110,000 x.35). The 35% is the percentage for the first year in the recovery period for the $110,000 adjustment. P does not use the 11.01% amount that it will use in Year Three for the $10,000 original basis because the 11.01% is the percentage for the fourth year of the recovery period for the $10,000.

Example — Remedial Method: B, C, and D form partnership P on Jan. 1, Year One. B and C each contribute $100,000. D contributes property with a fair market value of $100,000 and an adjusted basis of $10,000. The property was not depreciable in D's hands. The property is five-year MACRS property. Each year, P's expenses other than MACRS depreciation on the property equal its gross income.

For Year One, P properly computes MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducts $3,500 in Year One. P chooses to use the remedial method of allocating the MACRS depreciation. Book depreciation with respect to the property is $35,000 (using the 35%tax percentage against $100,000 book value). Before allocating the$3,500 B, C, and D each have a book capital account of $88,333 ($100,000 minus book depreciation of $11,667). B and C each have an adjusted basis of $100,000. D has an adjusted basis of $10,000. The book-tax disparity for B and C is $11,667, and D has a tax-book disparity of$78,333. Under the remedial method, the $3,500 MACRS depreciation deduction is allocated $11,667 to B, $11,667 to C, and ($19,834) to D. The allocation to D is a positive income amount.816 After the allocation, B and C have adjusted basis of $88,333, and D has an adjusted basis of $29,834.

For Year Two, P properly computes MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducts $2,600 in Year Two. Book depreciation with respect to the property is $26,000 (using the 26%tax percentage against $100,000 book value). Before allocation of the $2,600, B, C, and D each have a book capital account of $79,666($88,333 minus book depreciation of $8,667). B and C each have an adjusted basis of $88,333. D has an adjusted basis of $29,834. The book-tax disparity for B and C is $8,667, and D has a tax-book disparity of $49,832. Under the remedial method, the $2,600 MACRS depreciation deduction is allocated $8,667 to B, $8,667 to C, and ($14,734) to D. The allocation to D is a positive income amount.817 After the allocation, B and C have adjusted basis of $79,666, and D has an adjusted basis of $44,568.

On Jan. 1, Year Three, D sells D's partnership interest to E. Because the property has increased in value to $160,000, E pays D $120,000 for the partnership interest. (The partnership has cash of $200,000 and a $160,000 property.) Because the  § 754 election is in effect, P has an upward  § 743(b) adjustment with respect to E. E's previously taxed capital is $44,568, which is the$120,000 value of E's interest in P's property, reduced by the gain of $75,432 that would be allocated to E if P sold the five-year MACRS property for $160,000. The $75,432 is the disparity between E's book account of $120,000 (reflecting one-third of the book gain on the hypothetical sale of the property for $160,000) and the tax capital account of $44,568. The adjustment equals the excess of E's $120,000 adjusted basis in the partnership interest over the sum of the previously taxed capital of $44,568 plus E's zero share of P liabilities. The adjustment, therefore, is $75,432. It is allocated entirely to the five-year MACRS property because there are no other assets aside from cash.

Of the $75,432 adjustment, $68,776 reflects  § 704(c) gain built into the property and not yet accounted for under the allocation of depreciation in Year One and Year Two, and the remaining $6,666 reflects E's acquired share of the $20,000 post-contribution increase in the fair market value of the five-year MACRS property.

The $68,776 is recovered over the remaining four years in the six-year recovery period for the five-year MACRS property. The $6,666 is treated as a newly acquired separate MACRS property.

The portion of the $68,776 that is recovered in each of the remaining recovery periods is computed as follows. P's MACRS depreciation deductions for Year Three through Year Six, respectively, are $1,560, $1,101,$1,101, and $138. P's adjusted basis in the property at the time the adjustment is made is $3,900. Thus, for Years Three through Six, respectively, the recovery fractions are .4 ($15,600/$3,900), .282 ($1,101/$3,900),.282 ($1,101/$3,900), and .036 ($138/$3,900). Thus, for Years Three through Six, E is entitled to MACRS depreciation deductions on account of the $68,776 portion of the adjustment of $27,510, $19,395, $19,395, and $2,476.

With respect to the $6,666 portion of the adjustment held with respect to E, P computes MACRS depreciation as though it were a newly acquired asset. It remains five-year property. Assume P chooses to use the general depreciation system and accelerated method, i.e., to forgo any election to use the straight-line method. For Year Three, the MACRS depreciation deduction with respect to the $6,666 is $2,333($6,666 x .35). The 35% is the percentage for the first year in the recovery period for the $6,666 adjustment. P does not use the 11.01% amount that it will use in Year Three for the $10,000 original basis because the 11.01% is the percentage for the fourth year of the recovery period for the $10,000.

——————————————————————————————

816 For a detailed discussion of allocation of partnership income, see 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts.

817 For a detailed discussion of allocation of partnership income, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts.

——————————————————————————————

Observation: It is possible for an upward adjustment to be made to an item of depreciable partnership recovery property even though the overall  § 734(b) adjustment is a downward adjustment. This reflects the  § 755 allocation principles, discussed in VII, C, above.

2. Downward Adjustments 

If a partnership decreases the adjusted basis of any property because of a  § 743(b) basis adjustment, the amount of the decrease must be accounted for over the remaining recovery period of the property to which it is allocated.818 The portion of the decrease recovered in a particular year equals the amount of the decrease as of the date of the transfer819 multiplied by a fraction.820 The numerator of the fraction is the portion of the adjusted basis of the property recovered by the partnership in that year, and the denominator is the adjusted basis of the property as of the date of the transfer.821
——————————————————————————————

818 Regs. § 1.743-1(j)(4)(ii)(B).

819 Regs. § 1.743-1(j)(4)(ii)(B)(1).

820 Regs. § 1.743-1(j)(4)(ii)(B)(2).

821 Regs. § 1.743-1(j)(4)(ii)(B)(2).

——————————————————————————————

The transferee partner with respect to whom the adjustment is held subtracts the depreciation with respect to the adjustment from its distributive share of partnership depreciation deduction from the property to which the adjustment was allocated. If there is insufficient depreciation to absorb the reduction, any remaining reduction is subtracted from the transferee's distributive share of partnership depreciation or amortization deductions with respect to other property. The recovery of the negative basis adjustment generates ordinary income to the extent it exceeds the transferee's share of the partnership's depreciation deductions plus the transferee's share of deductions from other items of partnership property.822
——————————————————————————————

822 Regs. § 1.743-1(j)(4)(ii)(A).

——————————————————————————————

Example: XYZ partnership is a calendar year partnership with three equal partners, X, Y, and Z. XYZ paid $100,000 to acquire five-year MACRS property on July 1, Year One, and properly computed MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, XYZ deducted $35,000 in Year One, $26,000 in Year Two, and $15,600 in Year Three. On Jan. 1, Year Four, X sells X's partnership interest to D. XYZ appropriately makes a  § 743(b) downward adjustment, of which $10,000 is properly allocated to the five-year MACRS property and was held with respect to D. For Year Four, XYZ computes its MACRS deduction with respect to the property as follows. First, it computes $11,010 of MACRS depreciation with respect to the original $100,000 basis in the property, continuing with the percentages set forth in the MACRS Table applicable to the property. Absent special allocations, $3,670 of the $11,010 is allocated to D. Secondly, it computes an adjusted basis as of the date of the distribution, which, presumably, is the property's adjusted basis as of Jan. 1, Year Four, because the  § 734 regulations require that the decrease be taken into account for the Year Four recovery period. That adjusted basis is $23,400 ($100,000 –($35,000 + $26,000 + $15,600)). The fraction for Year Four is .4705($11,010 (the recovery for Year Four) ÷  $23,400). Thus, of the $10,000 decrease adjustment, $4,705 is taken into account in Year Four. Accordingly, XYZ allocates the $4,705 to D, which has the effect of eliminating the $3,670 of MACRS depreciation allocated to D on account of the $11,010 deduction reflecting the original $100,000 unadjusted basis in the property, and of subtracting the remaining$1,035 ($4,705 – $3,670) from D's distributive share of XYZ's depreciation or amortization deductions with respect to other property.

Observation: It is possible for a downward adjustment to be made to an item of depreciable partnership recovery property even when the overall  § 743(b) adjustment is an upward adjustment. This reflects the  § 755 allocation principles, discussed in VII, C, above.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

L. Section 743(b) Basis Increases in Amortizable Intangibles 

If a partnership with a  § 754 election in effect (or, presumably, a substantial built-in loss that generates a basis increase) owns an intangible asset that it cannot amortize because it acquired the asset before the appropriate effective date under  § 197 (a “§ 197(f)(9) intangible”), a taxpayer who acquires an interest in the partnership from an unrelated party nonetheless may amortize the basis increase that the taxpayer receives in the intangible under § 743(b).823 A transferee partner also may amortize a  § 743(b) basis increase in a  § 197(f)(9) intangible to the extent that either: (1) the partnership acquired the asset before August 11, 1993, and the transferor partner acquired its interest after August 10, 1993, so long as a prior partner (not related to the transferor) owned the interest at some time after August 10, 1993;824 or (2)the partnership acquired the  § 197(f)(9) intangible after August 10, 1993, but could not itself amortize the asset, and the transferor partner acquired its interest after the partnership acquired the asset from an unrelated prior partner.825 However, a  § 743(b) basis increase under (1) and (2), above, is not amortizable if the intervening partner's acquisition of the partnership interest was part of a transaction(or series of related transactions) to allow a member of a partnership to obtain amortization that otherwise would be disallowed.826 Also, if a partner whose interest in a partnership intangible was subject to anti-churning becomes a direct user of the intangible after a series of related transactions including a  § 743(b) basis increase, the partner's share of the basis increase remains subject to anti-churning.827
——————————————————————————————

823 Regs. § 1.197-2(h)(12)(v)(A).

824 Regs. § 1.197-2(h)(12)(v)(A)(1)(ii).

825 Regs. § 1.197-2(h)(12)(v)(A)(2)(ii).

826 Regs. § 1.197-2(h)(12)(v)(A)(1)(iii), (2)(iii).

827 Regs. § 1.197-2(h)(12)(vi)(A).

——————————————————————————————

For a detailed discussion of the anti-churning rules for  § 197 intangibles, including the definition of “related person,” see 533 T.M., Amortization of Intangibles.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

M. Relationship Between § 743(b)Adjustment and the Consolidated Return Rules 

Regs.  § 1.1502-13 governs the treatment of sales between members of a consolidated group. The regulations generally apply single entity treatment, implemented by matching and acceleration rules, to determine the timing and attributes of intercompany items. For further discussion of the regulations, see 756 T.M., Computation of Consolidated Tax Liability.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VII. Special Basis Adjustment Applicable to Transfer of Partnership Interest — Section 743(b)

N. Applicability of the  § 743(b)Adjustment to Oil and Gas Properties 

Section 613A(c)(7)(D) provides for the allocation of a partnership's basis in oil and gas property to the partners. Upon the transfer of a partnership interest, a transferor partner's adjusted basis in such property carries over to the transferee partner and, if a  § 754 election is in effect (or if there is a mandatory basis adjustment under § 743(b)), the basis in such property may be adjusted under § 743(b).828
——————————————————————————————

828 See Regs. § 1.613A-3(e)(6)(iv).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

A. Application and Computation of the Adjustment 

The general rule set forth in  § 734(a) is that the adjusted basis of partnership property is not adjusted as result of a distribution by the partnership to a partner.829 However, under certain circumstances, a discrepancy may arise between the partnership's adjusted bases in its assets and the partners' adjusted bases in their partnership interests. The discrepancy may arise following a distribution in which the distributee partner recognizes  § 731 gain or loss or in which the partner's adjusted basis in the distributed property is greater than or less than the partnership's adjusted basis in the property immediately preceding the distribution. These discrepancies create distortions in the amount and timing of income. For instance, if a partner's interest is liquidated for cash, the partner will recognize gain equal to the excess of the cash received over the partner's adjusted basis in the partnership interest. The gain represents the partner's share of the appreciation in the partnership's assets. However, absent a basis adjustment, upon a subsequent sale of the assets by the partnership the remaining partners will be subject to tax on the same gain.
——————————————————————————————

829 See Regs. § 1.734-1(a).

——————————————————————————————

The  § 734(b) adjustment is designed to eliminate these discrepancies by providing that, if a  § 754 election830 is in effect with respect to a distribution by a partnership to a partner, or if there is a “substantial basis reduction” with respect to a distribution, the partnership's basis in its assets is adjusted.831 There is a “substantial basis reduction” with respect to a distribution in liquidation of the distributee partner's interest if the following two amounts together exceed $250,000: (1) the distributee's loss on the distribution and (2) the excess of the basis of the distributed property to the distributee (determined under  § 732) over the adjusted basis of the distributed property to the partnership immediately before the distribution (as adjusted by § 732(d)).832 The  § 734(b) adjustment applies under the following four circumstances:
——————————————————————————————

830 The  § 754 election is discussed in IX, below.

831 For a discussion of the  § 734(b) adjustment, see Pennell, “Problems Involving the Optional Adjustments to Basis of Partnership Assets,” 34 S. Cal. Tax Inst. ¶  800(1982).

832 § 734(d). “Securitization partnerships,” as defined in § 743(f), are not treated as having substantial basis reductions. § 734(e).

——————————————————————————————

(1) the distributee partner recognizes gain under § 731(a)(1);833
  
(2)the distributee partner recognizes loss under § 731(a)(2);834
  
(3) the distributee partner's adjusted basis in the distributed property is less than the partnership's adjusted basis in the property immediately preceding the distribution (referred to as “disappearing basis”);835 or
  
(4) the distributee partner's adjusted basis in the distributed property is greater than the partnership's adjusted basis in the property immediately preceding the distribution (referred to as “created basis”).836

——————————————————————————————

833 § 734(b)(1)(A). Note that there is no basis adjustment for any gain recognized under § 731(c). § 731(c)(5).

834 § 734(b)(2)(A).

835 § 734(b)(1)(B).

836 § 734(b)(2)(B).

——————————————————————————————

In situations (1) and (3), the  § 734(b) basis adjustment is an upward adjustment equal to the amount of gain recognized (in situation (1)) or the difference in the basis of the distributed asset before and after the distribution(in situation (2)). In situations (2) and (4), the  § 734(b) basis adjustment is a downward adjustment equal to the amount of loss recognized (in situation (2)) or the difference in the basis of the distributed asset before and after the distribution (in situation (4)). A mandatory § 734(b) adjustment resulting from a substantial basis reduction applies only to liquidating distributions in situation (2) or situation (4), or a combination of situations (2) and (4); other  § 734(b) adjustments arise only when a  § 754 election is in effect.837 The  § 734(b) basis adjustment in either case is allocated in accordance with the rules in § 755.838 Unlike the  § 743(b) adjustment, the § 734(b) adjustment affects all of the remaining partners.
——————————————————————————————

837 § 734(b), (d). Note that the $250,000 threshold for a substantial basis reduction is determined at the partner level. See § 734(d). As discussed in VII, A, 1, above, the $250,000 threshold for a  § 743 substantial built-in loss on the transfer of a partnership interest is determined at the partnership level, even though it is triggered by a partner's transfer.

838 § 734(c); Regs. § 1.734-1(c).

——————————————————————————————

Example — Distributee Partner's Adjusted Basis in Distributed Property Is Less Than Partnership's Adjusted Basis in Property — Disappearing Basis: Partnership P has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $30,000	 $30,000	
Capital Asset #1	  45,000	  75,000 	
Capital Asset #2	  45,000	  45,000	
 	$120,000	$150,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0 	
Capital:	 	 	
B	  40,000	  50,000 	
C	  40,000	  50,000 	
D	  40,000	  50,000	
 	$120,000	$150,000	

The partnership distributes capital asset #2 to B, a one-third partner, in an operating distribution on Jan. 1.  Section 751(b) does not apply to the distribution because the partnership owns no  § 751 property (unrealized receivables and substantially appreciated inventory). B will recognize no gain or loss on the distribution.839 B's adjusted basis in the distributed capital asset is limited by B's adjusted basis in his partnership interest ($40).840 Thus, B's adjusted basis in the distributed capital asset is $40. Without a  § 734(b) adjustment, the partnership's balance sheet after the distribution is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	$30,000	 $30,000	
Capital Asset #1	 45,000	  75,000	
 	$75,000	$105,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	0	   5,000 	
C	 40,000	  50,000 	
D	 40,000	  50,000	
 	$80,000	$105,000	

As a result of the distribution, there is a $5,000 discrepancy between the partnership's adjusted bases in its assets and the partners' adjusted bases in their partnership interests. The partnership has lost $5,000 of adjusted basis on the distribution. However, if a  § 754 election is in effect, a  § 734(b) upward adjustment equal to the difference between the adjusted basis of the distributed property to B ($40,000) and the partnership's previous adjusted basis in the asset ($45,000) is applied to increase the partnership's bases in its remaining assets.841 This $5,000 adjustment is allocated to property in the same class as the property distributed (a capital asset)842 and thus increases the partnership's adjusted basis in Capital Asset #1 to $50,000.

——————————————————————————————

839 § 731(a).

840 § 732(a)(2).

841 § 734(b)(1)(B).

842 Regs. § 1.755-1(c)(1)(i).

——————————————————————————————

Example — Distributee Partner Recognizes § 731 Gain: Partnership P has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $50,000	 $50,000	
Capital Asset #1	  45,000	  75,000	
Capital Asset #2	  45,000	  45,000	
 	$140,000	$170,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	  40,000	  50,000 	
C	  40,000	  50,000 	
D	  40,000	  50,000	
 	$120,000	$150,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, the partnership distributes $50,000 cash to D in liquidation of D's entire one-third interest in the partnership. Under § 731(a)(1), D recognizes $10,000 of gain (the excess of the amount of money received over D's adjusted basis in the partnership interest) on the distribution. Absent a  § 734(b) adjustment, the partnership's balance sheet after the distribution is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	$0	$0	
Capital Asset #1	 40,000	  60,000	
Capital Asset #2	 40,000	  40,000	
 	$80,000	$100,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	 40,000	  50,000 	
C	 40,000	  50,000 	
D	     –0– 	      –0–	
 	$80,000	$100,000	

As a result of the distribution, there is a $10,000 discrepancy between the partnership's adjusted bases in its assets and the partner's adjusted bases in their partnership interests. The discrepancy is equal to the amount of gain recognized by D on the distribution. However, because a  § 754 election is in effect, a $10,000 upward  § 734(b) adjustment is applied to the partnership's remaining assets.843 The $10,000 adjustment is allocated under the rules set forth in § 755.

——————————————————————————————

843 § 734(b)(1)(A).

——————————————————————————————

Example — Distributee Partner Recognizes § 731 Loss: Partnership P has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $30,000	$30,000	
Capital Asset #1	  30,000	 20,000	
Capital Asset #2	  60,000	 40,000	
 	$120,000	$90,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	  40,000	 30,000 	
C	  40,000	 30,000 	
D	  40,000	 30,000 	
 	$120,000	$90,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, the partnership distributes $30,000 cash to D in liquidation of D's entire one-third interest in the partnership. Under § 731(a)(2), D recognizes $10,000 of loss (the excess of D's adjusted basis in D's partnership interest over the amount of money received in liquidation) on the distribution. Absent a  § 734(b) adjustment, the partnership's balance sheet after the distribution is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Capital Asset #1	 30,000	 20,000	
Capital Asset #2	 60,000	 40,000	
 	$90,000	$60,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	 40,000	 30,000 	
C	 40,000	 30,000 	
D	     –0– 	     –0– 	
 	$80,000	$60,000	

As a result of the distribution, there is a $10,000 discrepancy between the partnership's adjusted bases in its assets and the partners' adjusted bases in the partnership interests. The discrepancy is equal to the amount of loss recognized by D on the distribution. However, because there is a  § 754 election in effect,  a $10,000 downward  § 734(b) adjustment is applied to the partnership's remaining assets.844 The $10,000 adjustment is allocated under the rules set forth in § 755.

——————————————————————————————

844 § 734(b)(2)(A).

——————————————————————————————

Example — Distributee Partner's Adjusted Basis in Distributed Property Is Greater Than Partnership's Adjusted Basis in Property  — Created Basis:  Partnership P has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $30,000	$30,000	
Capital Asset #1	$35,000	$30,000	
Capital Asset #2	  55,000	 30,000	
 	$120,000	$90,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	  40,000	 30,000	
C	  40,000	 30,000	
D	  40,000	 30,000	
 	$120,000	$90,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, the partnership distributes Capital Asset #1 to D in liquidation of D's entire one-third interest in the partnership. Under § 732(b), D's adjusted basis in the distributed asset is equal to D's adjusted basis in D's partnership interest. Thus, D's adjusted basis in the distributed property is $40,000. Absent a  § 734(b) adjustment, the partnership's balance sheet after the distribution is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	$30,000	$30,000	
Capital Asset #2	 55,000	 30,000	
 	$85,000	$60,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	 40,000	 30,000 	
C	 40,000	 30,000 	
 	$80,000	$60,000	

There is a $5,000 discrepancy between the partnership's adjusted bases in its assets and the partners' adjusted bases in their partnership interests. The discrepancy is equal to the amount by which the distributee partner's adjusted basis in the distributed property exceeds the partnership's adjusted basis in the distributed property immediately preceding the distribution. However, because a  § 754 election is in effect, a $5,000 downward  § 734(b) adjustment is applied to the partnership's remaining assets.845 In this case, the adjustment would be allocated to Capital Asset #2 to decrease the partnership's basis in that asset to $50,000.

——————————————————————————————

845 § 734(b)(2)(B).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

B. Allocation of the § 734(b)Adjustment — § 755 

1. In General 

The  § 734(b) adjustment is allocated under the rules set forth in § 755.846 Under § 755(b), the partnership's assets are first divided into two classes, the capital asset class and the ordinary income class. Usually, the adjustment is allocated to only one of the classes, although, in rare instances, an adjustment arising from disappearing basis can be allocated to both classes if property in each class is distributed.847 Next, the adjustment is allocated among specific assets in the class.848
——————————————————————————————

846 § 734(c); Regs. § 1.734-1(c).

847 Regs. § 1.755-1(c)(1). This approach is in contrast to the manner in which a  § 743(b) adjustment is allocated between classes.

848 Regs. § 1.755-1(c)(2).

——————————————————————————————

2. Current Law 

a. Allocation Between the Classes 

If an adjustment arises from disappearing or created basis, it must be allocated to the class from which came the distributed property with respect to which there is disappearing or created basis.849 If the adjustment arises from the recognition of capital gain or loss under § 731(a), it is allocated to the capital asset class.850
——————————————————————————————

849 Regs. § 1.755-1(c)(1)(i).

850 Regs. § 1.755-1(c)(1)(ii).

——————————————————————————————

Observation: Although the regulations imply that it is possible to allocate a downward basis adjustment arising from created basis to the ordinary income asset class, this should, in fact, never happen. Basis cannot be created in ordinary income assets because, in both alternative liquidating distribution paradigms, there is no created basis in the partnership's ordinary income assets. In the first paradigm, the distributee partner receives at least one capital asset in the distribution, and under  § 732(c) any excess of the partner's adjusted basis in the partnership interest over the adjusted bases of the distributed assets is allocated to that capital asset. Therefore, the resulting downward basis adjustment is allocated to the capital asset category. Under the second paradigm, the distributee partner does not receive a capital asset. Therefore, if the partner's adjusted basis in the partnership interest exceeds the amount of cash, if any, distributed plus the partnership's adjusted basis in distributed ordinary income property, the partner recognizes capital loss under § 731(a). The downward basis adjustment created by the loss is allocated to the capital asset category.

b. Allocation Within the Classes 

If an upward adjustment is allocable to a class, it is allocated within the class as follows. First, it is allocated to properties with unrealized appreciation in proportion to the amount of unrealized appreciation in each item of property in that class, before the adjustment is taken into account. However, the amount of the adjustment allocated to an item of property cannot exceed the amount of unrealized appreciation in that item of property.851 Any remaining upward adjustment is allocated among the items of property within the class in proportion to their fair market values.852 If there are no items of property in the class to which the upward adjustment has been allocated, then the adjustment is made when the partnership subsequently acquires property belonging to that class.853
——————————————————————————————

851 Regs. § 1.755-1(c)(2)(i).

852 Regs. § 1.755-1(c)(2)(i).

853 Regs. § 1.755-1(c)(4).

——————————————————————————————

If a downward adjustment is allocable to a class, it is allocated within the class as follows. First, it is allocated to properties with unrealized depreciation in proportion to the amount of unrealized depreciation in each item of property in that class, before the adjustment is taken into account. However, the amount of the adjustment allocated to an item of property cannot exceed the amount of unrealized depreciation in that item of property.854  Any remaining downward adjustment is allocated among the items of property within the class in proportion to the partnership's adjusted basis in each item of property in the class, taking into account the adjustment allocated to the property under the first step.855 If there are no items of property in the class to which the downward adjustment has been allocated, then the adjustment is made when the partnership subsequently acquires property belonging to that class.856
——————————————————————————————

854 Regs. § 1.755-1(c)(2)(ii).

855 Regs. § 1.755-1(c)(2)(ii).

856 Regs. § 1.755-1(c)(4).

——————————————————————————————

If a downward adjustment allocable to an item of property  exceeds the partnership's adjusted basis in that property, then the adjustment is limited to the partnership's adjusted basis in that property. In effect, the adjusted basis in that item of property is zero.857 The portion of the downward adjustment that cannot be made because there is no remaining partnership adjusted basis in the asset is made when the partnership subsequently acquires property of a like character to which an adjustment can be made.858
——————————————————————————————

857 Regs. § 1.755-1(c)(3).

858 Regs. § 1.755-1(c)(4).

——————————————————————————————

Example (1): A partnership has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $50,000	 $50,000	
Capital Asset #1	  40,000	 v50,000	
Capital Asset #2	 v15,000	  10,000	
Capital Asset #3	   5,000	  40,000	
Ordinary Income Asset #1	
   10,000	
   30,000	
Ordinary Income Asset #2	
        0	
   60,000	
 	$120,000	$240,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	  40,000	  80,000 	
C	  40,000	  80,000 	
D	  40,000	  80,000	
 	$120,000	$240,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, the partnership distributes Capital Asset #1 and Ordinary Income Asset #1 to D in complete liquidation of D's one-third interest in the partnership. Under § 732(c)(1), D's basis in the distributed ordinary income asset is equal to the partnership's basis in the asset ($10,000). Under § 732(c)(2), D's basis in the distributed capital asset is $30,000 (D's basis in the partnership interest ($40,000) minus the basis allocated to the ordinary income asset ($10,000)).

Because a  § 754 election is in effect,  a $10,000 upward  § 734(b) adjustment is applied to the partnership's remaining assets.859 The adjustment arises under  § 734(b)(1)(B) (disappearing basis) and is attributable to a decrease in the partnership's basis in capital gain assets. Therefore, the entire adjustment is allocated to remaining capital gain assets.860 The $10,000 adjustment is allocated entirely to Capital Asset #2 because Capital Asset #2 accounts for 100% of the unrealized appreciation in the capital asset class. Accordingly, the partnership's basis in Capital Asset #2 is increased to $30,000.

——————————————————————————————

859 § 734(b)(1)(B).

860 Regs. § 1.755-1(c)(1)(i).

——————————————————————————————

Example (2): The facts are the same as in the preceding example, except that the partnership distributes Capital Asset #2 and Ordinary Income Asset #1 to D in liquidation of D's entire interest in the partnership. Under § 732(c)(1), D's adjusted basis in the distributed ordinary income asset is $10,000. Under § 732(c)(2), D's adjusted basis in the distributed capital asset is $30,000 (D's adjusted basis in the partnership interest ($40,000)minus the basis allocated to the ordinary income asset ($10,000)).

Because a  § 754 election is in effect,  a $10,000 downward  § 734(b) adjustment is applied to the partnership's remaining assets.861 The adjustment arises under  § 734(b)(2)(B) (created basis) and is attributable to an increase in the partnership's basis in capital gain assets. Therefore, the entire adjustment is allocated to the capital asset class. A downward adjustment is first allocated within a class to assets with unrealized depreciation in proportion to the amount of unrealized depreciation in each asset. However, in this case, the only asset in the class, Capital Asset #1, is appreciated. Thus, the adjustment is allocated in proportion to the partnership's adjusted basis in the assets in the class. Again, in this case, there is only one asset in the class, so the entire downward adjustment is allocated to Capital Asset #1.

——————————————————————————————

861 § 734(b)(2)(B).

——————————————————————————————

Example (3): Assume that the ABC partnership has the following balance sheet on January 1:
Assets	Adjusted Basis	Fair Market Value	
Cash	$3,000,000	$3,000,000	
Capital Asset #1	    10,000	   100,000	
Capital Asset #2	    50,000	    50,000	
Ordinary Income Asset #1	   120,000	   180,000	
Ordinary Income Asset #2	   180,000	    60,000	
 	$3,360,000	$3,390,000	
Liabilities &  Capital	 	 	
Liabilities    	$0	$0	
Capital:   B	 1,120,000	 1,130,000 	
C	 1,120,000	 1,130,000 	
D	 1,120,000	 1,130,000	
 	$3,360,000	$3,390,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, the partnership distributes Ordinary Income Asset #2 and $1,070,000 to D in complete liquidation of D's one-third interest in the partnership. Under § 732(b), D's basis in the distributed ordinary income asset is limited to $50,000 (the amount of D's adjusted basis in the partnership interest ($1,120,000) minus the amount of cash received ($1,070,000)).

Because a  § 754 election is in effect, a $130,000 upward  § 734(b) adjustment is applied to the partnership's remaining assets.862 The adjustment arises under  § 734(b)(1)(B) (disappearing basis) and is attributable to a decrease in the partnership's basis in ordinary income assets. Therefore, the entire adjustment is allocated to remaining ordinary income assets.863 First, the $130,000 adjustment is allocated to assets in the ordinary income class in proportion to their unrealized appreciation. In this case, the only asset in the class, Ordinary Income Asset #1 has unrealized appreciation of $60,000. The remaining$70,000 upward adjustment is next allocated to assets within the class in proportion to their fair market value. Again, in this case, there is only one asset in the class, so the entire remaining upward adjustment is allocated to Ordinary Income Asset #1.

——————————————————————————————

862 § 734(b)(1)(B).

863 Regs. § 1.755-1(c)(1)(i).

——————————————————————————————

3. Prior Law 

a. Allocation to One Class of Property 

Under prior law, if an adjustment arose from disappearing or created basis, it was allocated to the class from which came the distributed property with respect to which there was disappearing or created basis.864 If the adjustment arose from the recognition of capital gain or loss under § 731(a), it was allocated to the capital asset class.865
——————————————————————————————

864 Former Regs. § 1.755-1(b)(1)(i) (effective for distributions before Dec. 15, 1999).

865 Former Regs. § 1.755-1(b)(1)(ii)(effective for distributions before Dec. 15, 1999).

——————————————————————————————

b. Allocation Within a Class 

Under prior law, once the  § 734(b) adjustment was allocated to the appropriate class of partnership property, it was allocated among the assets in that class “in a manner which had the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties.”866 The partnership had to allocate the adjustment within a class in accordance with this rule unless it received permission from the District Director to allocate the adjustment in a different manner.867 In order to secure permission, a partnership had to file an application for permission no later than 30 days after the close of the partnership taxable year in which the adjustment was to be made. The application had to describe the adjustments in detail and set forth the reasons for the use of another method.868 The regulations provided that the District Director may allow a partnership to make offsetting allocations within a class.869
——————————————————————————————

866 Former Regs.  § 1.755-1(a)(1)(i) (effective for distributions before Dec. 15, 1999).

867 Former Regs. § 1.755-1(a)(2) (effective for distributions before Dec. 15, 1999).

868 Former Regs. § 1.755-1(a)(2) (effective for distributions before Dec. 15, 1999).

869 Former Regs. § 1.755-1(a)(2) (effective for distributions before Dec. 15, 1999).

——————————————————————————————

In addition to the general directive in the former regulations relating to allocation of the adjustment within a class, former Regs.  § 1.755-1(a)(1)(iii)provided that no decrease could be made to the basis of any asset if the fair market value of the asset equaled or exceeded its adjusted basis.

Example (1): A partnership has the following balance sheet on Jan. 1, 1995:
Assets	Adjusted Basis	Fair Market Value	
Cash	 $50,000	 $50,000	
Capital Asset #1	  40,000	  50,000	
Capital Asset #2	  20,000	  50,000	
Ordinary Income
  Asset #1	  10,000	  30,000	
Ordinary Income 
 Asset #2	       0	  60,000	
 	$120,000	$240,000
 	
Liabilities &  Capital	 	 	
Liabilities   	$0	$0	
Capital:   B	  40,000	  80,000	
C	  40,000	  80,000 	
D	  40,000	  80,000	
 	$120,000	$240,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, 1995, the partnership distributes Capital Asset #1 and Ordinary Income Asset #1 to D in complete liquidation of D's one-third interest in the partnership. Under § 732(c)(1), D's basis in the distributed ordinary income asset is equal to the partnership's basis in the asset ($10,000). Under § 732(b), D's basis in the distributed Capital Asset is limited to $30,000 (D's basis in D's partnership interest ($40,000) minus the basis allocated to the ordinary income asset ($10,000)).

However, because a  § 754 election is in effect,  a $10,000 upward  § 734(b) adjustment is applied to the partnership's remaining assets.870 The adjustment arises under  § 734(b)(1)(B) and is attributable to a decrease in the partnership's basis in capital gain assets. Therefore, the entire adjustment is allocated to remaining capital gain assets.871 The $10,000 adjustment is allocated entirely to Capital Asset #2 to increase the partnership's basis in the asset to $30,000, thus reducing the difference between the adjusted basis and the fair market value of the asset.

——————————————————————————————

870 § 734(b)(1)(B).

871 Former Regs. § 1.755-1(b)(1)(i)(effective for distributions before Dec. 15, 1999).

——————————————————————————————

Note: The result in this Example (1) under prior law is identical to the result under current law, as illustrated in Example (1) in VIII, A, above.

Example (2): The facts are the same as in the preceding example, except that the partnership distributes Capital Asset #2 and Ordinary Income Asset #1 to D in liquidation of D's entire interest in the partnership. Under § 732(c)(1), D's adjusted basis in the distributed ordinary income asset is $10,000. Under § 732(b), D's adjusted basis in the distributed capital asset is $30,000 (D's adjusted basis in D's partnership interest ($40,000)minus the basis allocated to the ordinary income asset ($10,000)).

Because there is a  § 754 election in effect, a $10,000 downward  § 734(b) adjustment is applied to the partnership's remaining assets.872 The adjustment arises under  § 734(b)(2)(B) and is attributable to an increase in the partnership's basis in capital gain assets. Therefore, the entire adjustment is allocated to remaining capital gain assets (in this case, Capital Asset #1). However, the adjustment must be allocated in a manner that reduces the difference between the adjusted basis and the fair market value of the asset. It is impossible to allocate a $10,000 decrease in basis to Capital Asset #1 in a manner that would reduce the difference between the adjusted basis and fair market value of the asset. In addition, former Regs. § 1.755-1(a)(1)(iii) prohibited the allocation of a decrease in basis to an asset that had a fair market value in excess of basis. Thus, the basis decrease is not currently of use to the partnership.

——————————————————————————————

872 § 734(b)(2)(B).

——————————————————————————————

Comment: Former Regs. § 1.755-1(b)(4) provided for the carryover of unused adjustments to be applied to subsequently acquired property of a like character. However, construed literally, these provisions applied only if the partnership currently owned no property of like character or if the partnership's adjusted basis in the property was insufficient to absorb a basis decrease.873 It was unclear whether this carryover applied to the situation set forth in the example above.
——————————————————————————————

873 Under former Regs. § 1.755-1(b)(3), the basis of partnership property could not be reduced below zero.

——————————————————————————————

Note: The result in this example is in sharp contrast to the result under current law, as illustrated by Example (2) in VIII, A, above.

Example (3): Assume that the ABC partnership has the following balance sheet on Jan. 1, 1995:

  Assets	
 Adjusted Basis	Fair Market Value	
Cash	$3,000,000	$3,000,000	
Capital Asset #1	    10,000	   100,000	
Capital Asset #2	    50,000	    50,000	
Ordinary Income Asset #1	
    120,000	
    180,000	
Ordinary Income Asset #2	
    180,000	
     60,000	
 	$3,360,000	$3,390,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
B	 1,120,000	 1,130,000 	
C	 1,120,000	 1,130,000 	
D	 1,120,000	 1,130,000	
 	$3,360,000	$3,390,000	

Assume that the partnership has a  § 754 election in effect. On Jan. 1, 1995, the partnership distributes Ordinary Income Asset #2 and $1,070,000 to D in complete liquidation of D's one-third interest in the partnership. Under § 732(b), D's basis in the distributed ordinary income asset is limited to $50,000 (the amount of D's adjusted basis in the partnership interest ($1,120,000) minus the amount of cash received ($1,070,000)).

Because a  § 754 election is in effect, a $130,000 upward  § 734(b) adjustment is applied to the partnership's remaining assets.874 The adjustment arises under  § 734(b)(1)(B) (disappearing basis) and is attributable to a decrease in the partnership's basis in ordinary income assets. Therefore, the entire adjustment is allocated to remaining ordinary income assets.875 The adjustment must be allocated in a manner that reduces the difference between the adjusted basis and the fair market value of the ordinary income assets (in this case, Ordinary Income Asset#1). The amount of unrealized appreciation in Ordinary Income Asset#1 is $60,000. Thus, $60,000 of the upward adjustment can be allocated to Ordinary Income Asset #1. However, it is impossible to allocate the remaining $70,000 upward adjustment in a manner that would reduce the difference between the adjusted basis and fair market value of the asset. Thus, the basis increase is not currently of use to the partnership.

——————————————————————————————

874 § 734(b)(1)(B).

875 Former Regs. § 1.755-1(b)(1)(i) (effective for distributions before Dec. 15, 1999).

——————————————————————————————

Note: Once again, the result in this example is in sharp contrast to the result under current law, as illustrated by Example (3) in VIII, A, above.

Comment: The former allocation rules were flawed at best, as applied to the  § 734(b) adjustment. The general rule that allocations within a class had to have the effect of reducing the difference between the adjusted bases and fair market values of the assets rendered the proper allocation of the adjustment impossible under several different factual situations.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

C. Reporting Requirements 

A partnership that is required to adjust the basis of partnership property under  § 734(b) upon a partnership distribution must attach a statement to the partnership return for the year in which the distribution occurs.876 The statement must set forth the computation of the adjustment and the partnership properties to which the adjustment has been allocated.877
——————————————————————————————

876 Regs. § 1.734-1(d). In Notice 2005-32, 2005-16 I.R.B. 895, the IRS provided interim guidance on reporting requirements for partnerships that must adjust the basis of partnership property because there is a substantial basis reduction with respect to a distribution (rather than because a  § 754 election is in effect). The notice states that such a partnership must comply with Regs.  § 1.734-1(d) as if a  § 754 election were in effect at the time of the distribution. See the Worksheets for a sample Regs.  § 1.734-1(d) basis adjustment computation statement.

877 Regs. § 1.734-1(d).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

D. Basis Adjustments for Distributions Under § § 704(c) and 737 

Before  the enactment of the Revenue Reconciliation Act of 1989,878 it was possible to avoid the effect of the mandatory  § 704(c) allocations by adjusting the basis of contributed property under § 734(b). The 1989 amendment to  § 704(c) was designed to eliminate this possibility by providing that a distribution of contributed property with precontribution gain or loss to a partner other than the contributing partner is treated as a sale of the property by the partnership to the distributee partner.879 As a consequence of this characterization, upon the distribution the  § 704(c) allocation is made and there is no  § 734(b) adjustment.
——————————————————————————————

878 P.L. 101-239.

879 § 704(c)(1). The 2004 AJCA, P.L. 108-357, § 833(a), amended  § 704(c)(1) again by adding  § 704(c)(1)(C) to eliminate the possibility of duplicating losses on contributed property when the contributing partner's interest in the partnership is transferred or liquidated. See V, K, above.  Section 704(c)(1)(C) requires a partnership to take into account built-in loss (i.e., excess of adjusted basis over fair market value) in contributed property only in allocating items to the contributing partner; in allocating items to the other partners, the partnership must treat the basis of the contributed property in the partnership's hands as the property's fair market value. It is not clear to what extent  § 704(c)(1)(C) is taken into account on a subsequent distribution.

——————————————————————————————

Regulations accomplish this result by treating the partnership's adjusted basis in the distributed  § 704(c) property as increased or decreased immediately before the distribution by the amount of gain or loss recognized by the contributing partner under § 704(c)(1)(B).880 Thus, any increase or decrease in basis is taken into account in determining the distributee partner's adjusted basis in the distributed property under § 732.
——————————————————————————————

880 Regs. § 1.704-4(e)(2). For further discussion of  § § 704(c) and 737 and the regulations thereunder, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts.

——————————————————————————————

Example: On Jan. 1, Year One, B, C, and D form a partnership as equal partners. B contributes land with a fair market value of$20,000 and an adjusted tax basis of $14,000. C and D each contribute$20,000 cash. On Dec. 31, Year Four, the land is distributed to C. B recognizes $6,000 on the distribution because that is the amount that would have been allocated to B under  § 704(c)(1)(A) on a sale of the land for its fair market value at the time of the distribution($20,000 fair market value less $14,000 adjusted basis). The adjusted basis of B's partnership interest is increased from $14,000 to $20,000 to reflect this gain. The partnership's adjusted tax basis in the land is increased from $14,000 to $20,000 immediately before the distribution. Therefore, under § 732(a)(1), C's adjusted tax basis in the land is $20,000.881

——————————————————————————————

881 Regs. § 1.704-4(e)(4).

——————————————————————————————

Consistent with the mandatory allocation under § 704(c), the regulations provide that any adjustments to the bases of partnership property(including the distributed  § 704(c) property) pursuant to a  § 754 election (or, presumably, a mandatory basis adjustment arising from a substantial basis reduction)must be made after, and must take into account, the adjustments required by the regulations pursuant to § 704(c).882
——————————————————————————————

882 Regs. § 1.704-4(e)(4).

——————————————————————————————

Under § 737, the contributing partner is also required to recognize all or a portion of the precontribution gain (but not loss), if, instead, the partnership distributes other property directly to the contributing partner. Regs. § 1.737-3 describes the adjustments to the partnership's basis in its property that this type of distribution requires. The partnership's adjusted basis in eligible property is increased by the amount of gain recognized by the distributee partner under § 737.883 “Eligible property” is defined as property that: (1) entered into the calculation of the distributee partner's net precontribution gain;884 (2)has an adjusted basis to the partnership that is less than its fair market value at the time of the distribution; (3) would have the same character of gain on a sale by the partnership to an unrelated party as the character of any of the gain recognized by the distributee partner under § 737;and (4) was not distributed to another partner in a distribution subject to  § 704(c)(1)(B) that was part of the same plan or arrangement as the distribution subject to § 737.885
——————————————————————————————

883 Regs. § 1.737-3(c)(1).

884 For a discussion of the “net precontribution gain,” see V, K, above.

885 Regs. § 1.737-3(c)(2).

——————————————————————————————

For purposes of allocating the basis increase among the items of eligible property, the regulations treat all eligible property of the same character as a single group.886 The basis increase is allocated among the separate groups of eligible property in proportion to the character of the gain recognized under § 737. The basis increase is then allocated among the properties within each group in the order in which the property was contributed to the partnership by the partner, starting with the property contributed first, in an amount equal to the difference between the property's fair market value and its adjusted basis to the partnership at the time of the distribution. For property that has the same character and was contributed in the same (or a related) transaction, the basis increase is allocated based on the respective amounts of unrealized appreciation in the properties at the time of the distribution.887
——————————————————————————————

886 Regs. § 1.737-3(c)(3).

887 Regs. §  1.737-3(c)(3).

——————————————————————————————

Example: On Jan. 31, Year One, B, C, and D form a partnership as equal partners. B contributes four parcels of land to the partnership:Parcel 1 (fair market value of $1,000 and adjusted basis of $500), Parcel 2 (fair market value of $4,000 and adjusted basis of $1,500), Parcel 3 (fair market value of $4,000 and adjusted basis of $6,000), and Parcel 4 (fair market value of $6,000 and adjusted basis of $4,000). The character of gain or loss in Parcels 1, 2, and 3 is long-term, U.S.-source capital gain or loss. The character of gain in Parcel 4 is long-term, foreign-source capital gain. B contributes land (Parcel 5) with a fair market value and adjusted basis of $15,000, and C contributes$15,000 cash. On Dec. 31, Year Four, Parcel 5 is distributed to B in complete liquidation of B's interest. B recognizes gain of $3,000 under § 737, an amount equal to the lesser of the excess distribution of $3,000($15,000 fair market value of Parcel 5 less $12,000 adjusted basis in B's partnership interest) and B's net precontribution gain of $3,000($15,000 aggregate fair market value of property contributed by B less $12,000 aggregate adjusted basis of the contributed property). Of B's gain, $2,000 is long-term, foreign-source capital gain ($3,000 total gain under  § 737 x($2,000 net long-term foreign-source capital gain/$3,000 total net precontribution gain)). Of B's gain, $1,000 is long-term, U.S.-source capital gain ($3,000 total gain x ($1,000 net long-term, U.S.-source capital gain/$3,000 total net precontribution gain)).

The partnership must increase the adjusted basis of the property contributed by B by $3,000. All property contributed by B is eligible property. Parcels 1, 2, and 3 have the same character and are grouped into a single group for purposes of allocating this basis increase. Parcel 4 is in a separate character group. Of the amount of the basis increase,$2,000 must be allocated to long-term, foreign-source capital assets because $2,000 of the gain recognized by B was long-term, foreign-source capital gain. The adjusted basis of Parcel 4 is therefore increased from $4,000 to $6,000. Of the amount of the increase, $1,000 must be allocated to Parcels 1 and 2 because $1,000 of the gain recognized by B is long-term, U.S.-source capital gain. No basis increase is allocated to Parcel 3 because its fair market value is less than its adjusted basis. The $1,000 basis increase is allocated between Parcels 1 and 2 based on the unrealized appreciation in each asset before the basis adjustment is made. As a result, the adjusted basis of Parcel 1 is increased by $167 ($1,000 x ($500/$3,000)), and the adjusted basis of Parcel 2 is increased by $833 ($1,000 x $2,500/$3,000)).888

——————————————————————————————

888 Regs.  § 1.737-3(e) Ex. 3.

——————————————————————————————

Any adjustments to the bases of partnership property (including eligible property) under  § 734(b) must be made after, and must take into account, adjustments to basis required by the regulations pursuant to § 737. However, basis adjustments under  § 734(b)(1)(A) that are attributable to distributions of money to the distributee partner that are part of the same plan or arrangement as the distribution of property subject to  § 737 are made before the basis adjustments required by the regulations.889
——————————————————————————————

889 See Regs.  § 1.737-3(e) Ex. 3.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

E. Effect of § 734(b) Adjustment on Depletion 

If an adjustment under  § 734(b) is made to the basis of partnership property subject to depletion, the depletion deduction is subsequently computed taking into account the adjustment.890
——————————————————————————————

890 Regs. § 1.612-1(a).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

F. Effect of § 734(b) Adjustment on Depreciation 

1. Upward Adjustment to Partnership Recovery Property 

If the application of  § 734(b) results in an upward adjustment to property that the partnership is depreciating under MACRS or ACRS, the amount of the adjustment is considered newly purchased property placed in service on the date of the transfer.891 The deemed separate property is treated as placed in service on the date of the distribution for which the optional basis adjustment is made. Any applicable recovery period and method may be used to determine the recovery allowance with respect to the increased portion of the basis.892
——————————————————————————————

891 Regs. § 1.734-1(e)(1). These principles apply to adjustments arising from distributions made after Dec. 14, 1999. Regs. § 1.734-1(e)(3). For adjustments arising from distributions made before Dec. 15, 1999, the guidance can be found in regulations that had been proposed under § 168 and were later withdrawn. Prop. Regs. § 1.168-2(n), LR-185-81, 1984-1 C.B. 659 (2/16/84), withdrawn by REG-209682-94, 63 Fed. Reg. 4408 (1/29/98).

892 Regs. § 1.734-1(e)(1).

——————————————————————————————

Note: The recovery period and method in effect for the partnership's basis in the property other than the basis adjustment is unaffected.893
——————————————————————————————

893 Regs. § § 1.734-1(e)(1), 1.743-1(j)(4)(i)(B)(1).

——————————————————————————————

Example: Partnership P is a calendar year partnership with three equal partners, B, C, and D. P paid $100,000 to acquire five-year MACRS property on July 1, Year One, and had properly computed MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducted$35,000 in Year One, $26,000 in Year Two, and $15,600 in Year Three. On June 20, Year Four, P made a distribution to B, that resulted in a  § 734(b) upward adjustment, of which $10,000 was properly allocated to the five-year MACRS property. For Year Four, P deducts $11,010 with respect to the original $100,000 basis in the property, continuing with the percentages set forth in the MACRS Table applicable to the property. With respect to the $10,000 adjustment, P computes MACRS depreciation as though it were a newly acquired asset. It remains five-year property. Assume P chooses to use the general depreciation system and accelerated method, i.e., to forgo any election to use the straight-line method. For Year Four, the MACRS depreciation deduction with respect to the $10,000 is $3,500 ($10,000 x .35). The 35% is the percentage for the first year in the recovery period for the $10,000 adjustment. P does not use the 11.01% amount that it uses for the $100,000 original basis, because the 11.01% is the percentage for the fourth year of the recovery period for the $100,000.

Example: The facts are the same as in the preceding example, except that the distribution generating the basis adjustment occurs on Dec. 5, Year Four,  no other distributions occur in Year Four, and P acquires no other property during Year Four. Presumably, the mid-quarter convention must be used with respect to the $10,000 because more than 40% of P's basis in property acquired during Year Four was acquired in the fourth quarter. This conclusion is a logical consequence of treating the adjustment as though it were newly acquired property.

2. Downward Adjustment to Partnership Recovery Property 

If the application of  § 734(b) results in a downward adjustment to property that the partnership is depreciating under MACRS or ACRS, the amount of the adjustment must be accounted for over the remaining recovery period of the property beginning with the recovery period in which the basis is decreased.894
——————————————————————————————

894 Regs. § 1.734-1(e)(2).

——————————————————————————————

Note: The  § 734 regulations do not specify how the decrease is “accounted for over the remaining recovery period,” but the  § 743 regulations provide an explanation and example with respect to a virtually identical principle applicable to  § 743(b) downward adjustments. The decrease is treated as reduced depreciation in each remaining year of the recovery period equal to an amount calculated by multiplying the total decrease by a fraction, the numerator of which is the portion of the adjusted basis in the property recovered by the partnership in that year, and the denominator of which is the adjusted basis of the property on the date of the distribution generating the adjustment, before taking any adjustments into account.895
——————————————————————————————

895 See Regs. § 1.743-1(j)(4)(ii)(B).

——————————————————————————————

Example: Partnership P is a calendar year partnership with three equal partners, B, C, and D. P paid $100,000 to acquire five-year MACRS property on July 1, Year One, and had properly computed MACRS depreciation deductions under the MACRS general depreciation system using the accelerated method and full-year convention. Thus, P deducted$35,000 in Year One, $26,000 in Year Two, and $15,600 in Year Three. On June 20, Year Four, P made a distribution to B that resulted in a  § 734(b) downward adjustment, of which $10,000 was properly allocated to the five-year MACRS property. For Year Four, P computes its MACRS deduction with respect to the property as follows. First, it computes an $11,010 deduction with respect to the original $100,000 basis in the property, continuing with the percentages set forth in the MACRS Table applicable to the property. Secondly, it computes an adjusted basis as of the date of the distribution, which, because the  § 734 regulations require that the decrease be taken into account for the Year Four recovery period, presumably is the property's adjusted basis as of Jan. 1, Year Four. That adjusted basis is $23,400 ($100,000 minus ($35,000 + $26,000+ $15,600)). The fraction for Year Four is .4705 ($11,010 (the recovery for Year Four) divided by $23,400). Thus, of the $10,000 decrease adjustment, $4,705 is taken into account in Year Four. Accordingly, P reduces the $11,010 by $4,705, resulting in a MACRS depreciation deduction for Year Four of $6,305. Because the recovery percentage for Year Five also is .1101, the same computations apply for Year Five. For Year Six, P computes a $1,380 deduction with respect to the original $100,000 basis in the property, continuing with the percentages set forth in the MACRS Table applicable to the property. Secondly, its adjusted basis as of the date of the adjustment remains $23,400. The fraction for Year Six is .0590 ($1,380 (the recovery for Year Six) divided by $23,400). Thus, of the $10,000 decrease adjustment,$590 is taken into account in Year Six. Accordingly, P reduces the$1,380 by $590, resulting in a MACRS depreciation deduction for Year Six of $790.

Comment: Thus, the $10,000 decrease adjustment in the example caused reductions in P's MACRS depreciation deductions for Years Four through Six, respectively, of $4,705, $4,705, and $590, a total of$10,000.

3. Upward Adjustment to Partnership Property Depreciated Under Pre-1981 § 167 Rules 

If  § 734(b) results in an upward adjustment to partnership property that the partnership is depreciating under the pre-1981 rules in § 167, the transferee partner is not allowed to use MACRS or ACRS with respect to basis attributable to the adjustment.896 The methods of depreciation available with respect to the basis increase are limited to the methods applicable to used property under § 167.897 In the case of a partnership electing to apply the Asset Depreciation Range (ADR) system to its non-ACRS property, it is unclear whether the amount of the adjustment is treated as a separate asset placed in service in the year of the transfer 898 or is depreciated over the remaining life of the asset. Computing depreciation as if the adjustment constituted a separate asset appears to be more consistent with the treatment of adjustments under the general  § 167 regulations applicable to property to which a partnership has not elected to apply the ADR system.
——————————————————————————————

896 See Prop. Regs.  § 1.168-4(d)(8) (1984).

897 Regs. § 1.167(c)-1(a)(6). See also Rev. Rul. 57-352, 1957-2 C.B. 150.

898 This approach is supported by the treatment of the adjustment as used property in Regs. § 1.167(c)-1(a)(6).

——————————————————————————————

4. Downward Adjustment to Partnership Property Depreciated Under Pre-1981 § 167 Rules 

Because there is no direct authority, a downward adjustment to the basis of pre-1981  § 167 property presumably is taken into account under the rules applicable to basis reductions generally. See 530 T.M., Depreciation: General Concepts;Non-ACRS Rules.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

G. Amortization of § 734(b)Increases in Bases of Intangible Assets 

A taxpayer may not amortize an intangible asset that is otherwise amortizable under  § 197 if the taxpayer acquired the asset before the appropriate effective date under  § 197 (i.e., if the asset is a “§ 197(f)(9) intangible”). When a partnership owns a  § 197(f)(9) intangible that receives a basis increase under § 734(b), the partnership's predistribution basis in the asset remains nonamortizable. A continuing partner in the partnership, however, may amortize that partner's share of the § 734(b) increase to the extent that the partner is an “eligible partner.” 899 An eligible partner is a partner in any of the following three categories.900
——————————————————————————————

899 Regs. § 1.197-2(h)(12)(iv)(A).

900 Regs. § 1.197-2(h)(12)(iv)(B).

——————————————————————————————

(1) A continuing partner who is not the Distributee Partner (i.e., did not receive the distribution that caused the  § 734(b) basis increase)and is not related to the Distributee Partner.

Example: Partnership XYZ owns only one asset, which is a  § 197(f)(9) intangible. Partners X, Y, and Z are unrelated. When the basis of the intangible is $80, XYZ distributes $100 to X. X's basis in X's partnership interest was $70 before the distribution. XYZ has a  § 754 election in effect for the year in which the distribution occurs. Because X recognizes $30 of gain under § 731(a)(1), the partnership increases the basis of the intangible by $30. Y and Z are eligible partners and, therefore, may amortize their shares($10 apiece) of the increased basis in the partnership's intangible.

(2) In a partnership that acquired a  § 197(f)(9) intangible before August 11, 1993, a continuing partner who was the Distributee Partner and who acquired the partnership interest after August 10, 1993, from an unrelated prior partner.

Example: A partnership owns only one asset, a  § 197(f)(9) intangible that it acquired in 1992. Partners X and Y are unrelated. In 2001, X sold X's partnership interest to Z, a person unrelated to X, for a price equal to X's basis in the interest. Several years later, when the basis of the intangible is $80, the partnership distributes $100 to Z. Z's basis in Z's partnership interest was $60 before the distribution. The partnership has a  § 754 election in effect for the year in which the distribution occurs. Because Z recognizes $40 of gain under § 731(a)(1), the partnership increases the basis of its intangible by $40. Z is an eligible partner and, thus, may amortize Z's share($20) of the increased basis in the partnership's intangible.

(3) In a partnership that acquired a  § 197(f)(9) intangible after August 10, 1993, but could not amortize the asset, a continuing partner who was the Distributee Partner and who acquired the partnership interest from an unrelated prior partner after the date on which the partnership acquired the asset.

Example: A partnership owns only asset, a  § 197(f)(9) intangible that it acquired after August 10, 1993, but could not amortize. Partners X and Y are unrelated. In 2001, X sold X's partnership interest to Z for a price equal to X's basis in the interest. Several years later, when the basis of the intangible is $80, the partnership distributes$100 to Z. Z's basis in Z's partnership interest was $60 before the distribution. The partnership has a  § 754 election in effect for the year in which the distribution occurs. Because Z recognizes $40 of gain under § 731(a)(1), the partnership increases the basis of its intangible by $40. Z is an eligible partner and, thus, may amortize Z's share ($20) of the increased basis in the partnership's intangible.

A continuing partner who was the Distributee Partner and who received the partnership interest from a prior partner in a transaction (or series of related transactions) designed to circumvent the anti-churning rules for  § 197 intangibles is not an eligible partner.901
——————————————————————————————

901 Regs. § 1.197-2(h)(12)(iv)(B)(2)(iii), (3)(iii).

——————————————————————————————

If a partnership makes the necessary election, the effective date for measuring all of the eligible-partner tests is July 25, 1991, instead of August 10, 1993.902 A partner determines its share of a  § 734(b) basis increase in an intangible by multiplying the basis increase by a fraction, the numerator of which is the amount of the partner's post-distribution capital account (determined immediately after the distribution) and the denominator of which is the total amount of the partnership's post-distribution capital accounts (immediately after the distribution). If the partnership does not maintain capital accounts, then the partner's share of the basis increase is measured by the partner's overall interest in the partnership, as determined under Regs.  § 1.704-1(b)(3) immediately after the distribution.903
——————————————————————————————

902 Regs. § 1.197-2(h)(12)(iv)(C).

903 Regs. § 1.197-2(h)(12)(iv)(D).

——————————————————————————————

If a continuing partner who also receives the distribution that causes the  § 734(b) increase in the basis of a  § 197(f)(9) intangible received the partnership interest in exchange for a contribution of cash or property, the partner is treated as acquiring a pro rata portion of that interest from the current members of the partnership, based on each current partner's proportionate interest in the partnership. Thus, if the continuing partner was related to any of the current partners at the time of the contribution, that continuing partner does not qualify under the second and third tests for eligibility with regard to the portion of the acquired interest attributable to the related current partner (or partners). If a continuing partner did not receive a distribution that caused the  § 734(b) increase in the basis of a  § 197(f)(9) intangible, but the distribution was the result of a transaction (or series of related transactions) that included the partner's contribution of the intangible to the partnership, the continuing partner is treated as related to the distributee (and the continuing partner, therefore, may not amortize the partner's share of the basis increase).904
——————————————————————————————

904 Regs. § 1.197-2(h)(12)(iv)(E).

——————————————————————————————

If one or more partners are subject to the anti-churning rules of Regs.  § 1.197-2(h)(12) with respect to a  § 734(b) basis increase in a  § 197(f)(9) intangible, the partnership may use any reasonable method to amortize the asset for book purposes, so long as the method does not contravene the purposes of the anti-churning rules. A method of amortization fails this test if its effect is to allocate any portion of the tax deduction from the basis increase, directly or indirectly, to a partner who is subject to anti-churning for the increase.905
——————————————————————————————

905 Regs. § 1.197-2(h)(12)(iv)(F).

——————————————————————————————

If a partner whose interest in a partnership intangible was subject to anti-churning becomes a direct user of the intangible after a series of related transactions including a  § 734(b) basis increase, the partner's share of the basis increase remains subject to anti-churning.906
——————————————————————————————

906 Regs. § 1.197-2(h)(12)(vi)(A).

——————————————————————————————

For a detailed discussion of the anti-churning rules for  § 197 intangibles, including the definition of “related person,” see 533 T.M., Amortization of Intangibles.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

H. Timing of § 734(b) Adjustment in Context of Complete Liquidation 

If a partnership liquidates a retiring partner's entire interest in the partnership in exchange for deferred cash payments, the distributee partner generally recognizes no gain until the payments received are in excess of the partner's adjusted basis in the partnership interest.907 However, under Regs. § 1.736-1(b)(6), the distributee partner may elect to recognize a pro rata portion of gain upon receipt of each payment when the total payments are a fixed sum. In Rev. Rul. 93-13,908 the IRS ruled that, in the context of a complete liquidation of a retiring partner's interest in exchange for deferred cash payments, the  § 734(b) adjustment “correspond[s] in timing and amount with the recognition of gain or loss by the retiring partner with respect to those payments.” According to the IRS, the adjustment is applied according to that rule regardless of whether or not the retiring partner elects to recognize pro rata portions of gain under Regs. § 1.736-1(b)(6).909
——————————————————————————————

907 § § 731(a)(1), 736(b);Regs. § 1.731-1(a)(1)(i).

908 1993-1 C.B. 126.

909 For a discussion of § 736, see 716 T.M., Partnerships —Current and Liquidating Distributions; Death or Retirement of a Partner.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

I. Relationship Between § 734(b)Adjustment and § 751(b) 

1. Section 751(b) —In General 

Section 751(b)(1) provides:910
——————————————————————————————

910 For a detailed discussion of § 751(b), see 720 T.M., Partnership Transactions — Section 751 Property.

——————————————————————————————

To the extent a partner receives in a distribution —

(A) partnership property which is —
  
(i) unrealized receivables, or
  
(ii) inventory items which have appreciated substantially in value,
  
in exchange for all or a part of his interest in other partnership property (including money), or
  
(B) partnership property (including money) other than property described in subparagraph (A)(i) or (ii)in exchange for all or a part of his interest in partnership property described in subparagraph (A)(i) or (ii),

such transactions shall, under regulations prescribed by the Secretary, be considered as a sale or exchange of such property between the distributee and the partnership (as constituted after the distribution).

For purposes of this discussion, unrealized receivables and substantially appreciated inventory are referred to as “hot assets.”All other partnership property is referred to as “cold assets.”Under § 751(b), if a partner receives an amount of cold assets in a distribution that is greater than the partner's share (referred to as a distribution of “excess cold assets”), the partnership — to account for the discrepancy — is deemed to have distributed hot assets to the partner, who is then deemed to have sold them back to the partnership in exchange for the excess cold assets. The distributee partner is likely recognize ordinary income or loss on the deemed sale back to the partnership. The recognition of this income is an exception to the general rules set forth in § 731(a). Without this exception, the distributee partner would be allowed to decrease the partner's interest in ordinary income assets in exchange for an increase in the partner's interest in capital gain assets and, therefore, to have converted ordinary income to capital gain.

Example: The XYZ partnership has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	$27,000	$27,000	
Inventory	0	27,000	
Land	  9,000	 18,000	
 	$36,000	$72,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
X	 12,000	 24,000 	
Y	 12,000	 24,000 	
Z	 12,000	 24,000	
 	$36,000	$72,000	

The partnership distributes to X, a one-third partner, $18,000 of cash on Jan. 1. After the distribution, X is a one-ninth partner.911 The cash and the land held by the partnership are cold assets. The inventory, however, is a hot asset because it is substantially appreciated. (The fair market value of the inventory ($27,000) is greater than 120%of the partnership's adjusted basis in the inventory ($0) and greater than 10% of the fair market value of all of the partnership property excluding cash ($45,000 x 10%, or $4,500)).

The exchange table reflecting the distribution is as follows:

 Assets	Partnership FMV Before	X's Interest Before	Partnership FMV After	X's Interest After	X Owns
 Individually	
 X Owns Total	
Cash	$27,000	$9,000	$9,000	$1,000	$18,000	$19,000	
Inventory	 27,000	 9,000	27,000	 3,000	0	  3,000	
Land	 18,000	 6,000	18,000	 2,000	0	  2,000	

Compare X's interest in each asset before the distribution with X's interest after the distribution (owned through the partnership and individually):
Assets	+	–	
Cash	$10,000 (interest went from $9,000 to $19,000)	 	
Inventory	 	$6,000 (from $9,000 to $3,000)	
Land	 	$4,000 (from $6,000 to $2,000)	

The table shows that $4,000 out of the $18,000 of cash distributed was in exchange for $4,000 of X's interest in the land. Both the cash and the land are cold assets, and, therefore, no  § 751(b) problem arises. However, $6,000 out of the $18,000 of cash distributed was in exchange for $6,000 of X's interest in the inventory, a hot asset. This portion of the distribution triggers § 751(b).

Following the analysis previously set forth, there is a deemed distribution of $6,000 of inventory. X's adjusted basis in the distributed inventory is carried over from the partnership ($0). There is no reduction in X's adjusted basis in X's partnership interest or the partnership's adjusted basis in the asset, because the adjusted basis is $0. Next, there is a deemed sale of the $6,000 of inventory back to the partnership in exchange for $6,000 of cash. X recognizes $6,000 of ordinary income, representing the difference between the fair market value of the cash received and the adjusted basis of the inventory exchanged. The partnership recognizes no gain, because the cash used to purchase the inventory has a fair market value equal to its basis. The partnership's adjusted basis in its inventory is increased by $6,000, representing the fair market value of the cash used to purchase the inventory. The remainder of the distribution ($12,000 of cash) is governed by the general distribution rules. The amount of the cash distributed is equal to X's adjusted basis in X's partnership interest, and, therefore, X recognizes no gain. X's adjusted basis in the partnership interest is reduced by the amount of cash distributed, to $0.

In the final analysis, after the distribution, the partnership's balance sheet is as follows:

 Assets	
 Adjusted Basis	Fair Market Value	
Cash	 $9,000	 $9,000	
Inventory	  6,000	 27,000	
Land	  9,000	 18,000	
 	$24,000	$54,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
X	0	  6,000 	
Y	 12,000	 24,000 	
Z	 12,000	 24,000	
 	$24,000	$54,000	

——————————————————————————————

911 The fair market value of X's partnership interest has been reduced from $24,000 to $6,000. The value of the partnership has been reduced from $72,000 to $54,000. Thus, the value of X's interest($6,000) in relation to the value of the partnership ($54,000) is$6,000 ÷  $54,000, or one-ninth.

——————————————————————————————

After the distribution, X owns $18,000 of cash and has recognized$6,000 of ordinary income.

Note: If  § 751(b) did not exist and the general distribution rules were applied, the $18,000 of cash distributed in the example would have resulted in $6,000 of gain ($18,000 distributed cash minus $12,000 of adjusted basis in partnership interest), but this gain would have been characterized as capital. Later, when the partnership sold its inventory, X would recognize $6,000 less of ordinary income and, therefore, would have succeeded in converting ordinary income into capital gain because X's one-ninth share of the $27,000 of ordinary income recognized by the partnership on the sale of the inventory would be $6,000 less than X's one-third share.

2. Interaction Between § 734(b)and § 751(b) 

The interaction between  § 734(b) and  § 751(b) can be illustrated by the following example.

Example: The XYZ partnership has the following balance sheet on Jan. 1:

 Assets	
 Adjusted Basis	Fair Market Value	
Accounts Receivable	$0	 $18,000	
Inventory (dealer land)	 18,000	  36,000	
Equipment (assume no recapture)	0	  18,000	
Investment Land	
   3,000	
   36,000	
 	$21,000	$108,000	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
X	  3,000	  36,000 	
Y	  9,000	  36,000 	
Z	  9,000	  36,000	
 	$21,000	$108,000	

The partnership distributes the equipment and one-half of the interest in the investment land to X in complete liquidation of X's partnership interest on Jan. 1.

In the distribution, X receives $36,000 of cold assets — $18,000 of equipment and $18,000 of land. The exchange table reflecting the distribution is as follows:

 Assets	Partnership FMV Before	X's Interest Before	Partnership FMV After	X's Interest After	X Owns
 Individually	
 X Owns Total	
Accts. Receivable	$18,000	$6,000	$18,000	$0	$0	$0	
Inventory	 36,000	12,000	 36,000	0	0	0	
Equipment	 18,000	 6,000	0	0	18,000	18,000	
Investment Land	 36,000	12,000	 18,000	0	18,000	18,000	

Compare X's interest in each asset before the distribution with X's interest after the distribution (owned through the partnership and individually):
Assets	+	–	
Accts. Receivable	 	6,000	
Inventory	 	12,000	
Equipment	12,000	 	
Investment Land	6,000	 	

Of the $36,000 distribution, $18,000 is received in exchange for X's one-third interest in the cold assets (1/3 of $54,000) and, therefore, presents no  § 751(b) problem. The remaining $18,000, however, is in exchange for X's interest in the partnership's hot assets, consisting of accounts receivable and inventory, and triggers § 751(b).

Following the analysis previously set forth, the partnership is deemed to have distributed $6,000 of accounts receivable with an adjusted basis of $0 and $12,000 of land inventory with an adjusted basis of$6,000. The partnership's adjusted basis in the inventory is decreased to $12,000. X takes a carryover adjusted basis of $0 in the accounts receivable. X also takes a carryover adjusted basis in the inventory, but X's adjusted basis is limited by  § 732 to X's adjusted basis in the partnership interest. Thus, X's adjusted basis in the distributed inventory is $3,000, and X's adjusted basis in the partnership interest is reduced to $0. The partnership's balance sheet immediately after the deemed distribution is as follows:
Assets	Adjusted Basis	Fair Market Value	
Accts. Receivable	$0	$12,000	
Inventory	 12,000	 24,000	
Equipment	0	 18,000	
Investment Land	   3,000	 36,000	
 	$15,000	$90,000	
Liabilities &  Capital	 	 	
Liabilities   	$0	$0	
Capital:  X	0	 18,000 	
Y	  9,000	 36,000 	
Z	  9,000	 36,000	
 	$18,000	$90,000	

As is evident from the balance sheet, $3,000 of the partnership's adjusted basis in its assets has “disappeared.”

Next, there is a deemed sale of the hot assets back to the partnership, in exchange for $12,000 of equipment and $6,000 of land. X recognizes$6,000 of ordinary income from the “sale” of the accounts receivable and $9,000 of ordinary income from the “sale”of the inventory. The partnership recognizes $12,000 of  § 1231 gain from the exchange of the equipment ($12,000 minus $0 adjusted basis) and $5,500 ($6,000 minus $500 adjusted basis) of capital gain from the exchange of the investment land. This gain passes through to Y and Z and increases their adjusted bases in their partnership interests by $8,750 (gain of 17,500 ÷  2) to $17,750. The partnership's adjusted basis in its hot assets is increased by the fair market value of the cold assets used to purchase them back. Thus, its adjusted basis in the accounts receivable is increased to $6,000 and its adjusted basis in the inventory is increased to $24,000. In addition, the partnership's basis in the remaining investment land is decreased by the adjusted basis of the exchanged portion ($500). The partnership's balance sheet immediately after the deemed sale is as follows:
Assets	Adjusted Basis	Fair Market Value	
Accts. Receivable	 $6,000	$18,000	
Inventory	 24,000	 36,000	
Equipment	0	  6,000	
Investment Land	  2,500	 30,000	
 	$32,500	$90,000	
Liabilities &  Capital	 	 	
Liabilities   	$0	$0	
Capital:   X	0	 18,000 	
Y	 17,750	 36,000 	
Z	 17,750	 36,000	
 	$35,500	$90,000	

There is still a $3,000 discrepancy between the partners' adjusted bases in their partnership interests and the partnership's adjusted bases in its assets.

The remainder of the distribution — $6,000 of equipment and$12,000 of investment land — is governed by the general distribution rules. The $6,000 of equipment leaves the partnership with an adjusted basis of $0, and, therefore, X has an adjusted basis of $0 in this portion of the equipment. The land leaves the partnership with an adjusted basis of $1,000, but X's adjusted basis in X's partnership interest was reduced to $0 on the  § 751(b) deemed distribution; X, therefore, has a basis decrease of $1,000, which is allocated under  § 732(c) to the land, leaving X with a $0 adjusted basis in the land. The partnership reduces its adjusted basis in the remaining investment land by $1,000. The partnership's balance sheet immediately after this entire transaction is as follows:
Assets	Adjusted Basis	Fair Market Value	
Accts. Receivable	 $6,000	$18,000	
Inventory	 24,000	 36,000	
Equipment	0	  6,000	
Investment Land	  1,500	 18,000	
 	$31,500	$72,000
 	
Liabilities &  Capital	 	 	
Liabilities	$0	$0	
Capital:	 	 	
Y	 17,500	 36,000 	
Z	 17,500	 36,000	
 	$35,500	$72,000	

As is evident from the balance sheet, the discrepancy between inside and outside basis has increased by $1,000. The partnership has “lost”$1,000 of adjusted basis on the remainder of the distribution.

The most significant question presented in the preceding example is if and when a  § 734 basis adjustment is available to the partnership to account for the two “disappearing”bases of $3,000 and $1,000. Clearly, the $1,000 of “disappearing”basis falls within the parameters of § 734.912 The adjustment arises from the excess of (i) the adjusted basis of the distributed property to the partnership immediately before the distribution over(ii) the basis of the distributed property to the distributee. Because the $1,000 adjustment arises from the distribution of a capital asset, under  § 755 it is allocated to the remaining capital asset (the land).
——————————————————————————————

912 § 734(b)(1)(B).

——————————————————————————————

The question of whether the $3,000 of “disappearing” basis caused by the deemed distribution of inventory falls within the parameters of  § 734 is more difficult. Some commentators believe that the  § 734(b) adjustment does not apply to the deemed distribution under § 751.913 The commentators appear to reach this conclusion through the process of elimination. By its language,  § 734 applies only when  § 731 gain or loss is recognized or when  § 732 limits or defines a partner's allowed adjusted basis in distributed assets.914  Section 731(d) states that  § 731(a) is not applicable to the extent that § 751(b) applies to the transaction. Thus, according to some commentators,  § 732(e) provides that  § 732 has no application to a distribution that falls under § 751(b).915 This does not appear, however, to be an accurate reading of § 732(e).  Section 732(e) states that  § 732 does not apply “to the extent that a distribution is treated as a sale or exchange of property under  section 751(b) ....” In the example above, therefore, the distribution of $12,000 of equipment and $6,000 of land in exchange for the inventory and accounts receivable (previously deemed distributed)is not within  § 732 and cannot trigger a  § 734(b) basis adjustment. This result makes sense because, under the normal rules of sale and exchange, the partnership takes a cost basis in this portion of the inventory and accounts receivable and, therefore, needs no adjustment.
——————————————————————————————

913 See, e.g., Willis, Pennell, &  Postlewaite, Partnership Taxation, ¶  13.05[3](6th ed. 1997). This conclusion is in contrast to the approach adopted by McKee, Nelson, &  Whitmire, Federal Taxation of Partnerships and Partners, § 25.03 (3rd ed. 1997).

914 § 734(b).

915 Willis, Pennell, &  Postlewaite, ¶  13.05[3].

——————————————————————————————

However, the deemed distribution of the inventory and accounts receivable is a separate distribution to which the rules of  § 732 do apply. Although the deemed distribution is part of the  § 751(b) analysis, it is not the sale or exchange portion of the transaction. The regulations accompanying  § 732 support the view that the  § 751(b) deemed distribution must be separated from the sale or exchange, and each treated differently for purposes of applying the  § 732 provisions.916
——————————————————————————————

916 See Regs. § 1.732-1(e).

——————————————————————————————

Following this analysis,  § 732 would apply to the deemed distribution of inventory and accounts receivable in the example above, and, therefore,  § 734(b) would apply to allow the partnership a basis adjustment to account for the $3,000 discrepancy. The next question is how that $3,000 basis adjustment is to be allocated. According to Regs. § 1.755-1(c)(1)(i), an adjustment arising from a  § 732(a)(2) limit on basis (a  § 734(b)(1)(B) adjustment) “must be allocated to remaining partnership property of a character similar to that of the distributed property... .” Does “distributed,”in this context, mean “actually distributed” (i.e., the equipment and land) or “deemed distributed” (i.e., the inventory and accounts receivable)? If it means “actually distributed,”then the $3,000 adjustment is allocated to the remaining land. This result is not in keeping with the purpose of § 734. The partnership “lost”basis attributable to inventory and, therefore, increased potential recognition of ordinary income. However, the basis adjustment, if allocated to the land, would decrease potential recognition of capital gain. In the context of § 751(b), the regulation makes more sense if interpreted to refer to the “deemed distributed” assets. The adjustment, under that interpretation, is allocated to the remaining inventory and accounts receivable, in proportion to the net appreciation in each asset.

Note: In Notice 2006-14,917 the IRS stated that Treasury and the IRS are considering alternative methods of implementing the purpose of § 751(b), i.e., to prevent the use of partnerships as a device for obtaining capital gain treatment on rights to income and appreciated inventory, by severing the income rights from the partnership interests.918 In keeping with this focus on income rights, the IRS suggested in Notice 2006-14 that regulations may be issued to replace the current  § 751(b) regulations with a “hypothetical sale approach,” which would require partnerships and their partners to compare (i) the amounts of ordinary income that the partnership would recognize if the partnership's hot assets (including distributed assets) were sold or exchanged for fair market value in a taxable transaction before the distribution with (ii) those amounts recognized in such a transaction after the distribution. If the amount of ordinary income that would be allocated to any partner (including the distributee) is reduced as a result of the distribution, an analysis under  § 751(b) would be required. The hypothetical sale approach also would incorporate rules on the preservation of a partner's predistribution share of hot assets, analogous to the  § 704(c) rules preserving a partner's precontribution share of gain or loss.919 In the case of disproportionate distributions, Notice 2006-14 suggests that regulations might add a “hot asset sale approach” to the hypothetical sale approach. Under the “hot asset sale approach,”  § 751(b) would apply if a distribution reduces any partner's share of the net unrealized appreciation in the partnership's hot assets; such a partner (whether or not the distributee) would be treated as receiving the relinquished hot assets in a deemed distribution, selling to the partnership the relinquished share immediately after the distribution, and recognizing ordinary income from the deemed sale. Under this approach, there would be no deemed exchange of hot assets for cold assets, thus eliminating the need to identify cold assets to be exchanged or to construct a deemed distribution of cold assets.
——————————————————————————————

917 2006-8 I.R.B. 498.

918 Notice 2006-14 (citing S. Rep. No. 1622, at 99 (1954)).

919 For example, partners X, Y, and Z each contribute$120 cash to partnership XYZ. The partnership purchases land for $210. At a time when the land has a value of $300, and the partnership has cash of $150 and $90 of zero-basis unrealized receivables, XYZ distributes$90 to Z. Z's entire predistribution share of the partnership's unrealized income in the accounts receivable was $30 (1/3 of $90). As a result of the distribution, Z's XYZ interest is reduced from 1/3 to 1/5, and the partnership's remaining assets have a total value of $450. If the partners' capital accounts are adjusted immediately before the distribution to reflect the partners' shares of unrealized appreciation in the partnership assets, Z's $30 pre-distribution share of the unrealized income in the accounts receivable is preserved in Z's post-distribution capital account, which has a value of $90 (1/5 of $450). The $30 of appreciation would be allocated to Z when the amount is recognized. Because of the § 704(c)-like principles, these facts would not trigger  § 751(b) at all. Notice 2006-14 Ex. 1.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

J. Application of § 734(b)to Distribution Preceded by § 743(b) Transfer 

If partnership property is distributed to a partner who acquired all or a portion of the partnership interest by transfer, any prior  § 743(b) adjustment is taken into account for purposes of computing the amount of the  § 734(b) adjustment.920 If a transferee partner receives a liquidating distribution of property (including money) with respect to which the partner has no  § 743(b) adjustment, in exchange for relinquishing the interest in property with respect to which the partner has a  § 743(b) adjustment,  the unused portion of the adjustment is applied, in determining the basis of the distributed property, as an adjustment to the partnership's basis in its remaining assets as to which the adjustment was attributable.921 The  § 743(b) adjustment is discussed in detail in VII, A, above.
——————————————————————————————

920 Regs. § 1.734-2(a).

921 Regs. § 1.734-2(b)(1).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

K. Relationship Between § 734(b)Adjustment and § 732(d) Adjustment 

If partnership property is distributed to a partner who acquired all or a portion of the partnership interest by transfer, any adjustment to basis under  § 732(d) is taken into account for purposes of computing the amount of the  § 734(b) adjustment.922 If a transferee partner receives a liquidating distribution of property (including money) with respect to which the partner has no  § 732(d) adjustment in exchange for relinquishing the interest in property with respect to which the partner has a  § 732(d) adjustment and the partner is unable to use the adjustment in determining the basis of the distributed property, the unused portion of the adjustment is applied as an adjustment to the partnership's bases in its remaining assets as to which the adjustment was attributable.923 The  § 732(d) adjustment is discussed in detail in V, D, above.
——————————————————————————————

922 Regs. § 1.734-2(a).

923 Regs. § 1.734-2(b)(1).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

L. Application of § 734(b)to Tiered Partnerships 

Rev. Rul. 92-15 924 sets forth the IRS's position on the application of  § 734(b) to tiered partnerships. Generally, the ruling treats each partnership as an independent entity for purposes of the adjustment. If an upper-tier partnership has a § 754 election in effect and distributes assets other than a lower-tier partnership interest, the  § 734(b) rules are applied regardless of whether or not the lower-tier partnership has a  § 754 election in effect. For purposes of applying the adjustment, the lower-tier partnership interest is treated as a capital asset.925 If the lower-tier partnership also has a  § 754 election in effect, any adjustment to the upper-tier partnership's basis in the lower-tier partnership interest flows through to either increase or decrease the lower-tier partnership's bases in its capital gain assets. However, only the upper-tier partnership's share of the basis of the lower-tier partnership's assets is affected by the adjustment.
——————————————————————————————

924 1992-1 C.B. 215. The IRS has yet to apply the mandatory  § 734 basis adjustment to tiered partnerships.

925 Rev. Rul. 92-15 (situation 1).

——————————————————————————————

If an upper-tier partnership makes a liquidating distribution of a lower-tier partnership interest and the upper-tier partnership is entitled to a basis increase under § 734(b)(1)(B), the upper-tier partnership may increase the bases of its remaining capital gain assets only if the lower-tier partnership has a  § 754 election in effect.926 This rule is intended to prevent the deferral or avoidance of tax through the use of inconsistent basis adjustment elections for related partnerships. Thus, if an upper-tier partnership makes a liquidating distribution of its interest in a lower-tier partnership, the upper-tier partnership may not increase its bases in its assets unless the lower-tier partnership makes corresponding decreases to the bases of its assets.
——————————————————————————————

926 § 734(b) (last sentence). See Rev. Rul. 92-15 (situation 2).

——————————————————————————————

If the upper-tier partnership is entitled to a basis decrease under § 734(b)(2)(B) on the distribution, the upper-tier partnership may decrease the bases of its remaining capital gain assets regardless of whether the lower-tier partnership has a  § 754 election in effect. Note, however, that in both circumstances the  § 755 allocation rules must still be complied with.

Under § 761(e), the distribution of a lower-tier partnership interest is treated as an exchange for purposes of applying  § § 708 and 743. Thus, if an upper-tier partnership distributes a lower-tier partnership interest and the lower-tier partnership has a  § 754 election in effect,  § 743(b) adjusts the bases of the lower-tier partnership's assets, regardless of whether the upper-tier partnership has a  § 754 election in effect. This is true regardless of whether the upper-tier partnership has a  § 754 election in effect.

Example: B and C are partners in partnership UTP, and each has a 50% interest in the capital, profits, and losses of UTP. B's partnership interest in UTP has an adjusted basis of $0 and a fair market value of $160. UTP has no liabilities and only two properties, capital asset X and a 10% interest in the capital, profits, and losses of partnership LTP. Asset X has an adjusted basis to UTP of $140 and a fair market value of $240. UTP's interest in LTP has an adjusted basis of $30 and a fair market value of $80.

LTP has no liabilities and only two properties, capital asset Y and non-capital asset Z. Asset Y has an adjusted basis of $200 and a fair market value of $700. Asset Z has an adjusted basis of $0 and a fair market value of $100. UTP's share of the adjusted basis of LTP's properties is $20 ($200 x 10%). UTP and LTP make valid elections under § 754. Capital assets X and Y, and non-capital asset Z, are not  § 751 assets, and  § 732(d) does not apply to B.

UTP distributes one-half of capital asset X to partner B, reducing B's 50% interest in UTP to 20% and increasing C's interest to 80%. The distribution reduces the value of B's partnership interest in UTP to $40.

Under § 732(a)(1), B's basis in the distributed half of asset X would be equal to the basis of the distributed half of asset X to UTP immediately before the distribution, or $70. However,  § 732(a)(2) limits B's basis in the distributed half of asset X to B's basis in its UTP partnership interest, or $0. Because UTP has a  § 754 election in effect, UTP increases the adjusted basis of its remaining property by $70 (excess of the adjusted basis of the distributed property immediately before the distribution ($70)over the distributed property's basis to B ($0)) under § 734(b)(1)(B).

According to  § 755(b) and Regs. § 1.755-1(c)(1)(i), the basis adjustment to undistributed partnership property under  § 734(b)(1)(B) is allocated to remaining partnership property of a character similar to that of the distributed property. Thus, the adjustment applies to all of UTP's remaining property because the undistributed half of asset X and its interest in LTP are both, like asset X, capital assets. Regs.  § 1.755-1(c)(2)(i) requires that a  § 734(b) basis increase be allocated among appreciated assets within a class in proportion to the amount of unrealized appreciation in each asset. The $70 basis adjustment is allocated equally between UTP's two capital assets, because both assets have $50 of unrealized appreciation. Therefore, UTP increases its basis in the undistributed half of asset X from$70 to $105, and increases its basis in LTP from $30 to $65.

Because both UTP and LTP have made elections under § 754, UTP's distribution is an event that triggers a  § 734(b) basis increase in UTP's share of LTP's assets. The basis adjustment to undistributed partnership property under  § 734(b)(1)(B) is allocated to remaining partnership property of a character similar to that of the distributed property under  § 755(b) and Regs. § 1.755-1(c)(1)(i). Accordingly, LTP increases its basis in UTP's share of asset Y from$20 to $55. This adjustment to basis is for UTP only and does not affect the basis in LTP property of other partners of LTP. No adjustment is made to UTP's share of LTP's basis in non-capital asset Z.

Although B's interest in UTP is reduced from 50% to 20%, the reduction of B's interest in UTP is effected by a distribution and, in Rev. Rul. 92-15, the IRS cited (former) Regs.  § 1.708-1(b)(1)(ii) (redesignated as Regs.  § 1.708-1(b)(2))in ruling that such a distribution is not considered a sale or exchange of an upper-tier partnership interest for purposes of § 708.

Comment: The IRS ruled in Rev. Rul. 92-15 that UTP's distribution was an event that triggered a  § 734(b) basis increase to UTP's share of LTP's assets. This is a favorable result for taxpayers, because the basis increase reduces UTP's gain on a subsequent sale of asset Y by LTP. However, the IRS's reasoning is questionable. A § 734(b)(1)(B) adjustment is a partnership-level adjustment that causes the adjusted basis of a partnership's assets to be adjusted upon a partnership distribution. On the other hand, a  § 743(b) adjustment is an adjustment to the basis of partnership property with respect to the transferee partner only.927 Therefore, it seems that the IRS should have based the adjustment to LTP's assets (with respect to UTP) on § 743(b). The IRS probably relied on  § 734(b) because § 743 is triggered by a sale or exchange of a partnership interest or death of a partner, and neither of these events occurred under the facts of the ruling.
——————————————————————————————

927 See  § 743(b) (flush language).

——————————————————————————————

The IRS cautioned in the ruling that if a partner in an upper-tier partnership (with a  § 754 election in effect) receives a distribution in liquidation of the partner's interest and the partner has a higher basis in its partnership interest than in the distributed partnership property, the upper-tier partnership must decrease its adjusted basis in its remaining partnership property under § 734(b)(2). The IRS stated that if this adjustment results in a reduction in the upper-tier partnership's basis in its partnership interest in a lower-tier partnership that also has a  § 754 election in effect, the lower-tier partnership must decrease its adjusted basis in the upper-tier partnership's proportionate share of the lower-tier partnership's assets under  § 734(b)(2) as well.928
——————————————————————————————

928 Rev. Rul. 92-15, 1992-1 C.B. 215.

——————————————————————————————

Example: The facts are the same as in the preceding example, except that UTP distributes its partnership interest in LTP to partner B, reducing B's 50% interest in UTP to 33%. The distribution reduces the value of B's partnership interest in UTP to $80. Under § 732(a)(2), B's basis in the distributed LTP interest is equal to B's basis in its UTP partnership interest, or zero. Because both UTP and LTP have  § 754 elections in effect, UTP increases the adjusted basis of its remaining property (asset X) by $30, the excess of the adjusted basis of the distributed property to UTP immediately before the distribution ($30) over the basis of the distributed property to B ($0), under § 734(b)(1)(B). UTP makes this basis adjustment only because both UTP and LTP have elections in effect under § 754.(See the last sentence of § 734(b), which limits the applicability of § 734(b)(1)(B).)

Under § 761(e), UTP's distribution of its interest in LTP is treated as an exchange of the interest in LTP for purposes of § 743. Because LTP has a  § 754 election in effect, LTP decreases the adjusted basis of its property by $20, the excess of B's proportionate share of the adjusted basis of LTP's property ($20) over the basis of B's interest in LTP ($0), under § 743(b)(2). The $20 downward adjustment is treated as a $10 upward adjustment to non-capital asset Z and a $30 downward adjustment to capital asset Y pursuant to Regs. § 1.755-1(b)(2).

Observation: It is unclear to what extent Regs.  § 1.755-1(b)(5) applies to a  § 743(b) adjustment that arises in a distribution of a lower-tier partnership interest by an upper-tier partnership. Regs.  § 1.755-1(b)(5) applies special rules with respect to the allocation of the adjustment if there is an exchange in which the transferee's basis in the interest is determined in whole or in part by reference to the transferor's basis in the interest.929 In a transaction in which the distributee partner does not have sufficient basis in the partner's upper-tier partnership interest to take an adjusted basis in the distributed lower-tier partnership interest equal to the upper-tier partnership's basis in it, the distributee partner's (transferee's) basis, arguably, is not determined by reference to the upper-tier partnership's (the transferor's) basis. However, what happens in a transaction in which the distributee partner has sufficient adjusted basis in the partnership interest to take an adjusted basis in the distributed lower-tier partnership interest equal to the upper-tier partnership's basis in it? The fact that no basis adjustment applies in these circumstances with respect to the distribution does not necessarily preclude a basis adjustment on the deemed  § 743 transfer of the partnership interest. For example, if, in the preceeding example, B's adjusted basis in UTP had been $30, B's adjusted basis in the distributed partnership interest would be $30, and there would be no  § 734(b) adjustment. However, it appears that there would be a  § 743(b) adjustment of $10, reflecting the difference between B's adjusted basis of $30 and B's$20 share of LTP's adjusted basis in its assets. B's basis in the LTP interest is, arguably, determined by reference to UTP's basis in it, and, therefore, the special rules in Regs.  § 1.755-1(b)(5) could apply. There is no specific guidance in the regulations with respect to whether the drafters intended the rules to apply to the distribution of an LTP interest. The regulations appear to focus on transfers of interests in  § 721 or § 351 exchanges, but they do not limit application of the rules to these transactions.
——————————————————————————————

929 For a discussion of these special rules, see VII, C, 3, above.

——————————————————————————————

Under § 761(e), UTP's distribution of its interest in LTP in the example is treated as an exchange of a 10% interest in UTP for purposes of the partnership termination provisions in § 708. Under Regs. § 1.708-1(b)(2), the reduction of B's interest in UTP is not considered a sale or exchange for purposes of § 708.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  VIII. Special Basis Adjustment Applicable to Distributions of Partnership Property — § 734(b)

M. Application of § 734(b)to Partnerships Holding Long-Term Contracts 

As discussed in V, N, above, the distribution of a long-term contract by a partnership to a partner is a “constructive completion transaction,” in which the distributing partnership recognizes income at the time of the distribution.930 The distributee partner's basis in a distributed long-term contract and any  § 734(b) adjustments in undistributed partnership property are determined by reference to the long-term contract's adjusted basis in the partnership's hands immediately before the distribution.931 The partnership's adjusted basis in the contract is equal to (i) the partnership's “allocable contract costs” (all costs allocable to the contract under Regs. § 1.460-5), including transaction costs, (ii) increased (or decreased) by the amount of taxable income(or loss) the partnership has recognized on the contract through the date of distribution, including amounts recognized as a result of the constructive completion transaction, and (iii) decreased by amounts the partnership has received or reasonably expects to receive under the contract.932
——————————————————————————————

930 Regs. § 1.460-4(k)(2)(iv). A 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).

931 § § 732, 734(b).

932 Regs. § 1.460-4(k)(2)(iv)(D).

——————————————————————————————

Example: W, X, Y, and Z each contribute $100,000 to form an equal partnership in Year One. The partnership enters into a long-term contract in the same year. In Year One, the partnership incurs costs of $600,000 and receives $650,000 in payments under the contract. In Year Two, the partnership distributes the contract to X. The fair market value of the contract is $150,000. The partnership incurs no costs and receives no payments in Year Two. The partnership has a § 754 election in effect in Year Two. For Year One, the partnership reports a profit of $150,000; in Year Two, the partnership has a profit of $50,000.933 X's basis in X's partnership interest immediately before the distribution is $150,000 (X's initial $100,000 contribution + $37,500 (X's one-fourth distributive share of the partnership's Year One income of $150,000) + $12,500 (X's distributive share of Year Two income)). The partnership's basis in the contract immediately before the distribution is $150,000 (allocable contract costs ($600,000)+ income the partnership recognized through the date of distribution($200,000) minus amounts the partnership has received ($650,000)). Under § 732, X's basis in the distributed contract is $150,000. There is no  § 734(b) adjustment, because X's basis in the contract immediately after the distribution is equal to the partnership's basis in the contract immediately before the distribution.934

——————————————————————————————

933 For an explanation of how the distributing partnership determines its profits, and a computation of the partnership's profits in this example, see V, N, 1, above.

934 Regs.  § 1.460-4(k)(5) Ex. 9.

——————————————————————————————

For purposes of allocating the  § 734(b) basis adjustment under Regs.  § 1.755-1(c) to undistributed partnership property of a class similar to that of the distributed long-term contract, the amount of ordinary income or loss attributable to the long-term contract is equal to the amount of income or loss the partnership would have taken into account if, at the time the partnership interest is distributed, the partnership had disposed of the contract for its fair market value in a constructive completion transaction.935
——————————————————————————————

935 Regs. § 1.460-4(k)(3)(v)(B). For further discussion of these rules, in the context of  § 743(b) adjustments, see VII, B, 4, above.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

A. In General 

A partnership must make the  § § 743(b) and 734(b) basis adjustments if (i) the partnership has a  § 754 election in effect or(ii) the partnership has a substantial built-in loss (in the case of a  § 743(b) adjustment)or there is a substantial basis reduction with respect to a distribution(in the case of a  § 734(b) adjustment).936 If an election is made, the  § § 743(b) and 734(b) adjustments must be made whenever applicable to a transfer of a partnership interest or a distribution.
——————————————————————————————

936 § § 734(a), 743(a). For a discussion of the mandatory basis adjustment under § 734, see VIII, A, above. For a discussion of the mandatory basis adjustment under § 743, see VII, A, above.

——————————————————————————————

Note: If a  § 754 election is made, it applies to all distributions during the taxable year and all subsequent years as well. Thus, once a  § 754 election is in effect, both the  § 743(b) adjustment and the  § 734(b) adjustment become mandatory. A partnership may not limit application of its election to only transfers or only distributions.937
——————————————————————————————

937 Regs. § 1.754-1(a).

——————————————————————————————

The election is made by the partnership in a written statement filed with the partnership return for the taxable year during which the transfer occurs. The statement must include the name and address of the partnership, a statement that the partnership intends to make the election under  § 754 to apply the  § 743(b) and § 734(b) adjustments, and the signature of any partner.938
——————————————————————————————

938 Regs. § 1.754-1(b)(1). See the Worksheets for a sample election.

——————————————————————————————

Both the IRS and the courts have been stringent in the past in requiring a timely  § 754 election.939 However, Regs.  § 301.9100-2 provides an automatic 12-month extension from the original deadline to file an election to adjust basis on partnership transfers and distributions under § 754.940 In order to be eligible for this extension, however, the taxpayer must take corrective action within the 12-month extension period.941 Corrective action refers to filing an original or an amended return for the year for which the  § 754 election should have been made and attaching the appropriate form or statement for making the election.942
——————————————————————————————

939 See, e.g., Gindes v. U.S., 661 F.2d 194 (Ct. Cl.  1981), aff'd, 740 F.2d 947 (Fed. Cir.  1984); Jones v. U.S., 553 F.2d 667 (Ct. Cl.  1977); Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir.  1982).

940 Regs. § 301.9100-2(a)(2)(vi).

941 Regs. § 301.9100-2(a)(1).

942 Regs. § 301.9100-2(c).

——————————————————————————————

Taxpayers ineligible for the automatic extension may request an extension under Regs. § 301.9100-3, which provides that the IRS may grant extensions of time when the taxpayer establishes that it acted reasonably and in good faith and the grant of relief will not prejudice the interests of the government.943
——————————————————————————————

943 Regs. § 301.9100-3(a). See PLRs 200806001 (partnership return filed, but § 754 election inadvertently omitted), 200704023 (partnership reasonably relied on tax advisor), 200316021 (partnership's accountant failed to advise partnership of availability and benefits of election), 200316006 (partnership's accountant inadvertently failed to file election), 200303038 (extension granted when partnership's tax return was inadvertently filed without § 754 election but partnership filed income tax returns from that time forward in a manner consistent with having made election), 200249005 (extension granted when partner's widow failed to inform partnership accountant of partner's death and partnership return was filed without § 754 election). See also PLRs 201002026 (extension of time for filing § 754 election denied because taxpayer did not provide evidence to establish that taxpayer acted reasonably and in good faith, and that granting relief would not prejudice interests of government), 200917018 (taxpayer denied extension of time for filing § 754 election to adjust basis of partnership property because grant of relief would prejudice government's interests; noting that under Regs. § 301.9100-3(c)(1)(ii) government's interests are ordinarily prejudiced—absent independent auditor's statement to the contrary—if taxable year in which election should have been made, or taxable years that election would have affected, are closed by § 6501(a) limitations period on assessment before taxpayer receives ruling granting relief).

——————————————————————————————

The most significant factors appear to be the exercise of due diligence and prompt action on the part of the taxpayer.944 In Rev. Rul. 86-139,945 the IRS ruled that, under certain circumstances, it will grant an extension of time within which to make a  § 754 election even if the partnership fails to determine the need for an election until after a  § 708(b)(1)(A) termination.
——————————————————————————————

944 Compare PLR 9421038 (extension granted) with PLR 8915033 (extension denied). See also PLR 200626003 (request for extension denied because made with benefit of hindsight).

945 1986-2 C.B. 95.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

B. Tiered Partnerships 

As discussed in VII, F, above, if a partner in an upper-tier partnership transfers an interest in the partnership, the  § 743(b) adjustment is applicable with respect to the assets of both the upper-tier and the lower-tier partnership if both partnerships have a  § 754 election in effect. If, on the other hand, only the upper-tier partnership has a  § 754 election in effect, the adjustment applies only to the basis of the upper-tier partnership's assets. If only the lower-tier partnership has a  § 754 election in effect, the adjustment is not available with respect to either partnership's assets.946
——————————————————————————————

946 Rev. Rul. 87-115, 1987-2 C.B. 163; Rev. Rul. 78-2, 1978-1 C.B. 202.

——————————————————————————————

As discussed in VIII, L, above, if both partnerships have  § 754 elections in effect, and the upper-tier partnership distributes property other than an interest in the lower-tier partnership, any  § 734(b) adjustment to the upper-tier partnership's basis in the lower-tier partnership interest flows through to increase or decrease the lower-tier partnership's bases in its capital gain assets, although the adjustment is for the upper-tier partnership only and does not affect the basis in lower-tier partnership property of other partners of the lower-tier partnership. If the upper-tier partnership distributes its interest in the lower-tier partnership to a partner of the upper-tier partnership while both partnerships have  § 754 elections in effect, and if  § 732(a)(2) applies to the distributed partnership interest, the upper-tier partnership increases the basis of its undistributed property to the extent provided in § 734(b)(1)(B).947
——————————————————————————————

947 Rev. Rul. 92-15, 1992-1 C.B. 215.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

C. Revocation of the Election 

Once a partnership files a  § 754 election, it applies to the year for which it is filed as well as all subsequent taxable years until and unless it is formally revoked.948 The ability to revoke an election is subject to any limitations provided in the regulations.949
——————————————————————————————

948 § 754;Regs. § 1.754-1(a).

949 Due to all of the changes in the final regulations under  § § 743 and 755 relevant to computation and allocation of the  § 743(b) adjustment, the regulations under  § 754 were amended to allow a partnership a one-time opportunity to revoke the § 754 election. A partnership with a  § 754 election in effect for its taxable year that included Dec. 15, 1999 could revoke the election effective for transfers or distributions occurring on or after Dec. 15, 1999, by attaching a statement to the partnership's return for the taxable year. Regs. § 1.754-1(c)(2). The statement had to be filed no later than the time prescribed for filing the return (including extensions).

——————————————————————————————

To revoke a  § 754 election, the partnership generally must file an application reciting the basis on which the revocation was being requested.950 The application has to be filed with the district director for the district in which the partnership filed its return. The filing has to take place within 30 days after the close of the partnership's taxable year with respect to which the revocation is requested and must be signed by one of the partners. The following circumstances are listed in the regulations as examples of sufficient grounds for revocation: (i) a change in the nature of the partnership business; (ii) a substantial increase in the assets of the partnership; (iii) a change in the character of partnership assets; and (iv) an increased frequency of retirements or shifts of partnership interests, so that an increased administrative burden would result to the partnership from the election.951
——————————————————————————————

950 Regs. § 1.754-1(c)(1).

951 Regs. § 1.754-1(c)(1).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

D. Partnership Terminations 

Section 708(b)(1)(B) provides that a partnership terminates upon the sale or exchange of 50% or more of the interests in partnership capital and profits within a 12-month period. If the terminating partnership has a  § 754 election in effect for the taxable year of termination, the election applies to an incoming partner. Therefore, the bases of the partnership assets are adjusted pursuant to  § § 743 and 755 before their deemed contribution to the new partnership. A  § 743 adjustment in the terminating partnership carries over to the new partnership, even if the new partnership does not make an election under § 754.952
——————————————————————————————

952 See Regs. § 1.708-1(b)(5).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

E. Election by Foreign Partnership 

A  § 754 election must be made in a written statement filed with the partnership return.953 Regs.  § 1.6031(a)-1(b)(1) provides that a foreign partnership is not required to file a return if it does not have any gross income effectively connected with the conduct of a trade or business within the United States and does not derive any gross income from sources within the United States. However, if a U.S. citizen or resident is a partner in such a foreign partnership and an election under  § 761 (relating to the election to be excluded from subchapter K, chapter 1 of the Code) is to be made by or for the partnership, the partnership must file a Form 1065.954 Even if no return is otherwise required to be filed by a foreign partnership, it must file a partnership return and attach a statement making the  § 754 election, in order for the election to be given effect.955
——————————————————————————————

953 Regs. § 1.754-1(b).

954 Regs. § 1.6031(a)-1(c)(1).

955 Regs. § 1.754-1(b).

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Detailed Analysis 
  IX. Election to Make Adjustment—§ 754

F. Relationship Between § 754 Election and § 197 Retroactive Transition Election 

Section 197 provides that the capitalized costs of certain enumerated “Section 197 intangibles” (including goodwill and going concern value) may be ratably amortized over a 15-year amortization period beginning in the month of acquisition. This provision generally applies to property acquired after the date of enactment. However, the regulations under  § 197 provide for a retroactive election to apply  § 197 to property acquired after July 25, 1991, and on or before August 10, 1993 (“transition property”). Regs. § 1.197-1T(c)(2)(i) provides that generally, for purposes of transition period property owned by a partnership, only the partnership may make the retroactive election. Regs.  § 1.197-1T(c)(2)(ii) provides, however, that with respect to any increase in basis treated as transition period property under Regs. § 1.197-1T(b)(8), only the partner may make the retroactive election. If a  § 754 election is in effect, any increase in basis under  § 734(b) or  § 743(b) is to be taken into account by a partner as if the increased basis were attributable to the partner's acquisition of the underlying property on the date of the distribution or transfer.956
——————————————————————————————

956 Regs. § 1.197-1T(b)(8).

——————————————————————————————

In Notice 94-41,957 the IRS determined that the exception in Regs.  § 1.197-1T(c)(2)(ii) (requiring the partner to make the retroactive election), as applied to the  § 734(b) basis adjustment, was too burdensome administratively. Therefore, effective March 15, 1994, Regs.  § 1.197-1T(c)(2)(ii) applies only to the  § 743(b) adjustment. Thus, only the partnership is permitted to make a retroactive election with respect to a basis increase under § 734(b). In contrast, the partner makes the retroactive election with respect to a basis increase under § 743(b).
——————————————————————————————

957 1994-1 C.B. 353.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

B-101
	
IRS PUBLICATIONS AND RULINGS

B-101
	
Worksheet 1
	
IRS Publication 541, “Partnerships”(including Form 1065).

B-201
	
Worksheet 2
	
Notice 2005-32, 2005-16 I.R.B. 895.

B-301
	
SAMPLE ELECTION AND COMPLIANCE STATEMENTS AND PARTNERSHIP AGREEMENT PROVISIONS

B-301
	
Worksheet 3
	
Sample § 754 Election, Computation, and Revocation Statements and Partnership Agreement Provision.

B-401
	
Worksheet 4
	
Sample Partnership's Basis Adjustment Computation Statement per 
 Regs. § 1.734-1(d).

B-501
	
Worksheet 5
	
Sample Election Under § 732(d)to Adjust the Basis of Distributed 
 Property (Regs. § 1.732–1(d)).

B-601
	
Worksheet 6
	
Partnership's Basis Adjustment Computation Statement  (Regs. § 1.743-1(k)(1)).

B-701
	
REFERENCE GUIDE AND FLOW CHARTS ON § 752 REGULATIONS 

B-701
	
Worksheet 7
	
Allocation of Recourse Debt:1991 Final Regulations and 1988
 Temporary Regulations.

B-801
	
Worksheet 8
	
Allocation of Nonrecourse Debt: 1991 Final Regulations and 1988 
 Temporary Regulations.

B-901
	
Worksheet 9
	
Section 752 Regulations Effective Date and Transition Rules.

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 1 IRS Publication 541, “Tax Information on Partnerships” (including Form 1065) 

IRS Publication 541

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 2 Notice 2005-32, 2005-16 I.R.B. 895 

Part III - Administrative, Procedural, and Miscellaneous 

Interim Rules and Procedures for Partnerships Under Section 833 of the American Jobs Creation Act of 2004 

Notice 2005-32 

Section 1. PURPOSE 

The American Jobs Creation Act of 2004, P.L. 108-357, 118 Stat. 1418 (the Act), was enacted on October 22, 2004. The Treasury Department and the Internal Revenue Service intend to issue regulations implementing sections 833 and 834 of the Act, which amended sections 704, 734, 743, and 6031 of the Internal Revenue Code. This notice provides interim procedures for partnerships and their partners to comply with the mandatory basis provisions of sections 734 and 743, as amended by the Act. This notice also provides interim procedures for electing investment partnerships(EIPs) and their partners to comply with sections 743(e) and 6031(f), as provided in section 833(b) of the Act.

Section 2. BACKGROUND 

Section 833(c) of the Act requires basis adjustments to be made following certain distributions from partnerships for which no section 754 election is in effect. As amended by section 833(c) of the Act, section 734(a) and (b) requires a partnership to reduce its basis in partnership property upon a distribution of partnership property after October 22, 2004 if there is a “substantial basis reduction.” Under section 734(d), there is a substantial basis reduction if a downward adjustment of more than $250,000 would be made to the basis of partnership assets if a section 754 election were in effect at the time of the distribution. EIPs, like other partnerships, are required to make any basis adjustments that are required under section 734 upon the distribution of partnership property.

Section 833(b) of the Act requires basis adjustments to be made following certain transfers of interests in partnerships for which no section 754 election is in effect. As amended by section 833(b) of the Act, section 743(a) and (b) requires a partnership to reduce the basis of partnership property upon a transfer after October 22, 2004 of an interest in the partnership by sale or exchange or upon the death of a partner, if, at the time of the relevant transfer, the partnership has a “substantial built-in loss.” Section 743(d)(1) provides that, for purposes of section 743, a partnership has a substantial built-in loss with respect to a transfer of a partnership interest if the partnership's adjusted basis in the partnership's property exceeds by more than $250,000 the fair market value of the property.

Section 833(b) of the Act also provides that an EIP is not treated as having a substantial built-in loss, and thus is not required to make basis adjustments to partnership property, with respect to any transfer of a partnership interest occurring while an election to be treated as an EIP is in effect. In lieu of the partnership basis adjustments otherwise required under section 743, a partner-level loss disallowance rule applies. Section 743(e)(2) provides that, in the case of a transfer of an interest in an EIP, the transferee partner's distributive share of the losses, without regard to gains, from the sale or exchange of partnership property is not allowed, except to the extent that it is established that the losses exceed the loss recognized on the transfer of the partnership interest by the transferor partner (or by a prior transferor to the extent not fully offset by a prior disallowance under section 743(e)(2)). Under section 743(e)(3), losses disallowed under this rule do not decrease the transferee partner's basis in its partnership interest. Section 743(e) is to be applied without regard to any termination of the partnership under section 708(b)(1)(B). In the case of a basis reduction to property distributed to the transferee partner in a nonliquidating distribution, section 743(e)(5) provides that the amount of the transferor's recognized loss taken into account under section 743(e)(2) is reduced by the amount of the basis reduction under section 732(a)(2).

Section 743(e)(6), as added by the Act, provides that an EIP means any partnership if (A) the partnership makes an election to have section 743(e) apply, (B) the partnership would be an investment company under section 3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption under paragraph (1) or (7) of section 3(c)of such Act, (C) the partnership has never been engaged in a trade or business, (D) substantially all of the assets of the partnership are held for investment, (E) at least 95 percent of the assets contributed to the partnership consist of money, (F) no assets contributed to the partnership had an adjusted basis in excess of fair market value at the time of contribution, (G) all partnership interests of the partnership are issued by the partnership pursuant to a private offering before the date which is 24 months after the date of the first capital contribution to the partnership, (H) the partnership agreement of the partnership has substantive restrictions on each partner's ability to cause a redemption of the partner's interest, and (I) the partnership agreement of the partnership provides for a term that is not in excess of 15 years. However, in the case of an EIP which is in existence on June 4, 2004, section 743(e)(6)(H) does not apply to the partnership, and section 743(e)(6)(I) is applied by substituting “20 years” for “15 years”.

Section 743(e)(7) provides that the Secretary shall prescribe regulations as may be appropriate to carry out the purposes of section 743(e), including regulations for applying section 743(e) to tiered partnerships.

Section 6031(f) provides that in the case of any EIP, the information required under section 6031(b) to be furnished to any partner to whom section 743(e)(2) applies shall include information as is necessary to enable the partner to compute the amount of losses disallowed under section 743(e).

Section 3. INTERIM PROCEDURES RELATING TO BASIS ADJUSTMENTS REQUIRED UNDER SECTION 833 OF THE ACT 

Sections 1.734-1(d) and 1.743-1(k) of the Income Tax Regulations require partnerships and partners to provide certain statements following distributions with respect to partnership interests, and transfers of partnership interests, in partnerships for which an election under section 754 is in effect. The Treasury Department and the Service intend to amend the regulations under sections 734 and 743 to require partnerships and partners to provide statements, similar to those contained in sections 1.734-1(d) and 1.743-1(k), following any distributions and transfers that trigger basis adjustments under section 833(b) or (c) of the Act.

Until further guidance is provided, partnerships that are required to reduce the bases of partnership properties under section 833(c) of the Act must comply with section 1.7341(d) as if an election under section 754 were in effect at the time of the relevant distribution. Partnerships that are required to reduce the bases of partnership properties under section 833(b) of the Act must comply with section 1.743-1(k)(1) as if an election under section 754 were in effect at the time of the relevant transfer. The transferee of an interest in a partnership that is required to reduce the bases of partnership properties under section 833(b) of the Act must comply with section 1.743-1(k)(2), within the time prescribed under section 1.743-1(k)(2) (or, if later, by May 19, 2005), as if an election under section 754 were in effect at the time of the relevant transfer. In addition, partnerships that are required to reduce the bases of partnership properties under section 833(b)of the Act may rely on, and must comply with, section 1.7431(k)(3),(4), and (5) as if an election under section 754 were in effect at the time of the relevant transfer.

Section 4. INTERIM PROCEDURES FOR EIP ELECTION 

Until further guidance is provided, a partnership must make the election to be treated as an EIP by attaching a written statement to an original or amended partnership return for the taxable year for which the election is effective. The statement must (i) set forth the name, address, and tax identification number of the partnership making the election,(ii) contain a representation that the partnership is eligible to make the election under section 743(e)(6)(A), and (iii) contain a declaration that the partnership elects under section 743(e) to be treated as an EIP. If a partnership has filed a return with respect to a taxable year that includes October 22, 2004, and desires to elect to be treated as an EIP for transfers after October 22, 2004, but did not attach a statement satisfying the requirements of this paragraph, then the partnership must file an amended return with a statement satisfying those requirements.

For the election to be valid, the original or amended return must be filed not later than six months after the time prescribed by section 1.6031(a)-1(e) of the Procedure and Administration Regulations (excluding extensions thereof)for filing the return for the taxable year for which the election is effective. Once an election is made, it is effective for all succeeding taxable years, unless terminated or revoked, as described below. In the case of an election filed for the partnership's taxable year that includes October 22, 2004, the election is effective for all transfers occurring after October 22, 2004. In all other cases, the election is effective for all transfers during the partnership's taxable year for which the election is effective. A partnership that has an election under section 754 in effect is ineligible to make an election to be treated as an EIP. If the partnership is not otherwise required to file a partnership return, the election to be an EIP shall be made in accordance with the rules of section 1.6031(a)-1(b)(5).

The election to be treated as an EIP shall terminate if the partnership fails to meet the definition of an EIP. In this case, the partnership will become subject to the mandatory basis adjustment rules with respect to the first transfer of a partnership interest that occurs after the partnership ceases to meet the definition of an EIP and to each subsequent transfer. An EIP also may terminate its election to be treated as an EIP without the consent of the Commissioner by filing an election under section 754. In this case, the partnership will become subject to the mandatory basis adjustment rules with respect to the first transfer of a partnership interest that occurs after the effective date of the election under section 754. In all other cases, except as provided in future guidance, a partnership having an election in effect to be treated as an EIP may revoke the election only with the consent of the Commissioner. The application for consent to revoke the election must be submitted to the Service in the form of a letter ruling request. If an election to be treated as an EIP is terminated, any losses that are subsequently allocated to a partner to whom a partnership interest was transferred while the EIP election was in effect shall remain subject to disallowance under section 743(e)(2).

Section 5. INTERIM REPORTING REQUIREMENTS 

A. Transferor Partner Required to Provide Information to Transferee Partner and Partnership 

Until further guidance is provided, if a partnership interest in an EIP is transferred in a sale or exchange or upon the death of a partner, the transferor (or, in the case of a partner who dies, the partner's executor, personal representative, or other successor in interest)must notify the transferee and the EIP in writing. The notice must be provided within 30 days after the date on which the transferor partner (or the executor, personal representative or other successor in interest) receives Schedule K-1 from the EIP for the partnership's taxable year in which the transfer occurred (or, if later, by May 19, 2005). The notice must be signed under penalties of perjury and must include (i) the name, address, and tax identification number of the transferor, (ii) the name, address, and tax identification number of the transferee (if ascertainable), (iii) the name of the partnership, (iv) the date of the transfer (and, in the case of the death of a partner, the date of the death of the partner), (v) the amount of loss, if any, recognized by the transferor on the transfer of the interest, together with the computation of the loss, (vi) the amount of losses, if any, recognized by any prior transferors to the extent the losses were subject to disallowance under section 743(e)(2) in the hands of a prior transferee and have not been offset by prior loss disallowances under section 743(e)(2), and (vii) any other information necessary for the transferee to compute the amount of loss disallowed under section 743(e)(2). If the transferor is a nominee (within the meaning of section 1.6031(c)-1T), then the nominee, and not the beneficial owner of the transferred interest, must supply the information to the transferee of the interest and to the EIP.

The transferee and the EIP shall retain the notice described in this Section 5.A as long as the contents thereof may become material in the administration of any internal revenue law.

B. Distributive Shares of Partnership Items of EIP 

Because the amount of losses disallowed under section 743(e) is determined without regard to gains, an EIP is required to separately state on Schedule K and K-1 of the partnership's return (Form 1065) all allocations of losses to all of its partners under section 1.702-1(a)(8)(ii), including losses that, in the absence of section 743(e), could be netted against gains at the partnership level. If a partnership has filed a return with respect to a taxable year that includes October 22, 2004 in which gain and losses were not separately stated, the EIP must, prior to the expiration of the period for making an EIP election for that year, file an amended return in which gains and losses are separately stated. If a partnership's election to be treated as an EIP is terminated, the partnership must continue to state such gains and losses separately in future returns relating to any period during which the partnership has one or more transferee partners that are subject to section 743(e)(2). If an EIP is not required to file a partnership return, the transferee of a partnership interest in the EIP may be required to provide to the Service similar information regarding the partner's distributive share of gross gains and losses of the EIP under section 1.6031(a)-1(b)(4).

C. Partnership Required to Provide Annual Statements to Partners 

Until further guidance is provided, an EIP must provide the following statement to all of its partners. The statement shall be attached to every statement provided to a partner or nominee under section 6031(b) that is issued with respect to any taxable year for which an election to be treated as an EIP is in effect (whether or not the election is in effect for the entire taxable year). If an EIP has provided statements under section 6031(b) with respect to a taxable year that includes October 22, 2004, and elects to be treated as an EIP for that year, but did not include the statements required by this section 5.C., then the EIP must provide amended statements under section 6031(b), prior to the expiration of the period for making an EIP election for that year, which do include the required statements.

Notice of Election. This partnership has elected to be treated as an electing investment partnership under section 743(e) of the Internal Revenue Code.

 Information for Transferors. If you transfer an interest in this partnership to another person, Notice 2005-32, 2005-16 I.R.B. 895, provides that you must, within 30 days after receiving a Schedule K-1 from this partnership for the taxable year that includes the date of the transfer, provide the transferee with certain information, including the amount, if any, of loss that you recognized on the transfer of the partnership interest, and the amount of losses, if any, recognized by prior transferors with respect to the same interest. See Notice 2005-32 for more information.

 Information for Transferees. If an interest in this partnership is transferred to you, section 743(e)(2) requires that you reduce your distributive share of losses from this partnership, determined without regard to gains from this partnership, to the extent of any losses recognized by the transferor partner when that partner transferred the partnership interest to you (and to the extent of other losses recognized on prior transfers of the same partnership interest that have not been offset by prior loss disallowances). Each year, you must reduce your share of losses as reported to you by this partnership by the amount of any loss recognized by the transferor partner (or any prior transferor to the extent not already offset by prior loss disallowances) until you have reduced your share of partnership losses by the total amount of losses required to be disallowed. If the transferor partner, or its legal representative in the case of a transfer by death, fails to provide you with the required statement, you must treat all losses allocated from the EIP as disallowed under section 743(e)(2) unless you obtain, from the EIP or otherwise, the information necessary to determine the proper amount of losses disallowed under section 743(e)(2). See Notice 2005-32 for more information. 

D. Effects of Failure to Notify Transferee Partner 

If the transferor partner, or its legal representative in the case of a transfer by death, fails to provide the transferee partner with the statement required by Section 5.A of this notice with respect to a transfer of an interest in the EIP, the transferee partner must treat all losses allocated from the EIP as disallowed under section 743(e)(2) unless the transferee partner obtains, from the EIP or otherwise, the information necessary to determine the proper amount of losses disallowed under section 743(e)(2). If the transferee does not have the information necessary to determine the proper amount of losses disallowed under section 743(e)(2), but does have information sufficient to determine the maximum amount of losses that could be disallowed, then the transferee may treat the amount of losses disallowed under section 743(e)(2) as being equal to that maximum amount. For example, if the transferee is able to ascertain the adjusted basis that a prior transferor had in its partnership interest, but is not able to ascertain the amount realized by that transferor, the transferee may assume, for purposes of calculating the amount of losses disallowed under section 743(e)(2), that the sales price when the prior transferor sold its interest was zero. If, following the filing of a return pursuant to the previous sentence, the transferor partner or the EIP provides the required information to the transferee partner, the transferee partner should make appropriate adjustments in an amended return for the year of the loss allocation from the EIP in accordance with section 6511 or other applicable rules.

Section 6. CHARACTER OF LOSSES DISALLOWED UNDER SECTION 743(e)(2) 

Until further guidance is issued, if an EIP allocates losses with a different character from the sale or exchange of property to the transferee(such as ordinary or section 1231 losses and capital losses) and the losses allocated to that partner are limited by section 743(e)(2), then a proportionate amount of the losses disallowed under section 743(e)(2) shall consist of each loss of a separate character that is allocated to the transferee partner.

Section 7. TRADES OR BUSINESSES OF LOWER-TIER PARTNERSHIPS 

As noted above, a partnership that is engaged in a trade or business, or that has previously engaged in a trade or business, is not eligible to elect to be treated as an EIP. The Treasury Department and the Service are studying the conditions under which a partnership (“upper-tier partnership”) that holds interests in one or more partnerships(“lower-tier partnerships”) that are engaged in a trade or business should be treated as engaged in a trade or business.

Until further guidance is issued, an upper-tier partnership will not be treated as engaged in the trade or business of a lower-tier partnership if, at all times during the period in which the upper-tier partnership owns an interest in the lower-tier partnership, the adjusted basis of its interest in the lower-tier partnership is less than 25 percent of the total capital that is required to be contributed to the upper-tier partnership by its partners during the entire term of the upper-tier partnership. This notice does not address the situation in which the upper-tier partnership's adjusted basis in its lower-tier partnership interest is, at any time, 25 percent or more of the total capital that is required to be contributed to the upper-tier partnership by its partners during the entire term of the upper-tier partnership.

The Treasury Department and the Service specifically request comments on rules that may be appropriate for future guidance. Factors that may be relevant in future guidance in determining whether an upper-tier partnership is treated as engaged in a trade or business that is conducted by a lower-tier partnership include (i) the relative amount of the upper-tier partnership's investment in the lower-tier partnership as compared to the total capital that is required to be contributed to the upper-tier partnership by its partners during the entire term of the upper-tier partnership, (ii) the degree to which the upper-tier partnership participates in the management of the lower-tier partnership's activities, and (iii) the motivations for the formation of the upper-tier partnership in making the investments in the lower-tier partnership.

The Treasury Department and the Service may adopt rules in future guidance that are more restrictive than the safe harbor provided for above. If a partnership that qualifies as an EIP under the safe harbor does not qualify as an EIP under future guidance, the partnership's election to be treated as an EIP will terminate for transfers occurring on or after the date on which such future guidance becomes effective.

Section 8. EXAMPLES 

A. Transfer of Partnership Interest 

PRS is a partnership which does not have an election under section 754 in effect. PRS has no liabilities. The fair market value of PRS‘s assets is $4 million and the adjusted basis of PRS‘s assets is $4.3 million. Under section 743(d), PRS has a substantial built-in loss because the adjusted basis of the partnership property exceeds the fair market value of the partnership property by more than $250,000. A , a partner of PRS, sells a 25 percent partnership interest in PRS to B for its fair market value of $1 million. Under section 743(b), an adjustment is required to the adjusted basis of PRS‘s assets with respect to B. Under Section 3 of this notice, B must provide the written notice described in section 1.743-1(k)(2) to PRS within 30 days after the sale, and PRS must attach the statement described in section 1.743-1(k)(1) to the partnership return for the year of the transfer.

B. Distribution of Partnership Property 

A and B each contribute $2.5 million and C contributes $5 million to a newly formed partnership, PRS, which does not have an election under section 754 in effect. PRS has no liabilities. PRS purchases LMN stock for $3 million and XYZ stock for $7 million. The value of each stock declines to $1 million. PRS distributes LMN stock to C in complete liquidation of C‘s interest in PRS. Under section 732(b), the basis of LMN stock in C‘s hands is $5 million and C would recognize a loss of $4 million if the LMN stock were sold for $1 million. There is a substantial basis reduction within the meaning of section 734(d), because the $2 million increase in the adjusted basis of LMN stock (described in section 734(b)(2)(B)) is greater than $250,000. Under section 734(b), PRS is required to decrease the basis of XYZ stock by $2 million (the amount by which the basis of LMN stock was increased), leaving a basis of $5 million remaining in the XYZ stock. Under Section 3 of this notice, PRS must attach the statement described in section 1.7341(d) to the partnership return for the year of the distribution.

C. EIP 

(i) PRS is a domestic partnership with a calendar year taxable year that desires to elect to be treated as an EIP for 2004 and all succeeding taxable years. PRS and all of its partners have a calendar year taxable year. PRS has no liabilities. Other than the making of the election, PRS meets all other requirements to be an EIP under section 743(e)(6). PRS elects to be treated as an EIP by attaching a statement to its income tax return for 2004 in accordance with Section 4 of this notice.

(ii)Between October 22 and December 31, 2004, the only transfer of a partnership interest in PRS occurred on November 30, 2004, when A transferred a 10 percent partnership interest to C. The purchase price for the 10 percent partnership interest was $3,000,000. A‘s adjusted basis in A‘s partnership interest on December 31, 2003 was $3,000,000. In 2004, the partnership's only items of income, gain, loss, and deduction are $3 million of long-term capital gain and $2 million of long-term capital loss. Because PRS has elected to be treated as an EIP, PRS must separately state this gain and loss on its return in accordance with Section 5.B of this notice.

(iii)If A had remained a partner for the entire year, A‘s distributive share of the partnership's items would have been $300,000 of long-term capital gain and $200,000 of long-term capital loss. Assume that under section 706, A‘s distributive share of these items are properly determined to be 334/365 of each of these amounts, or $274,521 of long-term capital gain and$183,014 of long-term capital loss, and that C‘s distributive shares of these items are properly determined to be 31/365 of each of these amounts, or $25,479 of long-term capital gain and$16,986 of long-term capital loss.

(iv) PRS must provide a statement to all of its partners in accordance with Section 5.C of this notice. The statement must be attached to each partner's Schedule K-1 for PRS‘s taxable year ending December 31, 2004. Assume that A receives A‘s Schedule K-1 on March 12, 2005. Within 30 days after receiving this Schedule K-1, A must provide statements to C and EIP as described in Section 5.A of this notice.

(v)The adjusted basis in A‘s partnership interest on November 30, 2004, $3,091,507, equals A‘s adjusted basis on December 31, 2003, $3,000,000, plus A‘s distributive share of partnership gain in 2004, $274,521, less A‘s distributive share of partnership loss in 2004,$183,014. The amount of loss recognized by A on the sale of A‘s partnership interest is $91,507, which equals the adjusted basis in A‘s partnership interest on the date of the sale, $3,091,507, less the amount realized by A, $3,000,000. Thus, the first $91,507 of gross loss allocated to C is disallowed under section 743(e)(2). The entire amount of C‘s long-term capital loss in 2004, $16,986, is disallowed under section 743(e)(2). The first $74,521 of any gross loss allocated to C in future years will also be disallowed under section 743(e)(2), regardless of whether PRS is an EIP in those future years.

(vi) C‘s adjusted basis as of December 31, 2004 is $3,025,479, the sum of C‘s purchase price paid for A‘s interest, $3,000,000, plus the distributive share of gain allocated to C, $25,479. Under section 743(e)(3), the $16,986 loss allocated to C , but disallowed under section 743(e)(2), does not reduce the basis of C‘s partnership interest.

Section 9. REQUEST FOR COMMENTS 

The Treasury Department and the Service intend to issue further guidance implementing sections 833 and 834 of the Act, including guidance addressing the application of these provisions to tiered partnership structures. Comments are requested concerning the scope and content of this guidance. In particular, comments are requested concerning the application of these provisions to tiered partnerships and the reporting obligations that should be imposed on tiered partnerships and their partners. As stated earlier, comments are also requested on the rules provided in Section 7 of this Notice. Comments should be submitted in writing on or before July 19, 2005 and should include a reference to Notice 2005-32. Comments may be submitted to CC:PA:LPD:PR (Notice 2005-32), Room 5226, Internal Revenue Service, PO box 7604, Ben Franklin Station, Washington, DC 20044. Alternatively, comments may be submitted electronically via the following e-mail address: Notice.Comments@irscounsel.treas.gov. Please include “Notice 2005-32 “in the subject line of any electronic communications.

Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to CC:PA:LPD:PR (Notice 2005-32), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224.

PAPERWORK REDUCTION ACT 

The collections of information contained in this notice have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1939. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

The collections of information in this notice are in Sections 3, 4, and 5. This information is required, and will be used, to assure compliance with the new provisions of the American Jobs Creation Act of 2004. The collections of information are required to obtain a benefit or are mandatory. The likely respondents are individuals and businesses or other for-profit institutions. The estimated total annual reporting burden and/or recordkeeping burden is 552,100 hours.

The estimated annual average burden per respondent/recordkeeper varies from is 0.05 hours to 3 hours, depending on individual circumstances, with an estimated average of 2.07 hours.

The estimated number of respondents and/or recordkeepers is 266,400.

The estimated annual frequency of responses (used for reporting requirements only) is various.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

DRAFTING INFORMATION 

The principal author of this notice is Sean I. Kahng of the Office of Associate Chief Counsel (Passthroughs &  Special Industries). However, other personnel from the Treasury Department and the Service participated in its development. For further information regarding this notice, contact Mr. Kahng at (202) 622-3050 (not a toll-free call).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 3 Sample § 754 Election, Computation, and Revocation Statements
 and Partnership Agreement Provision 

Section 754 Election Fact Pattern 

The fact pattern below and the following worksheets illustrate an election under § 754 to adjust the basis of partnership property in the manner specified by § 743(b), and a revocation of the election.

Fact Pattern 

On January 1, Year One, individuals A, B, and C form ABC Associates (the “Partnership”). Each partner contributes $200,000 in cash for a 1/3 interest in partnership capital and profits. The Partnership reports its income on a calendar year basis. The Partnership is engaged in the activity of investing in land for speculative purposes. The partnership agreement contains a provision requiring the Partnership to make an election under § 754 upon the transfer of a partnership interest or a distribution, at the request of a transferor, transferee, or distributee.

In Year Two, the Partnership acquires a tract of land for $600,000. In June, Year Three, the municipal transit authority announces that it will construct a subway station near the land owned by the Partnership. The value of the land increases to $900,000. On October 1, Year Three, C sells his entire interest in the Partnership to X for $300,000. The Partnership attaches an election to adjust the basis of partnership property pursuant to § 754 to its Form 1065 (U.S. Partnership Return of Income) for Year Three. In addition, the Partnership attaches a computation of the adjustment to the basis of partnership property with respect to X resulting from the election.

In August, Year Four, the Partnership sells the land for $900,000. X attaches to his individual income tax return for Year Four a computation statement reflecting the adjustment to his basis in the land and the effect of the § 754 election on the tax consequences of the sale of the property.

In Year Five, the partners decide to change the activity of the Partnership to the business of residential real estate development. In order to finance the proposed venture, the Partnership plans to admit as many as 50 new partners. The proceeds from the capital contributions will be used to purchase and improve various tracts of land. The partnership interests will be freely transferable. Due to the change in the nature of the Partnership's business and the anticipated increased frequency of shifts in partnership interests, the Partnership attaches to its Form 1065 for Year Five a request to revoke its § 754 election.

Partnership Agreement Provision Requiring
 Partnership to Make § 754 Election Upon Request 

GENERAL PARTNERSHIP AGREEMENT
 OF
 ABC ASSOCIATES 

* * * 

Section 9
 ELECTIONS 

* * * 

Section 9.5 — Section 754 Election. In connection with any transfer of or distribution with respect to a partnership interest, the Managing Partner shall, upon written request by any transferor, transferee, or distributee, cause the Partnership to make an election pursuant to I.R.C. § 754 and Regs. § 1.754–1(b) to adjust the basis of partnership property in the manner provided in I.R.C. § § 734(b) and 743(b). Such transferor, transferee, or distributee shall pay all costs incurred by the Partnership in connection with such election.

Election to Adjust Basis of Partnership Property Pursuant to Section 754 

Election Pursuant to I.R.C. Section 754 

ABC Associates hereby elects under I.R.C. § 754 and Regs. § 1.754–1(b)(1)to apply the provisions of I.R.C. § § 734(b) and 743(b) beginning with the taxable year ending December 31, 200X.  
___________	 	__________________	 	
Date	 	Signature	 	
 	 	Mr. A	 	
 	 	Partner, ABC Associates	 	
 	 	1000 Pennsylvania Avenue	 	
 	 	Washington, D.C. 20016	 	

[The election statement should be attached to Form 1065 for the taxable year in which the election is to become effective.]

Partnership Computation Statement for § 754 Election 

ABC Associates

200X Form 1065

Attachment to Question R

Adjustment to Basis of Property 

Resulting From  I.R.C. Section 754 Election 

Balance Sheet as of December 31, 200X	
Assets	
  
 	 	Adjusted Basis	Value	 	
 	Land	$600,000	$900,000	 	
 	 	Capital	 	 	
 	Mr. A	200,000	300,000	 	
 	Mr. B	200,000	300,000	 	
 	Mr. X	200,000	300,000	 	
 	 	$600,000	$900,000	 	
  
Computation of Adjustment to Mr. X's Basis in Property	

Mr. X's proportionate share of partnership's basis in property	 	$200,000	
Computation of section 743(b) adjustment:	 	 	
Mr. X's basis in his partnership interest
   less	300,0001 	 	
Mr. X's proportionate share of partnership's basis in property	200,000 	 	
Section 743(b) adjustment	 	100,000	
Mr. X's adjusted basis in partnership property	 	$300,000	

——————————————————————————————

1  Mr. X purchased a 1/3 interest in the capital and profits of ABC Associates on October 1, Year One from Mr. C for $300,000.

——————————————————————————————

Computation Statement for Partner's
 Return Reflecting § 754 Adjustment 

Mr. X

200X Form 1040

Attachment to Schedule D, Line 12

Adjustment of Partner's Basis in Partnership Property Sold Pursuant to Sections 754 and 743(b) 

On October 1, Year One, Mr. X purchased a one–third interest in the capital and profits of ABC Associates (the “Partnership”)for $300,000. On that date, the only asset held by the Partnership was unimproved land which had an adjusted basis to the Partnership of $600,000 and a fair market value of $900,000. Because the Partnership held the land as an investment, the land constituted a capital asset. Mr. X's share of the Partnership's basis in the land at the time of his purchase of the partnership interest was $200,000. The Partnership had previously filed an election pursuant to I.R.C. § 754 to adjust the basis of partnership property as provided in I.R.C. § § 734(b) and 743(b).

In August, Year Two, the Partnership sold the land for $900,000. As a consequence of the adjustment to Mr. X's basis in his proportionate share of the land pursuant to § 743(b), Mr. X realized no gain from the sale of the land.

The federal income tax consequences to Mr. X from the Partnership's sale of the land is determined as follows:  
Computation of Adjustment to Mr. X's Basis in Property	

Mr. X's proportionate share of partnership's basis in property	 	$200,000	
Computation of Section 743(b) adjustment:	 	 	
Mr. X's basis in his partnership interest
  less	300,000	 	
Mr. X's proportionate share of partnership's basis in property	200,000	 	
Section 743(b) adjustment	 	100,000	
Mr. X's adjusted basis in partnership property	 	$300,000	
  
 Computation of Gain (Loss) on Sale of Land	

Mr. X's proportionate share of the amount realized from the sale	$300,000	
Mr. X's adjusted basis in his share of the land	300,000	
Mr. X's distributive share of gain (loss) from the sale of the land (Schedule D, Line 12)	       0	

Request to Revoke § 754 Election 

District Director

Internal Revenue Service

[address]

 	Re:	ABC Associates	
 	 	Employer Identification Number 99–9999999	
 	 	Revocation of Election under I.R.C. Section 754	

Dear Sir:

Pursuant to Section 1.754–1(c)(1), Income Tax Regulations, and for the reasons stated below, ABC Associates(the “Partnership”) hereby requests permission to revoke its election pursuant to I.R.C. § 754, effective for with its taxable year ending December 31, 200X.1
——————————————————————————————

1 A request for permission to revoke the § 754 election must be made within 30 days of the end of the taxable year for which it is intended to take effect. See Regs. § 1.754-1(c)(1).

——————————————————————————————

The Partnership filed with its Form 1065 for its taxable year ending December 31, 200X an election pursuant to I.R.C. § 754 to adjust the basis of partnership property pursuant to I.R.C. § § 734(b) and 743(b). Regs. § 1.754–1(c)(1) provides that a partnership that wishes to revoke such an election must file an application setting forth the grounds on which the revocation is desired. The regulation further provides that a change in the nature of the partnership's business or an increased frequency of retirements or shifts in partnership interests which creates an increased administrative burden to the Partnership as a consequence of the election may be considered sufficient reasons for approving an application for revocation.

The Partnership recently changed the nature of its activities from investing in land for speculative purposes to the real estate development business. To finance this new business, the Partnership anticipates admitting as many as 50 new partners in the near future. These partnership interests will be freely transferable. Thus, a substantial increase in the frequency of shifts of interests in the Partnership are anticipated. As a consequence of the change in the nature of the business of the Partnership and the anticipated increased frequency of shifts of interests in the Partnership, the Partnership will experience a substantially increased administrative burden attributable to the election. Accordingly, the Partnership requests permission to revoke the election effective for its taxable year ending December 31, 200X.

Please contact me if any additional information is needed.

 	Sincerely	
 	 	
___________________________	__________________________	
Date	Signature	
 	Mr. A	
 	Partner, ABC Associates	
 	1000 Pennsylvania Avenue	
 	Washington, D.C. 20016	

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 4 Sample Partnership's Basis Adjustment Computation Statement per
 Regs. § 1.734-1(d)1 

——————————————————————————————

1 The statement is attached to the partnership return for the year of the distribution. Regs. § 1.734-1(d).

——————————————————————————————

GRF Partners

582 Union Turnpike

Flushing, NY

EIN #11-1111111

GRF Partners made an election pursuant to Internal Revenue Code § 754 in a statement filed with its tax return for the 20XX calendar year.

On October 26, 200x, Marvin K. Mooney withdrew from GRF Partners, receiving a parcel of real estate (Property X)as a liquidating distribution in full payment for his interest. Immediately before the distribution, GRF Partners' balance sheet was as follows: 
 	Assets	Adjusted Basis	Value	 	
 	Cash	$ 4,000	$ 4,000	 	
 	Property X	 11,000	 11,000	 	
 	Property Y	 15,000	 18,000	 	
 	 	 30,000	 33,000	 	
 	Liabilities and Capital	 	 	 	
 	Liabilities	$ 0	$ 0	 	
 	Capital:	 	 	 	
 	  Marvin K. Mooney	10,000	11,000	 	
 	   Melvin L. Marcus	10,000	11,000	 	
 	   Manny M. Melnick	10,000	11,000	 	
 	 	30,000	33,000	 	

The § 734 adjustment is computed as follows: 
Basis of Property X to GRF Partners:  	$11,000 	
Less basis of Property X to Mooney after distribution: 	(10,000)	
Adjustment: 	$ 1,000 	

The $1,000 adjustment is added to the basis of Property Y, making a post-distribution basis in that property of $16,000.2
——————————————————————————————

2 Regs. § 1.734-1(b)(1), Ex. 2.

——————————————————————————————

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 5 Sample Election Under § 732(d) to Adjust the Basis of Distributed Property
 (Regs. § 1.732-1(d)) 

Editor's Note: A basis adjustment may be elected by a partner who acquired all or part of his partnership interest by a transfer with respect to which an election under § 754(Optional Adjustment to Basis of Partnership Property) was not in effect and to whom a distribution of property (other than cash) was made within two years after such transfer. In addition, taxpayers may be required under Regs. § 1.732-(d)(4) to apply the special basis rules of § 732(d) to distributions, whether or not made within two years after the transfer, if certain conditions are met.

The election is made pursuant to Regs. § 1.732-1(d)by the transferee partner and filed with the tax return for (1) the year of distribution, if the distribution includes property subject to depreciation, depletion, or amortization, or (2) for any tax year no later than the first taxable year in which the basis of any of the distributed property is pertinent in determining tax liability. The election statement must: (1) indicate the taxpayer's intention to make the election, and (2) set forth the computation of the adjustment and list the properties to which the adjustment is allocated. Since the time for filing the election is not fixed by the Code itself, the election is subject to the regulatory relief provisions for late elections in Regs. § 301.9100-1. The election is discussed in the Detailed Analysis at V, D.

Election Under § 732(d) to Adjust the Basis of Distributed Property 

Attachment to Form 1040
 Tax Year 20XX 

Taxpayer, John Smith (218-66-4897), hereby elects under § 732(d) to adjust the basis of property received in a liquidating distribution from ABCD partnership on August 30, 20XX. Taxpayer acquired his partnership interest on January 1, 20XX, in a transfer with respect to which an election under § 754 was not in effect. Taxpayer paid$25,000 for his 25% partnership interest. At that time, ABCD had inventory with a basis to ABCD of $50,000 and a value of $60,000. The remaining assets had a value equal to their basis. On the distribution date, Taxpayer had a basis in his partnership interest of $20,000. Taxpayer received $1,000 in cash and the assets listed below. The following is the partnership's basis in the assets distributed and the basis allocated to each asset by Taxpayer pursuant to this election:  
 	Item	Basis to ABCD of Assets Distributed	Taxpayer's Basis In Distributed Assets	 	
 	Inventory	$10,000	$12,500	 	
 	Property A	  2,000	  2,600	 	
 	Property B	  3,000	  3,900	 	
 	Total	$15,000	$19,000	 	

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 6 Partnership's Basis Adjustment Computation Statement (Regs. § 1.743-1(k)(1)) 

Basis Adjustment Computation Statement 

 	 	
MJS Partners	 	
1060 Northern Blvd.	 	
Great Neck, NY	 	
EIN: 12-3456789	 	

The partnership attaches this statement to its tax return for the 200X taxable year, as required by Income Tax Regulations § 1.743-1(k)(1), because of the sale of certain partnership property (Property A) during the taxable year and because the resulting gain that is attributable to one of the partners is affected by a special basis adjustment. 
Transferee Partner:	 	

Ms. H. James	 	
933 Northern Boulevard	 	
Douglaston, NY	 	
SSN: 345-67-8910	 	

On March 20, 200X, the transferee partner purchased a one-third partnership interest in MJS Partners from Mr. D. Smith for $24,000. At that time, MJS Partners had an election in effect under Internal Revenue Code § 754, and its assets consisted entirely of three unimproved parcels of real estate.

Immediately before the transferee purchased her interest, MJS Partners' balance sheet was as follows:  
Assets	Adjusted Basis	Value	

Property A	$20,000	$24,000	
Property B	 20,000	 24,000	
Property C	 20,000	 24,000	
 	 60,000	 72,000	
 	Liabilities and Capital	 	
Liabilities	$ 0 	$ 0 	
Capital:	 	 	
  D. Smith	20,000	24,000	
  E. Jones	20,000	24,000	
  F. Brown	20,000	24,000	
 	60,000	72,000	

After adjustment pursuant to Internal Revenue Code § § 754 and 743(b), the transferee partner's basis in his share of Property A is $8,000:  
Share of Basis in Property A	 	
   ($20,000 x 1/3)	$6,666.66	
Basis Adjustment	 	
   (transferee partner's basis in partnership interest less share of partnership's basis in assets:
    $24,000 -$20,000 = $4000; one third of the $4000 is allocable to Property A)	
   1,333.34	
 	$8,000.00	

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 7 Allocation of Recourse Debt: 1991 Final Regulations and 1988 Temporary Regulations 

Allocation of Recourse Debt: 1991 Final Regulations and 1988 Temporary Regulations

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 8 Allocation of Nonrecourse Debt: 1991 Final Regulations and 1988 Temporary Regulations 

Allocation of Nonrecourse Debt: 1991 Final Regulations and 1988 Temporary Regulations

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Working Papers

Worksheet 9  Section 752 Regulations Effective Date and Transition Rules 

Section 752 Regulations Effective Date and Transition Rules

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Bibliography

OFFICIAL 

Statutes: 

Internal Revenue Code of 1986, as amended: § § 701, 705, 721, 722, 723, 731, 732, 733, 734, 741, 742, 743, 751, 752, 754, 755.

Treasury Regulations: 

See the regulations promulgated and proposed under the above Code sections.

Committee Reports: 

H.R. Rep. No. 861, 98th Cong., 2d Sess. (1984).

H.R. Rep. No. 432, 98th Cong., 2d Sess. (1984).

S. Rep. No. 938, 94th Cong., 2d Sess. (1976).

S. Rep. No. 313, 99th Cong., 2d Sess. (1986).

S. Rep. No. 33, 105th Cong., 1st Sess. (1997).

Staff of Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (1985).

Public Laws: 

P.L. 108-357.

P.L. 106-554.

P.L. 105-34.

P.L. 103-66.

P.L. 103-465.

P.L. 101-239.

P.L. 99-514.

P.L. 98-369.

P.L. 94-455.

Revenue Rulings and Revenue Procedures: 

Rev. Proc. 93-27, 1993-2 C.B. 343, clarified by Rev. Proc. 2001-43, 2001-34 I.R.B. 191.

Rev. Proc. 2001-43, 2001-34 I.R.B. 191.

Rev. Rul. 56-5, 1956-1 C.B. 630.

Rev. Rul. 66-94, 1966-1 C.B. 166.

Rev. Rul. 72-352, 1972-2 C.B. 395.

Rev. Rul. 73-301, 1973-2 C.B. 215.

Rev. Rul. 77-458, 1977-2, C.B. 220.

Rev. Rul. 78-2, 1978-1 C.B. 202.

Rev. Rul. 78-182, 1978-1 C.B. 265.

Rev. Rul. 79-84, 1979-1 C.B. 223.

Rev. Rul. 79-92, 1979-1 C.B. 180.

Rev. Rul. 79-124, 1979-1 C.B. 224.

Rev. Rul. 79-205, 1979-2 C.B. 255.

Rev. Rul. 80-235, 1980-2 C.B. 229.

Rev. Rul. 81-242, 1981-2 C.B. 147.

Rev. Rul. 84-15, 1984-1 C.B. 158.

Rev. Rul. 84-52, 1984-1 C.B. 157, amplified by Rev. Rul. 95-37, 1995-1 C.B. 130.

Rev. Rul. 84-53, 1984-1 C.B. 159.

Rev. Rul. 84-102, 1984-2 C.B. 119.

Rev. Rul. 84-118, 1984-2 C.B. 120.

Rev. Rul. 86-139, 1986-2 C.B. 95.

Rev. Rul. 87-115, 1987-2 C.B. 163.

Rev. Rul. 87-120, 1987-2 C.B. 161.

Rev. Rul. 88-77, 1988-2 C.B. 128.

Rev. Rul. 89-7, 1989-1 C.B. 178.

Rev. Rul. 92-15, 1992-1 C.B. 215.

Rev. Rul. 92-97, 1992-2 C.B. 124.

Rev. Rul. 93-7, 1993-1 C.B. 125.

Rev. Rul. 93-13, 1993-1 C.B. 126.

Rev. Rul. 94-4, 1994-1 C.B. 195.

Rev. Rul. 95-26, 1995-1 C.B. 131.

Rev. Rul. 95-41, 1995-1 C.B. 132.

Rev. Rul. 96-10, 1996-1 C.B. 138.

Rev. Rul. 96-11, 1996-1 C.B. 140.

Rev. Rul. 99-57, 1995-1 I.R.B. 678.

Rev. Rul. 2003-56, 2003-23 I.R.B. 985.

Cases: 

Aladdin Industries v. Comr., 41 T.C.M. 1515 (1981).

Au v. Comr., 330 F.2d 1008 (9th Cir. 1964).

Bollinger, Comr. v., 485 U.S. 340 (1988).

Brown v. Comr., 40 T.C.M. 725 (1980), aff'd without pub. opin. (9th Cir. 1982).

Bussing v. Comr., 88 T.C. 449 (1987).

Campbell v. Comr., 59 T.C.M. 236 (1990), rev'd, 943 F.2d 815 (8th Cir. 1991).

Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970).

Colm Producer, Inc. v. U.S., 460 F. Supp.2d 713 (N.D. Tex. 2006).

Cornish, U.S. v., 348 F.2d 175 (9th Cir. 1965 ), rev'g and rem'g 221 F. Supp. 658 (D. Ore. 1963).

Crane v. Comr., 331 U.S. 1 (1947).

Deputy v. du Pont, 308 U.S. 488 (1940).

Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

Dill Co. v. Comr., 33 T.C. 196 (1959), aff'd, 294 F.2d 291 (3d Cir. 1961).

Dillingham v. U.S., 81-2 USTC ¶  9601 (W.D. Okla. 1981).

Fahey v. Comr., 38 T.C.M. 62 (1979).

Federal Projects, Inc. v. Comr., 53 T.C.M. 623 (1987).

Foster v. U.S., 329 F.2d 717 (2d Cir. 1964).

Gardner v. Comr., 54 T.C.M. 250 (1987), aff'd in unpub. opin. (6th Cir. 1989).

Gemini Twin Fund III v. Comr., 62 T.C.M. 104 (1991), aff'd in unpub. opin. (9th Cir. 10/21/93).

Gershkowitz v. Comr., 88 T.C. 984 (1987).

Goodall Est. v. Comr., 68-1 USTC ¶  9245, 391 F.2d 775 (8th Cir. 1968), cert. denied, 393 U.S. 829.

Gindes v. U.S., 661 F.2d 194 (Ct. Cl. 1981), aff'd, 740 F.2d 947 (Fed. Cir. 1984).

Grubb v. Comr., 60 T.C.M. 458 (1990).

Hambuechen v. Comr., 43 T.C. 90 (1964).

Helmer v. Comr., 34 T.C.M. 727 (1975).

Hirsch v. Comr., 47 T.C.M. 1006 (1984).

Hunter v. Comr., 140 F.2d 954 (5th Cir. 1944).

IPO II v. Comr., 122 T.C. 295 (2004).

Jones v. U.S., 553 F.2d 667 (Ct. Cl. 1977).

Kenroy, Inc. v. Comr., 47 T.C.M. 1749 (1984).

Kingbay v. Comr., 46 T.C. 147 (1966).

Klamath Strategic Inv. Fund, LLC v. U.S., 440 F. Supp. 2d 608 (E.D. Tex. 2006).

Laney v. Comr., 39 T.C.M. 654 (1979), aff'd, 674 F.2d 342 (5th Cir. 1982).

LaRue v. Comr., 90 T.C. 465 (1988).

Long v. Comr., 77 T.C. 1045 (1981).

Miller v. Comr., 52 T.C. 752 (1969).

Muserlain v. Comr., 932 F.2d 109 (2d Cir. 1991), aff'g 58 T.C.M. 100 (1989).

National Carbide Corp. v. Comr., 336 U.S. 442 (1949).

National Oil Co. v. Comr., 52 T.C.M. 1223 (1986).

Oden v. Comr., 41 T.C.M. 1285 (1981), aff'd without pub. opin., 679 F.2d 885 (4th Cir. 1982).

Ourisman v. Comr., 760 F.2d 541 (4th Cir. 1985).

Raphan v. U.S., 759 F.2d 879 (Fed. Cir. 1985), cert. denied, 474 U.S. 843 (1985), rev'g 83-2 USTC ¶  9613 (Ct. Cl. 1983).

Richardson v. Comr., 76 T.C. 512 (1981).

Roccaforte v. Comr., 708 F.2d 986 (5th Cir. 1983).

Schrott v. Comr., 57 T.C.M. 981 (1989).

Scott v. Comr., T.C. Memo 1997-507.

Seay v. Comr., 63 T.C.M. 2911 (1992).

Shaheen v. Comr., 44 T.C.M. 694 (1982).

Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir. 1982).

Smith v. Comr., 84 T.C. 889 (1985), aff'd without pub. opin. (D.C. Cir. 1986).

St. John v. U.S., 84-1 USTC ¶  9158 (C.D. Ill. 1983).

Vaughn v. U.S., 740 F.2d 941 (Fed. Cir. 1984).

Virginia Iron, Coal &  Coke Co. v. Comr., 37 B.T.A. 195 aff'd, 99 F.2d 919 (4th Cir. 1938), cert. denied, 307 U.S. 630 (1939).

Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992).

U.S. Income Portfolios: Partnerships 
  Portfolio 714-3rd: Partnerships — Allocation of Liabilities; Basis Rules 
  Bibliography

UNOFFICIAL 

Tax Management Portfolios: 

535 T.M., Time Value of Money: OID and Imputed Interest.

549 T.M., Passive Loss Rules.

550 T.M., At-Risk Rules.

554 T.M., The Attribution Rules.

570 T.M., Accounting Methods —General Principles.

710 T.M., Partnerships —Conceptual Overview.

712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts.

716 T.M., Partnerships —Current and Liquidating Distributions; Death or Retirement of a Partner.

718 T.M., Partnerships—Dispositions of Partnership Interests or Business; Partnership Termination.

Treatises: 

W. McKee, W. Nelson and R. Whitmire, Federal Taxation of Partnerships and Partners (2d ed. 1990).

A. Willis, J. Pennell and P. Postlewaite, Partnership Taxation (4th ed. 1993).

Periodicals: 

1973 

Lurie, “Diamond in the Rough,”169 N.Y.L.J. 1.

1980 

Klein, “Optional Adjustments to Basis of Partnership Properties — Special Problems,”38 N.Y.U. Tax Inst. ch. 10.

1981 

Kalish and Schneider, “Is There Partnership Basis After Death?,” 35 Tax Law. 143.

1982 

Pennell, “Problems Involving the Optional Adjustments to Basis of Partnership Assets,” 34 S. Cal. Tax Inst. ¶  800.

1985 

Charyk, “The Partnership Corner: New Problems With § 751(b) — A Review of Revenue Ruling 84-102,” 12 J. Real Est. Tax'n 166.

1989 

Abrams, “Long-Awaited Regulations Under Section 752 Provide Wrong Answers,” 44 Tax L. Rev. 627.

Frankel and Coffin, “New Section 752 Regulations Clarify Treatment of Partnership Liabilities,”6 J. Partnership Tax'n No. 3.

Levine, Loffman and Presant, “A Practical Guide to the Section 752 Temp. Regs. — Part I,”70 J. Tax'n, No. 4, 196; Part II, 70 J. Tax'n No. 5, 260.

Schmalz, “The Effect of Partnership Liabilities on Basis, At-Risk Amounts, and Capital Accounts,”5 J. Partnership Tax'n No. 4, 291.

Schmalz, “Proper Application of the Rules Governing Partnership Liabilities Remains Crucial,”6 J. Partnership Tax'n No. 1, 3.

1990 

Bradshaw and Itakura, “Campbell Renews Controversy Over Taxation of a Partnership Interest For Services,”7 J. Partnership Tax'n No. 3, 211.

Lord, “Amendments to Recent Liability Regulations Clarify Ambiguities and Provide Consistency,”7 J. Partnership Tax'n No. 2, 115.

1991 

Carman and Fortini-Campbell, “The Dark Side of the Campbell Decision: Its Potential Collateral Consequences,”7 J. Partnership Tax'n No. 4, 324.

Frost, “Receipt of Capital and Profits Interests Continues to Have Uncertain Tax Consequences,”75 J. Tax'n No. 1, 38.

Liveson, “Determining Basis in Partnership Distributions of Contributed Property,” 74 J. Tax'n No. 2, 116.

1992 

Berman, “Admission of a Partner to a Service Partnership: Resolving the Tax Problems,”9 J. Partnership Tax'n No. 3, 211.

Hagen, “The Final Regulations Under IRC Sections 704(b) and 752: Envisioning Economic Risk of Loss Through a Glass Darkly,” 49 Wash. &  Lee L. Rev. No. 2, 487.

Pennell and Postlewaite, “Adjusting the Basis of Assets in Tiered Partnerships Under IRS’ Questionable New Ruling,” 77 J. Tax'n No. 1, 4.

Pickron, “Final Rules on Allocation of Partnership Liabilities Still Leave Unanswered Questions,”76 J. Tax'n No. 5, 272.

Ruffer, Jr., “Eighth Circuit's Decision in Campbell Clarifies the Limited Scope of Diamond,”9 J. Partnership Tax'n No. 1, 3.

1993 

Egerton, “Rev. Proc. 93-27 Provides Limited Relief on Receipt of Profits Interest from Services,”79 J. Tax'n No. 3, 132.

Frankel and Coffin, “Partnership Workouts: Problems and Solutions Under Final Section 704(b) and 752 Regulations,” 9 J. Partnership Tax'n No. 4, 287.

1994 

Krumwiede, “Encumbered Property Complicates Partnership Formation,” 53 Tax'n for Acct. 99.

1995 

Schmalz and Edquist, “Proposed Regulations Give Some Guidance on Partnership Mixing Bowl Transactions,”12 J. Partnership Tax'n 133 (Summer).

1996 

Jackel, “Mixing Bowl Reprise:Final Regulations Under Secs. 704(c)(1)(B) and 737,” 12 Tax Mgmt. Real Est. J. 146.

Dienst and Frydland, “Revenue Ruling 95-41 Analyzes the Effect of Section 704(c) on the Allocation of Nonrecourse Liabilities,” 12 J. Partnership Tax'n 285.

1997 

Schachat and Mahoney, “A Step Towards Simplification: The Final Section 708(b)(1)(B) Regulations,”38 Tax Mgmt. Memo. Spec. Ed. 1997-7: Corp. Tax and Bus. Plan. Rev.  S-178 (7/21/97).

1998 

McCloskey and Streer, “The TRA ’97's New Basis Allocation Rules for Property Distributions,”29 Tax Advisor No. 7, 486.

Walter and Ricketts, “New Basis Rules for Partnership Property Distributions,” 61 Tax'n for Acct. No. 1, 10.

1999 

Latta, “Cancellation of Debt and Basis Reduction: The Final Regulations Under § 108 and 1017,” 15 Tax Mgmt. Real Est. J. 31 (Feb. 3).

2000 

Bowers &  Lee, “Warrants and Convertible Preferred Interests for Partnerships and LLCs,”468 PLI/Tax 723.

Cuff, “New Section 743/755 Regulations for Adjusting ‘Inside’ Basis,” 92 J. Tax'n No. 5, 281.

2005 

Abrams, “The Truth About Partnership Debt. Guaranteed,” Tax Mgmt. Real Est. J. (Mar. 2, 2005).

2006 

Abrams, “Simple Distributions from Leveraged Partnerships,” Tax Mgmt. Real Est. J. (July 5, 2006).