U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Portfolio Description

Elliott Manning
 Professor
 Faculty Chair, Graduate Program in Taxation
 University of Miami School of Law
 Coral Gables, FL 33124
 
 Special Consultant to Tax Management

Elliott Manning, AB (with honors) Columbia College(1955), JD m.c.l., Harvard Law School (1958). Author of Tax Management Portfolios 710 T.M., Partnerships—Conceptual Overview; 711 T.M., Partnerships—Formation and Contributions of Property or Services; 718 T.M., Partnerships—Disposition of Partnership Interests or Partnership Business; Partnership Termination;Choosing the Business Entity (Little Brown 1995); and Corporate Buy-Sell Agreements (Little Brown 1995).

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  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 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Portfolio Description

PORTFOLIO DESCRIPTION 

Tax Management Portfolio No. 716-2nd, Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner, provides a detailed discussion of the tax consequences of distributions by partnerships to partners, including those arising from distributions of a partner's share of the results of partnership operations, and other distributions by the partnership that do not result in termination of the distributee's interest in the partnership even though accompanied by a change in the distributee's and remaining partners' shares of capital or profits and losses, whether in money or property—all called current distributions—and distributions of money or property on the withdrawal of a partner whether on death or withdrawal—called liquidating distributions. Liquidating distributions may be accompanied by other retirement payments that do not represent consideration for the withdrawing partner's interest in partnership property, and may be deferred compensation, or other claims against past or future partnership income. When the withdrawal is a result of death, there may be other collateral income and transfer tax consequences. Distributions, usually liquidating distributions, are important components of major partnership restructurings, including divisions, mergers, incorporations, and changes in legal form.

As with all other aspects of partnership taxation, the dual nature of a partnership for tax purposes—as at times an aggregation of its partners, and at times an entity—complicates the discussion, particularly because no one, including the author, has been able to articulate a comprehensive statement of when the aggregate, and when the entity, aspect should predominate. Further complication arises because the “tax” partnership includes not only entities organized as general partnerships or limited partnerships(“LP”) under state law, but also the newer forms of limited liability partnerships (“LLP”), initially primarily for professionals, and the increasingly popular limited liability company(“LLC”). The newer forms, particularly the LLC, have many more entity characteristics, particularly when full advantage of the freedom to contract that is part of the latest revisions of the governing statutes in most commercial states is taken into account, so that it is hard to distinguish them from corporations. All but the traditional general partnership have limited liability, and a general partnership can, in most states, achieve limited liability by a simple filing to become an LLP, but, particularly for professionals that limited liability protects against vicarious liability but not against liability for one's own malpractice, including, of course malpractice in giving advice related to partnership tax matters. All but the general partnership can also have continuity of life, centralized management and free transferability of interest, subject only to the usual practical problems of transferring interests in closely held businesses. Even the general partnership can achieve most of these characteristics by a carefully drafted partnership agreement. Nevertheless, Subchapter K has not been amended to recognize these changes. Despite these factors, the Check-the-Box regulations, Regs. § § 301.7701-2 and -3, recognize partnership as the default tax classification for all domestic entities that are not organized as corporations or joint stock companies, or engaged in certain regulated businesses like banking and insurance. A number of problems have emerged, particularly for LLCs treated as disregarded entities, including a controversial decision by the IRS to treat the disregarded entity as the one responsible for payroll taxes for its employees, and questions about the status of recourse liabilities of a disregarded entity, particularly one that owns a partnership interest.

This Portfolio analyzes not only the relevant statutory and regulatory materials, but also the large body of case law, revenue rulings, and other IRS pronouncements, including technical advice memoranda and private letter rulings, that are all part of this, unfortunately complex, body of tax law.

Part I, Introduction, briefly discusses important general principles not directly related to distributions, but that will nevertheless frequently be referred to throughout the Portfolio, including partnership capital accounts, § 704(c) and reverse § 704(c)allocations. Part I then addresses the vexing question of distinguishing a partner withdrawal from sale of a partnership interest (which are considered in more detail in 718 T.M. Partnerships—Disposition of Partnership Interests or Partnership Business;Partnership Termination). Part I concludes with a brief discussion of the general anti-abuse regulations. Part II discusses the principles applicable to all distributions—current and liquidating—including distinguishing between them—and the general principles for nonrecognition of gain or loss on distributions of partnership property in kind, and the effect of partnership liability shifts as part of distributions. Part III deals with the specific tax consequences of current distributions, including the basis of distributed property, the effects on the outside basis of the distributee partner's interest of money and property distributions, and the effects on the inside basis of the partnership's assets of in-kind distributions, as well as the effects of § 751 to recharacterize non-pro rata distributions by partnerships that have § 751 property and other property as taxable exchanges instead of nonrecognition distributions. The tax consequences of liquidating distributions are discussed in Part IV, including the different rules for the basis of distributed property, and the effect on the partnership's inside basis of gain or loss recognized by the distributee partner. Finally, Part V analyzes § 736, which characterizes partnership payments made to a retiring partner or the successors of a deceased partner, dividing them between those that are liquidating distributions allocable to the retiring or deceased partner's interest in the partnership(including goodwill and similar intangibles) that are governed by the principles discussed in Part IV, and any other withdrawal payments, which are classified as either distributive share payments, with their character determined by the allocable share of partnership income, or guaranteed payments, which are ordinary income to the distributee without regard to partnership income, depending on whether their amount is determined by partnership income or not, and are, in effect, deductible(or excludible) by the partnership (remaining partners). It also addresses estate and income tax considerations relevant to a deceased partner's successors, other than those involving § 736.

For a discussion of related federal tax rules applied to partnerships, see 710 T.M., Partnerships—Conceptual Overview; 711 T.M., Partnerships—Formation and Contributions of Property or Services ; 712 T.M., Partnerships—Taxable Income;Allocation of Distributive Shares Capital Accounts; 714 T.M., Partnerships—Allocation of Liabilities; Basis Rules; 718 T.M., Partnerships—Disposition of Partnership Interests or Partnership Business; Partnership Termination; and 720 T.M., Partnership Transactions—Section 751 Property. For a discussion of the specific tax issues related to limited liability companies, see 725 T.M., Limited Liability Companies. For a discussion of the specific tax issues raised by foreign partners or foreign partnerships, see 910 T.M., Partners and Partnerships—International Aspects (Foreign Income Series).

This Portfolio may be cited as Manning, 716-2nd T.M., Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  I. Introduction

The tax consequences of distributions by partnerships are governed primarily by Subpart B—Transfer of Interests in Partnership of Part II of Subchapter K, which consists of six sections, § § 731–736. This is deceptive because other provisions, particularly Subpart D—Provisions Common to Other Subparts—are equally, if not more important, with § § 751, 754 and 755 having particular application to distributions in kind by partnerships, including distributions upon withdrawal of a partner. Withdrawal distributions may be hard to distinguish from sales of partnership interests to the remaining partners. Sales of partnership interests are discussed in 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination. In addition,  § 752 and the treatment of changes in liability shares as contributions and distributions and not as consideration for the transfer of property, even encumbered property, by the partnership to partners, pervades every aspect of the discussion.

Sections 731 to 735 deal with distributions to partners, whether in money or in kind. Although conceptually different, two types of distributions — (i) current distributions and (ii)liquidating distributions — are covered by the same provisions, but some subsections refer specifically to liquidating distributions,1 and others to nonliquidating distributions.2 Liquidating distributions are those that are in exchange for all, but not less than all, of the distributee's partnership interest.3 This, of course, means that all other distributions are current distributions, even when they adjust the distributee's interests in capital, distributions of money or property, and profits or losses.4 Part II of this portfolio discusses principles common to all distributions, Part III covers current distributions, and Part IV deals with liquidating distributions.
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1 § § 731(a)(2), 732(b).  All section references in this portfolio are to the Internal Revenue Code and the regulations thereunder, except as specifically otherwise stated.

2 § § 732(a)(1), 733.

3 § § 731(a)(2), 761(d); Regs. § § 1.731-1(a)(2), 1.761-1(d).

4 § § 731(a)(1), 761(d); Regs. § § 1.731-1(a)(2), 1.761-1(d).

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Reflecting the mixed entity-aggregate nature of the partnership, distributions are treated as being from an entity to an owner, but the general nonrecognition treatment for distributions in kind, provided by  § 731 for the partnership and the partner, and the transferred basis provided by  § § 732 and 733, are more consistent with the aggregate approach. Section 751, which treats distributions, current or liquidating, that adjust interests in certain assets as an exchange of ordinary income assets for other assets, applies the ultimate aggregate approach.  Section 735 provides a carryover, to the distributee of the character of certain assets to the partnership, further reflecting the aggregate aspect.

On the other hand, applying an entity approach, § 734(a) provides that the partnership does not adjust the basis for other assets to reflect the partner's gain on the distribution except, under a 2004 amendment to § 734(b), which provides a downward adjustment to inside basis when the partnership has a substantial (more than $250,000) basis reduction resulting from a liquidating distribution.5  Section 734(b) substantially modifies the entity approach and reverts to an elective aggregate approach by providing inside basis adjustments when an election under § 754 applies. Adjustments under the  § 754 election do not affect the book value of partnership assets, or the capital accounts of the continuing partners. The amendments made in 2004 limits these planning opportunities by mandating adjustments when there are substantial built-in losses.  As one reason for not making the election is to avoid having to reduce basis, the 2004 amendment to  § 734 comes close to eliminating legitimate reasons for not making it.
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5 § 734(a) and (d), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(c), effective Oct. 22, 2004.

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The remaining provision in subpart B, § 736, considers specific issues when a partner completely retires from the partnership.  Section 736 characterizes partnership payments made to a retiring partner or the successors of a deceased partner, primarily from the standpoint of the withdrawing partners, generally following a mixed entity-aggregate approach, in treating part of the payments or distributions as in exchange for the partner's share of partnership assets.  Section 736 divides withdrawal payments between those that are liquidating distributions allocable to interests in the partnership governed by the principles discussed in Part IV, and any other withdrawal payments, which are classified as either distributive share payments, with their character determined by the allocable share of partnership income, or guaranteed payments, governed by general principles relating to allocation of partnership income or to guaranteed payments. Part V deals with these issues. Part V, D, addresses estate and income tax considerations relevant to a deceased partner's successors, other than those involving § 736.

Reflecting the entity principle, a partner's receipt of money or property from a partnership may be a loan instead of a distribution, governed by § 707(a), but only when the partner is under an “unconditional and legally enforceable obligation to repay a sum certain at a determinable date.”6 Guaranteed payments to partners under § 707(c), and independent capacity payments under § 704(a)7 are not partnership distributions. Similarly, the proceeds of actual or disguised sales of property or of the partnership interest, are not partnership distributions.8 Under the special allocation regulations, partnership assets are revalued when there are distributions in kind, and distributed assets are applied against capital accounts at fair market value.9
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6 See II, C, 1, below, for a discussion of partnership loans.

7 See II, C, 2, below, for a discussion of guaranteed payments.

8 See III, G, 1, below, for a discussion of disguised sales of property to partners, and III, G, 2, below, for a discussion of disguised sales of partnership interests.

9 Regs. § 1.704-1(b)(2)(iv)(e) and (f). See I, A, below, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of revaluation of capital accounts.

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Reflecting the aggregate nature of a partnership when one partnership (upper-tier partnership) owns an interest in another partnership (lower-tier partnership), various tax characteristics usually pass through the tiers. Some of these are pursuant to specific Code provisions.10 Others are provided in the regulations.11 Others are not provided in either the Code or the regulations, but should still be taken into account.12 These and other situations in which tax consequences are determined by passing through the tiers are discussed throughout this portfolio, but there is no systematic discussion of tiered partnerships in view of the variety of circumstances and consequences of passing through the tiers.
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10 See, e.g., § 734(b) (flush language) relating to inside basis adjustments when a  § 754 election applies. See III, C, 2, below, for a discussion of when the adjustment passes through the tiers.

11 See, e.g., Regs. § 1.752-4(a). See II, D, below, for a discussion of liabilities passing through the tiers.

12 See, e.g., III, B, 1, c, below, for a discussion of the probable pass-through of qualified liabilities despite a lack of reference to tiered partnership in the regulations.

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Particularly for a small partnership, a single attorney may be asked to represent all of the parties in circumstances in which the distinction between the partnership and its partners is not clear—in which the aggregate and entity aspects are blurred. In view of the differing interests of the parties, any such combined representation raises several significant issues of professional responsibility, including confidentiality, conflict of interest and the ability to represent one or more of the parties if there is a subsequent dispute. An attorney who determines that representation of the differing interests is appropriate, should insist on a written consent to the multiple representation that advises the clients of the potential for conflict. The client should also be advised: (i) that nothing said to the attorney is confidential unless all other parties agree,13 and(ii) that the attorney may not be able to represent any parties if a dispute arises relating to the distribution, particularly a distribution reflected a withdrawal of a partner or a significant change in partnership interests. Further, the clients' informed consent to the joint representation should be in writing.14
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13 Under the Rules of Professional Responsibility, such consent can be given in advance to the attorney's keeping some communications from a partner confidential and not disclosed to other partners. See ABA Model Rules of Professional Conduct, Rule 1.7. The author, however, generally requires that his clients consent to no confidentially since he does not believe he is capable of performing his professional obligations while keeping some information confidential.

14 A form of representation letter dealing with similar issues at the withdrawal stage that can be adapted to other stages of partnership operations is included in the Working Papers.

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Foreign partnerships and domestic partnerships with foreign partners raise special issues.15 Although some of those issues may be touched on in this portfolio, they are not dealt with in any systematic way.
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15 See 910 T.M., Partners and Partnerships — International Tax Aspects (Foreign Income Series), for a comprehensive treatment of these issues; see also Humphreys, “Partnership Combinations of U.S. and Non-U.S. Corporations, 92 Tax Notes 241 (Jul. 9, 2001).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  I. Introduction

A. Capital Accounts 

It is difficult to understand any aspect of partnership taxation without some understanding of the fundamental role that the partners' capital accounts play in determining the economic and tax relations among the partners.16 Although not technically required by any Code or regulations provisions, capital accounts have a key role, not only in special allocation of income to the partners, principally, allowing designated items of income or deduction, or items attributable to specified operations, in a manner different from general profit and loss sharing ratios, as long as the allocation has substantial economic effect,17 but also in allocating liabilities.18 Indeed, as is the case for the writers of the partnership regulations, and most who write about, or teach about, partnership taxation, the author finds it almost impossible to discuss any significant issue without resort to capital-account analysis. Capital accounts essentially represent the necessity of determining the results of partnership operations at the partnership level, but play an essential role in application of conduit principles, including distributions to partners.
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16 See Park Cities Corp. v. Byrd, 534 S.W.2d 668 (Tex. 1976) (finds deficit make-up under state partnership law for partner allocated losses to conform economic effects to tax benefit); but cf. Hogan v. Comr., T.C. Memo 1990-295 (does not find deficit make-up under applicable nontax law; distinguishes Byrd). See 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments of the capital accounting rules for special allocations.

17 § 704(b); Regs. § 1.704-1(b). This permits, for example, allocating research and experimental expenditures or depreciation deductions to the capital partner who provides the funds for them. Regs.  § 1.704-1(b)(5) Ex. 3.

18 See 710 T.M., Partnerships —Conceptual Overview, for summary discussions, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for a comprehensive treatment, of the role of capital accounts in liability allocations.

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A partner's capital account measures the partner's equity in the partnership. The capital accounts required by the special allocation regulations19 are established using fair market values(not tax basis) of property contributed.20 Thus, there is an inevitable disparity between the books maintained by the partnership to comply with the special allocation regulations and the records needed to reflect tax basis (a book-tax disparity).21 The required capital accounts may be, but are not required to be,22 adjusted periodically, primarily at the time of contributions or distributions of money or property,23 but do not otherwise reflect changes in the fair market value of the assets. Thus, they are normally adjusted in connection with the distributions that are the principal subject of this portfolio.  They are not adjusted for sales of partnership interests.
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19 Regs. § 1.704-1(b)(2)(ii)(b)(1) and (iv)(a).

20 Regs. § 1.704-1(b)(2)(iv)(d). 

21 In the examples throughout this portfolio, “Book” refers to accounts maintained in accordance with the special allocation regulations for capital accounts, reflecting contributed assets and capital accounts using fair market values at the time of contribution, as adjusted for any subsequent revaluations to reflect fair market value; “Tax”refers to accounts that reflect the tax basis to the partnership of the contributed property, as adjusted for the application of § 704(c).

22 Except possibly under reverse  § 704(c) considerations, Regs. § 1.704-1(b)(2)(iv)(f) (flush language) and (5) Ex. 14(iv);see I, B, below, for a summary discussion, and 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments, of how the special allocation regulations treat inherent partnership tax attributes when new partners are admitted.

23 Regs. § 1.704-1(b)(2)(iv)(f), (iv)(g) and(5) Exs. 14(i), (iii) and (iv) and 18(ii), (vii) and (xi).

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Income and losses are allocated through the capital account,24 as are contributions and distributions, all measured by fair market values.25 This means that all partnership property and interests are revalued at the time of most distributions, except current money distributions of income.26 Partnership borrowings and payments of liabilities do not affect the capital accounts, because the asset and liability changes offset each other.27 Any corresponding changes in the partners' shares of partnership liabilities are deemed contributions and distributions that do affect the partners' outside basis in the partnership interests.28 When there is a disparity between the capital accounts maintained in accordance with the regulations for book purposes and those required to reflect tax basis, the difference, inevitably, must be accounted for, primarily under the principles of § 704(c).29
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24 Regs. § 1.704-1(b)(2)(ii)(b)(2).

25 Regs. § 1.704-1(b)(2)(iv)(b), (d)(1), (e)(1), and (h).

26 See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of revaluation of capital accounts.

27 Regs. § 1.704-1(b)(2)(iv)(c). In contrast, increases or decreases in a partner's share of partnership liabilities are deemed contributions by, or distributions to the partner that must be reflected in the partner's capital account. See § 752(a), (b). See II, D, below, and 710 T.M., Partnerships — Conceptual Overview, for discussions, and 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment, of the relationship between liabilities and capital accounts.

28 § 752(a), (b);see II, D, below, for a discussion of the relationship between liabilities, capital accounts and outside basis.

29 See II, A, below, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a more comprehensive treatment, of how the book-tax disparity is accounted for.

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Although the special allocation regulations must be complied with for special allocations to be respected, there is no requirement that they be followed for partnerships that do not make special allocations,30 particularly simple general partnerships (or LLCs) that allocate income and losses, make distributions, and have capital accounts all in same proportions.31 Nevertheless, most tax partnerships will follow the fair-market-value capital accounting approach because it is in accordance with standard accounting practice,32 and because capital accounts must be maintained to the extent needed to comply with § 704(c).33 Capital accounts essentially represent the necessity of determining the results of partnership operations at the partnership entity level.
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30 See Friedman, “Some Thoughts on Partners' Interests in Partnerships” 115 Tax Notes, 995 (June 4, 2007)(suggests that partners' interests in the partnership has independent meaning outside of capital accounts and suggests an adjusted cash flow system to measure it).

31 See Revised Uniform Partnership Act (1997)  § § 401(b) (charging losses to capital account) and 807(b) (requiring partners to make-up deficits on liquidation).

32 See, e.g., Bears, Brovosky &  Shoulder, Advanced Accounting 601(7th ed. 2000); Weiygandt, Kieso &  Kell, Accounting Principles 551 (3rd ed. 1993); see also Revised Uniform Partnership Act (1976/1985)  § 401(a)(3) providing for a limited capital accounting including crediting “the value of any other property” contributed to the partnership. The Official Comment recognizes that it is a rudimentary capital account provisions to apply in the absence of another system.  § 401 Comment 2, 6 ULA 134(2001).

33 Regs. § 1.704-3(a)(3)(i);see II, D, below, for a discussion of the requirement that such inherent tax attributes be allocated to the contributor.

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Example: Maintenance of Capital Accounts. Propp#1 owns a parcel of land valued at $100,000 with a basis of $60,000. Propp#2 owns an adjacent parcel of land valued at $80,000 with a basis of $90,000. Propp#1 and Propp#2 form a partnership, Oppar, to develop the two parcels as a single tract. In addition, Propp#2 contributes $20,000 cash. Each receives a 50% interest in Oppar for the contribution. Propp#1 does not recognize any gain, and Propp#2 does not recognize any loss on the contribution. Propp#1 and Propp#2 are each credited with capital accounts of $100,000, the FMV of their respective contributions. Oppar's balance sheet is:
Assets	Tax	Book	
Cash	$ 20,000	$ 20,000	
Propp#1's Land	 60,000	100,000	
Propp#2's Land	90,000	 80,000	
 	$170,000 	$200,000	
Capital	 	 	
Propp#1	$ 60,000	$100,000	
Propp#2	110,000	100,000	
 	$170,000	$200,000	

The Book balance sheet items represent those required by the special allocation regulations. When Oppar subsequently sells the land contributed by Propp#1 for $120,000, there is a book gain of $20,000 ($120,000 selling price less $100,000, but a tax gain of $60,000 ($120,000 selling price - $60,000 transferred basis). The book gain is allocated equally between Propp#1 and Propp#2, but the remaining $40,000 tax gain is all allocated to Propp#1 under § 704(c). If Propp#1 or Propp#2 sells the partnership interest to Perch before the sale of the contributed land, Perch succeeds to the selling partner's capital account (at least when the special allocation regulations apply) and to the seller's  § 704(c) adjustment.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  I. Introduction

B. Section 704(c)(and Reverse § 704(c)) Adjustments 

Although the nonrecognition principle of  § 721 prevents immediate tax consequences to the contributing partner on transfers of property, under § 704(c), the contributing partner (and not the other partners) remains responsible for the inherent tax consequences when the unrecognized gains or losses are realized by the partnership,34 but with the character of the gain, apparently, determined at the partnership level.35 Under a 2004 amendment to § 704(c),36 when property is contributed with a built-in loss, regardless of amount, the built-in loss is taken into account only by the contributing partner, and for all other purposes, the partnership's basis in the contributed property is its fair market value (except to the extent regulations may otherwise provide). This means that if the contributor's interest is transferred or liquidated before the partnership recognizes the loss, the loss disappears as far as the partnership is concerned, and is recognized by the contributor only to the extent recognized on disposition or liquidation of the interest, or when there is a nonrecognition disposition, by the successor.37
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34 § 704(b), (c);Regs.  § 1.704-3(a)(3)(ii) (defining built-in gain or loss). There is an exception for small disparities. Regs. § 1.704-3(e)(1); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 10.08[3] (6th ed. 1997). See 711 T.M., Partnerships —Formation and Contributions of Property or Services, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatment of § 704(c).

35 Regs.  § § 1.704-4(b) and 1.737-1(d), expressly so provide when  § 704(c) gain is accelerated under the mixing bowl rules. See III, E, below, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor. The character of the partnership's gain may be affected by the character of the property to the contributor. See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of how the tax character of property for the contributor controls the partnership's tax character for the contributed property.

36 § 704(c)(1)(C), as added by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(a), effective Oct. 22, 2004.

37 See V, D, 1, below, for a discussion, and 714 Partnerships — Allocation of Liabilities; Basis Rules, and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for more comprehensive treatments, of the 2004 amendment to § 743(b).

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In contrast, unrealized gain or loss on property transferred to a corporation is shared ratably by all shareholders, directly for shareholders of an S corporation, by being allocated ratably in proportion to their ownership of stock,38 and indirectly, for shareholders of a C corporation, because the burden or benefit of the corporate tax or saving is allocated ratably to the corporate shares. Thus, as a result of the application of the entity principle, contributing shareholders are allowed, or arguably required, to assign a portion of precontribution gain or loss to the other shareholders, subject only to any discount the other shareholders may apply as a business matter.39
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38 § 1366(a). See 730 T.M., S Corporations: Formation and Termination, for a discussion of this problem.

39 See generally Abrams, “Dealing with Contributions of Property, Part 1,” 2 Bus. Ent. 16 (Nov./Dec. 2000) (ceiling rule favors contributing partner; others favor other partners); “Part 2,” 3 Bus. Ent. 18 (Jan./Feb. 2001) (remedial allocation better than installment sale for long-lived property).

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Section 704(c) adjustments are made not only on disposition of contributed property, but also by adjustment of depreciation and similar allowances in the interim.40 Since book depreciation is deducted on the same schedule as tax depreciation,41 the book-tax disparity is eliminated when the property is fully depreciated for tax purposes, even though the partnership has not disposed of it.  Section 704(c) basically restores aggregate or pass-through principles to overcome the effect that the entity principle would otherwise have, if the contributing partner shifted inherent tax attributes at contribution to other partners. A purchaser of a partnership interest succeeds to the seller's  § 704(c) adjustment.42 Under the “mixing bowl” rules, all or part of the  § 704(c) adjustment may be realized if the contributed property is distributed within seven years to another partner, or other property is distributed within seven years to the contributing partner.43 When the mixing bowl rules do not apply, the contributing partner may indirectly recognize the  § 704(c) adjustment on distributions in determining the amount of gain or loss recognized, or the basis of distributed property.44
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40 Regs.  § § 1.704-3(b)(1) and (b)(2) Ex. 1(ii); 1.704-3(c)(1); (4) Ex. 1(ii) and Ex. 2; and 1.704-3(d)(2) and (7) Ex. 1(ii).

41 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of depreciation of contributed property.

42 Regs. § § 1.704-3(a)(7), 1.743-1(j)(2). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the seller's partnership tax characteristics to which the purchaser succeeds.

43 See III, E, below, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

44 See III, B, 1, a, below, for a discussion of the limitation of the distributee's transferred inside basis of distributed to the outside basis of the partnership interest for current distributions.

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The Code does not contain a provision equivalent to  § 704(c) for a partnership that has appreciated property when a new partner is admitted.45 The special allocation regulations permit revaluations of the partner's capital accounts to reflect the fair market value of partnership assets, and any book-tax disparities at that time, and generally encourage, if not require, equivalent adjustments that allocate unrealized gain or loss to continuing partners,46 for property distributed in kind,47 and on adjustments of partnership interests as a result of contributions of money, property or services, or distributions of money or property.48 Example 14(iv) in Regs. § 1.704-1(b)(5) suggests that failure to provide for such adjustments may involve substance-over-form, disguised gift, or compensation issues. Interestingly, it is hard to see how any of these apply on the facts of the Example itself, which seem to involve a business arrangement among unrelated parties dealing at arm's length in an investment transaction. Such adjustments of partnership unrealized gain or loss are sometimes called “reverse 704(c) adjustments,” because they apply to continuing partners when there are new partners or when a partner withdraws, but, functionally, they are equivalent to the  § 704(c) adjustments that apply to contributing partners. Obviously, to the extent made, reverse  § 704(c) adjustments are the mirror image of  § 704(c) adjustments. Since the provisions for reverse  § 704(c) adjustments are part of the special adjustment regulations, the result for partnerships not otherwise making special allocations is ambiguous at best, but the provisions that imply that failure to make reverse  § 704(c) adjustments may be improper under more general tax principles may require the purchaser to succeed to the seller's reverse  § 704(c) adjustments as well.
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45 There is also no  § 754 adjustment when a new partner contributes property to a partnership. Regs. § 1.743-1(a); see III, C, and IV, C, below, for a discussions of how the  § 754 election adjusts for differences between inside basis and value.

46 Regs. § 1.704-1(b)(2)(iv)(d)(3), (e) and (f), (b)(4)(i), and (b)(5)  Ex. 14(i), (ii) and (iv), and Ex. 18(ii), (vii), (ix) and (x); Regs. § 1.704-1(b)(1)(iv).

47 Regs. § 1.704-1(b)(2)(iv)(e).

48 Regs. § 1.704-1(b)(2)(iv)(f).

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Example: § 704(c) and Reverse § 704(c) Adjustments. Propp contributes a building(on leased land) with a 10-year remaining depreciable life, valued at $100,000 with a basis of $60,000, and Munn contributes $100,000 cash to form a partnership, Oppar, to repair and operate the building. Each receives a $100,000 capital account and a 50% interest in Oppar's capital and profits for their contributions. The Oppar partnership agreement satisfies the special allocation regulations. Neither Propp nor Munn recognizes any gain on the contribution. The $40,000 inherent gain in the office building is allocated to Propp under § 704(c). The book depreciation on the building is $10,000, allocable $5,000 each to Propp and Munn. The annual tax depreciation is only $6,000. Under § 704(c), $5,000 of the tax depreciation is allocated to Munn, and only $1,000 to Propp, eliminating the book-tax disparity over the 10-year period. Ignoring any other changes for operating results, both partners' book capital accounts are reduced to $80,000, over the first four years. Munn's tax capital account is reduced by the $20,000 tax depreciation to $80,000, while Propp's is reduced by the $4,000 depreciation to $56,000. Thus the book-tax disparity has been reduced from $40,000 ($100,000 -$60,000) to $24,000 ($60,000 adjusted book basis - $36,000), which, not coincidentally, is the difference between Munn's $80,000 capital account and Propp's $56,000 capital account.

If Oppar sells the building after four years for $120,000, when its book value, after depreciation, is $60,000($100,000 - $40,000 book depreciation), and its adjusted tax basis is $36,000 ($60,000 - $24,000 tax depreciation), there is $60,000 of book gain and $84,000 of tax gain. Propp's remaining § 704(c) adjustment of the  § 1231 gain is only $24,000 ($60,000 book value - $36,000 tax basis), since she has suffered $16,000 of reduced or “lost” depreciation, compared to Munn. $24,000 of the tax gain is allocated to Propp under § 704(c), and the remaining$60,000 tax gain is allocated equally to Propp and Munn, so that Propp recognizes $54,000 of tax gain, while Munn recognizes $30,000, corresponding to his book gain. Their book capital accounts are each increased to$120,000 by the gain. Their tax capital accounts are also increased to $120,000, eliminating the book-tax disparity.

If instead of selling the building, Propp sells her Oppar interest to Perch for $120,000, when the assets acquired with Munn's $100,000 contribution have a basis and value of cost, Propp realizes the same $54,000 gain ($120,000 price - $56,000 basis). Despite paying $120,000, Perch's capital account is the same$56,000 as Propp's, and he is subject to the same  § 704(c) adjustment for subsequent depreciation and gain on the office building.  An election under  § 754 can eliminate this problem.

Instead of purchasing Propp's Oppar interest, Perch contributes $120,000 cash to fund needed repairs at the beginning of the fifth year, and becomes an equal partner. As permitted, and encouraged by the special allocation regulations, Oppar revalues the building to $120,000 on its books with corresponding increases to Propp's and Surv's book capital accounts. Thus, the $40,000 inherent gain in the office building is allocated $20,000 each to Munn and Propp. The book depreciation on the building is $12,000, allocable$4,000 each to Propp, Surv and Munn. The tax depreciation remains only $6,000. Under  § 704(c) principles,$4,000 of the tax depreciation is allocated to Munn, reducing the book-tax disparity over the six-year balance of the depreciable life. The remaining $2,000 is allocated $1,000 each to Munn and Propp, reflecting the reverse  § 704(c) adjustment. Unsurprisingly, the result is the same as before Perch's admission, since Munn and Propp are entitled to their shares of the tax depreciation in preference to Perch.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  I. Introduction

C. Distribution or Withdrawal v. Sale 

Because of the pass-through nature of a partnership, it may be unclear whether a partner's withdrawing in consideration of a transfer to, and receipt by, the partner of money or property represents the withdrawing partner's retirement or withdrawal from the partnership or a sale of the partnership interest to the remaining partners.  When there is a contribution by a new partner close in time to what is labeled a distribution, the transaction may be a disguised sale to the new partner of what is usually only part of the partnership interest.49 The basic economic consequences are similar in that the withdrawing or distributee partner receives money or other consideration and terminates or reduces the interest in the partnership, but, as discussed in the following paragraphs and throughout this portfolio, the tax consequences may be dramatically different depending on which classification applies.
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49 § 707(a)(2)(B).  See III, G, 2, below, for a discussion of disguised sales of partnership interests.

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When the transaction is a sale of all or part of the partnership interest, under the entity principle, the selling partner has sold an asset with its own character, basis and holding period that is independent of the character, basis and holding period of partnership assets.50 Thus, the selling partner's gain or loss is determined by any difference between the amount realized and the outside basis of the partnership interest.51 The partnership interest is almost always a capital asset, but, under a reversion to the aggregate principle, a portion of the amount realized may be allocated to a ratable share of the partnership's ordinary income assets, producing ordinary income and capital gain or loss.52 Similarly, the purchaser has acquired a separate asset with its own basis and holding period independent of the partnership's inside basis in its assets.53 The inside basis of the partnership's assets is not adjusted to reflect any income, gain or loss realized by the seller, or for any difference between the purchase price and a ratable share of the inside basis of partnership assets including the selling partner's allocable share of goodwill, going concern value or similar intangibles whether or not shown on the partnership books.54 An adjustment may be made, when an election by the partnership under  § 754 applies.55 Because this applies only as to the purchasing partner, as a practical matter, this means that any portion of the purchase price allocable to goodwill, going concern value or other  § 197 intangibles may be amortized over 15 years,56 but only for the benefit of the purchaser.57 In addition, under a 2004 amendment to § 743, there is a mandatory downward adjustment when a partnership has a substantial (more than$250,000) built-in loss, even when no  § 754 election applies.58
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50 § 741; Regs. § 1.741-1. See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the consequences of a sale of partnership interest summarized in this section.

51 § 741; Regs. § 1.741-1(a).

52 § 751(a); Regs. § 1.751-1(a), (g) Ex. 1. See III, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

53 § 742; Regs. § 1.742-1. See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of determination of basis and holding period for sales of partnership interests.

54 § 743; Regs. § 1.743-1(a).

55 § § 743(b), 754 and 755; Regs. § § 1.743-1, 1.754-1, and 1.755-1(a) and (b).

56 § 197(c); Regs. § 1.197-2(a), (b), (h)(1) and (k) Ex. 27. See 533 T.M., Amortization of Intangibles, for a comprehensive treatment of amortization of  § 197 intangibles by the purchaser.

57 § 743(b); Regs.  § 1.743-1(a) to (e).

58 § 743(a) and (d), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(b), effective Oct. 22, 2004. See Notice 2005-32, § 3, 2005-1 C.B. 895 (interim guidance stating intent to amend regulations under  § 734 to require partnerships and partners to provide statements similar to those in Regs.  § 1.743-1(k) following distributions triggering mandatory basis adjustments; partnerships required to reduce basis of retained partnership property must comply with Regs.  § 1.743-1(a) as if a  § 754 election were in effect).

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Sale of a partner's entire interest terminates the partnership tax year for that partner only, which requires that the allocable share of partnership items until the date of disposition be reported for the year of disposition without regard to when the partnership tax year ends; while a sale of only part of a partnership interest does not close the partnership tax year, and the varying interests of the selling partner (and the purchaser) are taken into account in allocating partnership items for the year of sale.59 A disposition of 50+% of partnership profits and capital within a 12-month period terminates the partnership for tax purposes, and thus terminates the partnership tax year for every partner.60
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59 § 706(c); see IV, E, below, for a discussion of the closing of a partnership year on liquidation of a partnership interest.  The same principles apply to a sale of a partnership interest.

60 § 708(b)(1)(B); Regs. § 1.708-1(b)(2);see IV, F, 1, below, for a discussion of the kinds of disposition that terminate the tax partnership and the consequences of termination.

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On the other hand, when the transaction is a current or liquidating distribution to the distributee-partner the partner recognizes taxable gain only to the extent that money (generally, including marketable securities)61 distributed exceeds the outside basis of the partnership interest, and loss only when solely cash (not including marketable securities) and certain ordinary income assets are distributed.62 No loss is allowed for the distributee partner for current distributions, even when the distribution is limited to money and ordinary income assets and the interest of the distributee in partnership capital, distributions, profits and losses is reduced, proportionately or otherwise.63 The basis of ordinary income property received by the withdrawing partner generally is the same as the inside basis to the partnership, but limited by the outside basis of partnership interest reduced by any money distributed. The same limits apply to any other property (generally capital or  § 1231 assets) received in a current distribution,64 but the basis of other property received in a liquidating distribution is the same as any remaining outside basis, whether more or less than the inside basis or value of the property.65 The holding period of the partnership in the assets distributed generally is “tacked” to the holding period of the partnership interest, which, as a practical matter, means that it is the same as the holding period to the partnership.66 Neither the partnership nor the other partners are affected by current or liquidating distributions of money or other partnership assets, unless they involve distributions of ordinary income assets that result in a deemed exchange under § 751(b),67 or when an election under  § 754 is in effect to adjust the inside basis of partnership assets.68 Current or liquidating distributions in kind generally involve revaluing partnership property, including the distributed property, and making reverse  § 704(c) allocations.69
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61 § 731(c); Regs. § 1.731-2(a); see III, F, below, for a discussion of the meaning of marketable securities, and the consequences of partnership distributions of marketable securities.

62 § 731(a)(1); Regs. § 1.731-1(a)(1)(i). See IV, below, for a more comprehensive treatment of the tax treatment of liquidating distributions that are summarized in this and the following paragraphs.

63 § 731(a)(2); Regs. § 1.731-1(a)(2). See III, below, for a more comprehensive treatment of current distributions that are summarized in this and the following paragraphs.

64 § 732(a)(2); Regs. § 1.732-1(a).  See III, B, 1, a, below, for a discussion of the limitation of the transferred distributed basis of property to the outside basis of the partnership interest.

65 § 732(b); Regs. § 1.732-1(b). See IV, B, below, for a discussion of the basis of distributed property received in a liquidating distribution.

66 § 735(b); Regs. § 1.735-1(b). See II, B, 2, below, for a discussion of the tacked holding period for distributed property.

67 § § 731(b), 734(a) and 751(b) See 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the deemed exchange that is taxable to both the distributee partner and the partnership (remaining partners) when an otherwise nonrecognition distribution in kind results in shifts in interests in  § 751 property. See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of analogous ordinary income treatment under  § 751(a) on sales of all or part of a partnership interest.

68 § § 734(b), 754 and 755; Regs. § 1.734-1, 1.754-1(a), 1.755-1(c). See III, C, and IV, C, below, for discussions of the inside basis of partnership property to reflect gain or loss to the distributee or differences between the transferred inside basis of the distributed property and the basis of such property to the distributee.

69 Regs. § 1.704-1(b)(2)(iv)(e) and (f).

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Withdrawal payments on complete termination of a partner's interest may include not only liquidating distributions, also called  § 736(b) payments, but also  § 736(a) payments, which are any withdrawal payments that are not payments for the withdrawing partner's interest in partnership assets.70 Section 736(a) payments are classified as either distributive share payments, with their character determined by the allocable share of partnership income, or guaranteed payments, which are ordinary income to the distributee without regard to partnership income, depending on whether or not their amount is determined by partnership income.70.1 Section 736(a) payments are, in effect, deductible (or excludible) by the partnership (remaining partners), even when they may properly be considered attributable to unstated goodwill or similar intangibles.71 A 1993 amendment requiring partnerships in which capital is a material income producing factor to value, and to capitalize and amortize, the portion of a liquidating distribution attributable to unstated goodwill by such partnerships effectively limits this benefit to service partnerships.72 If they wish, service partners can provide for payments that are capitalized as goodwill by so providing in the agreement that provides for the withdrawal.73 When goodwill is capitalized, and a  § 754 election applies, the amount of the liquidating distribution allocable to it can be amortized by the remaining partners over 15 years.74 As a result, the stake for the partnership (remaining partners) is no longer the difference between deductibility and permanent capitalization, but only between current deduction and amortization. Nevertheless, it remains an important difference that can create significant professional responsibility problems, including conflict and confidentiality issues for the attorney representing the partnership in drafting the partnership or withdrawal agreement that should deal with these issues, in view of the differing interests of the potential or actual withdrawal and remaining partners(unless each partner has separate representation, which is far from the common situation).75
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70 § 736(a); Regs. § 1.736-1(a). See V, below, for a discussion of distinguishing between  § 736(a) payments and  § 736(b) payments.

70.1 See Wallis v. Comr., T.C. Memo 2009-243 (10/27/09) (Tax Court ruled that payments for partner's “units” were guaranteed payments taxed to partner as ordinary income, noting that: (1) each partner received same number of units each year for services rendered to partnership regardless of size of partner's partnership interest and without regard to partnership's income; and (2) units were not treated as part of partner's respective shares of partnership income or partnership property and were not reflected in partners' respective capital accounts).

71 § 736(a); Regs. § 1.736-1(a). See V, B, below, for a discussion of  § 736(a) payments. See Foxman v. Comr., 41 T.C. 535 (1965), acq., aff'd, 352 F.2d 466 (3d Cir. 1965) (withdrawal treated as sale based on terms of agreement); Tolmach v. Comr., T.C. Memo 1991-538 (payments after dissolution from continuing firm, not from partners as individuals); PLR 9715008 (partnership agreement revision to have remaining partners purchase interest of withdrawing partner instead of having limited partnership make liquidating payments is effective, so that payments by remaining partners to withdrawing partner under revised agreement are purchase of withdrawing partner's interest under § 741, and are not liquidation of that interest under § 736; portion of contingent payments is imputed interest and is deductible under § 163, subject to any applicable limitations).

72 § 736(b)(3). See V, B, 1, b, below, for a discussion of unstated goodwill in service partnerships.

73 § 736(b)(2)(b); Regs. § 1.736-1(a)(2), (3). See V, B, 1, a, below, for a discussion of what constitutes an agreement specifying a payment for goodwill.

74 It is probably no coincidence that the adoption of  § 736(b)(3) requiring capitalization for nonservice partnerships and  § 197 permitting the amortization of goodwill were both part of the Omnibus Budget Reconciliation Act of 1993, P.L. 106-66, § § 13261(a), 1362(a). See 533 T.M., Amortization of Intangibles, for a discussion of these amendments.

75 A form of Representation Letter dealing with such issues is included in the Working Papers.

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The partnership tax year closes for a withdrawing partner upon the final payment in liquidation of the interest, even if the interest terminates earlier under state law.76 The withdrawing partner does not recognize gain on liquidating payments paid over time until aggregate payments exceed the outside basis of the partnership interest, and does not recognize loss until receipt of the final payment.77 A liquidating distribution, even to a 50+% partner, does not terminate the partnership.78
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76 Regs. § 1.736-1(a)(1)(ii);see IV, E, below, for a discussion of the closing of the tax year for a withdrawing partner.

77 § 731(a)(2); Regs. § 1.731-1(a)(2). See V, C, 3, below, for a discussion of recognition of loss when there is a series of liquidating distributions.

78 See IV, F, 1, below, for a discussion of the kinds of transactions that are sales or exchanges terminating the partnership.

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A current or liquidating distribution may be recast as a disguised sale of all or part of the partnership interest when the payment is in substance financed by a new or continuing partner.79 On the other hand, the regulations explicitly recognize that one partner in a two-person partnership may either sell the interest to the other partner,80 or receive liquidation payments under § 736.81 The choice is apparently part of the flexibility intended by Subchapter K, giving the parties freedom without concern about the anti-abuse rules.82
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79 § 707(a)(2)(B). See III, G, 2, below, for a discussion of disguised sales of partnership interests.

80 Regs. § 1.741-1(b).

81 Regs. § 1.736-1(a)(6).

82 Regs. § 1.701-2(a)(3). See I, D, below, for a discussion of the anti-abuse rules.

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Unless the facts indicate a disguised sale, when the documents are unambiguous, the stated form of the transaction—as a sale to the continuing partners, or as a liquidating distribution by the partnership of the withdrawing partner's interest—generally controls the tax consequences.83 When there is no agreement, or the agreement is ambiguous, the courts seek the substance of the transaction.84 Obviously, the partners should be advised to make the choice explicit. This may, however, involve negotiations over the differences that advantage one party and disadvantage the other, and may be particularly tricky when the only lawyer involved is the partnership's lawyer. 85
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83 See, e.g., Foxman v. Comr., 41 T.C. 535 (1965), aff'd, 352 F.2d 466 (3d Cir. 1965) (finds agreement provided for sale so that no  § 736(a) payments; emphasizes that parties have a choice); Cooney v. Comr., 65 T.C. 101 (1975) (finds that ambiguous agreement provides for liquidation of interest); Miller v. U.S., 67-2 USTC ¶ 9685 (Ct. Cl. 1967) (payment to retiring partner based on share of future commissions is for goodwill;emphasizes that payments for unspecified goodwill are deductible under § 736(a) but not under § 741;find liquidation of interest even though withdrawing partner established that it was a sale when IRS bungled case); Sloan v. Comr., T.C. Memo 1981-641 (although two partners formed new partnership with a third party, treats old partnership as terminated; since new partnership did not assume obligation for  § 736(a) payments to terminating partner, old partners deduct payments under § 162(a)); Champlin v. Comr., T.C. Memo 1977-196 (liquidation agreement become part of partnership agreement; find liquidation, not sale of interest based on a “careful examination of the record and all the factors affecting the negotiations between the parties”); Zager v. Comr., T.C. Memo 1987-107, aff'd in unpub. opin. 842 F.2d 336 (Table)(9th Cir. 1988) (amounts owed by partner to partnership offset against withdrawal payment are part of  § 736 payment).

84 See, e.g., Smith v. Comr., 37 T.C. 1033 (1977), aff'd, 313 F.2d 16 (10th Cir. 1962) (premium over book value paid to expelled partner in service partnership not explicitly designated as goodwill was  § 736(a) payment); Comr. v. Jackson Investment Co., 346 F.2d 187 (9th Cir. 1965) rev'g and rem'g 41 T.C. 675 (1964) (payment referred to as “guaranteed payment or a payment for ‘goodwill’”determined to be for goodwill because agreement elsewhere referred to it as a payment for goodwill); Spector v. Comr., 641 F.2d 376 (5th Cir. 1981) (payment to retiring accountant immediately following merger of his practice with continuing partnership was not for goodwill when agreement characterized it as guaranteed payment, even though the withdrawing partner never rendered services to continuing partnership). See V, B, I, b, below, for a discussion of determining goodwill in connection with withdrawal payments for service partnerships when the agreement is unclear.

85 The working papers contain a form of representation letter designed to deal with the representation issues that arise in negotiating the partnership agreement or the withdrawal agreement as a result of the ambiguities and differing interests of the terminating and continuing partners when one partnership lawyer represents all parties.

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Example: Withdrawal v. Sale. Munn, Propp and Surv are equal (one-third) partners in a partnership law firm, Oppar, so that capital is not a material income-producing factor. The Oppar partnership agreement satisfies the special allocation regulations. Munn's capital account is $50,000, primarily representing accumulated income that, along with similar accumulated income of Propp and Surv, provides working capital. As a result of personal and policy dissension, Munn wants out, and Propp and Surv are glad to see him go. Munn insists on receiving $75,000 over three years for his interest. Propp and Surv agree. Munn insists on receiving notes signed by Propp and Surv, individually, to represent the deferred payment obligation. Oppar guarantees the notes, and all parties recognize that the funds to pay Propp will come from Oppar. As a matter of economic substance, there is little difference between Munn's interest being liquidated by Oppar, and its being sold to Propp and Surv. Nevertheless, since there are different tax consequences of following one route or the other (in this case, principally the tax consequences of the excess of the payment to Munn over his capital account), a choice must be made. If the parties expressly state that the transaction is a sale of Munn's Oppar interest to Propp and Surv, the $25,000 premium, presumably, represents goodwill, that is a capital gain to Munn, and that represents part of the purchase price for Propp and Surv, amortizable over 15 years under  § 197 when a  § 754 election applies. Similarly, if the agreement expressly states that it is a liquidating distribution to Munn from Oppar, and that Propp and Surv's endorsement is an additional security, the $25,000 premium may still represent goodwill, but as long as the agreement does not say so, the payment is a  § 736(a) payment, deductible as a guaranteed payment by Oppar, that is ordinary income to Munn. If the parties expressly state that the withdrawal payment is a liquidating distribution, there is no current guidance on the issue since former proposed regulations dealing with the issue have been withdrawn.

Since capital is not a material income-producing factor for a law firm, if the parties leave it ambiguous, the IRS or a court must decide, primarily based on the terms of any written document. The imposition of primary responsibility for the deferred payments on Propp and Surv in their individual capacities probably indicates a sale. On the other hand, an Oppar note guaranteed by Propp and Surv probably indicates a withdrawal. If the agreement specifically labels the amount as being for goodwill, or if Oppar is a capital partnership, but the agreement does not label the excess as for goodwill(or is ambiguous), the $25,000 should be capital gain for Munn, and capitalized by Oppar, amortizable under  § 197 only if a  § 754 election applies.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  I. Introduction

D. Anti-Abuse Regulations 

Controversial “anti-abuse” regulations represent the IRS's response to its perception that the partnership rules sometimes are used for improper tax avoidance. The “anti-abuse”regulations permit 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.86 In general, they apply to transitory and artificial arrangements.87
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86 Regs. § 1.701-2(b). See 710 T.M., Partnerships —Conceptual Overview, for a comprehensive discussion of the anti-abuse regulations.

87 See, e.g., Notice 2002-65, 2002-2 C.B. 690 (attacks a use of straddles in pass-through entities with redemptions of the interests of some owners at FMV between closing the gain and loss legs of the straddle); Notice 2002-50, 2002-2 C.B. 98 (attacks a similar straddle deal using tiered partnerships and no  § 754 election);FSA 200205021 (anti-abuse rule does not apply to foreign partnership representing joint venture of two U.S. corporations in country of formation; valid reason to form foreign partnership;  § 482 issue left open); FSA 200230001 (discusses application of § 482); Notice 2000-44, 2000-2 C.B. 255. Marion, “The Final Partnership Anti-Abuse Regulation:The Treasury Redefines the ‘Intent of Subchapter K,’”73 Taxes 161 (1995); Dell, “Sanctifying the Smell Test: Some Thoughts on the Final Partnership Anti-Abuse Regulations,”23 J. Real Est. Tax'n 307 (1995); Liveson, “Anti-Abuse Reg. Confuses and Clarifies,” 24 Tax'n for Law. 4 (July/Aug. 1995).

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The anti-abuse regulations are grounded on the “intent”of subchapter K, but, since the provisions of subchapter K reflect different resolutions of the entity versus aggregate dichotomy in different contexts, or even within the same context, and, particularly with the numerous amendments during the more than half century since original enactment, determining a single intent for Subchapter K is well beyond difficult. Nevertheless, the regulations state that subchapter K is intended to “permit taxpayers to conduct joint business(including investment) activities through a flexible economic arrangement without incurring an entity-level tax.”88 Thus, both conduit (aggregate) taxation and flexibility are recognized as major principles of partnership taxation, but in a manner that does not provide any meaningful guidance on the limits of those principles.89
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88 Regs. § 1.701-2(a).

89 See, e.g., Gann and Stroud, “The Recent Evolution of Anti-abuse Rules,”66 Tax Notes 1189 (1995); Banoff, “Anatomy of an Antiabuse Rule: What's Really Wrong with Reg. § 1.701-2,” 66 Tax Notes 1859 (1995); Hyde, “Anti-antiabuse Rule Rhetoric Is Full of Holes,” 67 Tax Notes 299 (1995).

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The regulations add the unsurprising requirements:(i) that each partnership must be bona fide (without elaboration), and that each partnership transaction have a substantial business purpose; (ii) that the form of any partnership transaction must be one respected under general substance-over-form principles; and (iii)that application of partnership tax principles to a transaction must reflect the economic agreement.90
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90 Regs. § 1.701-2; see T.D. 8588, Subchapter K Anti-Abuse Rule, 60 Fed. Reg. 23, 24 (1/3/95) (“Overview of Provisions”).

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The regulations acknowledge that certain provisions of subchapter K and the regulations were adopted “to promote administrative convenience and other policy objectives,” but that the application of such provisions in some circumstances may “produce tax results that do not properly reflect income.”91 The regulations provide that, nevertheless, the clear reflection of income requirement will be satisfied if the bona-fide partnership, business-purpose and substance-over-form requirements are satisfied, and the application of the provision to the transaction, as well as the ultimate tax results, are “clearly contemplated”by the provision in question.92
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91 Regs. § 1.701-2(a)(3).

92 Regs. § 1.701-2(a)(3). See, e.g., Regs.  § 1.701-2(d) Ex. 6.

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The regulations authorize the IRS to recharacterize a transaction that involves the use of a partnership if a principal purpose of the arrangement is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner inconsistent with subchapter K.93 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.94
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93 Regs. § 1.701-2(b).

94 Regs. § 1.701-2(e).

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Thus, virtually any partnership transaction may have to run the gauntlet of the anti-abuse regulations. Of particular note with respect to the subject matter of this portfolio, several examples in the regulations address the use of the  § 754 election and the basis allocation rules of § 732. In addition, as discussed when appropriate, a number of regulations relating to provisions discussed in this portfolio have their own anti-abuse provisions, most of which do not refer to the general anti-abuse provision.

Under the anti-abuse regulations, the IRS reserves broad power to disregard partnerships and treat the activities as conducted individually, ignore partners, adjust methods of accounting, reallocate partnership income, or make other adjustments or modifications when it finds abuse.95
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95 Regs. § 1.704-2(b).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  II. Partnership Distributions—In General

This section deals with the principles that apply to all partnership distributions, whether current or liquidating. There are, naturally, some differences in application of these principles to current and liquidating distributions that are discussed in III and IV, below, respectively, with additional considerations for liquidating distributions covered in V, below.96 A “liquidation of a partner's interest” is defined as a single distribution, or a series of distributions, by a partnership to a partner resulting in a termination of the distributee's entire interest in the partnership.97 A current distribution is defined as any distribution other than a liquidating distribution.98 Thus, a distribution that reduces a partner's interest in partnership capital and profits from 50% to 5%, resulting in a partial liquidation of his partnership interest, is still classified as a current distribution. Examples of current distributions include a distribution of the partner's share of either current or prior year's earnings of the partnership, and a return of even the partner's entire capital investment, as long as the partner continues to share in partnership profits or losses. There are also numerous other exceptions and qualifications to these general principles that are discussed in the following sections of this chapter, and in the rest of this portfolio.
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96 E.g.,  § § 731(a)(1) and 732(a) for current distributions and  § § 731(a)(2) and 732(b) for liquidating distributions.

97 § 761(d); Regs. § § 1.731-1(a)(2), 1.761-1(d).

98 Regs. § 1.761-1(d).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  II. Partnership Distributions—In General

A. Nonrecognition of Gain or Loss 

Paralleling  § 721 providing nonrecognition on transfers to partnerships,99  § 731 provides that the distributee partner and the partnership—the remaining partners—do not recognize gain or loss on distribution of property, including money unless the amount of the money exceeds the outside basis of the partnership interest.100 This is consistent with the pass-through principle, because the partners have already paid tax on the income when received by the partnership,101 There is no reference to money in § 721, presumably because a contributor never realizes gain or loss on transfers of money, which always has a basis equal to value.102 Under § 752(b), a reduction in a distributee's share of partnership liabilities is a constructive money distribution,103 that may result in gain recognition by the distributee.
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99 See 710 T.M., Partnerships —Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussions of the nonrecognition on contributions to partnerships.   Section 351 provides similar, but more limited, nonrecognition for transfers to controlled corporations.

100 § 731(a), (c);Regs. § 1.731-1(a). See III, A, 1, below, for a discussion of gain recognition on distributions that exceed outside basis.

101 See 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of how partners are taxed on partnership income.

102 But cf., e.g., Rev. Rul. 82-96, 1982-1 C.B. 113 (exchange of gold bullion for Canadian Maple Leaf coins traded for bullion value well above face is like-kind exchange); Rev. Rul. 76-249, 1976-2 C.B. 21 (sale of real estate for silver dollars—worth three times face based on silver content—is exchange for value of the coins, not sale for face amount.

103 See Rev. Rul. 84-102, 1984-2 C.B. 119 (deemed distribution to continuing partners, when new partner is allocated a share of liabilities); Rev. Rul. 79-205, 1979-2 C.B. 255 (increase in outside basis from the distributee's taking on partnership liability individually is simultaneous with any reduction in the distributee's share of partnership liabilities);see II, D, below, for a discussion, and 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for detailed treatments of how shifts in liabilities are treated as contributions and distributions).

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A distributee partner must recognize gain under § 731(a)(1), however, to the extent that any “money” distributed (including a reduction in a partner's share of partnership liabilities) exceeds the adjusted basis of the distributee's interest in the partnership. The fair market value of marketable securities is considered “money”for purposes of § 731(a)(1).104 Since liabilities are taken into account in determining outside basis of partnership interests, it is difficult to see how net liability distributions can occur for a pro rata distribution.
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104 § 731(c); Regs. § 1.731-2(a), (b); see III, F, below, for a discussion of the tax consequences of distribution of marketable securities when they are considered to be money and when they are not.

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When the distribution involves a change in interest in ordinary income property, technically known as  § 751 property, gain or loss may be recognized by both the distributee partner and the partnership(remaining partners).105 In addition, when the distribution involves property contributed with a built-in gain or loss (§ 704(c) adjustment), a distribution within seven years of contribution may result in gain recognition by the contributing partner under the “mixing bowl” rules.106 Moreover, when the distribution is sufficiently related to a contribution by the distributing partner or another partner, there may be gain under the disguised sale rules.107
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105 § 751(b). See II, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

106 § § 704(c)(1)(B), 737. See III, E, below, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

107 § 707(a)(2). See III, G, 2, below, for a discussion of when distributions and contributions are sufficiently related to be disguised sales of partnership interests.

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  II. Partnership Distributions—In General

B. Basis and Holding Period 

Although initially, and frequently thereafter, the sum of the partnership's basis in its assets (“inside basis”)equals the sum of the partners' bases in their partnership interests(“outside basis”) plus partnership liabilities, under the entity principle, this relationship is frequently not the case.108 On the other hand, and as a normal consequence of nonrecognition of gain or loss for partnership distributions, the starting point of the distributee partner's basis in any property distributed by the partnership is a transferred basis measured by the inside basis of the distributed property;109 the holding period is a tacked holding period measured by the partnership's holding period of the distributed property, not by the holding period of the partnership interest;110 and, in some circumstances, the character of the property to the partnership carries over.111 The distribution reduces the distributee's outside basis in the partnership interest by the amount of money and the basis of property distributed.112 The distribution does not affect the partnership's basis in undistributed property,113 unless there is a substantial (more than $250,000) basis reduction for a liquidating distribution,114 or unless an election under  § 754 applies.115 Under the special allocation regulations, partnership assets are revalued when there are distributions in kind, and distributed assets are applied against capital accounts at fair market value.116
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108 See II, B, 1, below, for a discussion of the outside basis of a partner's interest, including factors that make it vary for the inside basis of partnership assets.

109 § 732(a), (b);Regs. § 1.732-1(a), (b).  See III, B, 1, and IV, B, below, for discussions of the basis of property distributed, including limiting the transferee inside basis to the outside basis of the partnership interest, and possibly increasing the basis of capital and  § 1231 property to equal the outside basis.

110 § 735(b). See III, B, 2, b, below, for a discussion of the transferred holding period of distributed property.

111 § 735(a). See III, B, 2, a, below, for a discussion of the continuation of the character of distributed property, particularly when it is less advantageous than the character to the distributee.

112 § 733; Regs. § 1.733-1. See III, B, 1, b, below for a discussion of the effects of distributions of money and property on the partner's outside basis.

113 § 734(a); Regs. § 1.734-1(a). See III, C, and IV, C, below, for discussions of this factor.

114 § 732(a), (d); see IV, C, 1, below, discussion of the effect of a substantial basis reduction.

115 § 734(b); Regs. § 1.734-1(a); see III, C, and IV, C, below, for discussions of inside basis adjustments when a  § 754 election applies.

116 Regs. § 1.704-1(b)(2)(iv)(e), (f). See I, A, above, for a discussion of revaluation of capital accounts.

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1. Partner's Outside Basis 

The outside basis of those who form a partnership is initially the amount of money and the basis of property contributed, which is adjusted for income, losses, subsequent contributions and distributions, and partnership liabilities. The initial outside basis of a purchaser of a partnership interest is the purchase price117 including money, debt obligations, and property paid,118 similarly adjusted for subsequent events. Similarly, the initial outside basis of a donee is generally equal to the donor's basis at the time of the gift, possibly adjusted for gift tax paid.119 The initial basis of the successor to a deceased partner's interest's is the fair market value of the interest on the date of the decedent's death (or on the alternate valuation date if so elected by the personal representative of the decedent's estate), at least as long as there is an estate tax.120 The distributee's outside basis in the partnership is reduced by current distributions of money (including distributions from reduction in the share of liabilities),121 with gain recognized if there is an excess.122
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117 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M. Partnerships —Allocation of Liabilities; Basis Rules, for comprehensive treatments of determining outside basis.

118 § § 742, 1012.

119 § § 742, 1015.

120 § § 742, 1014 (for property acquired from a decedent dying before 2010). See also FSA 199935053 (adjusted basis for sale of inherited partnership interest is FMV increased by decedent's partnership liabilities measured as of the date of decedent's death plus adjustments for interim years in accordance with  § § 705 and 752). Cf. § 1022, as added by the 2001 Tax Relief Act, P.L. 107-16, § 542, for property acquired from a decedent dying after 2009.

121 § 733(a); Regs. § 1.733-1.

122 § 731(a)(1); Regs. § 1.731-1(a)(1)(i).

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A partner with several classes of interests, for example, as both a general and a limited partner (or equivalent classes of LLC member interests), nevertheless has only a single or unitary basis in the tax partnership interest.123 Although liability sharing rules may create allocation complications on a sale of part of a partnership interest,124 the same complications should not apply to partnership distributions in light of the bifurcation approach to liability allocations.125
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123 See Rev. Rul. 84-53, 1984-1 C.B. 159 (partner with several classes of interests, for example, as both a general and a limited partner, nevertheless has only a single basis in a partnership interest; applied in several situations involving sale of interests in limited partnership; in effect subtract out liabilities and transfer share with interest to which it relates, e.g., recourse liabilities with general partnership interest). 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).

124 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of how liability allocations affect the basis and amount realized when a partner with different classes of interest transfers less than all of the interest.

125 See III, A, 2, b, below, for a discussion of the bifurcation approach to liability allocations for liabilities transferred in distributions and contributions of encumbered property.

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When property is transferred in nonrecognition transactions, including contributions to,126 and distributions by,127 partnerships, the transfer usually does not result in a cost basis for the property, but a substituted basis,128 which ensures that the unrecognized gain or loss in the transferred property will eventually be recognized. The transferee's basis in the property contributed or distributed is a transferred basis that is the same as the basis to the transferor, possibly adjusted for any gain recognized by transferor.129 The adjustment to the outside basis of the contributing or distributee partner's partnership interest is an exchanged basis, also measured by the basis of the transferred property.130 There is considerable authority that transferred basis includes not only the amount of the transferor's basis, but also other characteristics that are closely entwined with basis or liabilities transferred.131
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126 § 721; Regs. § 1.721-1(a).

127 § 731; Regs. § 1.731-1(a).

128 § 7701(a)(42).

129 § § 7701(a)(43), 723, 732; cf. § 362 (similar principle for corporations).

130 § § 7701(a)(44), 722, 723; cf. § 358 (similar principle for corporations).

131 See, e.g., Comr. v. Joseph E. Seagram &  Sons, Inc., 394 F.2d 738 (1968), rev'g 46 T.C. 698 (1966) (subsidiary required to retain parent's LIFO inventory layers for property transferred in a  § 351 transaction); Rev. Rul. 70-565, 1970-2 C.B. 110 (follows Seagram); Rev. Rul. 79-127, 1979-1 C.B. 189 (transferee of partnership reporting inventories using lower of cost or market must restore write-downs by transferor to income as a condition of electing LIFO); Philadelphia and Reading Corp. v. U.S., 602 F.2d 338 (Ct. Cl. 1979) (transferee in  § 351 transaction entitled to amortize mining development expenditures made by transferor); cf., Hempt Bros. Inc. v. U.S., 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S. 826 (1974) (transferee corporation must report, as ordinary income, receivables transferred by cash-method partnership and has zero basis in inventory when predecessor partnership improperly expensed costs).

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Example: Outside Basis of Partnership Interest. Munn, Propp and Surv each have a one-third interest in the residual profits of a limited partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn acquired his Oppar limited partnership interest by contributing$100,000; Propp acquired her Oppar limited partnership interest by contributing real estate with a basis of $40,000 and a value of $100,000;and Surv, Oppar's sole general partner, received a profits-only interest. The Oppar partnership agreement provides that all losses are allocated equally to Munn and Propp, with an income chargeback equal to the losses allocated to Munn and Propp before the equal one-third allocation of profits begins, and provides that nonrecourse liabilities are allocated in accordance with profit shares. Oppar borrowed $800,000 on a nonrecourse mortgage to improve the real estate contributed by Propp. Oppar has allocated $100,000 of losses attributable to interest and depreciation$50,000 each to Munn and Propp, but has reduced the principal of the nonrecourse mortgage only to $790,000. The shares of the $790,000 nonrecourse mortgage should be Propp $320,000 ($60,000  § 704(c) adjustment + $50,000 income chargeback + $210,000 (1/3  of $630,000 balance of nonrecourse mortgage ($790,000 – $60,000 – $100,000 income chargeback))allocated on residual profit share); Munn $260,000 ($50,000 income chargeback + $210,000 residual profit share), and Surv $210,000 (residual profit share).  The outside basis of each partner's interest is Munn$310,000 ($100,000 contribution – $50,000 loss + $260,000 nonrecourse mortgage share), Propp $310,000 ($40,000 basis of contribution –$50,000 loss + $320,000 share of nonrecourse mortgage), and Surv $310,000(share of nonrecourse mortgage). Their respective capital accounts are Munn $50,000 ($100,000 cash contribution – $50,000 loss), Propp $50,000 ($100,000 value of property – $50,000 loss) and Surv $0. Note that the nonrecourse mortgage allocation provides Propp with the basis to deduct the losses.

Surv purchased Munn's limited partner interest for $100,000. Surv succeeded to Munn's $50,000 capital account. After the purchase, Surv's outside basis in her Oppar interest, general and limited, became $360,000 ($100,000 purchase price + $260,000 Munn's share of nonrecourse mortgage). Her capital account became $50,000(Munn's transferred capital account).

More than one year later, when she and Propp have each been allocated an additional $50,000 loss and the nonrecourse mortgage has been reduced to $770,000, Surv receives a distribution of $150,000 in connection with a reduction in her residual profits interest to 50%.  Before the distribution, the shares of the $770,000 nonrecourse mortgage should be Propp $330,000 ($60,000  § 704(c) adjustment + $100,000 income chargeback + $170,000 (1/3  of $510,000 balance of nonrecourse mortgage ($770,000 – $60,000 – $200,000 chargeback); and Surv $440,000 ($100,000 income chargeback + $340,000 (2/3  of$510,000 balance of nonrecourse mortgage)).  The outside basis of each partner's interest is now Propp $270,000 ($40,000 basis of contribution –$100,000 loss + 330,000 share of nonrecourse mortgage), and Surv $440,000($100,000 [Munn] contribution – $100,000 [Munn and Surv] losses+ $440,000 nonrecourse mortgage share). Their respective capital accounts are Propp $0 ($100,000 value of property – $100,000 losses)and Surv $0 ($100,000 [Munn] contribution – $100,000 total losses).

Under the agreement, the reduction in her profits interest is all allocated to the limited partnership interest and reduces her share of future losses to one-third share of profits (after the income chargeback) to one-sixth interest as a limited partner and retains her one-third profits interest as a general partner. After the distribution, the shares of the $770,000 nonrecourse mortgage should be Propp $415,000 ($60,000  § 704(c) adjustment + $100,000 income chargeback + $255,000(1/2  of $510,000 balance of nonrecourse mortgage ($770,000 -$60,000 - $200,000 income chargeback); and Surv $355,000 ($100,000 income chargeback + $255,000 (1/2  of $510,000 balance of nonrecourse mortgage)). The change in profit shares shifted $85,000 of the nonrecourse mortgage from Surv to Propp, increasing the distribution to $185,000. The outside basis of each partner's interest is now Propp $355,000($40,000 basis of contribution - $100,000 loss + 415,000 share of nonrecourse mortgage), and Surv $290,000 ($100,000 [Munn] contribution -$100,000 [Munn and Surv] losses + $355,000 nonrecourse mortgage share) -$150,000 cash received.  Their respective capital accounts (ignoring any revaluation to reflect the appreciation implied by the excess of the distribution over the book value of the capital accounts) are Propp $0 ($100,000 value of property - $100,000 losses) and Surv $150,000 ($100,000 [Munn] contribution - $100,000 total losses) - $150,000 cash distribution. Surv does not realize any gain on the distribution (including the distribution related to the liability shift, since the total $235,000 distribution ($150,000 cash + $85,000 liability shift) does not exceed her $440,000 outside basis before the distribution.

2. Holding Period of a Partnership Interest 

Since the reinstatement of a significant capital gains preference for long-term gains, the partnership's holding period for its assets and the partner's holding period for the partnership interest are important.132 Under an application of an entity approach, a partner's holding period for the partnership interest, like outside basis, is determined separately from the partnership's holding period of the assets.133 A purchaser's holding period begins at acquisition, but, as is common for nonrecognition transactions, the holding period rules under  § 1223 ensure that long-term capital gains and losses are not converted into short-term capital gains and losses by nonrecognition transactions, including contributions, distributions and other transfers,134 or for any other purposes for which holding period is relevant, including the application of § 1231. Partnership income and losses passed through to the partner do not affect the holding period.135
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132 The cutoff for distinguishing between short-term and long-term is currently “more than one year.”  § 1222(1) to (4). In addition, property used in a trade or business cannot be treated as a  § 1231 asset unless it is held for more than one year. § 1231(b)(1). See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of holding period issues.

133 See GCM 36196; Comr. v. Lehman, 165 F.2d 383 (2d Cir. 1948), aff'g 7 T.C. 1088 (1946), acq., cert. denied, 334 U.S. 819 (1948) (holding period of partnership interest is not determined by partnership's holding period of assets; partners do not split holding period for increase in percentage interest on withdrawal of a partner, but some language may not be inconsistent with splitting the holding period, since the issue of actual contributions was not involved).

134 § § 1223(1) and (2), 723;Regs. § § 1.1223-1(b), 1.723-1.

135 Regs. § 1.1223-3(a).

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The holding period rules generally provide that the period the property transferred in a nonrecognition transaction was held before its transfer to the partnership is added to the period it was held by the transferee in determining satisfaction of the holding period requirements for long-term capital gain and other purposes. Thus in a nonrecognition contribution, the period that the contributor held the property is included in both the partner's holding period in the partnership interest, and in the partnership's holding period in the property received.  Note, however, that in determining the holding period of the partnership interest, tacking is permitted only for nonrecognition contribution of capital assets and  § 1231 property, including recapture property, but not to the extent it is attributable to money or to inventory or other ordinary income assets,136 or to depreciable property not held for more than one year when contributed.137
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136 § 1223(1); Regs.  § 1.1223-3(e) (all § 751(c) property is ineligible for tacking). Although a corporate shareholder making a nonrecognition transfer under  § 351 can convert ordinary income inherent in some contributed property into capital gain, if it has been held for the appropriate period, § § 704(c), 735 and 751 effectively prevent a similar benefit for a partner. See I, B, above, and III, B, 4 and III, E, below, for discussions, and 710 T.M., Partnerships — Conceptual Overview, for a comprehensive treatment of how these provisions prevent such conversion.

137 Under § 1231(b), trade or business property held for one year or less is not  § 1231 property.

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If a partner acquires partnership interests at different times or for different kinds of property, the regulations expressly provide a split holding period for the entire partnership interest, allocated in proportion to the fair market value of the contributed property,138 so that on sale or exchange of all or part of the partnership interest there may be both long- and short-term gain or loss.139 All  § 751 property, including potential depreciation recapture, is ineligible for tacking,140 so that any portion of the partnership interest attributable to contributions of  § 751 property starts a new holding period. Since gain attributable to  § 751 property is ordinary income, contribution of  § 751 property within one year of sale is disregarded in determining the holding period of the interest if any portion has a holding period of more than one year.141 Subsequent capital contributions and deemed capital contributions from the partner's assumption of a partnership liability, but not from a shift of partners' shares of liabilities,142 can start new split holding periods.143 Money contributions and money distributions within one year before a sale or exchange, including a distribution, of all or a portion of the partner's interest in the partnership are netted.144 Although a purchase by a partner of an interest of another partner starts a new holding period for the purchased interest,145 an increase in proportionate interest when another partner's interest is liquidated, in whole or part, does not.146 In certain cases, a portion of the interest in a publicly traded partnership may be treated as having a separate holding period.147 Any gain recognized on a distribution of money in excess of the outside basis is gain on the partnership interest, which can include long- or short-term gain, depending on the holding period.148
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138 Regs. § 1.1223-3(a), (b) and (f) Ex. 1;T.D. 8902, “Capital Gains, Partnership, Subchapter S, and Trust Provisions,” 65 Fed. Reg. 57092 (9/21/00); see Aliber v. Comr., T.C. Memo 1987-10 (separate holding periods for blocks of limited partnership interests purchased on different dates); Banoff, “Partnership Interest Transfers Under the Holding Period Final Regs: Opportunities and Traps Remain,”94 J. Tax'n 211 (2001) (all you ever wanted to know about split holding periods, but didn't know enough to ask).

139 Regs.  § 1.1223-3(c)(1) and (2)(ii). A portion of the interest in a publicly traded partnership may be treated as having an ascertainable holding period. Regs. § 1.1223-3(c)(2)(i).

140 Regs. § 1.1223-3(e). See III, D, 3, below, for a summary discussion; and 710 T.M., Partnerships —Conceptual Overview, for a more comprehensive treatment of including depreciation recapture in the definition of unrealized receivables for certain purposes.

141 Regs.  § 1.1223-3(b)(4) and (c)(2)(ii).

142 Regs.  § 1.1223-3(b)(3) (incorporating Regs. § 1.704-1(b)(2)(iv)(c)) (presumably because liability shifts not reflect any increase partnership net assets).

143 Regs.  § 1.1223-3(f) Ex. 4; see ABA Section of Taxation, “Comments on Proposed Regulations under Section 1(h) and 1223 Issued August 9, 1999,” 19 Tax Mgmt. Weekly Rep. 986 (June 12, 2000) (objects to split holding period for pro rata contributions and in some other cases); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 4.02[2][a]at S4-4 to S4-6 (2002 Cum. Supp. No. 4).

144 Regs.  § 1.1223-3(b)(2) and (f) Ex. 3. Regs.  § 1.1223-3(b)(3) provides that deemed contributions of cash are to be disregarded to the extent the amounts are disregarded under Regs. § 1.704-1(b)(2)(iv)(c) (disregards transfers of liabilities unless personal liability is assumed, the assuming party is ultimately liable, and the creditor is aware of the transfer and can directly enforce the liability against the transferee).

145 Regs. § 1.1223-3(a)(1).

146 Regs. § 1.1223-3(b)(3), (f) Ex. 7. The regulations incorporate the rule in Regs. § 1.704-1(b)(2)(iv)(c). The rationale for this rule is that a deemed contribution of cash resulting from a shift among partners in their shares of liabilities or as a result of a partnership incurring new debt does not expand the net asset base of the partners represented by the partners' interests in the partnership.

147 Regs. § 1.1223-3(c)(2)(i).

148 Regs. § § 1.731-1(a)(3), 1.1223-3(d)(2).

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Example: Split Holding Period. On Jan. 1, 20X1, Propp owned a 50% interest in the capital and profits of a partnership, Oppar, worth $900,000, with an outside basis of$750,000 and a long-term holding period. Propp contributed $100,000 to Oppar on Jan. 2, 20X1. On June 1, 20X1, Propp received a distribution of $40,000 cash from Oppar. On Sept. 1, 20X1, when the value of Propp's interest in Oppar was $1,350,000, Propp contributed $230,000 cash to Oppar, and on Oct. 1, 20X1, Propp received another $40,000 cash distribution from Oppar. Propp sold her entire Oppar interest on Nov. 1, 20X1, for $1,600,000. Propp's outside basis in the Oppar interest at the time of the sale was $1,000,000 ($750,000 + $100,000 -$40,000 + $230,000 - $40,000). Propp's cash contributions and distributions are netted. The total distributions of $80,000 are applied on a last-in-first-out basis from the date of the sale to contributions during the year, reducing the contribution made on Sept. 1, 20X1, to $150,000 ($230,000 - $80,000). Propp's split period in the Oppar interest was reduced to 90% long-term after the $100,000 Jan. 2, 20X1 contribution ($900,000/($900,000 + $100,000)) and 10% short-term($100,000/($900,000 + $100,000)). The $150,000 contribution on Sept. 1, 20X1, caused an additional 10% of Propp's Oppar interest ($150,000/$1,350,000+ $150,000)) to have a new holding period. Accordingly, immediately after the contribution on Sept. 1, 20X1, Propp's holding period in Propp's Oppar interest was 81% long-term (.9 x 90%) and 19%short-term (9% (.9 x 10% with a holding period beginning Jan. 1, 20X1) and 10% with a holding period beginning Sept. 1, 20X1. As a result, $486,000 ($600,000 x .81) of the gain from Propp's sale of the Oppar interest is long-term capital gain, and $114,000($600,000 x .19) is short-term capital gain.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  II. Partnership Distributions—In General

C. Payments and Transfers That Are Not Distributions 

Reflecting the entity principle, a partnership may make some payments or transfers to partners that are not partnership distributions.

1. Partnership Loans to Partners 

Despite the breadth of the definition of distribution, a loan by a partnership to a partner is not a distribution. The regulations provide that receipt by a partner of money or property from a partnership under an obligation to repay the money or return the property is not a current distribution subject to § 731, but is a loan governed by § 707(a).149 However, the IRS has ruled that a loan by a partnership to a partner will be respected as such only where the partner is under an “unconditional and legally enforceable obligation to repay a sum certain at a determinable date.”150 Thus, the fact that a withdrawal creates a deficit in a partner's capital account is not enough to cause the withdrawal to be characterized as a loan, even if the partner is under an obligation to restore the deficit. Although there is no express requirement that a partnership loan to a partner bear interest or otherwise have arm's-length terms in order to avoid being characterized as a distribution, it is hard to imagine a transfer of funds that does not have arm's-length terms that would be respected as an unconditional obligation.151 If the partner's obligation to the partnership is subsequently canceled, the partner will be treated as receiving a current distribution at the time of cancellation,152 or, possibly, discharge of indebtedness income,153 subject, of course, to the limitation of § 108.154
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149 Regs. § 1.731-1(c)(2).

150 See Rev. Rul. 73-301, 1973-2 C.B. 215 (capital account deficit and restoration obligation is not enough to cause a distribution be a loan).

151 See Notice 97-47, 1997-2 C.B. 300 (obligation with unreasonably long maturity may not be debt if equity characteristics present).

152 Regs. § 1.731-1(c)(2).

153 § 61(a)(12).

154 See 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, for a comprehensive treatment of the provisions and limitations of § 108.

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In addition, if there is an unconditional obligation that does not bear interest at or above the applicable federal rate, interest may be imputed under § 7872, if any of the relationships described in that section exist. It is worth noting that, although corporate-shareholder loans are covered in § 7872,155 there is no similar provision for partnership-partner loans, although the proposed regulations indicate that partner-partnership loans relating to services are covered.156 In addition, § 482, which gives the IRS broad power to reallocate income among two or more trades or businesses directly or indirectly under common control in order to clearly reflect income, may apply.157  Section 482 can “create” income, that is, allocate to one member of a controlled group of trades or businesses an arm's-length charge in the absence of specifically traceable income from the other member.158 The definitions of trades or businesses and common control are quite broad, and may well encompass a partnership and a major partner.159
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155 § 7872(c)(1)(C);Prop. Regs. § 1.7872-4(d).

156 Prop. Regs. § 1.7872-4(c)(iii).

157 See 551 T.M., Section 482 Allocations: General Principles in the Code and Regulations, for a comprehensive discussion of circumstances in which  § 482 might apply to a partnership-partner loan.

158 Regs. § 1.482-2(a); see Latham Park Manor, Inc. v. Comr., 69 T.C. 199 (1977) (when operating subsidiaries borrowed money and loaned the funds interest free to the holding company that used the funds in a shareholder buy-out that did not generate any income,  § 482 applied to “create” interest income for the subsidiaries); Powers v. Comr., 724 F.2d 64 (7th Cir. 1983) (poor financial condition of tenant does not justify controlling shareholder's leasing property from one controlled corporation at an inflated rent and releasing it to another corporation at a rent that was less than fair market value;  § 482 applies to readjust shareholder's rents, increasing rent from tenant corporation and reducing rent to owning corporation).

159 See, e.g. Rubin v. Comr., 56 T.C. 1155 (1971) (explicitly stating it did not find employee status constituting, in and of itself, a trade or business, but nevertheless allocating income to the shareholder-employee on the ground that he was in an independent management business); Ach v. Comr., 358 F.2d 342 (6th Cir. 1966) (income reallocated to shareholder who had transferred it to corporation); Foglesong v. Comr., 691 F.2d 848 (7th Cir. 1982) (employment not trade or business for purposes of § 482); Rev. Rul. 88-38, 1988-1 C.B. 246 (the dual trade or business requirement of  § 482 is satisfied because the corporation is in the business of providing goods or services to customers and the employee is in the business of providing services to the corporation).

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2. Guaranteed Payments 

Payments to partners as salary or interest on capital, the amount of which is determined without regard to the income of the partnership,160 are treated as if made to a nonpartner, but only for purposes of  § § 162(a) and 61(a),161 so that they are taxed currently to the partners as ordinary income.  Guaranteed payments for capital services are capitalized.162 Guaranteed payments that qualify for current deduction may be deducted, even if they exceed the partnership's income before the payment, and may produce losses allocated to the partners.163 They are useful to recognize special contributions of capital or services. The line between guaranteed payments and partnership distributive share is thin at best.164 Thus, management fees paid to a general partner based on percentage of gross income were held by a court to be distributive shares, not guaranteed payments.165 The IRS, however, ruled that such fees are guaranteed payments.166 Similar payments may be made to a partner acting in an independent capacity, such as a provider of services, and as the name implies are taxed essentially outside of the partnership provisions, subject to a special timing rule.167 The independent capacity is most likely to be established if the property or services are provided by a partner who provides the same property or services to unrelated parties on substantially similar terms.168 The line between independent capacity payments, guaranteed payments and partnership distributive share is also thin at best,169 with the distinction relating principally to timing.
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160 Rev. Rul. 81-300, 1981-2 C.B. 143 (management fee of 5% of gross rentals paid to a general partner in a partnership engaged in real estate development was unrelated to the partnership income and was a guaranteed payment). But see Pratt v. Comr., 64 T.C. 203 (1975) (payments based on a percentage of gross rentals are not guaranteed payments), aff'd on this issue, 550 F.2d 1023 (5th Cir. 1977). See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments of guaranteed payments.

161 § 707(c). See TAM 9320004 (lump-sum payment to partner was not a guaranteed payment, because the payment was in consideration for the partner's relinquishing her rights under an insurance policy, and not for services or the use of capital).

162 § 704(c); Cagle v. Comr., 539 F.2d 409 (5th Cir. 1976) (capitalized guaranteed payment before amendment of  § 707(c) to provide explicitly for capitalization).

163 Regs.  § 1.707-1(c) Ex. 3; McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 13.03[1][a] (3d ed. 1997).

164 See 710 T.M., Partnerships —Conceptual Overview, for a discussion, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of the differences between guaranteed payments and distributive shares. Other items of partnership income, gain, loss, deduction and credit are to be taken into account separately to the extent provided by regulations, according to § 702(a)(7). Finally, each partner is to take into account his share of the taxable income or loss of the partnership other than those items that are required to be separately stated, pursuant to § 702(a)(8).

165 See Pratt v. Comr., 64 T.C. 203 (1975), aff'd, 550 F.2d 1023 (5th Cir. 1977).

166 See Rev. Rul. 81-300, 1981-2 C.B. 143.

167 See § 267(e).

168 See Rev. Rul. 81-301, 1981-2 C.B. 144 (investment management fees to general partner with independent advising business are independent capacity payments).

169 See Pratt v. Comr., 64 T.C. 203 (1975), aff'd, 550 F.2d 1023 (5th Cir. 1977); Rev. Rul. 81-300, 1981-2 C.B. 143; S. Rep. No. 169, 98th Cong. 2d. Sess., at 230; Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (“1984 Bluebook”), at 230–31 (such payments are independent capacity payments).

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Example: Guaranteed Payment v. Independent Capacity Payment. Munn#1, Munn#2, and Munn#3 and Surv, an investment manager, form a partnership, Oppar, to invest in an actively managed portfolio of securities. The Oppar partnership agreement satisfies the special allocation regulations. Each of the Munns contributes $10,000,000 and receives an equal interest in the profits and losses of the portfolio. Surv has a 1% interest in cumulative net losses and a 10% interest in cumulative net profits. Surv provides investment management services and receives a fee based on a percentage of any excess of the total return of the portfolio, including dividends, interest and appreciation, over the return on a market portfolio. Surv devotes full time to managing the Oppar portfolio. The fee should be a guaranteed payment. If, instead, Surv maintained an independent investment managing service that invested Oppar's portfolio as a fractional interest of a larger portfolio managed for numerous other clients, the fee should be an independent capacity payment.

3. Actual and Disguised Sales 

Other payments by a partnership that are not distributions include: (i) payments for the purchase of property from a partner,170 (ii) purported distributions of property that are closely related to the contributions to the partnership and that are recharacterized as disguised sales of the property by the partnership,171 and (iii) distributions by the partnership that are closely related to contributions by others to the partnership that are recharacterized as disguised sale of the partnership interest to the contributor.172
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170 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of issues that arise when a partner sells property to a partnership.

171 § 707(a)(2); Regs. § 1.707-6. See III, G, 1, below, for a discussion of the relation between the contribution and the distribution that justifies treatment of the distribution as a disguised sale of the distributed property by the partnership to the partner.

172 § 707(a)(2). See III, G, 2, a, below, for a discussion of the relation between the contribution and the distribution that justifies treatment of the distribution as a disguised sale of all or part of the partnership interest of the distributee.

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  II. Partnership Distributions—In General

D. Partnership Liabilities and Obligations 

Although not a direct part of the provisions on partnership distributions,  § 752 governing the treatment of liabilities for partnership tax purposes profoundly affects almost all aspects of the tax treatment of partnership distributions.  In an application of the aggregate principle, a partner's outside basis in the partnership interest for purposes of determining gain or loss on distributions, and for many other purposes, includes the partner's share of partnership liabilities.173 Thus, the distributee's share of partnership liabilities determines the amount of gain or loss on distributions. Correspondingly, any decrease in the partner's share of liabilities (for example when an obligation is satisfied or shifts to another partner) is a partnership distribution.174 A distribution resulting from a reduction in a partner's share of liabilities requires that the partner actually be relieved of the economic obligation for the liability.175
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173 § 752(a) (increase in partner's share of liabilities treated as money contributed to partnership); Regs. § 1.752-1(b). See 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for comprehensive treatments of the rules governing basis and the allocation of partnership liabilities.

174 § 752(b) (decrease in a partner's share of partnership liabilities treated as a distribution of cash); Regs. § 1.752-1(c); see TAM 9619002 (discharge of partner's share of partnership recourse indebtedness in personal bankruptcy is partnership distribution, not cancellation of indebtedness, because partnership not discharged; although not stated, in effect, recourse debt converted to nonrecourse for partner, and reallocated to other partners). See generally Sowell, “Partnership Workouts: Is It That Time Again?,” 42 Tax Mgmt. Memo. 414 (2001) (reviews issues in reduction of partnership liabilities and effect of allocations and deemed distributions).

175 See Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (no distribution of share of liabilities to expelled partner who remained liable under local law, because expelled partner not relieved by creditor or remaining partners) Richardson v. Comr., 76 T.C. 512 (1981), aff'd, 693 F.2d 1189 (5th Cir. 1982) (existing partners did not receive a deemed cash distribution to the extent that they established that existing partnership liabilities remained their sole and personal obligations); See also Austin v. U.S., 461 F.2d 733 (10th Cir. 1972) (husband whose interest in partnership terminated as part of divorce proceedings in which wife received all partnership assets and assumed all partnership liabilities realized gain equal to the excess of the share of liabilities over his adjusted basis for his partnership interest); cf. Gardner v. Comr., T.C. Memo 1987-420, aff'd in unpub. opin. (6th Cir. 1989) (limited partner relieved of share of partnership nonrecourse liabilities and received distribution when forfeited partnership interest for failure to make required capital contribution).

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Where the same transaction involves both increases and decreases in a partner's share of liabilities, the increases and decreases are netted.176 Thus, when a new or existing partner contributes money or property to a partnership for a new or increased interest, the contributor generally shares in the partnership's existing liabilities, resulting in a deemed additional contribution of money, while the existing partners have a deemed distribution of money. When the contribution involves encumbered property and the liability is transferred to the partnership, a portion of the liability is transferred to the other partners, resulting in a deemed distribution of money to the contributor, and a deemed contribution for the existing partners.177 The deemed contribution from undertaking a share of partnership liabilities and the deemed distribution from the transfer of a portion of the liability on the encumbered property are offset against each other before determining the tax consequences of the transaction. If the liabilities undertaken exceed those transferred, there is a net contribution, and if not, there is a net distribution. Liability shares flow through tiers of partnerships.178 Liability allocations do not affect capital accounts,179 but capital accounts do affect the allocation of, at least, recourse liabilities.180
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176 Regs. § § 1.752-1(f), 1.722-1 Ex. 1. See FSA 200242004 (LLC member that contributed property subject to a liability in year 1, followed by deemed distribution when liability settled early in year 2, with a similar transfer of property subject to a liability late in year 2, cannot net liability reduction early in year 2 against contribution late in year 2 because not part of same transaction).

177 See Rev. Rul. 79-205, 1979-2 C.B. 255; Rev. Rul. 84-111, 1984-2 C.B. 88 (distribution of all assets to partners in liquidation, subject to all liabilities;net deemed distribution from relief of share of partnership liabilities against deemed contribution from partners' assumption of share of partnership liabilities; results in zero net); PLR 8304038 (same on partnership split off of some encumbered properties to two controlling families). See II, D; III, A, 2, b;and IV, A, 2, below, for discussions of partnership distributions of property subject to liabilities.

178 Regs. § 1.752-4(a); see Rev. Rul. 77-309, 1977-2 C.B. 216 (nonrecourse liabilities pass through the tiers to determine basis of limited partners for absorbing losses).

179 Regs. § 1.704-1(b)(2)(ii)(c). See 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for more comprehensive treatments of the capital account effect of transfers of liabilities between a partner and the partnership.

180 See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments of how capital accounts and deficit make-up allocations affect allocation of liabilities to reduce the loss limitation of § 704(d).

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Example: Liability Shares and Outside Basis. Munn and Surv form a limited partnership, Limpar. Munn, the venture capitalist, contributes $1,000,000 for a limited partnership interest, and Surv, who is a talented executive, contributes $100,000 for a general partnership interest. The Limpar partnership agreement satisfies the special allocation regulations, and allocates all profits and losses equally. During its first year of operation, Limpar borrows $1,000,000 on a nonrecourse basis. The nonrecourse liability is initially allocated equally to Munn and Surv. Accordingly, Munn's outside basis in Limpar is $1,500,000, his $1,000,000 contribution + his $500,000 share of the liability. Similarly, Surv's outside basis is $600,000, her $100,000 contribution + her share of the liability. Their capital accounts, however, only include the amounts contributed. Limpar's inside basis of its assets is the sum of these amounts, $2,100,000, reflecting the $1,100,000 contributed + the $1,000,000 borrowed.

1. Liability Defined 

Regulations issued in 2005181 define a liability for purposes of  § 752 to include only items that: (i) go into the basis of the property, including cash proceeds of borrowing, (ii) give rise to a deduction, or (iii)give rise to an expenditure that is neither capital nor deductible. The same basic concept has been expressed, although not as explicitly or comprehensively, in numerous other authorities.182 The regulations do not provide when an obligation gives rise to an expenditure. Since basis is generally increased when the obligation to pay for the property becomes fixed, without regard to the partnership's method of accounting, a liability should be considered incurred and the first part of the definition should be satisfied when the property is acquired.  Similarly, since when a deduction is incurred is generally determined by the taxpayer's method of accounting (subject to deferral under the economic-performance and other provisions that generally require that the obligor defer the deduction until the recipient takes it into income), the incurrence of a liability under the second part should be based on the taxpayer's method of accounting. Since nondeductible, noncapital expenditures tend to be expenses that are denied deduction on tax policy grounds, like federal income taxes or fines and penalties, or are personal items that are similar to expenses, the expenditure and related liability probably should be deemed incurred when they would have been deductible under the partnership's method of accounting, if they were deductible,183 or would have been included in basis if they would normally have been capitalized.
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181 Regs. § 1.752-1(a)(4), as finalized in T.D. 9207, 70 Fed. Reg. 30334 (5/26/05) and proposed in REG-106736-00, 68 Fed. Reg. 37434 (6/24/2003).

182 See, e.g., Rev. Rul. 88-77, 1988-2 C.B. 128 (defining liabilities for purposes of partnership provisions as excluding payables of a cash basis partnership that have not provided a deduction); Rev. Rul. 95-26, 1995-1 C.B. 131 (an obligation under a short sale is a partnership liability); Rev. Rul. 95-45, 1995-1 C.B. 53 (same for corporations under § 357(c)); Regs.  § 1.446-1(c)(1)(ii)(B) (defines liability for accrual purposes as any item allowable as a deduction, cost, or expense and any amount otherwise allowable as a capitalized cost, and prepaid expenses); Salina Partnership LP v. Comr., T.C. Memo 2000-352 (short sale obligation is a liability taken into account in determining basis of the partnership interest, and basis in the partnership's assets determined under the distribution-recontribution approach of former Regs. § 1.708-1(b)); cites Rev. Rul. 88-77, Rev. Rul. 95-26 and former Regs. § 1.752-1T(g);fact that short sale is open transaction under  § 1233 is not controlling), cf., Comr. v. Tufts, 461 U.S. 300 (1983) (nonrecourse liability included in basis is also included in amount realized on disposition even if greater than fair market value of property);  § 357(c)(3) (obligations that give rise to a deduction or payments treated as a distributive share under  § 736 are not liabilities for purposes of liability over basis rules);  § 704(c) (accounts payable and accrued items of a cash-method taxpayer are allocated to contributing partner). See Sheppard, “Dissecting Partnership Gambits for Rich People,” 96 Tax Notes 22 (Jul. 1, 2002) (urges adopting equivalent of Temporary Regulation in war on tax shelters). See Manning, “Proposed Regulations Deal with Partnership Assumption of Partner ‘Liabilities,' Part 1,” 6 Bus. Ent. 22 (Nov./Dec. 2004); “Part 2,” 7 Bus. Ent. 20 (Jan./Feb. 2005), reprinted in “Tax Planning for Domestic &  Foreign Partnerships, LLCs, Joint Ventures &  Other Strategic Alliances 2005,”655 PLI/Tax 209, for the author's discussion of these and other issues, including recommendations of changes in the regulations).

183 Regs.  § 1.461-1(a)(1) (cash method) and (2) (accrual method).

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Not all obligations that are treated as liabilities for state law or other purposes are liabilities for tax purposes. There is a vast literature on determining when a corporate obligation is debt or equity.184 The distinction between debt and equity is less important for partnerships, because the stake is one of allocation of income and liabilities, and does not involve potential double taxation.185 For example, when a nonrecourse liability appears to be grossly in excess of the fair market value of the encumbered property, it is not recognized for purposes of determining the purchaser's basis or interest deductions.186 Such an obligation is not a liability for purposes of  § 752 or other partnership provisions, and may make the purported lender a partner.187
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184 See, e.g., Bittker &  Eustice, Federal Income Taxation of Corporations and Shareholders, Ch. 4 (6th ed. 1994); Plumb, “The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal,” 26 Tax L. Rev. 369 (1971); New York State Bar Association Tax Section Committee on Reorganization Problems, “Recommendations as to Federal Tax Distinction Between Corporate Stock and Indebtedness,” 25 Tax Law. 57 (1971).

185 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ ¶ 4.06[1], 7.02[1], 7.02[2] and 13.02[1](3d ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ ¶ 6.03[2] and 11.03[3] (6th ed. 1997). Of course, classification of a partnership obligation as a liability may have important basis implications. See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of the effect of treating funds supplied to a partnership as debt or equity.

186 See Franklin Est. v. Comr., 544 F.2d 1045 (9th Cir. 1976) (liabilities that are not bona fide are not included in basis, and no interest deduction allowed); Brountas v. Comr., 692 F.2d 152 (1st Cir. 1982) (nonrecourse obligation for carved out oil payment in excess of value not recognized, even though  § 636 treats carved out oil payments as mortgages). But see CCA 200226014 (suggests purchase of partnership interest by outside investors in what looks like a special purpose entity was really a loan with a limited partnership interest as an addition to monthly interest payments).

187 See, e.g., Rev. Rul. 72-350, 1972-2 C.B. 394 (nonrecourse “loan” to an otherwise unrelated limited partnership in the business of exploring for oil and gas, secured by the partnership's properties consisting of some unproven leases and some expensive but virtually unsalvageable oil and gas well installations that was convertible into a 25% interest in the partnership's profits was not a bona fide debt but capital placed at the risk of the venture by the investor); Rev. Rul. 72-135, 1972-1 C.B. 200 (nonrecourse loan by general partner to limited partnership is capital contribution). See II, C, 1, above, for a discussion of the related issue whether a person advancing funds is a creditor or a partner.

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The regulations' definition of “obligation”specifies that environmental, tort, contract, pension, short sale, derivative financial instrument, option, forward contract and future contract obligations are included. Under this definition, a deficit make-up obligation is not a liability that increases outside (or other)basis.188 Although the regulations do not state it explicitly, short sale and other financial instrument obligations are liabilities, because the premium or other consideration received, usually in cash, has provided its own basis.189 This means the amount of the liability should be the consideration received regardless of any changes in the amount of the exposure. The regulations' definition of obligation does not, as it should, limit obligations to those arising from events that have already occurred. This sensible limitation would mean that there is no obligation until, without regard to the taxpayer's method of accounting, the all-events test for accrual of an expense has been satisfied (although not the requirement that the amount be determinable with reasonable accuracy), so that, for example, amounts owed for goods not yet delivered or services not yet performed would not be “obligations”for purposes of the regulation's definition. Only an obligation that involves a deferred deduction that might properly be accrued under the “all events” test for accrual accounting190 (without regard to whether economic performance has occurred,191 or another provision delays deduction,192 or to whether the amount can be determined with reasonable accuracy193)should be an obligation. Under the regulations, this standard should be applied for all taxpayers whatever their method of accounting, not only accrual-method taxpayers, and to all executory obligations, whether the obligation is deductible, capital or neither.
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188 See Falconer v. Comr., 40 T.C. 1011 (1963), acq.(a general partner's possible obligation to other partner to make up a deficit does not support allocation of loss that was financed by the capital of the other partner nor does it provide basis); Rev. Rul. 72-135, 1972-1 C.B. 200; Rev. Rul. 72-350, 1972-2 C.B. 394.

189 See Rev. Rul. 95-26, 1995-1 C.B. 131; Rev. Rul. 95-45, 1995-1 C.B. 53.

190 Regs. § 1.461-1(a)(2)(i). See, e.g., U.S. v. Hughes Properties, Inc. 476 U.S. 593 (1986) (unpaid guaranteed jackpots that might be postponed indefinitely properly accrued (before § 461)); U.S. v. General Dynamics Corp., 481 U.S. 239 (1987) (estimated obligations under self-insured health plan for services performed but for which no claims yet submitted not properly accruable; claim submission was prerequisite to liability); Dixie Pine Products v. Comr., 320 U.S. 516 (1944) (contested liability not accruable (before § 461(f))).

191 § 461(h).

192 See, e.g., § 404(a)(5) and (d) (deferred compensation); § 83(f) (compensation paid in property,  § 267(a)(2) (deductible expenses owed to related taxpayers).

193 See, e.g., ABKCO Industries, Inc. v. Comr., 482 F.2d 150 (3d Cir. 1973) (royalty payments not accruable on goods shipped when amount was subject to returns and the possible returns were substantial); Dana Distributors, Inc. v. Comr., 874 F.2d 102 (2d Cir. 1989) (similar result for refunds of container deposits).

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Implicit in the regulations' definition of a liability (and the earlier concepts and authorities on which it is based) is that the amount of the liability, for tax purposes, is not an obligation's principal or face amount, but the amount taken into account for tax purposes (including amounts that are not includible in income, deductible or capitalized).194 This concept of the tax amount of a liability is the equivalent of the concept of basis for assets. There is, however, no consistent terminology for this concept in the Code or Regulations.195 When relevant, this portfolio uses the terms of amount of liability and tax amount of liability to designate the amount that is significant for tax purposes.
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194 This is clearly the concept embodied in  § 704(c)(3) (rules similar to  § 704(c)(1) apply to cash-method payables and accruals);  § 357(c)(3) (liabilities under  § 357 do not include amounts that give rise to a deduction when paid); Rev. Rul. 88-77, 1988-2 C.B. 128 (obligation that has not given rise to a deduction is not a liability; potential deduction goes to transferee); Rev. Rul. 80-198, 1980-2 C.B. 113 (same for corporations); Rev. Rul. 95-74, 1995-2 C.B. 36 (contingent obligations, whether deductible or capital are not liabilities under § 357(c);deductible or capitalizable when satisfied; follows Rev. Rul. 80-198); Rev. Rul. 95-26, 1995-1 C.B. 131; Rev. Rul. 95-45, 1995-1 C.B. 53.

195 Section 752 and the regulations under it refer only to the “partner's share of liabilities”;  § 357(c) refers to the “amount” of a liability; § 108(b) also refers to the “amount” of indebtedness excluded from gross income;  § 171(b) refers to the “amount payable at maturity”; and  § § 1273(b) and 1272(a)(4) of the original issue discount rules refer to the “issue price” and “adjusted issue price” (the latter term being the equivalent of adjusted basis, that is, the issue price after taking into account amortization of discount).

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Thus, accounts payable of a cash-basis taxpayer, and similar obligations of any taxpayer, that would give rise to a deduction when paid are not liabilities transferred under § 752.196 These include deductions deferred under the economic-performance provisions of  § 461(h) until payment is made to a specific obligee, for example, real estate taxes that cannot generally be deducted by accrual-method taxpayers until paid, and warranty claims.197 Similar deduction deferrals are provided under  § 83(f) (compensatory property)and  § 404(a) (5) and (d) (deferred compensation).198 A further complication is that under the principle of Commercial Security Bank Inc. v. Comr.,199 and Regs. § 1.461-4(d), some obligations become deductible when transferred, so that they become liabilities at that time. Obligations transferred that are not treated as liabilities are deductible, when paid, by the transferee.200 When the transferee is a partnership that receives the obligation in a nonrecognition contribution under § 721, the deduction is allocated to the transferor partner.201 There are special provisions relating to partner obligations assumed by a partnership, known as  § 1.752-7 liabilities,202 that apply: (i) when there is a liquidating distribution to the transferring partner, known as the § 1.752-7 liability partner;203 (ii)when the  § 1.752-7 liability is transferred to another partner;204 or(iii) when the partnership interest of the  § 1.752-7 liability partner is transferred.205
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196 § § 357(c)(3) and 704(c)(3).

197 Regs.  § 1.461-4(g)(6)(i) and (5).

198 § § 404(a)(5) and (d) (deferred compensation)and 267 and 707(b) (related-party transactions).

199 See Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981) (accrued interest and accounts payable of cash basis bank deductible on sale under former § 337);see 710 T.M., Partnerships — Conceptual Overview, for a discussion of the application of the Commercial Security principle.

200 Rev. Rul. 80-198, 1980-2 C.B. 113; Rev. Rul. 95-74, 1995-2 C.B. 36; PLR 200013044 (allows deduction of business expenses, interest, taxes and qualified and nonqualified deferred compensation by domestic corporate successor to branch of foreign insurance company; follows Rev. Rul. 80-198 and Rev. Rul. 95-74);H.R. Rep. No. 432 (Part 2), 98th Cong., 2d Sess., 1208-10 (1984);1984 Bluebook, at 211–16, (Partnerships). Rev. Rul. 83-155, 1983-2 C.B. 38 (payments to former partners by corporation succeeding to partnership business are deductible by corporation); GCM 39054, Nov. 24, 1981(same; background for Rev. Rul. 83-155; expressly follows Rev. Rul. 80-198).

201 § 704(c)(3); see H.R. Rep. No. 861, 98th Cong., 2d Sess. 856 (1984) (allocation rule applies to liabilities, such as accounts payable). Although the legislative history discusses only cash-method taxpayers, there is no reason that the accounts payable of an accrual-method taxpayer that are deferred under the economic performance rules, or otherwise, should not also be covered; but cf. Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991) (payables not yet deducted included as liabilities; the taxpayer failed to argue until too late that the payables were not liabilities; there was no consideration of who is entitled to deduction for payables, or when).

202 See II, D, 4, below, for a discussion of when obligations transferred by a partner to a partnership are  § 1.752-7 liabilities, including exceptions, principally for obligations transferred with a related business, as well as a significantly large de minimis exception.

203 See IV, A, 3, below, for a discussion of  § 1.752-7 liabilities in liquidating distributions.

204 See III, H, below, for a discussion of assumption of a  § 1.752-7 liability by another partner in a current or liquidating distribution.

205 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the effect of  § 1.752-7 liabilities when a partnership interest is transferred.

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Example: Liabilities and Obligations. Munn, Propp and Surv are members of an LLC, Limco, that is taxed as a partnership. The Limco operating agreement satisfies the special allocation regulations, and allocates all profits and losses equally. Limco, which is an R& E operation using the cash method, has outstanding the following “obligations”: (i)a note payable to a bank in the principal amount of $100,000 for which it received $90,000 after the bank deducted points and fees; (ii)accounts payable of $18,000 for materials and supplies and $12,000 for services; (iii) an option that permits the holder to receive an exclusive license to exploit Limco's current research project when patented, that will require payment of specified royalties, including minimum annual royalties if the option is exercised, for which Limco received $150,000 that it has used to financing its operations, including the research; (iv) an obligation under a lease of its facility at$30,000 a year for five years; and (v) obligations under options granted to key employees that gave them the right to acquire 10,000 interests in Limco for $1 an interest when the $1 per share price was the then value of the interest, the current value of which to the employees is $30,000 reflecting its favorable research results. The note is a liability in the amount of the $90,000 cash received, not its $100,000 principal amount (although it will increase to $100,000 as the discount is amortized). The option, although an open transaction for income recognition purposes, is a $150,000 liability because Limco received that amount in cash. The $20,000 accounts payable for materials and supplies should be obligations that are not liabilities, because, as is the usual case, when the materials and supplies are not inventoriable, the deduction occurs only on payment (although, if they are inventoriable, it is a liability because Limco has an immediate basis in the inventoried items). Similarly, the $10,000 accounts payable for services is an obligation, because the services have been rendered, but is not a liability, because the deduction occurs only on payment. The lease should not create even an obligation, much less a liability, because it relates to future occupation, which has not occurred. The stock option spread is clearly not a liability because it is for deferred compensation, not deductible until the option is exercised and the employees include the income, and, because it is contingent and has no tax recognizable value, it may not even be an obligation.

2. Transfer 

As is the case for the meaning of “liability,”there is a terminology problem for the meaning of the “transfer”of a liability or obligation,206 that is, when an existing liability obligation becomes a partner or partnership liability or obligation.  A number of Code and regulation provisions refer, usually in connection with the transfer of property, to “liabilities assumed” or “liabilities to which the property is subject,”207 or to the “discharge” of a liability.208 Some of these provisions are explicit about distinctions between recourse and nonrecourse liabilities,209 but most of the rest are not. Although the general regulations under  § 752 make the distinction,210 the specific provisions relating to liability transfers do not.211 None of the provisions (other than Regs.  § 1.751-1(a)(4))refers to obligations, except as implicit in provisions like  § 357(c) that treats deductible items as not being liabilities.
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206 See II, D, 2, for a summary discussion, and 711 T.M., Partnerships — Formation and Contributions of Property or Services, for a more comprehensive treatment, of the meaning of liability “transfer” for partnerships.

207 E.g.,  § § 357(a)(1) (“assume”), 357(c) (“assume”)and 358(d) (“assumed”);Regs.  § § 1.752-1(d) (“assumption”); 1.752-1(e) (transfer of property subject to a liability as “assumption”); and 1.1031(a)-1(a)(2) (“assumption”or “subject to”).

208 Regs. § 1.1001-2; cf. § 108 (“discharge of indebtedness”).

209 Regs. § 1.1001-2;  § 357(d) defines assumptions of recourse liabilities, specifically, and narrowly, and limits transfers of nonrecourse liabilities to the fair market value of the encumbered property transferred.

210 Regs. § 1.752-1(a).

211 Regs. § 1.752-1(d) and (e).

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The principal general regulation relating to liability transfer, Regs. § 1.1001-2, is misleadingly titled “Discharge of liabilities.”This is misleading because the basic focus of the regulation is the transfer of a liability as part of the consideration for the transfer of property. It states the unsurprising general principle that the transfer of a liability is part of the amount realized.212 A recourse liability is transferred when the transferee assumes it, even if the transferor remains secondarily liable, and apparently, even when the transferor does not assume it, at least to the extent of the fair market value of the property transferred.213 The regulation is silent on the effect of any excess of the amount a recourse liability over the value of the encumbered property when the transferee does not expressly agree to assume it.214 A nonrecourse liability is transferred, without regard to the fair market value of the property—applying the principle of the Tufts case.215 When the transaction straddles two taxable years, for example a deferred nonrecognition exchange under § 1031, any net decrease in liability is taken into account at the end of the first year, but any net increase is not taken into account until the second year.216 Although Regs.  § 1.1001-2 does not state it, when the transferor expressly retains primary responsibility for payment of a liability encumbering property, in a wrap-around mortgage or otherwise, the liability should not be transferred.217 Fortunately, although partnership liabilities are allocated to partners for purposes of determining outside basis and amount realized, they remain partnership liabilities that are automatically transferred with the transfer of the partnership interest. Accordingly, these principles apply primarily to individual liabilities of the transferor-partner that are transferred in connection with the disposition of the partnership interest. On the other hand, if the transferor partner expressly agrees to indemnify the transferee from the consequences of any partnership liability or obligation, the indemnity should be taken into account in determining the gain recognized on the transaction, either as a reduction in the amount realized or as an addition to basis.
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212 See Crane v. Comr., 331 U.S. 1 (1947).

213 Regs. § 1.1001-2(a)(4)(ii); see Jackson v. Comr., 708 F.2d 1402 (9th Cir. 1983) (no gain to transferor-shareholder under  § 357(c) on transfer of a partnership interest to corporation that did not assume the primary obligation; the liability in question was one incurred by the transferor-partner on property that he subsequently transferred to the partnership; dissent argues that transferee expected to pay); Maher v. Comr., 469 F.2d 225 (8th Cir. 1972) (taxpayer-shareholder, who remained secondarily liable, did not recognize gain under  § 304 on transfer to controlled corporation of stock subject to liability, even though the corporation assumed liability); Regs.  § 1.1001-2(a)(4)(ii) (liability transferred if another assumes it, even if transferor remains secondarily liable); Doe v. Comr., 97-1 USTC ¶ 50,460 (10th Cir. 1997) (liability not transferred on transfer for tax purposes, but not under state law, of mortgaged property to corporation that did not assume mortgage); Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (no distribution of share of liabilities to expelled partner who remained liable under local law, because expelled partner not relieved by creditor or remaining partners); Rev. Rul. 77-360, 1977-2 C.B. 86 (follows Maher).

214 Regs. § 1.1001-2(a)(4)(ii) (recourse liability transferred if acquirer (or another person) assumes it even if transferor remains secondarily liable); (b) (fair market value is irrelevant is determining if transferor discharged, but refers to -2(a)(2) (amount realized does not include discharge of indebtedness); and (c) Ex. 8 (when liability in excess of fair market value is discharged by creditor, excess is discharge of indebtedness income). The gap is that the regulation makes no direct provision when the creditor does not discharge the liability and the acquirer does not assume it. Although (b) arguably implies that the transferor is discharged, (a)(2) only covers the case of assumption. The author does not believe this is sloppy drafting in light of provisions like  § 752(c) that provide that transfer of property subject to a liability transfers the liability to the extent of the fair market value of the property.

215 Comr. v. Tufts, 461 U.S. 300 (1983) (nonrecourse liability included in basis is also included in amount realized on disposition even if greater than fair market value of property).

216 Rev. Rul. 2003-56, 2003-1 C.B. 985 (the rationale is that the net decrease is attributable to the liability transferred on the relinquished property, but the liability increase is attributable to the transfer on acquisition of the replacement property).

217 See Professional Equities, Inc. v. Comr., 89 T.C. 99 (1977), acq. (liability under wrap-around mortgage for full price, unreduced by prior mortgage encumbering property at sale that seller agreed to pay, did not reduce contract price and was not payment in year of sale; follows Stonecrest Corp. v. Comr., 24 T.C. 659 (1955), notwithstanding changes made in the Installment Sales Revision Act of 1980, P.L. 96-471.

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Although none of the provisions refer to obligations, the same principles should apply. Thus, an obligation should be considered transferred when it would be transferred if it were a liability, so that a nonrecourse obligation should be transferred when the encumbered property is transferred and a recourse obligation transferred when the transferee assumes primary responsibility or when accompanied by a transfer of property with a net fair market value at least equal to the amount of the obligation. This is complicated by the fact that since, under the principle of Commercial Security Bank, Inc. v. Comr.,218 and under Regs.  § 1.461-4(d) providing that transfer of obligations as part of the transfer of a business is economic performance, some obligations become deductible when transferred, what is transferred has become a liability as a result of the act of transfer.
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218 See Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981) (accrued interest and accounts payable of cash basis bank deductible on sale under former § 337);see 710 T.M., Partnerships — Conceptual Overview, for a discussion of the application of the Commercial Security principle.

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Example: Liability (and Obligation)Transfer. Munn, Propp and Surv are members of an LLC, Limco, that is taxed as a partnership. The Limco operating agreement satisfies the special allocation regulations, and allocates all profits and losses equally. Limco is an R& E operation that uses the cash method. Limco has the following liabilities and obligations: (i) a note payable to a bank in the principal amount of $100,000 for which it received$90,000 after the bank deducted points and fees; (ii) accounts payable of $18,000 for materials and supplies and $12,000 for services; (iii)an option that permits a holder to receive an exclusive license to exploit Limco's current research project when patented, that will require payment of specified royalties, including minimum annual royalties if the option is exercised, for which Limco received $150,000 that it has used to finance its operations, including the research; (iv)an obligation under lease of its facility at $30,000 a year for five years; and (v) obligations under options granted to key employees to acquire 10,000 interests in Limco for $1 an interest, the current value of which to the employees is $30,000 reflecting its favorable research results. Without taking into account liabilities and obligations, Munn's outside basis is $50,000. Since the note payable to the bank, the option and the account payable for the materials and supplies are liabilities, Munn's outside basis is $136,000 ($50,000 + $80,000(1/3  of the $90,000 bank note + the $150,000 option). The accounts payable for the materials and supplies (unless inventoriable) and for the services, under the lease, and under the employee options are not liabilities, and do not affect outside basis. Munn receives a liquidating distribution for his interest from Limco for $35,000 cash. The amount realized is $140,000 including the liabilities, so that Munn realizes $10,000 gain. Since the liabilities are Limco liabilities allocated to its tax partners they are automatically allocated to Propp and Surv, increasing the outside basis of their Limco interests. The same is true for the nonliability obligations, so that Propp and Surv will receive increased shares of the allocation of the deductions when they are satisfied. The effect of transfer of these items in connection with a transfer by Limco of its assets and business is discussed in the example in II, D, 1, above.

3. Sharing Partnership Liabilities 

A partner's share of partnership liabilities depends on whether the liability is recourse or nonrecourse.219 A recourse liability is a partnership liability for which one or more partners bears the economic risk of loss.220 Correspondingly, a nonrecourse liability is a partnership liability for which no partner bears the economic risk of loss.221 LLC liabilities are, in effect, nonrecourse liabilities unless the members assume the liabilities.222 When a partner(or related person) makes a nonrecourse loan to the partnership, the lending partner (or related person) bears the economic risk of loss, which makes it, in effect, a recourse liability for that partner. Nevertheless, the obligation is called, somewhat euphemistically, partner nonrecourse debt.223 In other words, a partner cannot make a nonrecourse loan to a partnership that gives other partners basis.224 Loans by LLC members to the LLC are, presumably, partner nonrecourse debt.225 Thus, the concept of economic risk of loss is key to determining whether liabilities are recourse or nonrecourse, and, since there are different rules for allocating the two types of liabilities in determining their effect on outside basis.226
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219 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for comprehensive treatments of the liability allocations that are summarized in this section.

220 Regs. § 1.752-1(a)(1); Raphan v. U.S., 759 F.2d 879 (Fed. Cir. 1985) (guarantee by general partner of a partnership nonrecourse liability makes it a recourse liability); Rev. Rul. 81-283, 1981-2 C.B. 115 (recourse liability convertible to nonrecourse by making relatively small fixed payment not at-risk, and, implicitly, not recourse, except to the extent of the fixed payment). PLR 200050032 (liability on property contributed to an LLC, guaranteed by contributor, is recourse liability allocated to contributor, notwithstanding assumption by the LLC, where the contributor retained primary liability and waived rights over against LLC).

221 Regs. § 1.752-1(a)(2). A liability can be partially recourse and partially nonrecourse, in which case it is treated as two liabilities. Some commentators believe it is improper to determine outside basis by including a share of liabilities for which limited liability owners have no risk, because it facilitates tax shelters. See, e.g., Johnson, “Point: Singing Reason: The Case for Excluding of Entity-Level Debt from the Basis of Limited Liability Owners,” 17 Newsletter ABA Sec. of Tax'n 13 (1997). Others disagree; see, e.g., Schler, “Counter Point: Subchapter S Is Out of Tune: Treat Partners the Same as Owners,” Id. at 15.

222 See PLR 200050032 (liability for mortgage on property contributed to LLC that assumed primary liability that was guaranteed by contributor is recourse liability allocated to contributor).

223 Regs. § 1.704-2(b)(3). Nevertheless, its allocation is covered by the nonrecourse deduction regulations. Regs. § 1.704-2(i).

224 Regs. § 1.752-2(c).

225 In an LLC, even a recourse loan to the LLC by a member should be partner nonrecourse debt. See 725 T.M., Limited Liability Companies, for a discussion of the characterization of LLC debt.

226 Regs. § 1.752-2(b)–(j).

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a. Recourse Liability Shares 

A partner's share of the partnership's recourse liabilities is the portion for which the partner (or a related person)bears the economic risk of loss.227 Economic risk of loss is a partner's obligation to make a net payment to a creditor or a payment or contribution to the partnership if the partnership is liquidated, without a right over against another partner.228 Regulations adopted in 2006 limit a partner's economic risk of loss when the interest is held through a limited liability disregarded entity to the net value of the entity's assets.229 Economic risk of loss is not in proportion to, or directly determined by, the partners' loss-sharing ratios. It is measured by the obligation of the partner, in the event of the ultimate catastrophe, that is, in a hypothetical liquidation of the partnership when all partnership assets (including cash) are worthless, and disposed of in a transaction in which losses (or gains for nonrecourse liabilities under the Tufts principle230) are recognized and charged to capital accounts.231 Thus, the special allocation provisions of Regs.  § 1.704-1(b)(2) are implicitly incorporated, and the loss-sharing ratio is indirectly implicated.232 The net contribution rule means that if capital accounts are not in proportion to loss sharing ratios, then liability is allocated to make up the difference,233 and, in effect, adjusted for any differences between shares of capital and loss-sharing ratios.
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227 Regs. § 1.752-2(a).

228 Regs. § 1.752-2(b).

229 Regs. § 1.752-2(k).

230 Tufts v. Comr., 461 U.S. 300 (1983) (amount realized on transfer of property subject to nonrecourse liability is amount of liability, even if value of property is less).

231 Regs.  § 1.752-2(b)(2) and (f) Ex. 1 and Ex. 2.

232 See 710 T.M., Partnerships —Conceptual for a discussion, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment, of special allocations.

233 Regs.  § 1.752-2(b)(1) and (f) Ex. 1 and Ex. 2.

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Under the hypothetical liquidation approach, the partner's share of the recourse liability is the net liability, after taking into account any rights of contribution, indemnity, etc., including those resulting from a deficit make-up obligation.234 The result is that, even in a general partnership, liabilities are not simply allocated by using the stated loss sharing ratios. A party who is potentially indemnified for a liability does not have the economic risk of loss;235 the indemnifier or guarantor, if a partner, does. Accordingly, a limited partner can receive an allocation of even a recourse liability, and the corresponding basis, by entering into a guarantee, indemnity or assumption or other agreement undertaking personal liability, or by issuing a promissory note, as long as the limited partner's obligation is not offset by the general partners' deficit make-up obligation.236
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234 Regs.  § 1.752-2(b)(3) and (f) Ex. 3 and Ex. 4; see Abramson v. Comr., 86 T.C 360 (1986) (limited partner guaranteeing part of partnership nonrecourse liability has basis); Melvin v. Comr., 88 T.C. 63 (1987) (limited partners' recourse notes given to creditor support allocation of liability, but not to extent of rights over against other partners); but see Falconer v. Comr., 40 T.C. 1011 (1963) (general partner's possible obligations to other partner do not support allocation of loss financed by capital of other partner); FSA 200045008 (partner with a deficit capital account, but a positive outside basis, did not recognize gain on transfer of its partnership interest, when it had only a limited deficit make-up obligation, and the partnership's assets were less than liabilities; deficit capital account is not a liability).

235 Regs.  § 1.752-2(b)(5) and (f) Ex. 4.

236 Regs.  § 1.752-2(b)(3) and (f) Ex. 3. The agreement can limit the limited partner's exposure to a pro rata share of the liability.

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Example: Recourse Liability Shares. Munn and Surv form a partnership, Oppar. Munn, the venture capitalist, contributes $1,000,000, and Surv, who is a talented executive, contributes $100,000. The Oppar partnership agreement allocates all profits and losses equally, and satisfies the special allocation regulations. Oppar borrows $5,000,000 on a recourse basis. Despite the equal profit and loss sharing ratios, $2,950,000 of the liability is allocated to Surv and only $2,050,000 is allocated to Munn. On a hypothetical liquidation there is a loss of $6,100,000 (initial capital, $1,100,000 contributions + $5,000,000 borrowed). The determination is as follows:

 	  Surv	  Munn	
Initial Capital	$100,000	$1,000,000	
Hypothetical 
 Liquidation Loss	(3,050,000)	(3,050,000)	
Total (deficit to be made up)	(2,950,000)	(2,050,000)	

Thus, Surv and Munn each have an outside basis of $3,050,000—Munn, $1,000,000 capital + $2,050,000 liability share, and Surv $100,000 capital + $2,950,000 liability share. Accordingly each has the basis to deduct an equal amount of loss.

b. Nonrecourse Liability Shares 

The regulations use a three-tier approach to allocating nonrecourse liabilities.237 Liabilities of an LLC taxed as a partnership that are recourse liabilities to the LLC (and that are not guaranteed by members) are nonrecourse liabilities. If they are recourse to the partnership, and not secured by specific property, they can be called exculpatory liabilities.238
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237 T.D. 8906, Allocation of Partnership Debt, 65 Fed. Reg. 64888 (10/31/00).

238 See T.D. 8385, Allocations Attributable to Partnership Nonrecourse Liabilities, Preamble, 56 Fed. Reg. 66978, 66982 (12/27/91). See 710 T.M., Partnerships — Conceptual Overview, for a discussion of the special issues in allocating exculpatory liabilities for LLCs.

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First, nonrecourse liabilities are allocated in accordance with shares of minimum gain under the nonrecourse deduction regulations,239 which can be viewed as a special kind of profit share, although a peculiar one in that the allocation of nonrecourse deductions produces the minimum gain that results in the allocation of the liability that produces the basis that allows deduction of the loss. Partnership minimum gain is the sum of the gains the partnership would realize under the Tufts principle if the partnership disposed of all assets subject to nonrecourse liabilities solely in satisfaction of those liabilities.240 The partner's share of minimum gain is, basically, the cumulative share of nonrecourse deductions, plus the share of any distribution of the proceeds of nonrecourse loans.241
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239 Regs. § 1.752-3(a)(1);see 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for comprehensive treatments of minimum gain and minimum gain chargebacks.

240 Regs. § 1.704-2(d); PLR 9507023 (liabilities allocated among collateralized property based on amount bank can recover from each property).

241 Regs. § 1.704-2(g).

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The next tier allocates nonrecourse liabilities to the portion of any  § 704(c) gain of a contributing partner, or of the portion of any reverse  § 704(c) gain of continuing partners that represents the excess of the nonrecourse liability over tax basis.242 Here the unrealized gain provides the allocation that limits deemed distributions. This next tier—§ 704(c) minimum gain—primarily relates to contributions of encumbered property, or the admission of new partners to an existing partnership.  Section 704(c) minimum gain represents a partner's share of the gain allocated under  § 704(c) to a partner contributing appreciated property,243 or to continuing partners as reverse  § 704(c) adjustments on admission of new partners,244 computed, in both situations, on the assumption that the property subject to the nonrecourse liability was disposed of in satisfaction of the nonrecourse liability.245  Section 704(c) minimum gain differs from partnership minimum gain because it is the excess of the nonrecourse liability over the basis of contributed property (or partnership retained property, for reverse  § 704(c) adjustments), while partnership minimum gain is allocated only with respect to nonrecourse deductions.
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242 Regs. § 1.752-3(a)(2);see 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for more comprehensive treatments of such allocations.

243 See I, B, above, for a discussion, and 711 T.M., Partnerships — Formation and Contributions of Property or Services, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for more comprehensive treatments, of allocation of inherent gain on contribution to the contributor.

244 See I, B, above, for a summary discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for more comprehensive treatments, of allocation of inherent gain to continuing partners.

245 Regs. § 1.752-3(a)(2). See Dienst and Frydland, “Revenue Ruling 95-41 Analyzes the Effect of  Section 704(c) on the Allocation of Nonrecourse Liabilities,” 12 J. Part. Tax'n 385 (1996).

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Only after the foregoing allocations are the excess nonrecourse liabilities allocated in accordance with general shares of profits,246 but safe harbor alternates are likely to be more important. The regulations allow a partnership to allocate excess nonrecourse liabilities first to any balance of  § 704(c) or reverse  § 704(c) gain over the  § 704(c) (or reverse  § 704(c)) minimum gain.247 Each partner's interest in partnership profits is determined by all of the facts and circumstances, presumably as determined under the special allocation regulations under § 704(b),248 although, somewhat surprisingly, this is not stated.249 The regulations finesse the issue by providing a safe harbor if the agreement provides the shares of profits for allocations of nonrecourse liabilities and the allocations are reasonably consistent with some item that has substantial economic effect.250 Rev. Rul. 95-41251 spells out the rules that apparently apply. The ruling takes into account reasonable expectations of future partnership general profits, as well as the shares of  § 704(c) adjustments not taken into account in determining  § 704(c) minimum gain. Neither the regulation nor the ruling gives any clue as to how profit shares are to be determined other than stating that all the facts relating to the economic deal are to be taken into account.
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246 Regs. § 1.752-3(a)(3). See Hamilton v. U.S., 687 F.2d 408 (Ct. Cl. 1982) (allocation of nonrecourse liability respected under prior law).

247 Regs. § 1.752-3(a)(3).

248 Regs. § 1.704-1(b)(2).

249 Regs. § 1.752-3(a)(3). See 710 T.M., Partnerships — Conceptual Overview, for a summary discussion, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment, of special allocations.

250 Regs. § 1.704-2(e)(2).

251 1995-1 C.B. 132.

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The regulations also allow the parties to use reasonable expectations relating to sharing of future deductions attributable to the nonrecourse liabilities as a safe harbor.252 Thus, the allocation of the remaining nonrecourse liability appears to have little practical effect, since the first two rules and the safe-harbors usually result in allocations that provide adequate basis to absorb losses, and to prevent shifts in liabilities on contribution of encumbered property that result in boot.253 Most of the liabilities of LLCs are likely to be allocated under the profit share approach, with the safe harbors.254
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252 Regs.  § 1.752-3(a)(3) and (c) Ex. 2 (allocation to partner to whom depreciation deduction is allocated); see Rev. Rul. 95-41, 1995-1 C.B. 132 (takes into account  § 704(c) adjustments).

253 See 710 T.M., Partnerships —Conceptual Overview  and 714 T.M. Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the potential for such gain.

254 See 710 T.M., Partnerships —Conceptual Overview, for a summary discussion, and 725 T.M., Limited Liability Companies, for a more comprehensive treatment of the special issues in applying the liability allocation rules to LLCs.

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Operating LLCs are likely to borrow on a recourse basis like a corporation, because the owners' exposure is limited to LLC assets, even for entity “recourse” liabilities, unlike limited partnerships (including tax shelters) that usually borrow on a traditional nonrecourse basis with the liability secured by specific property. Accordingly, the Tufts principle that the entire amount of the liability is consideration for property transferred subject to it should not apply. Nevertheless, liabilities of an LLC (or other unincorporated limited liability entity) that is taxed as a partnership are nonrecourse liabilities for partnership tax purposes, because no member is personally liable.255 Two interrelated allocations of LLC exculpatory liabilities are needed—allocation of the liabilities among the LLC's assets, and allocation among the LLC's members. Allocation among the assets affects the determination of the minimum gain and the application of the nonrecourse deduction regulations. LLC liabilities that are not secured by specific assets must be allocated under the multiple liability rules of the nonrecourse deduction regulations,256 and the multiple property rules of the nonrecourse liability regulations.257
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255 Regs. § 1.752-1(a)(2). They remain recourse liabilities for other tax purposes, particularly in determining the consequences of transferring property in kind to discharge the liability. Regs. § 1.1001-2(a).

256 Regs. § 1.704-2(d)(2)(ii).

257 Regs. § 1.752-3(b).

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Example: Shares of Nonrecourse Liabilities. Munn#1 and Munn#2 are each 49% limited partners in a limited partnership, Limpar, of which Surv is the 2% general partner. The Limpar partnership agreement allocates all losses to the limited partners, and satisfies the special allocation rules. Munn#1 and Munn#2 each contributed cash of $100,000, so that each has an initial capital account and outside basis of $100,000, and Surv contributed a nominal $100. During its first year, Limpar borrows$800,000 (nonrecourse), uses the capital and the proceeds of the borrowing to purchase depreciable property, and has a net loss of $300,000, allocated equally to Munn#1 and Munn#2 ($150,000 each). The adjusted basis of the Limpar's property at the end of the year is $700,000. The nonrecourse deductions allocated to each are $50,000, the excess of their respective shares of the deductions over their capital contributions(not the total amount of the loss). The Limpar minimum gain is $100,000(the excess of the $800,000 borrowing over the $700,000 adjusted basis of the property). Thus, each partner is allocated $50,000 of the nonrecourse liability and has sufficient basis to deduct the losses allocated. Since only $100,000 of the nonrecourse borrowing is allocated in accordance with the minimum gain, and there is no  § 704(c) minimum gain, because there is no  § 704(c) gain, the remaining $700,000 is allocated in accordance with profit shares. On these facts, that means 49% each to Munn#1 and Munn#2 and 2% to Surv. If, as is likely, the Limpar partnership agreement provides that profits are allocated 50% each to Munn#1 and Munn#2 until the profits equal prior loss allocations (sometimes called an income chargeback), the remaining $700,000 is allocated 50% to each. The same result is reached under the safe harbor for allocating the liability in accordance with the sharing of future deductions attributable to the nonrecourse liabilities.

c. Liability Shares Follow the Losses 

The net result of these rules is that the liability follows the loss. If a loss, including a loss on a hypothetical liquidation, produces a capital account deficit, any partnership recourse liability is allocated to offset any disproportionate capital account.258 Ironically, it is, in effect, the obligation to pay the liability that provides the justification for the loss allocation under the special allocation rules. Thus, the recourse liability allocation rules limit the effect of the limitation of losses to basis in § 704(d).259 Since partnership minimum gain is primarily a result of allocation of nonrecourse deductions that are the result of partnership losses financed with nonrecourse liabilities, the corresponding allocation of nonrecourse liabilities first to partnership minimum gain has the same basis-enhancing result. There are, predictably, a number of specific anti-avoidance rules that add complications by disregarding obligations to make payments when the facts and circumstances raise doubts about the genuineness of the obligation.260
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258 Regs.  § 1.752-2(f) Ex. 2.

259 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the outside basis limitation on deducting losses.

260 Regs. § 1.752-2(j). See, e.g., 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; distribution of proceeds of loan to limited partners was taxable to the extent that it exceeded outside basis determined without share of general partner recourse loan).

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Example: Liability Follows the Loss. Munn and Propp form a partnership, Oppar. Munn, the venture capitalist, contributes $1,000,000 and Propp contributes natural resource property with a basis of $100,000 and a value of $1,000,000. The Oppar partnership agreement satisfies the special allocation regulations, and allocates all losses to Munn, then charges profits back to Munn until profits have equaled net losses allocated to him, and then allocates all subsequent profits and losses equally. Oppar incurs a $5,000,000 recourse mortgage to raise funds to exploit the property. The liability is initially allocated equally to Propp and Munn, because their capital accounts are equal, even though the outside basis of their Oppar interests are not, because of Propp's exchanged basis. Oppar uses Munn's capital and the loan proceeds to make deductible mining exploration expenditures, all allocated to Munn. The $6,000,000 loss results in a $5,000,000 deficit in Munn's capital account. Because Munn would have to contribute that amount if all Oppar's assets were worthless, the $5,000,000 liability is allocated to him, providing basis to deduct the loss in full.

The result is substantially the same if Oppar borrows the funds under a nonrecourse mortgage loan, although the analysis is different. After the first $1,000,000, the loss represents nonrecourse deductions, so that the remaining $5,000,000 loss allocated to Munn represents his share of Oppar minimum gain. This provides the basis needed to deduct the loss.

4. Reducing Outside Basis for Unsatisfied Assumed Partner Obligations 

The liability and obligation definitions discussed above are a small part of regulations the principal portion of which represent the partnership adaptation of § 358(h).261 The basic device Congress considered objectionable in adopting  § 358(h) involved sale of the corporate stock, usually shortly after a contribution of property in a nonrecognition transfer under § 351, subject to obligations transferred that are not liabilities under § 357(c)(3), that is, deductible (and contingent) obligations so the transfer did not reduce the basis of the stock because it was not a liability.  The obligations did, however, reduce the fair market value of the stock, so that an arm's-length sale resulted in a loss, accelerating, and possibly duplicating, deductions inherent in the obligations, frequently deductions that would otherwise be delayed for many years, for example, deferred compensation obligations.262  Section 358(h) provides for an immediate basis reduction for the obligations even though they are not liabilities. The provision authorizes regulations extending the attack to partnerships. The pass-through nature of partnerships makes the problem more complex, because the  § 358(h) basis reduction might deprive a transferor who does not dispose of the partnership interest of the basis needed to claim the deduction for the obligation when the deduction is allocated under § 704(c). Thus, to the extent that the obligation is satisfied while the contributing partner remains a partner, there is no problem.  Accordingly, the partnership version of regulations recognizes that the problem is not the transfer of the obligation to the partnership, but the separation of the contributing partner from the tax consequences of the obligation before satisfaction, and applies only when there is such a separation.263
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261 Regs. § 1.752-7, as originally proposed in REG-106736-00, 68 FR 37434 (6/24/03), and finalized in T.D. 9207, 70 Fed. Reg. 303334 (5/26/05). See Manning, “Proposed Regulations Deal with Partnership Assumption of Partner ‘Liabilities,' Part 1,” 6 Bus. Ent. 22 (Nov./Dec. 2004); “Part 2,” 7 Bus. Ent. 20 (Jan./Feb. 2005), reprinted in “Tax Planning for Domestic &  Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 2005,” 655 PLI/Tax 209, for the author's discussion, from which this summary is taken.

262 P.L. 106-554, The Community Renewal Tax Relief Act of 2000, § 309(a); see Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 106th Congress (“106 Bluebook”), at 153–56(2001).

263 Regulations, effective for the period between October 18, 1999, and June 24, 2003, reduced the outside basis for the obligation immediately on contribution. Former Regs. § 1.752-6. This may have had the effect of denying the contributor the benefit of the deduction when the obligation became a liability, because they did not provide for increasing the basis to reflect the change in status. Note that in 2009, the U.S. Court of Federal Claims ruled that Regs. § 1.752-6 (requiring reduction of a partner's outside basis for contingent obligations transferred to a partnership) is invalid, because it does not satisfy any of the exceptions to the statutory bar on retroactive application of regulations under § 7805(b). Murfam Farms LLC v. U.S., No. 1:06-cv-00245 (Fed. Cl.7/30/09). See Klamath Strategic Investment Fund, LLC v. U.S., 440 F. Supp.2d 608 (E.D. Tex. 2006) (denies retroactive effect of the regulation to transactions before the date of promulgation of Notice 2000-44, 2002-2 C.B. 255).

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a. Definitions and Rules 

The regulations contain a complex set of definitions that are best understood in a transactional context. What is confusingly defined as a “§ 1.752-7 liability”is an obligation but only to the extent that it is not a liability as defined in Regs. § 1.752-1(a)(4), which means that a single obligation can be part a  § 1.752-7 liability and in part a liability as defined. Although “§ 1.752-7 obligation”would have been a better term, this portfolio follows the term used in the regulations. A  § 1.752-7 liability is usually a potentially deductible obligation, but it can also represent a potential capital expenditure, in which case the amount to be capitalized is a built-in loss treated in the same manner as a  § 1.752-7 liability under § 704(c), including application of the ceiling rule and the alternate elections.264 The transferor is a “§ 1.752-7 liability partner”The “amount” of the  § 1.752-7 liability is equal to the cash price that a willing assignor would pay to a willing assignee at that time to induce the assumption of the obligation.265 When the  § 1.752-7 liability is a long-term obligation, like a deferred compensation or pension obligation, time value of money considerations will make  § 1.752-7 liability amount considerably less than the potential deduction. Since time value of money factors are a key element of value, not prescribing use of the applicable federal rate, or some rate based on it, creates unnecessary administrative burdens, not only for taxpayers, but more for the IRS and the courts.
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264 Regs.  § 1.704-3(a)(8) and (12). See I, B, above, for a summary discussion, and 711 T.M., Partnerships — Formation and Contributions of Property or Services, for a comprehensive treatment of § 704(c).

265 Regs. § 1.752-7(b)(3)(ii). The preamble to the final regulations rejects a comment requesting guidance in valuing  § 1.752-7 liabilities, on the ground that it should be left to the “negotiation of the financial arrangements among the parties.” Preamble, T.D. 920770 Fed. Reg. 30334, 30340(5/26/05). The preambles to T.D. 9059 and to REG-107872-99, 68 Fed. Reg. 37434 (6/24/03), are included in the working papers.

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When a  § 1.752-7 liability is transferred in connection with a  § 721(a) nonrecognition transfer, the transfer is an “assumption” of the  § 1.752-7 liability, defined as taking property subject to the  § 1.752-7 liability, but only to the extent of the value of the encumbered property,266 apparently without regard to whether the § 1.752-7 liability is recourse or nonrecourse, or to whether the partnership expressly assumes the payment obligation, leaving the partner only secondarily liable.267 Until sale (or liquidation) of the interest, the tax consequences of the § 1.752-7 liability are allocated to the “§ 1.752-7 liability partner”268 under § 704(c),269 as a built-in loss.270 Thus, the  § 1.752-7 liability partner shares any eventual deduction in excess of the amount of the  § 1.752-7 liability with the other partners.
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266 Regs. § 1.752-7(b)(4)(i).

267 See Preamble to T.D. 9207, 70 Fed. Reg. 30335, 30340 (5/26/05)(explaining that because a  § 1.752-7 liability is not relevant for purposes of Regs. § § 1.752-1 through 1.752-5, the IRS and the Treasury Department did not adopt a suggestion that the final regulations include guidance on the recourse or nonrecourse treatment of  § 1.752-7 liabilities for all purposes of subchapter K.

268 Regs. § 1.752-7(b)(5).

269 See I, B, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a comprehensive treatment, of  § 704(c) allocations.

270 Regs. § 1.752-7(c).

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The regulations do not expressly deal with the capital account and outside basis effects of the assumption of the § 1.752-7 liability, but do specify that  § § 704(c)(1) and 737 apply to  § 1.752-7 liabilities, and that any changes in value of a  § 1.752-7 liability that are reflected in capital accounts on revaluations under Regs. § 1.704-1(b)(2)(iv)(f), are partnership allocation items under § 704(b), and are not  § 704(c) items.271 In addition, an example indicates that the contributing partner's capital account is credited with an amount equal to the value of the property contributed, net of the fair market value of the  § 1.752-7 liability, and that the corresponding allocation of the partnership deduction equal to that amount is allocated for tax purposes but not for book purposes.272 The example refers to Regs. § 1.704-1(b)(2)(iv)(b).273
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271 Id.

272 Regs.  § 1.752-7(c)(2) Ex.

273 The cited provision, as amended by the regulations, provides for crediting the fair market value of property contributed net of liabilities. This implicitly means that, although a  § 1.752-7 liability is, by definition, not a liability for partnership tax purposes, it is being treated as one for book purposes. Regs.  § 1.704-2(b)(3) was amended to include  § 1.752-7 liabilities in the definition of nonrecourse liabilities for purposes of the nonrecourse deductions, but there is no similar provision in the special allocation regulations capital accounting provisions, Regs. § 1.704-1(b)(2)(iv). If so, the appropriate reference is to Regs. § 1.704-1(b)(2)(iv)(g)(2), which contains a cryptic reference to treating an unrealized deduction in accounts payable under analogous rules and principles to those in Regs.  § 1.704-1(b)(2)(iv) and (b)(4)(i). As no example illustrates this principle, it would have been helpful if the example(and other examples in the regulations) spelled it out.

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Example: Partnership Assumption of § 1.752-7 Liability. Munn, Propp and Surv have equal(one-third) shares in profits and losses of a capital partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. When Oppar was formed, Munn and Surv each contributed$2,000,000 and Propp contributed $4,000,000, but subject to deferred compensation obligations that have nothing to do with Oppar's business in the amount of $8,000,000, due, on the average in 10 years. Accordingly, at a 35% tax bracket, the after-tax cost should be about $5,200,000. The present value of $8,000,000 due in 10 years is about $2,000,000, which is the value assigned by the parties in considering that Propp made an equal contribution. The present value used by the parties does not take into account the tax deduction on the assumption that the deduction is allocated to Propp under § 704(c). The deferred compensation obligation is a  § 1.752-7 liability, and Propp is a “§ 1.752-7 liability partner.” Apparently, the “amount” of the  § 1.752-7 liability is$2,000,000. Since Propp contributed $4,000,000, the  § 1.752-7 liability is assumed by Oppar. These determinations have no significant tax consequences as long as Propp remains a partner. Each Oppar partner has an initial capital account of $2,000,000 (in Propp's case, the net of the $4,000,000 value of the assets she contributed and the $2,000,000 value assigned to the deferred compensation obligation that will be a book, although not a tax, liability). Apparently, Propp's  § 704(c) adjustment is the$2,000,000, not the full $8,000,000 deferred compensation amount, so that if she is still a partner when the deferred compensation is paid, she is allocated the first $2,000,000 of deductions, and all partners, including Propp, share equally in the remaining $6,000,000, a factor apparently ignored by the parties, except to the extent, if any, that they took it into account in valuing the  § 1.752-7 liability.

The balance of the regulations deals with transactions that separate the interest of the  § 1.752-7 liability partner from the partnership, or the § 1.752-7 liability, before satisfaction—sales of the  § 1.752-7 liability partner's interest,274 distribution of partnership assets in liquidation of the  § 1.752-7 liability partner's interest,275 and assumption of the  § 1.752-7 liability by another partner.276 The last two are transactions discussed in this portfolio.277
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274 Regs. § 1.752-7(e). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the application of Regs.  § 1.752-7(e) to a sale of partnership interest.

275 Regs. § 1.752-7(f).

276 Regs. § 1.752-7(g).

277 See III, H, below, for a discussion of assumption of a  § 1.752-7 liability by another partner, usually as part of a distribution, and IV, A, 3, below, for a discussion of the basis reduction when a  § 1.752-7 liability partner receives a liquidating distribution.

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b. Exceptions 

There are two exceptions—one from § 358(h), and one by administrative grace. Consistent with § 358(h)(2)(A), there is an exception when the transfer of the § 1.752-7 liability is part of a transfer of the trade or business that incurred the obligation, and the partnership continues to carry on the trade or business.278 The regulations' definition of trade or business279 is basically the one used in determining the active conduct of a trade or business for purposes of  § 355 relating to corporate separations.280 The examples are consistent with the  § 355 regulations, excluding holding vacant land,281 including transfer of a part of a business,282 and permitting the separation of a research operation.283 Although there is no anti-abuse provision in the regulations, it is possible that even a transfer of a trade or business with related obligations, followed shortly by a sale of the interest, may be subject to the general partnership anti-abuse rules.284 Although the exception means that the  § 1.752-7 liability, as such, never affects the outside basis of the contributing partner's interest, any agreed value assigned to the obligation by the partnership should reduce the contributor's capital account in the same manner as for other contributed obligations.285
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278 Regs.  § 1.752-7(d)(2)(i)(A) and (ii), Ex. 1. The requirement of continuing the trade or business is not in § 358(h)(2)(A).

279 Regs. § 1.752-7(b)(10). An exception under the proposed regulations, that treated trading in financial instruments as a trade or business in the case of an investment company registered with the SEC, Prop. Regs. § 1.752-7(b)(8), has been deleted and a suggestion to broaden the exception rejected. See New York State Society of Certified Public Accountants, “Comments on Internal Revenue Service and Treasury Proposed and Temporary Regulations under Section 752,”2003 TNT 95-16 (Sep. 15, 2003) (objecting to limitation to investment companies filed with the SEC as excluding legitimate hedge funds and venture capital funds, but not suggesting how to distinguish them from potential tax shelters).  The preamble to the final regulations explains that the exception was intended to apply narrowly to master-feeder partnerships, but it appeared that the exception could apply to a broader range of entities, some of which could be carrying on the types of transactions that the regulations were intended to address. 70 Fed. Reg. 30334, 30338 (5/26/05).

280 See Regs. § 1.355-3(b)(2).

281 Regs.  § 1.752-7(b)(10)(ii) Ex. 1. See Regs.  § 1.355-3(c) Exs. 3 and 4.

282 Regs.  § 1.752-7(b)(10)(ii) Ex. 2. See Regs.  § 1.355-3(c) Exs. 6, 7, and 8.

283 Regs.  § 1.752-7(b)(10)(ii) Ex. 3. See Regs.  § 1.355-3(c) Ex. 9.

284 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the partnership anti-abuse rules.

285 See I, A, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of capital accounts.

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A de minimis exception (by administrative grace)eliminates the basis reduction if the aggregate amount of the remaining built-in loss (the amount of the  § 1.752-7 liability reduced for any part of the liability already taken into account by the  § 1.752-7 liability partner) for all  § 1.752-7 liabilities (not counting those qualifying for the trade or business exclusion) is less than the lesser of $1,000,000 or 10% of the gross value of partnership assets, at the testing date, that is, the date of separation event—the sale or liquidation of the partnership interest or the assumption of the  § 1.752-7 liability by another partner.286 Presumably, only  § 1.752-7 liabilities of the  § 1.752-7 liability partner are counted, but this is not explicit.287
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286 Regs. § 1.752-7(d)(2)(ii)(B).

287 The relevant example, Regs.  § 1.752-7(d)(2)(B) Ex. 2, assumes there are no other  § 1.752-7 liabilities.

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Example: Contributed Trade or Business Obligation Followed by Sale of a Partnership Interest. Munn, Propp and Surv have equal (one-third) shares in profits and losses of a business partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. When Oppar was formed, Munn and Surv each contributed $2,000,000, and Propp contributed $4,000,000 in basis and value of the assets of a business, but subject to deferred compensation obligations for employees of that business, aggregating$8,000,000 that have a fair market value of only $2,000,000, reflecting the value of the inherent deduction and the discount for the deferred payment. Oppar will continue the contributed business. Accordingly, the regulations do not apply, and the tax consequences are determined under general partnership tax principles. Each Oppar partner had an initial capital account of $2,000,000 (in Propp's case, the net of the $4,000,000 value of the assets and the $2,000,000 value assigned to the deferred compensation obligation that will be a book, although not a tax, liability). Her initial outside basis was $4,000,000, since the deferred compensation liability did not offset the basis of the contributed property. This book-tax disparity will be eliminated by allocations to her under  § 704(c) of the Oppar deduction as the deferred compensation deduction is satisfied, if she is still a partner.

Oppar now has assets worth $12,000,000 including cash and tangible assets, none of which are  § 751 property, with an inside basis and book value of $10,800,000, and unrealized appreciation in the tangible assets of $1,080,000, leaving $720,000 as a residual allocation to  § 197 intangibles, presumably, goodwill and going concern value. The inside basis and book value reflect $1,950,000 of book net income (allocated $650,000 to each) determined without deducting $350,000 paid to satisfy a portion of the deferred compensation obligation that was treated as payment of the corresponding book (but not tax) liability. The $350,000 tax deduction was allocated to Propp under § 704(c). Oppar owes bank loans and accrued liabilities of $1,200,000, and the $1,650,000 balance of the deferred compensation obligation. Propp's capital account is now $2,650,000 including her allocable share of the Oppar income, as are those of her partners. The outside basis in her Oppar interest is now $4,700,000 ($4,000,000 + $650,000 share of Oppar profits -$350,000 allocation of the deferred compensation deduction + her $400,000 share of the Oppar liabilities). Even though the remaining built-in loss for the deferred compensation obligation is $1,650,000 ($2,000,000 on contribution - $350,000 satisfied), the value of the remaining deferred compensation obligation is $1,800,000, reflecting that the payment dates are now closer.

Accordingly Oppar's balance sheet is:
Assets	Tax	Book	Value	
Non-§ 751 Assets	$10,800,000	$10,800,000	$11,880,000	
§ 197 Intangibles	       -0-	       -0-	  720,000	
Total	$10,800,000	$10,800,000	$12,600,000	
Liabilities &  Capital	Tax	Book	Value	
Bank Loans &  Accr. Liab.	$1,200,000	$1,200,000	$1,200,000	
Deferred Compensation	-0-	1,650,000	1,800,000	
Munn Capital	2,650,000	2,650,000	3,200,000	
Propp Capital	4,300,000	2,650,000	3,200,000	
Surv Capital	2,650,000	2,650,000	3,200,000	
 	$10,800,000	$10,800,000	$12,600,000	

Propp sells her Oppar interest to Perch for $3,200,000 and Perch agrees to indemnify her against Oppar's liabilities, including the deferred compensation obligation. Her total amount realized is $3,600,000, including relief from her $400,000 share of the Oppar liabilities(but not the share of the deferred compensation obligation, which is not a tax liability, although it would be a  § 1.752-7 liability if not transferred with a trade or business). Her $4,700,000 outside basis results in a (presumably capital) loss of $1,100,000, representing the net of the reduction in value for the deferred compensation obligation of $1.700,000 ($1,650,000 remaining  § 704(c) adjustment + $50,000 (her 1/3  share of the $150,000 excess of the $1,800,000 value of deferred compensation obligation over the  § 704(c) adjustment)offset against her $600,000 share of the unrealized appreciation. Accordingly, Propp is entitled to a (presumably capital) loss deduction on the sale of the Oppar interest. Propp's deferred ordinary deduction has become an accelerated capital loss. Although the deferred compensation deduction would be ordinary, there is no provision in  § 751 or otherwise for treating it as anything other than a loss on the partnership interest.

Oppar will be entitled to the deduction for the deferred compensation when paid, allocated to Perch, to the extent of Propp's  § 704(c) adjustment, with the balance allocated equally among Perch, Munn and Surv. Perch's low purchase price and correspondingly low outside basis may limit his ability to absorb the deduction. Perch also succeeds to Propp's$2,650,000 capital account (since the special allocation regulations apply). When a  § 754 election applies, Perch is entitled to a corresponding adjustment under § 743(b). The adjustment is the $550,000 difference between the $3,600,000 price (including the $400,000 liability share) and the $3,050,000 share of the inside basis of Oppar's assets represented by Propp's $2,650,000 capital account and $400,000 share of Oppar liabilities.288 This adjustment is applied to the $600,000 (1/3  of$1,800,000 unrealized appreciation in non-§ 751 property) leaving $190,000 to be applied to the $240,000 share of the goodwill and going concern value. This is $50,000 less than the amount that was implicitly included in the price. It is offset by Perch's $50,000 future share of the deferred compensation deduction for the excess of the amount paid when it is satisfied, in effect, changing the timing of the lost amortization deduction under § 197.

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288 Although each partner has a one-third share of partnership profits and losses, the shares of partnership assets must reflect their capital accounts and shares of partnership liabilities. See III, D, 3, below, for a discussion of such shares in the application of § 751. In this case, this requires crediting Propp with $4,000,000 for the basis of the contributed assets(without reduction for the $2,000,000 deferred compensation obligation that reduces her capital account) + $400,000 (1/3  share of the assets acquired with the proceeds of the liabilities) - $350,000 (Oppar assets used to pay deferred compensation) + $650,000 (1/3  of the assets acquired with the reinvested earnings). The equivalent numbers for Munn and Surv are $3,050,000 each—$2,000,000 original contribution + $400,000 share of assets attributable to liabilities + $650,000 share attributable to reinvested earnings. Thus, because of the allocation of the entire book liability for the deferred compensation, her share of the $10,800,000 Oppar assets is more than one-third, while the shares of Munn and Surv are each less than one-third, even though their capital accounts and shares of profits and losses are equal.

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

All partnership distributions are current distributions, unless they terminate the distributee's partnership interest, or are one of a series of distributions in liquidation of the partner's entire interest.289 Accordingly, current distributions are not limited to those that are proportional to interests in profits or capital, or even those made to all or most partners.  Thus, a significant distribution to a partner reflecting a major reduction of the partner's interest in capital or profits or both, as a result of a beginning of retirement or withdrawal, partial disability, or any other factor, but not leading to total withdrawal, is, nevertheless, a current distribution.  A current distribution may be made in property as well as money. In addition, a reduction in a partner's share of partnership liabilities is treated as a distribution of money.290
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289 Regs. § 1.761-1(d). See IV and V, below, for a discussion of liquidating distributions.

290 See III, A, 2, b, below, for a discussion of distribution of encumbered property as involving distributions and contributions on shifts in liability shares, and IV, A, 2, below, for a discussion of liability relief as a distribution of money in a liquidating distribution.

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A partner who ceases to be a partner for state law purposes remains a tax partner as long as retirement payments continue,291 but payments in a series that are applied toward liquidation of the interests are liquidation payments characterized under § 736.292
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291 Regs. § § 1.731-1(c)(1)(i), 1.736-1(a)(1)(ii), 1.761-1(d).

292 See V, A, below, for a discussion of payment for the withdrawing partner's interest in the partnership as liquidating distributions.

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

A. Nonrecognition of Gain or Loss 

Partners do not recognize gain or loss on pro rata current distributions,293 either at the partnership or partner level,294 even if the distribution consists of the type of assets: (i) described in § 751,295 which includes unrealized receivables of a cash basis partnership, LIFO or other substantially appreciated inventory,296 (ii) items subject to depreciation and similar recaptures,297 (iii) installment obligations,298 and (iv) previously deducted items,299 except to the extent the amount of money distributed exceeds the outside basis of the partnership interest of one or more partners.300
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293 See III, D, 2, below, for a discussion of factors to be considered in determining whether a distribution is pro rata.

294 § 731(a)(1); Regs.  § § 1.731-1 and 1.732-1(b).

295 There may, however, be investment tax credit recapture. § 50(a); Regs.  § § 1.47-2(a) and 1.47-3(f).

296 § 751(c); Regs. § 1.751-1(b)(1)(ii).

297 See, e.g.,  § § 1245(b)(3) and 1250(d)(3); Regs.  § § 1.1245-4(c)(2)(vii) and 1.1250-3(f)(1).

298 Regs.  § 1.453-9(c) (excludes § 731 distributions, from disposition that accelerate gain, except as provided in  § 736(a) or § 751).

299 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of how contributions of these and other items are treated in partnership formations.

300 § 731(a)(1); Regs. § 1.731-1(a).

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1. Money Distributions 

A distributee partner must recognize gain under § 731(a)(1), however, to the extent that any “money” distributed (including a reduction in a partner's share of partnership liabilities) exceeds the adjusted basis of the distributee's interest in the partnership.300.1 The fair market value of marketable securities is generally considered “money” for purposes of § 731(a)(1).301 Since liabilities are taken into account in determining outside basis of partnership interests, it is difficult to see how a net liability reduction can occur for a pro rata distribution.
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300.1 See CCA 200916023 (under § 731(a)(1), limited partners must recognize gain on distribution of recourse loan proceeds made by partnership to extent that distribution exceeds their respective adjusted bases in their partnership interests immediately before distribution;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).

301 § 731(c); Regs.  § 1.731-1(a) and (b); see III, F, below, for a discussion of the tax consequences of distribution of marketable securities when they are considered to be money, and when they are not.

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Since the partner's outside basis is adjusted for partnership income and loss only on the last day of the partnership year,302 cash distributions representing drawing accounts or advances against earnings might result in gain, particularly in professional and other service partnerships where the capital investment is ordinarily low. To avoid this inappropriate result, the regulations allow a partner's advances or drawings against the share of partnership income to be treated as current distributions made on the last day of the partnership's taxable year,303 after the adjustment in outside basis to reflect the distributive share of partnership income, but the computation is made before the determination of allowable losses, with the effect of reducing potential gain on the distribution, but reducing the partner's ability to deduct losses.304 Since the regulations do not explain what constitutes an advance or drawing against income, partners apparently can treat all distributions during the year as advances.305 The IRS apparently does not require that the distributee be required to return any advances, even if they ultimately exceed the partner's share of partnership income for the year.306 A partnership agreement term providing for interim advances, including those that exceed income at the date of the distribution should limit any IRS attack. Of course, a distribution that liquidates a partner's entire interest could not be characterized as an advance or draw against partnership income, because the partnership's tax year closes for a partner who sells or exchanges the entire partnership interest or receives a liquidating distribution for the entire partnership interest.307 Similarly, a distribution accompanied by a reduction in the partner's percentage interest in profits and losses and in capital probably should not be treated as an advance or draw, even though the partnership tax year does not close,308 but the change may require that the income for the year be allocated to reflect the varying interests.309
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302 § 706(a); Regs. § 1.706-1(a).

303 Regs. § 1.731-1(a)(1)(ii).

304 See Rev. Rul. 66-94, 1966-1 C.B. 166 (distributions are taken into account before losses for the year in determining gain realized on money distributions during the year).

305 See Rev. Rul. 92-97, 1992-2 C.B. 124 (deemed distribution from cancellation of debt is offset against distributive share of discharge-of-indebtedness income); Rev. Rul. 94-4, 1994-1 C.B. 195 (deemed distribution resulting from shift in share of liabilities occurs at year-end to extent of share of distributive share of income for year; emphasis added).

306 Regs. § 1.731-1(c)(2). See Rev. Rul. 81-241, 1981-2 C.B. 146 (payments to partners funded by interim payments on a long-term contract that were not included in income under the completed contract method, but were credited to partners' capital accounts, are advances treated as distributions on the last day of the tax year, since there was no unconditional obligation of partners to repay;treated as income since receipt of the payments, which were still treated as unrealized receivables by partnership, did not increase outside basis; gain treated as ordinary under § 751(b)).

307 § 706(c) and Regs. § 1.706-1(c). See IV, E, below, for a discussion of the effect of the closing of the tax year for the withdrawing or terminating partner.

308 § 706(c)(2)(B); Regs. § 1.706-1(c)(4). REG-144689-04, 74 Fed. Reg. 17119 (4/14/09), would redesignate Regs. § 1.706-1(c)(4) as Regs. § 1.706-1(c)(3). See 710 T.M., Partnerships—Conceptual Overview, for a discussion of the consequences of this rule of administrative convenience.

309 § 706(d). See IV, E, below, discussion of the effect of the varying interest rule.

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Any gain recognized is generally capital gain on sale or exchange of the distributee's partnership interest.310 The gain may be part short-term, if the interest has a split holding period,311 but part may be ordinary income, if it involves a shift in shares of  § 751 property.312 A loss is never recognized by the distributee partner or the partnership in connection with a current distribution of money (or property),313 because whether the distributee will ultimately suffer an economic loss with respect to his partnership interest is not determinable until the interest is disposed of or completely liquidated.314
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310 § 731(a).

311 See II, B, 2, above, for a discussion of how contributions can create a split holding period. Since gain attributable to  § 751 property is ordinary income on sale, contribution of  § 751 property within one year of sale is disregarded in determining the holding period of the interest. Regs. § 1.1223-3(b)(4).

312 § 751(b); Regs. § 1.751-1(b). See III, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution. Since gain attributable to  § 751 property is ordinary income on sale, contribution of  § 751 property within one year of sale is disregarded in determining the holding period of the interest. Regs. § 1.1223-3(b)(4).

313 § 731(a)(2), (b).

314 Regs. § 1.731-1(a)(2).

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Example: Partnership Current Cash Distribution. Propp owns a 50% interest in a partnership, Oppar, with an outside basis of $10,000, reflecting a prior nonrecognition transfer under  § 721 of land with a value of $100,000, and Munn owns the other 50% interest with a basis of $100,000. Each has a capital account of $100,000, reflecting the value of their respective contributions. The Oppar partnership agreement satisfies the special allocation regulations. Oppar distributes $50,000 cash to each partner on July 1, 20X1. Oppar has only $20,000 income during 20X1 prior to the date of the distribution and only earns $60,000 during the entire year. The distribution should be an advance against earnings, so that it is considered to occur only at the end of the year after the increase in the partners' outside basis and capital accounts for the year's earnings. Munn realizes no gain or loss and reduces the basis of her Oppar interest to $80,000($100,000 outside basis + $30,000 share of earnings - $50,000 distribution).  Propp reduces the outside basis of his Oppar interest to zero and realizes a gain of $10,000, because the distribution exceeds his outside basis as increased by the year's results ($10,000 outside basis + $30,000 share of earnings - $50,000 distribution). Each partner's capital account is reduced to $80,000 ($100,000 -$30,000 earnings - $50,000 distribution)

2. Property Distributions 

Neither the partnership nor the distributee partner recognizes gain or loss on current distributions of property,315 except to the extent that  § 751(b) applies.316 Such a broad nonrecognition provision is unique among business entities.317 It is also a temptation to convert what would otherwise be a money distribution into a property one.  Section 731(c) now generally treats distributions of marketable securities, whether purchased for purposes of the distribution, or previously held as partnership assets as money, not property, for purposes of gain recognition.318 Attempts to convert partnership money distributions into other property selected by the distributee are likely to fail under step-transaction or other anti-abuse principles.319
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315 § 731(a), (b);Regs. § 1.731-1(a), (b).

316 See III, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

317 Although there is no express nonrecognition, there is a similar result for trusts and estates. See § 643(e)(2); 855 T.M., Estate and Trust Administration — Tax Planning, for a comprehensive treatment of trust distributions in kind.

318 § 731(c); Regs. § 1.731-2; see III, F, below, for a discussion of the treatment of marketable securities as money, not only for purposes of § 731, but also for purposes of § 737, one of the “mixing bowl” provisions discussed in III, E, below.

319 See CCA 200650014 (residence purchased through an LLC and distributed in a liquidating distribution to a partner treated as money not property for purposes of the nonrecognition provisions of  § 731 and the substituted basis provisions of  § 732 treated as distribution of cash to distributee and purchase of residence by distributee; also should be so recast under the anti-abuse principles of Regs. § 1.701-2, the step-transaction doctrine and the economic substance doctrine, all of which are analyzed in the ruling).

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The distributee's capital account is reduced by the fair market value of the distributed property. The capital account adjustments may influence partners' rights to future distributions, particularly if there are special allocations.320 Under what is known as the “mixing bowl” provisions, a partner may recognize gain if, within seven years of contribution, the contributed property is distributed to other partners, or if other property is distributed to the contributor.321
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320 See Regs.  § § 1.705-1(a)(3) (basis reduced, but not below zero, by distributions) and 1.704-1(b)(2)(ii) (requirement that capital accounts be maintained and affect liquidation distributions in order for special allocations to have economic effect); see I, A, above, for a discussion of the provisions on revaluing capital accounts in specified situations.

321 § § 704(c)(2)(B) and 737. See III, E, below, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

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Corporations, including S corporations, recognize gain on all distributions to shareholders,322 and recognize loss on most liquidating corporate distributions.323 Shareholders recognize dividend income on C corporation distributions to the extent made out of earnings and profits,324 and recognize, generally capital, gain on nondividend distributions that exceed the basis of the shares on which made.325 They recognize loss on redemption distributions that are less than the basis of the shares redeemed.326 S corporation shareholders generally apply distributions against basis, recognizing gain when the distribution exceeds basis (adjusted for the share of S corporation income or loss, including any gain or loss on distributions of property in kind), and loss when a redemption distribution is less than basis (as adjusted).327 If the S corporation has ever been a C corporation, the shareholder treats as a dividend any portion of any distributions that are not redemptions and that exceed net accumulated S corporation earnings (known as the accumulated adjustments account).328
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322 § § 311(b) and 336(a). There are exceptions for subsidiary liquidations and reorganizations. § § 332, 337, and 362. See 700 T.M., Choice of Entity, and 784 T.M., Corporate Liquidations, for comprehensive treatments of these corporate provisions.

323 § 336(d); see  § 311(a) (no loss on nonliquidating distributions). See 764 T.M., Dividends — Cash and Property, for a comprehensive treatment of the loss limitation.

324 § § 301(c)(1) and 312. See 764 T.M., Dividends —Cash and Property, for a comprehensive treatment of shareholder taxation.

325 § § 301(c)(3), 302(a), and 331. See 764 T.M., Dividends —Cash and Property, 767 T.M., Redemptions, and 784 T.M., Corporate Liquidations, for comprehensive treatments of corporate taxation on these distributions.

326 § 302(a). See 767 T.M., Redemptions, for a comprehensive treatment of loss recognition.

327 § § 1368(a) and (b) and 1371(a) See 731 T.M., S Corporations: Operations, for a comprehensive treatment of taxation of distributions to S corporation shareholders.

328 § 1368(c). See 731 T.M., S Corporations: Operations, for a comprehensive treatment of s corporation distributions out of C earnings and profits.

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Example: Nonrecognition Distribution. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar distributes a  § 1231 asset with an inside basis of $60,000 and a value of $120,000 equally to its partners, each of whom has an outside basis and capital account of $25,000. None of Oppar, Propp, Munn, or Surv recognizes any gain on the distribution. The $60,000 inherent gain in the  § 1231 asset is credited to each partner's capital account($20,000 each), before the capital accounts are reduced by $40,000 each for the value of the  § 1231 asset, leaving each partner with a capital account and outside basis of $5,000.

a. Distributee's Indebtedness 

The IRS views the distributee's own indebtedness as money received by the distributee, not property, since it is extinguished by the distribution to the obligor, so that any inherent tax consequences cannot be preserved.329 Under the IRS view, the distributee may recognize gain for any excess of the fair market value of the obligation over the applicable outside basis of the partnership interest, or discharge of indebtedness income for any excess of the tax amount of the indebtedness,330 over the fair market value. On the other hand, the partnership treats the transfer of the partner's indebtedness as a nonrecognition property distribution. A partner obligation that is not treated as bona fide debt for tax purposes should not be treated as money if distributed to the partner.331 A partner may also realize discharge of indebtedness income when the partner's debt obligation to a third party is acquired by the partnership, if the partnership is considered a related party, generally when the partner owns more than 50% of the partnership.332
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329 See Rev. Rul. 93-7, 1993-1 C.B. 8 (so holding, but holding that adjustment under a  § 754 election is excess of partnership basis over outside basis of partnership interest, not gain recognized by distributee; in effect gives adjustment of distributee's discharge of indebtedness income).

330 See II, D, 1, above, for a summary discussion; and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of the tax meaning of liability.

331 See II, D, 1; 710 T.M., Partnerships —Conceptual Overview, 711 T.M., Partnerships — Formation and Contributions of Property or Services, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of when obligations that are debt under state law are not treated as debt for tax purposes because they represent equity or are otherwise not genuine indebtedness.

332 § 108(e)(4). See 540 T.M., Discharge of Indebtedness, Bankruptcy and Insolvency, for a comprehensive treatment of discharge of indebtedness, including the effect of acquisition of debt obligations by related parties.

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Example: Distributee's Indebtedness. Oppar in the example in III, A, 1, above, also owns Munn's note, originally issued to an unrelated party for $120,000 that it acquired for $60,000. Since Munn is only a one-third partner, the acquisition of the note did not require Munn to recognize discharge of indebtedness income under § 108(e)(4). If Oppar distributes Munn's note that is now worth $90,000 ratably to its partners, Munn recognizes $25,000 of gain, ($30,000 fair market value of the note - $5,000 outside basis), because the cancellation of Munn's share of the note on distribution to him is treated as a money distribution, not a property distribution. Munn also recognizes $10,000 of discharge of indebtedness income, reflecting the excess of the $40,000 tax amount of his one-third share of the $120,000 note over the $30,000 fair market value of his share. Propp and Surv do not recognize gain, and have in Munn's note a basis of $5,000 each, which represents market discount of $35,000 (the excess of the $40,000 tax amount of their shares of the note over its $5,000 basis to them). This discount will eventually be taxed to them as ordinary income under § 1276. If a  § 754 election applies, Oppar, apparently, adjusts the inside basis of its assets by $15,000 to reflect the excess of Munn's $20,000 ratable share of the inside basis of the note over his $5,000, basis.  The adjustment is not measured by Munn's $35,000 gain and $10,000 discharge of indebtedness. There are similar adjustments for the $15,000 excess of $20,000 shares of the inside basis of the portion of Propp's note distributed to Propp and Surv over their respective outside basis. Each partner's capital account is increased for a ratable share of the $30,000 inherent gain in Munn's note and reduced for the $90,000 value of Munn's note.

b. Encumbered Property 

Most commentators333 agree that, unlike the archetypal nonrecognition transaction in which liabilities encumbering transferred property are treated as consideration for the property transferred, liabilities encumbering property distributed by (or contributed to) partnership are treated as a distribution on the partnership interest.334 The transaction is, in effect, bifurcated, with the distribution of the property treated as a nonrecognition transaction without regard to the encumbering liability. The liability transfer is treated as a separate contribution by the distributee partner.335 Thus, when a nonrecognition distribution by a partnership involves transfer of encumbered property, there is a simultaneous contribution by the distributee of the amount of the encumbering liability, offset, in part, by the reduction in the contributor's (or continuing partners’)share of the encumbering liability.336 Of course, if the distribution is considered part of a disguised sale, any liabilities transferred by the contributor that are part of the sale are amount realized on the sale, without regard to the partnership bifurcation and netting principles.337
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333 See, e.g., McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 4.01[4](3rd ed. 1997); Willis, Pennell & Postlewaite, Partnership Taxation, ¶ ¶ 4.04[1]and [2][a] (6th ed. 1997).

334 See Manning and Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Two),” 11 Tax Mgmt. Real Est. J. 35, 40–42 (1995).

335 Regs. § 1.752-1(e) and (g) Ex.; see Rev. Rul. 84-15, 1984-1 C.B. 158 (partner contributing encumbered property realizes gain only to the extent net reduction in share of liabilities exceeds basis in partnership interest including retained share of liability;no basis step-up for gain recognized); Rev. Rul. 79-205, 1979-2 C.B. 255; see also II, D, 2, above, for a summary discussion, and 710 T.M., Partnerships —Conceptual Overview, 711 T.M., Partnerships — Formation and Contributions of Property or Services, 714 T.M., Partnerships—Allocation of Liabilities; Basis Rules, and 718 T.M., Partnerships—Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive look at the partnership tax treatment of the liability transfers.

336 Regs. § 1.752-1(d), (e); see Rev. Rul. 84-15, 1984-1 C.B. 158 (partner contributing encumbered property realizes gain only to the extent the net reduction in share of liabilities exceeds the outside basis of the partnership interest, including the retained share of the liability; no inside basis step-up for the gain recognized by partner); Regs.  § 1.722-1 Ex. 1 and Ex. 2. See II, D, 3, above, for a discussion of how a partner's liability share is determined.

337 See III, G, 2, below, for a discussion of disguised sales of partnership interests.

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Any pro rata transfer of liabilities is a contribution by the partners of the amount of the liability to the partnership, and a simultaneous distribution by the partnership to the partner of the same amount,338 thus, zeroing out. The shares of liabilities transferred may not be in proportion to the shares of liabilities before the distribution, in view of the different sharing in recourse and nonrecourse liabilities,339 and rules relating to transfer of liabilities,340 which may affect the partner's outside basis. Even when the difference is not enough to result in tax on the distribution, it may cause even an otherwise pro rata distribution to become a recognition transaction under § 751.341
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338 See Rev. Rul. 79-205, 1979-2 C.B. 255; cf. Rev. Rul. 84-15, 1984-1 C.B. 158 (transfer of liability to partnership in connection with transfer of property is treated as partnership distribution, rather than as consideration for property).

339 See II, D, 3, above, for a discussion, and 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment of partners' shares of recourse and nonrecourse liabilities.

340 See II, D, 2, above, for a discussion of transfer of partnership liabilities.

341 See Rev. Rul. 84-102, 1984-2 C.B. 119 (shift of liability on admission of new partner resulted in income to continuing partners under § 751(b), but not to new partner, because he did not receive any deemed distribution). See III, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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In the rare case in which overmortgaged property, i.e., property encumbered by a nonrecourse liability in excess of its value, is distributed, the tax consequences are complex and uncertain. For example, assume that property with a book value of $400,000 and subject to a nonrecourse liability of $1,000,000 (incurred when the value of the property was at least that amount) has declined in value to $700,000.

In applying the general rule that distributed property must be recorded in the capital accounts at its fair market value net of liabilities,342 the regulations require that the property be valued taking into account § 7701(g),343 which provides that the fair market value of property subject to a nonrecourse liability can never be less than the tax amount of the nonrecourse liability. This requires that the property in the example be valued at $1,000,000 and that $600,000 of “gain” be allocated ratably to the partners' capital accounts, including of course that of the distributee. The same regulation requires that in adjusting the distributee's capital account, the value of the property be determined without regard to § 7701(g).344 Thus, on the distribution, the distributee's capital account is reduced only by the $700,000 actual value, not the $1,000,000 value determined under § 7701(g), even though it has been increased to reflect gain based on that value.
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342 Regs. § 1.704-1(b)(2)(iv)(b)(5).

343 Regs. § 1.704-1(b)(2)(iv)(e)(1) (next to last sentence).

344 § 1.704-1(b)(2)(iv)(e)(1) (first sentence).

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Because the distributed property is encumbered, the liability transferred must also be accounted for. For this purpose, the amount of the liability transferred is limited to the fair market value of the encumbered property,345 $700,000 in this example, so that the net capital account adjustment is zero ($700,000 value of distributed property -$700,000 nonrecourse liability transferred). The excess of the tax amount of the nonrecourse liability over the amount transferred to the distributee apparently remains a liability of the partnership, presumably to be accounted for when the distributee disposes of the encumbered property.
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345 § 752(c);Regs. § 1.752-1(d), (e).

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The remaining tax consequences of the distribution should be the same as for any other distribution. The outside basis of the distributee's partnership interest is increased for any excess of the amount of the liability transferred over the distributee's share of the liability before the distribution, and the other partners have a deemed money distribution for their shares of the transferred liability. The distributee's outside basis is reduced by the inside basis of the distributed property, but not below zero, and the basis of the distributed property is the same as the inside basis to the partnership, limited by the outside basis of the partnership interest (as increased for the deemed contribution of the excess of the amount of the liability transferred over the distributee's share).

To carry the analysis one step further, if while still a partner the distributee pays off the entire nonrecourse liability ($1,000,000 in the example), the excess over the amount transferred ($300,000 in the example) is a contribution to partnership capital, increasing the distributee's outside basis and capital account in the amount of the excess of the share of the hanging liability. If instead the distributee arranges with the holder of the nonrecourse mortgage to write it down to the value of the property, the discharge of indebtedness income should be allocated to the partnership and to its partners in proportion to their shares of the write-up under § 7701(g). The same should be true on a taxable disposition of the distributed property: the distributee includes only the portion of the nonrecourse liability transferred, measured by the fair market value of the property at the time of the distribution, and the rest should be treated as gain recognized by the partnership.

Any obligations that have not been deducted, but that become deductible when paid, when economic performance occurs, or when contingencies are satisfied, should not be deducted upon distribution. The distributee should be entitled to deduct the amount properly accrued or paid after the distribution.346 They may become deductible by the partnership, if the delay in deduction is because economic performance has not occurred and the distribution amounts to a transfer of a trade or business.347 There is an argument, under the deemed-payment principle of Commercial Security Bank,348 that any property transferred with the obligation is a payment allowing deduction by a cash-method taxpayer, but this acceleration should not apply to a nonrecognition partnership distribution. Although a distribution under  § 731 is not expressly covered by the authorities dealing with accounts payable and similar obligations, the principles should remain the same, so that the potential deduction passes to the transferee partner, even though the obligation was incurred by the partnership.349 There is no way to allocate the subsequent deduction to the partnership under reverse  § 704(c) principles, or otherwise, when the distributee pays it.350 Of course, if the obligation is a  § 1.752-7 liability, the § 1.752-7 liability partner may recognize a basis adjustment or other consequences if the  § 1.752-7 liability is distributed to another partner,351 but should have no tax consequences if the obligation remains with the partnership and  § 1.752-7 liability partner remains a partner, since the tax consequences of settlement of the obligation remain with the  § 1.752-7 liability partner.
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346 See § 704(c) (similar rule for claims on transfers to partnerships); Rev. Rul. 88-77, 1988-2 C.B. 128 (defining liabilities for purposes of partnership provisions as excluding payables of a cash basis partnership that have not have provided a deduction); Rev. Rul. 80-198, 1980-1 C.B. 113 (similar rule for claims on transfers to corporations); Manning and Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Two),” 11 Tax Mgmt. Real Est. J. 35, 41–42 (1995).

347 Regs. § 1.461-4(d), (g)(1)(ii)(C) (economic performance occurs when purchaser assumes liability in connection with a trade or business transfer).

348 Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981) (accrued interest and accounts payable of cash basis bank deductible on sale under former § 337).

349 Rev. Rul. 75-154, 1975-1 C.B. 186 (even after partnership terminated, former partners entitled to deduct retirement payments to previously retired partner); Flood v. U.S., 133 F.2d 173 (1st Cir. 1943) (same); Rev. Rul. 83-155, 1983-2 C.B. 38 (same for payments by corporation succeeding to partnership business); GCM 39054, Nov. 24, 1981 (same; background for Rev. Rul. 83-155;expressly follows Rev. Rul. 80-198, 1980-2 C.B. 113 (transferee in  § 351 transaction entitled to deduct accounts payable of cash-method transferor).

350 See I, B, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of reverse  § 704(c) allocations.

351 See III, H, below, for a discussion of the assumption of a  § 1.752-7 liability by another partner, usually in connection with a distribution.

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Example: Distribution of Encumbered Property. Munn and Propp are partners in a cash-method partnership, Oppar. Munn's share of profits and losses is 2/3  and Propp's is 1/3 . The Oppar partnership agreement satisfies the special allocation regulations. Oppar owns land acquired for an office-building project that has been abandoned because of a local glut. The land has a basis of $24,000 and a value of $30,000, and is subject to a$18,000 recourse mortgage, taken out more than two years before—a net value of $12,000. Munn's capital account is $30,000 and his outside basis is $50,000, including his share of the mortgage. Propp's capital account is $15,000 and her outside basis is $25,000, including her share of the mortgage. Since the property is no longer useful to Oppar, it distributes the land ratably to its partners so that they can make individual decisions about disposition. Each agrees to assume a ratable share of the mortgage and notify the mortgagee. Each has simultaneous increases in individual liability and reductions in shares of Oppar liability, $10,000 for Munn and $5,000 for Propp. Their capital accounts increase for the $6,000 inherent gain, and are reduced for their shares of the $30,000 value of the property (not the net value after offsetting the mortgage).

If the partners also assume liability for an uninsured tort claim of $6,000, for which Oppar had acknowledged responsibility but that would not be paid until the next year, because the claim is not a tax liability, the partners should be entitled to deduct payments each makes on the tort claim when made. The basis consequences are discussed in the next section. If the distribution is of a commercial property that is a trade or business, the transfer of the liability may satisfy the economic performance requirement.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

B. Distributee's Basis, Holding Period and Character 

The most fundamental definition of basis is that it is cost.352 The partnership's basis in its assets, including any contributed property, is commonly referred to as “inside basis.” The partner's basis in the partnership interest is commonly referred to as “outside basis.353
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352 § 1012.

353 See II, B, 1, above, for a discussion of a partner's outside basis.

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1. Distributee's Transferred Basis in Distributed Property 

As for nonrecognition transfers generally, the distributee's basis in property received in a current distribution is determined by the partnership's inside basis in the distributed property.354 The distributee continues to use the partnership's depreciation period and method as if there had been no transfer,355 but with respect to other accounting aspects, such as inventory method, does not.356 Special rules apply to the transferred basis of any marketable securities.357
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354 § 732(a)(1); Regs. § 1.732-1(a).

355 § 168(i)(7); see 711 T.M., Partnerships —Formation and Contributions of Property or Services, and 759 T.M., Transfers to Controlled Corporations — Related Problems, for comprehensive treatments of depreciation continuity.

356 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of the separate accounting methods of partners and partnerships.

357 See III, F, 2, below, for a discussion of the consequences for the outside basis of the partnership interest and of the marketable securities themselves on the distribution.

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When the distributee is a purchaser or other transferee who acquired the partnership interest when the partnership had a substantial built-in loss,358 or when a  § 754 election was in effect,359 the inside basis includes any basis adjustment allocable to the distributee under the § § 743(b)/754 election,360 or its equivalent for a substantial built-in loss. The  § 743(b) and substantial built-in loss adjustments are to the inside basis of the partnership's assets, but only as they affect the transferee partner, to adjust for the difference between the outside basis of the partner's interest and the transferee's share of the inside basis of partnership assets.361 When the distributed property is not the property with the  § 743(b) adjustment, the adjustment is, in effect, transferred to distributed property in the same class, that is capital gain or ordinary income property.362
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358 A partnership has a “substantial built-in loss” if the partnership's total adjusted basis in the partnership's property exceeds the aggregate fair market value of partnership property by more than $250,000.  § 743(d).  See IV, C, 1, below, for a discussion of a similar adjustment for a substantial basis reduction for liquidating distributions.

359 See IV, C, 1, below, for a discussion of the application of the similar election for liquidating distributions.

360 Regs. § 1.732-2. See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the effect of the  § 754 election and substantial built-in loss in adjusting the partnership's inside basis, solely for the benefit of a purchaser, to reflect the purchase price.

361 § 743(c); Regs. § § 1.743-1(g)(3), 1.755-1(a) and (c)(1)(i).

362 Regs. § 1.755-1(a).

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a. Outside Basis Limitation 

The transferred basis is, however, limited to the outside basis of the distributee's partnership interest, after deducting any money, including any net reduction in the distributee's share of partnership liabilities as a result of the distribution, or adding any contribution resulting from an excess of the liability of any encumbered property distributed,363 any marketable securities,364 and any debt obligations of the distributee,365 that are included in the distribution.366 Because any liability encumbering distributed property affects the outside basis of the partnership interest, both the inside basis of the distributed property and the outside basis to the distributee are determined without adjusting for the encumbrance.367 The outside basis limitation, in effect, transfers the inherent gain in the partnership interest to the distributed property and the distributee. A pro rata distribution imposes any ultimate income on the parties who would have borne it if realized by the partnership. Accordingly, the basis to different partners of their pro rata share of partnership property distributed in kind can be different, depending on whether, and how, the outside basis limitation applies.
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363 See III, A, 2, b, above, for a discussion of the effect of distribution of encumbered property.

364 See III, F, 1, below, for a discussion of marketable securities as equivalent to money in determining gain on a distribution.

365 See III, A, 2, a, above, for a discussion of the treatment of the distributees' own debt as money in determining gain on a distribution.

366 § 732(a)(2), (c); Regs. § 1.732-1(b), (c). See  Rev. Rul. 95-24, 1995-1 C.B. 14 (even though basis of bond is determined by basis to partnership, only fair market value is taken into account in determining amortizable bond premium). See 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment of the inside basis adjustment rules.

367 Regs.  § 1.732-1 never mentions liabilities in its text or its examples, but this must be the approach. See Regs.  § § 1.736-1(b)(1) (partner's value of partner's interest in property and partnership interest to be adjusted so that both take into account the partner's share of liabilities); 1.743-1(d)(1) (transferee's share of inside basis is generally equal to share of previously taxed capital plus share of liabilities). See III, A, 2, b, above, for a discussion of the effect of bifurcated partnership approach to contributions and distributions of encumbered property.

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When multiple properties are distributed by a partnership, to the extent the transferred basis is limited by the outside basis, the partner's outside basis (as reduced for any money or deemed money distributed368), is allocated first to  § 751 property,369 with any excess to other property. Any reduction in the basis of  § 751 property, is applied: (i) in proportion to (but not in excess of) any unrealized decline in value of each property, and (ii) then in proportion to each property's basis (as already reduced for unrealized decline in value).370 Any other property distributed has a zero basis.371 When there is sufficient outside basis to provide a transferred basis to all  § 751 property, a similar process is then applied to other property (capital assets and  § 1231 property),372 with any decrease first applied to reducing unrealized decline in value, with any remaining decrease allocated among the distributed properties in proportion to their respective adjusted bases (as determined after reducing the bases for unrealized decline in value).373 When the outside basis limitation applies to distributed depreciable or amortizable property, the effect of the basis adjustment is immediate, because, although the distributee generally continues the partnership's depreciation period and method,374 the basis decrease reduces the distributee's subsequent deductions ratably.375 Despite the special treatment of  § 751 property, the inherent loss should be allocated to the partners' capital account and the value of the distributed  § 751 property should be charged to the distributee's capital account.376 When there is “lost” basis—an excess of partnership inside basis over the distributee's outside basis—the partnership may make a compensating adjustment to the inside basis of other partnership property when a § § 734(b)/754 election applies.377
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368 § § 733(2), 732(a); Regs. § § 1.731-1(a)(1)(i), 1.732-1(a), Ex. (1).

369 § 732(c)(1)(A)(i);Regs. § 1.732-1(c)(1)(i). See III, D, 3, below, for a discussion of the definition of  § 751 property.

370 § § 732(c)(1)(A), 732(c)(3); Regs. § § 1.732-1(c)(1)(i), (c)(2)(i).

371 These allocation rules have potential for abuse. See CCA 200128053 (confusing, incomplete facts, but recasts transfer of assets to a partnership, followed 10 days later by a sale of partnership interest, as sale of share of assets followed by creation of partnership, apparently because basis results were different from allocation under  § 732(b) and (c); essentially applies step-transaction principles).

372 § § 732(c)(1), 732(c)(3). Regs. § § 1.732-1(c)(1), (c)(2)(i). Under former § 732(c), the allocation was in proportion to inside basis, which could create strange distortions. See Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (“1997 Bluebook”), at 255–56. Regs. § 1.701-2(b) Ex. 11 illustrates the distortion (two properties each with a basis of $5, one with a $5 value and the other with a $95 value distributed to a partner with a outside basis of $100, resulting in a $50 basis in each property). Section 704(c), which was amended after the adoption of the anti-abuse regulations, cures this abuse and renders the example obsolete on its facts.

373 § § 732(c)(1)(B)(ii), 732(c)(3)(B); Regs. § § 1.732-1(c)(1)(ii), 1.732-1(c)(2)(i).

374 § 168(i)(7)(A), (B)(i); Prop. Regs. § § 1.168-5(b)(1) and (2) and -4(d)(5)(i) (depreciation); § 197(f)(2); Regs.  § 1.197-2(g)(2) (amortization). See 531 T.M., Depreciation: MACRS and ACRS, for a comprehensive treatment of depreciation and amortization by transferees in nonrecognition transactions.

375 Prop. Regs. § § 1.168-5(b)(6), (d), -2(d)(3) (depreciation);Regs.  § 1.197-2(g)(2)(ii)(B) (amortization).

376 Regs. § 1.704-1(b)(2)(iv)(g)(2).

377 See III, C, and IV, C, below, for a discussion of the effect of the election.

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Example: Distributee's Basis in Distributed Property. Munn and Propp are partners in an accrual-method partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar makes a current distribution to Propp, whose outside basis in the Oppar interest is$800,000, of: (i) a receivable that has an inside basis of $300,000, but a fair market value of $200,000; (ii) an inventory item that has an inside basis of $100,000, and fair market value of $200,000; and(iii) real property with an inside basis and value of $1,000,000. Under § 732(a)(2), Propp's outside basis is allocated first to the  § 751 property, the receivable and inventory, so that each receives a transferred basis equal to Oppar's inside basis. Propp's $500,000 remaining outside basis ($800,000 -($200,000 + $100,000)) becomes her basis in the real property, even though the inside basis is $1,000,000. Accordingly, if she sells the real property for its value, she recognizes the unrealized $500,000 gain in her Oppar interest, but the inherent gain is deferred as long as she continues to hold the real property. If the limitation did not apply, and Propp's basis in the real property was a transfer of Oppar's $110,0000 inside basis, the gain would be unrecognized, since the outside basis of the interest cannot be reduced below zero. If the real estate is depreciable, Propp continues depreciating it using Oppar's remaining life and method, but her annual deduction is proportionately reduced. The effect of the  § 754 election on Oppar is discussed in the next section.

If Oppar makes an identical distribution to Munn, whose outside basis is $1,500,000, Munn has a transferred basis equal to Oppar's inside basis in each item distributed. Thus, although Propp's basis in the real property is $500,000, Munn's is $1,000,000. If the real estate is depreciable, Munn continues Oppar's depreciation schedule without change. Oppar credits Munn's and Propp's capital accounts with their pro rata shares of the inherent gain and loss on the distributed properties, and reduces each capital account by the fair market value of the properties, below zero for Propp, if appropriate.

If Propp's outside basis is only $250,000, the$50,000 excess of the $30,000 inside basis in the  § 751 property must be allocated between the two items. Since only the receivable has a value less than the inside basis, the entire reduction is allocated to it, leaving it to Propp with a basis of $150,000, which is still more than its value. Propp's basis in the inventory is equal to its inside basis,$100,000. Since the sum of these amounts equals Propp's outside basis, the basis of the real estate is zero.

b. Effect on Distributee's Outside Basis 

After reduction for any simultaneous money distributions, the outside basis is reduced (but not below zero) by the inside basis of any property in a current distribution.378 This, of course, results in a zero remaining outside basis when the transferred inside basis for the distributed property is limited by the outside basis. Except for advances against current income, the adjustment occurs at the time of the distribution, without any adjustment for income or loss of the current year.379 When more than one property is distributed, the order of distribution may have significant consequences, because the limit applies to the distributions in the order made, so that, for example, if money is distributed first, property distributed later is more likely to have a limited (or zero)basis, but gain is recognized only if the money exceeds outside basis. When the property is distributed first, its basis is less likely to be limited, but the money is more likely to result in taxable gain.
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378 § § 733(2), 732(a); Regs. § § 1.731-1(a)(1)(i), 1.732-1(a), Ex. (1).  See III, B, 1, a, above, for a discussion of the consequences when the inside basis of the property distributed in a current distribution exceeds the outside basis of the distributee's partnership interest.

379 Regs. § 1.731-1(a); see Rev. Rul. 94-4, 1994-1 C.B. 195 (deemed distribution resulting from shift in share of liabilities occurs at year-end to extent of share of distributive share of income for year).

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If a partnership distributes encumbered property in a current distribution, the distributee's basis in his partnership interest may actually be increased, even though the interest in partnership profits and capital may be reduced. This is the result of the bifurcation approach that treats the encumbrance as a contribution increasing the basis of the partnership interest and not as consideration for the distributed property.380
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380 See III, A, 2, b, above, for a discussion of the effect of bifurcated partnership approach to contributions and distributions of encumbered property.

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Example: Distributee's Outside Basis in Partnership Interest. Munn and Propp are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $600,000. Oppar makes a current distribution to Propp of unencumbered real property with an inside basis of $500,000 and a fair market value of $750,000, and $500,000 in cash. The cash is first applied to Propp's outside basis, reducing it to $100,000. The basis in the real property is $100,000. If the real property is distributed to Propp first, the basis of Propp's Oppar interest is reduced to$100,000. The subsequent cash distribution results in $400,000 of taxable gain to Propp, since Propp's outside basis is only $100,000 after the real property distribution. Thus, the simultaneous (or prior)distribution of cash allows deferral of gain on the subsequent property distributions, at the price of a reduced basis in the real property. The deferral is shorter if the reduced basis reduces depreciation. Regardless of the order of the distributions, Propp's and Munn's capital accounts increase by their ratable shares of the $250,000 inherent gain in the real property, and Propp's capital account is reduced, below zero if appropriate, by $1,250,000, the sum of the cash and the value of the real property. Despite the basis limit, Oppar should increase the Munn and Propp capital accounts for the $250,000 inherent gain in the real property and reduce Propp's capital account, below zero, by any excess of the $750,000 fair market value of the real property over the capital account as increased for the $125,000 ratable share of the inherent gain. If a  § 754 election applies, Oppar adjusts inside basis for the lost basis.

If the real property is encumbered by a $250,000 mortgage that Propp assumes, Propp makes a $125,000 contribution ($250,000 liability assumed - $125,000 ratable share of the liability)that increases her outside basis. As a result, her basis in the real property is $225,000. The liability shift reduces Munn's outside basis by $125,000, which could result in gain, if his outside basis is less than $125,000. The capital account and  § 754 results are the same. The liability shift does not affect capital accounts.

c. Inside Basis Reduction for Corporation Distributed to Controlling Corporate Partner 

Section 732(f) contains a special rule for distributions of corporate stock to a partner that is a controlling shareholder.381 The problem arises because, under the corporate liquidation rules for distribution of assets of a controlled subsidiary, the parent's basis in the distributed assets is a transferred basis equal to the inside basis of the assets to the subsidiary, without regard to the parent's outside basis in the stock of the subsidiary.382 Subject to step-transaction and other anti-abuse rules, this would allow a corporate partner to avoid the § 732(a)(2) limitation of the basis of distributed property to the outside basis of the distributee's partnership interest by arranging for the distribution to be in the form of controlling stock of a corporation to which the property with a higher inside basis had been contributed, directly if it liquidated the corporation and held the distributed corporation's assets with a transferred inside basis, and indirectly if it does not liquidate the corporation since the distributed corporation's assets retain their higher basis.
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381 For discussions of other problems that arise from the interplay of partnership and corporate tax principles:See IV, C, 2, for a discussion of Regs.  § 1.705-2 dealing with a similar issue when the partnership disposes of corporate partner stock, and for  § 755(c) when the partnership is required to allocate a decrease in basis to property that might otherwise include corporate partner stock owned by the partnership;and 710 T.M., Partnerships — Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussions of issues that arise when corporate partner stock is used to compensate employees of a corporate joint venture taxed as a partnership.

382 § 334(b); Regs. § 1.334-1(a).

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If the outside basis of the distributee corporate partner's partnership interest is less than the distributing partnership's inside basis of the distributed corporation, the inside basis of the assets to the distributed corporation is adjusted to reflect that difference,383 even if the distributed corporation is not liquidated.  Thus the corporate partner cannot preserve the benefit of the higher basis indirectly through the distributed corporation. Any basis reduction required under  § 732(f) is allocated among assets of the distributed corporation in accordance with the rules of § 732(c).
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383 § 732(f)(1).

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The amount of the basis reduction is limited to the excess of the inside basis of the property (including money)of the distributed corporation over the corporate partner's distributed basis in the stock of the distributed corporation.384 This limitation roughly mirrors the result that would occur if the distributed corporation's assets were distributed to the controlling corporate partner, ignoring liabilities and any minority shareholders. Another limitation prevents reducing inside basis below zero (with no basis reduction permitted for money).385 When the full amount of the basis reduction under the first limitation does not apply, because it exceeds the aggregate adjusted basis of the distributed corporation's property(so that the second limitation applies), the excess is treated as long-term capital gain to the controlling corporate partner, apparently because it is likely to represent money that would have resulted in gain if distributed.  There is a corresponding step-up in the basis of the distributed corporation's stock.386
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384 § 732(f)(1)(A).

385 § 732(f)(3)(B).

386 § 732(f)(4).

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The  § 732(f) basis reduction is generally limited to a partnership distribution of stock if the corporate partner controls the distributed corporation immediately after the distribution or at any other time thereafter,387 applying the control definition of  § 1504(a)(2) (generally, an 80% vote and value requirement).388 The reduction generally occurs immediately after the distribution to the corporate partner, but if the corporate partner does not have control at that time, when the partner first has such control.389 There is an exception to the basis reduction when the corporate partner does not have control immediately after the distribution and establishes that the distribution was not part of a plan or arrangement to acquire control,390 which presumably applies only after the corporate partner has acquired control. The basis reduction can apply even when stock of a controlled corporation is not acquired by distribution from a partnership, but the basis of stock is determined in whole or in part by reference to  § 732(a)(2) or (b), presumably because the controlled corporation's basis in the stock is a substituted basis for property distributed by a partnership.391 According to the legislative history, if controlling stock is distributed to two corporate partners, neither of which has control, but the two corporate partners subsequently merge, since the basis of the now controlled corporation is determined by the basis to the distributee partners, the  § 736(f) basis reduction would apply at the time of the merger,392 presumably subject to the possibility that the merging partners could establish, under § 732(f)(2)(B), that the merger was not part of a plan or arrangement to acquire control of the distributed corporation, although the legislative history does not mention the possibility. The legislative history also gives an example of a distribution of property to a corporate partner, followed by a contribution by the corporate partner of the real estate to another corporation in a nonrecognition transaction under § 351, which is stated as not being subject to the basis reduction, presumably because the property suffered the basis reduction on distribution, so that there should be no difference between the basis of the new corporation's stock and the inside basis of the contributed property attributable to the partnership distribution, although, again, the explanation is the author's, not one set out in the legislative history.
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387 § 732(f)(1)(B).

388 § 732(f)(5).

389 § 732(f)(1) (flush language).

390 § 732(f)(2).

391 § 732(f)(6).

392 See H. Rep. No. 106-478, pt. II, H (1999).

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When property held by a distributed corporation includes stock in a corporation that the distributed corporation controls, then the basis reduction applies and reapplies through the tiers393 to any property of any controlled corporation if that property is stock in a corporation that it controls.  Section 732(f) authorizes regulations to provide rules to avoid double counting and to prevent the abuse of the purposes of the provision,394 which the legislative history indicates includes the use of tiered partnerships.395 Further, § 732(f) states that the regulations should prevent the avoidance of the purposes of the basis reduction through the use of tiered partnerships.396
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393 § 732(f)(7).

394 § 732(f)(8).

395 See H. Rep. No. 106-478, pt. II, H (1999).  See III, C, 2, a, below, for a discussion of application of basis adjustments through the tiers of partnerships.

396 Tax Relief Extension Act of 1999, P.L. 106-170, § 538(b)(1), effective generally for distributions made after July 14, 1999.

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Example: Inside Basis Reduction for Corporation Distributed to Controlling Corporate Partner.  Corpar is a partner in Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Corpar's outside basis in its partnership interest is$600,000. Oppar owns all of the stock of Distco.  Oppar's outside basis in its Distco stock is $1,000,000, but Distco's inside basis in it assets is $900,000. Distco's assets consist of unencumbered real property with an inside basis of $500,000 and a fair market value of $750,000, and $400,000 in cash. Oppar makes a current distribution of the Distco stock to Corpar. Corpar's basis in the Distco stock is limited to its $600,000 outside basis.  In the absence of § 732(f), if it liquidated Distco, its basis in the Disco assets would be the same as Distco's—$500,000 in the unencumbered real property and $400,000 in the cash.  If it did not liquidate Distco, it would have had the indirect advantage of the same high inside basis.  The inside basis of Distco's assets is reduced by the $400,000 excess of the $1,000,000 inside basis of the Distco stock to Oppar, over Corpar's $600,000 outside basis in its Oppar interest.  Accordingly, Distco reduces its basis in its unencumbered real property to $100,000. This mirrors the result that would have occurred if Corpar had received a distribution of the Distco assets, since the $500,000 cash would have reduced its outside basis to $100,000, which would become the distributed basis of the unencumbered real property. If a  § 754 election applies, Oppar is entitled to an inside basis adjustment for the $400,000 lost basis.

If the outside basis of Corpar's Oppar interest is only $400,000, the inside basis of Distco's assets should be reduced by the $600,000 excess of the $1,000,000 inside basis of the Distco stock to Oppar, over Corpar's $400,000 outside basis in its Oppar interest. Since the reduction is, however, limited to the $500,000 inside basis in the unencumbered real property, Corpar realizes long-term capital gain of $100,000 for the excess of $600,000 required inside basis reduction of Distco's assets over the $500,000 maximum basis reduction, and increases its basis in the Distco stock to $500,000. Again this roughly mirrors the result that would have occurred with a direct distribution, since the $500,000 cash distribution would have resulted in $100,000 gain for the excess of the cash over the$400,000 outside basis. The $100,000 increase in the outside basis of the Distco stock brings it in line with the inside basis of the unencumbered real property, which prevents duplicating the gain.

If the amount of Distco's cash is only $100,000 and the basis in the unencumbered real property is still $500,000, the total basis adjustment is limited under  § 732(f)(3)(A) to the $200,000 excess of the $600,000 inside basis of Distco's assets($100,000 cash + $500,000 unencumbered real property) over the $400,000 outside basis of Corpar.  Accordingly, the basis reduction in the unencumbered real property is only $200,000, from $500,000 to $300,000. This again mirrors the result of a direct distribution—the $100,000 cash would reduce the Corpar's outside basis to $300,000, which would become the distributed basis of the unencumbered real property. The limitation should not affect Oppar's entitlement to a $600,000 inside basis adjustment when a  § 754 election applies,

In any of the examples, if the unencumbered real estate was stock in Subco, a corporation controlled by Distco, that owned the unencumbered real estate, the basis reduction would not only be to the stock of Subco, but would pass up the tiers to the unencumbered real property owned by Subco.

2. Character and Holding Period of Distributed Property 

Under the entity principle, the distributing partnership's purpose for holding distributed property should not generally determine the character of income, gain, deduction or loss realized by the distributee on subsequent use and disposition of the distributed property, which should be determined by the distributee's purpose for holding the distributed property. Section 735(a), in a partial return to the aggregate principle, however, preserves the character of unrealized receivables and inventory to prevent conversion of ordinary income to capital gain,397 but does not apply to capital assets that have declined in value.398 There is no equivalent  § 735 for S corporations, presumably because the S corporation realizes gain on distribution of property to shareholders.399  Section 735(b) also provides for a transfer of the partnership's holding period for the distributed property.
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397 Under § 724, a similar provision applies to contributions of ordinary income property to partnerships. See 710 T.M., Partnerships — Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussions of the operation of § 724. Section 735 was part of Subchapter K in the Internal Revenue Code of 1954 as originally enacted — see Internal Revenue Code of 1954, P.L. 83-591, 83d Cong., 2d Sess., § 735 —while  § 724 was added in 1984 by the Tax Reform Act of 1984, P.L. 98-369, § 74, which also amended § 735. See 1984 Bluebook, at 234–36.

398 Section 724 provides capital loss treatment for contributed capital loss property, even if converted to ordinary income property by the corporation.  See 710 T.M., Partnerships — Conceptual Overview, and 711 T.M., Partnerships — Formation and Contributions of Property or Services, for discussions of the limitation on conversion of contributed capital loss property.

399 See 731 T.M., S Corporations: Operations, for a comprehensive treatment of property distributions by S corporations.

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a. Character of Distributed Property—§ 735(a) 

The gain or loss recognized by a distributee partner who disposes of, or collects, an “unrealized receivable”distributed by a partnership is ordinary income or loss, regardless of the partner's intent in holding the distributed receivable and the length of time the receivable is held by the distributee after the distribution.400 For this purpose, “unrealized receivables”is defined by reference to § 751(c).401 Although the  § 751(c) definition of “unrealized receivables” also includes recapture items, it does so only for purposes of specific provisions of the Code, not including § 735,402 but, as discussed below, the general recapture provisions continue to apply.
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400 § 735(a)(1); Regs. § 1.735-1(a).

401 § 735(a)(1); Regs. § 1.735-1(a). See III, D, 3, below, for a discussion, and 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the meaning of unrealized receivables.

402 § 751(c) (flush language).

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Similarly, if inventory items are sold by a distributee partner within five years after distribution, the entire gain or loss on the sale is ordinary income or loss, even if attributable to post-distribution changes in value.403 After the five-year period, the character depends on the character of the assets in the hands of the distributee partner,404 as it does for partnership capital assets or  § 1231 assets distributed to the partner, that may change character in the hands of the partner. “Inventory items” is defined by reference to § 751(d)(2), so that it includes any property that is not a capital or  § 1231 asset for the partnership,405 that would produce ordinary income if sold.406 In addition, even if the distributed property is not an “inventory item” to the partnership, it becomes one, if it is inventory of the distributee partner,407 for example, if unimproved land held by the partnership for expected construction of a commercial building is distributed when the partnership project is abandoned, to a partner who intends to use the land for a single-family residential real estate project.
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403 § 735(a)(2).

404 Regs. § 1.735-1(a)(2).

405 Although depreciable property generally must be held for a period of one year before it qualifies as  § 1231 property, property qualifies as  § 1231 property for purposes of  § 735 without regard to the holding period requirement. § 735(c)(1).

406 § 735(a)(2). See III, D, 3, below, for a discussion, and 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the expansive meaning of inventory.

407 § 751(d)(3). For tax years of foreign corporations beginning before 2005, and for tax years of U.S. shareholders with or within which such tax years of foreign corporations end, property subject to ordinary income treatment under former § 1246(a) (i.e., certain stock in foreign investment companies)is also considered inventory items. Former § 751(d)(3).

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The ordinary-income taint is transferred when the property is transferred in a nonrecognition transaction,408 and also applies to any exchanged basis property received by the distributee partner in a transferee entity,409 with an exception for C corporation stock received in a  § 351 nonrecognition exchange.410
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408 § 735(c)(2)(A). In a nonrecognition transaction, the transferee succeeds to the distributee partner's basis in the property. § 1223(2).

409 § 735(c)(2)(A).

410 § 735(c)(2)(B).

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Similarly, although not provided in § 735, if property distributed to a partner is subject to recapture in the hands of the partnership, the property retains the potential recapture after the distribution;the distributee generally must recognize potential recapture of the partnership when the distributee subsequently disposes of the recapture property.411 There are a number of less common recapture provisions that follow similar patterns.412 Although the recapture rules also provide for the recognition of gain even in certain nonrecognition transactions, there is a broad exception for other specified nonrecognition transactions, including distributions by partnerships under § 731.413
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411 § § 1245(b)(6), 1250(d)(6). The recapture amount for tangible personal property is the lesser of (i) the gain realized or (ii) the aggregate prior depreciation deductions for the asset. § 1245(a)(1). Before 1986, for most buildings, the recapture amount was limited to the amount by which the aggregate of the prior depreciation deductions exceeds straight line depreciation, in some cases phased out based on the holding period of the property.  § 1250(a)(1) and (b). Since all real property placed in service after January 1, 1987 is depreciated under the straight-line method, and since the excess of accelerated depreciation over straight line becomes small after approximately one-half of a building's useful life, there is now little real property depreciation recapture. See 563 T.M., Depreciation Recapture — Sections 1245 and 1250, for a comprehensive treatment of depreciation recapture.

412 Depletion, mining exploration and development expenditures and intangible drilling costs on disposition of oil, gas, geothermal and mineral properties,  § 1254(a)(1)(A) and Regs. § 1.1254-1(a), (b)(1)(i)(B);mining exploration expenditures when the property reaches the producing stage,  § 617(b) and Regs. § 1.617-3;soil and water conservation expenditures and pre-1986 land clearing costs on disposition of farm land,  § 1252(a) and Regs. § 1.1252-1(a)(1);certain excluded cost sharing (§ 126) payments on disposition of property benefited by the excluded payments, § 1255(a); converted wetlands,  § 1257(a) and Temp. Regs. § 16A.1255-1(a);equity acquired for debt,  § 108(e)(7) (write-off treated as depreciation); disposition of property for which a reserve for mining and solid waste reclamation and closing costs has been established, § 468(a)(5); and replacement property following a sale to an ESOP, § 1042(e)(3).  See 601 T.M., Mineral Properties — Exploration, Acquisition, Development and Disposition, for a comprehensive treatment of recapture of expenditures related to mineral properties.

413 § § 1245(b)(3) (depreciable personal property) and 1250(d)(3) (depreciable realty). Most other recapture provisions adopt similar principles. § § 1252(b), 1254(b), 1255(b), 1257(d), and 617(d)(3). But see Rev. Rul. 2000-18, 2000-1 C.B. 847 (transfer of replacement property acquired after sale under  § 1042 to a partnership triggers recapture of unrealized gain, no exception in § 1042(e)(3).

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The partnership's recapture potential is transferred,414 apparently, notwithstanding the limit of the basis of distributed property to the outside basis of the distributee's partnership interest, but is limited by the amount of potential recapture that would be realized on a hypothetical sale at the time of distribution, and is reduced by any gain to which  § 751(b) applies.415 In addition to depreciation recapture, other recapture provisions include  § 1254 (intangible drilling and development costs with respect to oil and gas property and mining development and exploration expenditures),  § 617 (mine exploration expenditures), and  § 1252 (soil and water conservation expenditures and land clearing expenditures). The distributed property continues to be treated as recapture property in the hands of the distributee, so that even if the distributee does not continue to depreciate the contributed property,416 the partnership's potential recapture is passed on to the distributee partner.417 Whether the distributee continues to depreciate the property or not, the amount of recapture is limited to any gain that the distributee realizes on the disposition.418 As a practical matter, depreciation on real property is no longer taxed as ordinary income, but, for noncorporate taxpayers is subject to a 25% tax rate as “unrecaptured  section 1250 gain.”419
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414 See, e.g., § 1245(b)(3) and § 1250(d)(3). See 563 T.M., Depreciation Recapture — § § 1245 and 1250, for a comprehensive treatment of the effect of carryover basis on recapture; and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of analogous results on contributions to partnerships.

415 § § 1245(b)(5), 1250(d)(5). There is no hypothetical sale limitation under  § 617 for recapture of exploration expenditures. See § 617(g)(1); Regs. § 1.617-3(d)(4). Although  § 1252(b) directs the IRS to promulgate regulations under  § 1252 that are similar to the rules of § 1245, the  § 1252 regulations do not provide a hypothetical sale limitation to  § 1252 property distributed by a partnership. Similarly, proposed regulations under  § 1254 do not contain a hypothetical sale rule.

416 Regs. § § 1.1245-2(c)(2), 1.1250-3(c)(3)(i);see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment of recapture.

417 § 1245(a)(1).

418 § § 1245(a)(1)(B), 1250(a)(1)(A)(ii).

419 § 1(h)(1)(D), (6). See V, A, 4, below, for a discussion, and 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the special tax rates that apply to unrecaptured  § 1250 gain and collectibles gain on sale of a partnership interest. There is no provision in  § 735 for preserving the partnership's collectibles gain.

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Since  § 735 does not provide for preserving an inherent capital loss, a distributee may be able to convert capital loss property to an ordinary or  § 1231 asset, and realize ordinary loss, including the inherent loss at distribution. Presumably, potential unrecaptured  § 1250 gain is transferred for purposes of the 25% rate.420 Since there is no provision for preserving the tax status of collectibles, the general entity principle should permit the distributee's use to determine whether distributed property is a collectible when the distributee disposes of it, but if it remains a collectible, the 28% collectibles rate should apply to the entire gain.421
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420 § 1(h)(6). The 2003 reduction of the general capital gain rate to 15% did not change the rate on unrecaptured  § 1250 gain.

421 § 1(h)(4). The 2003 reduction of the general capital gain rate to 15% did not change the rate on collectibles gain.

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Example: § 735(a) Characterization in Operation. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar distributes to Munn in reduction of his interest:(i) a subdivided lot with a basis of $135,000 and a value of $150,000,(ii) a balloon mortgage note on another subdivided lot sold last year with payments of interest only, at a rate 4 points above the AFR over 20 years that has a value of $60,000 (face value $100,000) and a zero basis, (iii) an isolated lot acquired with a basis of $300,000 and value of $250,000, held for investment since it is not suitable for sale as part of its normal dealer activities; and (iv) a computer on which it has claimed $25,000 of depreciation with a basis and value of $75,000. Munn intends to build and operate gas stations on the lots, converting both parcels to  § 1231 property. Zoning problems prevent building gas stations on the lots, and Munn sells them for $200,000 each. The entire$65,000 gain on the subdivision lot (including post contribution appreciation)is ordinary income. Assuming the second lot was effectively converted to a  § 1231 property, the entire loss, including the $50,000 decline in value while it was held by Oppar as investment, property is potential ordinary loss under § 1231. If the sales are more than five years after distribution, the entire gain on the subdivision lot is potential capital gain under § 1231. Under § 1221(a)(4), the gain on the mortgage note will be ordinary income, even if not collected for 20 years. The potential depreciation recapture for the computer is not  § 751 property for purposes of § 735(a), but remains potential depreciation recapture in addition to any depreciation Munn deducts. The $175,000 net inherent gain in the distributed property is allocated ratably to the partners' capital accounts. Munn's capital account is reduced by the value of the distributed properties.

b. Holding Period of Distributed Property—§ 735(b) 

A partner is permitted to “tack”the partnership's holding period the partnership held distributed property, whether the property is distributed in a current or a liquidating distribution.422 The partnership's holding period includes any holding period tacked to the holding period of distributed property that was contributed to the partnership, or received by it in another a nonrecognition transaction.423 Thus, a partner may have a long-term holding period for distributed property, even if the holding period of the partnership interest is short-term.424 Although  § 735(b) states that the distributee's holding period “includes” the period held by the partnership, the distributee should not be able to add the partnership's holding period to the holding period of the partnership interest. Indeed, it is doubtful whether a partner's long-term holding period in the partnership interest can be used to convert a short-term distributed asset into a long-term one.425 Apparently, the tacking applies even if the basis is reduced, or, in the case of a liquidating distribution, increased with reference to outside basis.426 There is, however, no tacking in determining the holding period of property for purposes of the five-year period in § 735(a)(2).427 The IRS's position that a purchase of all partnership interests is a deemed purchase of assets, means that the share of assets attributable to the purchased interest is not considered received in a partnership distribution, but is deemed purchased, so that there is no tacking under  § 735(b) when a partner purchases all other interests, or when a third party purchases all interests, thereby terminating the partnership.428
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422 § 735(b).

423 § 1223(2).

424 See Rev. Rul. 68-79, 1968-1 C.B. 310 (sale of long-term assets by partnership passes through long-term gain to partner who purchased within holding period).

425 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 20.01 (3rd ed. 1997) (states categorically, without citation, that the holding period of the interest is irrelevant).

426 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 20.01(3rd ed. 1997); see III, B, 1, a, above, and IV, B, below, for discussions of the limitation on, and potential increase in, transferred inside basis, respectively.

427 § 735(b).

428 See McCauslen v. Comr., 45 T.C. 588 (1966) (when partnership terminated on purchase by one partner of the entire partnership interest of the other, the purchaser was not entitled to “tack” the partnership's holding period for the one-half interest attributable to the interest of the other partner, but was treated as purchasing that portion of the assets). Rev. Rul. 99-6, 1999-1 C.B. 432 (applying McCauslen treats sale of all interests as having been preceded by a distribution of all of the assets to the selling members for purposes of determining basis and holding period of the assets for the acquirer). See IV, F and IV, G, 5, b, below, for discussions of the collateral effects of this position.

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Example: § 735 Holding Period Tacking. Perch, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Perch acquired her interest in a taxable transaction from Munn, an original partner, nine months before the distribution by Oppar to her, in reduction of her purchased interest, of the following:(i) a subdivided lot held for more than one year, (ii) a balloon mortgage note on another subdivided lot sold within the current year, (iii)an isolated lot held for more than one year for investment since it is not suitable for sale as part of its normal dealer activities;and (iv) a computer on which it has claimed $2,500 of depreciation held for more than one year. There are no  § 754 adjustments allocable to these assets. Perch originally intended to build and operate gas stations on the lots, converting both parcels to  § 1231 asset, but zoning problems prevented this. Even though the subdivided lot was a held for sale, Perch should be able to tack the holding period, for both lots, satisfying the one-year holding period requirement, even though she has held her Oppar interest for only nine months. Nevertheless, as stated in the example in III, B, 2, a, above, the subdivided lot remains ordinary income property, and the five-year period is not reduced by tacking. This taint does not affect the investment lot. Similarly, because the mortgage note is not a capital asset, tacking is irrelevant. Tacking also satisfies the  § 1231 holding period for the computer, although, of course, Perch remains subject to depreciation recapture.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

C. Effect on Partnership's Inside Basis—§ 754 

Section 734(a), applying the entity principle, provides there is no corresponding adjustment of partnership inside basis. even when a distribution results in recognition of gain, because money distributed exceeds the distributee's outside basis,429 or when the basis of distributed property to the distributee is less than the inside basis to the partnership, when the limitation to outside basis applies.430 The failure to adjust inside basis creates a possibility of double inclusion or double deduction, albeit one that is corrected in the long run.431 For example, if a service partner with a carried interest that has a zero basis received a $100,000 money distribution of a share of unrealized appreciation, the $100,000 is immediately taxed as a capital gain.  When the appreciated asset is sold, the partnership realizes the full gain, with $100,000 (or more)allocated to and taxed to the service partner, even though it represents the $100,000 on which tax was paid at the time of distribution. Since the $100,000 gain increases the outside basis of the partnership interest that will not result in a further distribution, the service partner will eventually realize a $100,000 loss or reduced gain but only on liquidation of the partnership interest, but the eventual offset is cold comfort for the earlier double inclusion. Of course, there is also a possible doubling of loss in the relatively rare case in which loss is realized on a distribution. There is a similar duplication issue on sales or other dispositions of partnership interests.432
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429 See III, A, 1, above, for a discussion of gain recognition on money distributions.

430 Regs. § 1.734-2(a). See III, B, 1, a, above, for a discussion of the effect of limiting the transferred basis of distributed property to the distributee's outside basis.

431 See III, C, below, for a discussion of possible doubling of gain or loss when no inside basis adjustment applies to reflect a distribution.

432 § 743(a), (b);Regs. § 1.743-1(a), (b). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of adjustments under the § § 743(b)/754 election on sale or other disposition of a partnership interests.

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Section 734(a) immediately provides, however, for an adjustment eliminating the duplicated gain, if an election under  § 754 is made.433 Although § 734(b), as amended in 2004, also provides for an adjustment of the inside basis of partnership property without an election when there is a substantial (more than $250,000) basis reduction, it applies only to liquidating (not current) distributions.434 The adjustment was made elective, apparently, as a matter of administrative convenience.435 The partnership makes the election, but once the election is made, it is irrevocable without IRS consent.436 The election is made by the partnership's filing a written statement containing the information requested under regulations with its timely-filed tax return (including extensions)for the year in which the election is to first apply.437 The application for revocation must similarly be filed with the District Director where the partnership files its returns within 30 days of the end of the year to which the revocation is to apply.438
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433 § 734(b). See 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for a comprehensive treatment of these basis adjustment rules. Since making the  § 754 election may result in increases or decreases in the inside basis of partnership property for continuing and transferee partners, the decision to make the election may involve conflicts among the partners and other ethical issues. When the partnership attorney, in effect, represents all partners, there should be informed written consent to the conflict and other ethical issues. A form of Representation Letter dealing with similar issues at the withdrawal stage that can be adapted to deal with other stages of partnership operation is included in the Working Papers.

434 See IV, C, 1, below, for a discussion of the adjustment of the inside basis of remaining partnership partner when the distributee partner has a substantial basis reduction.

435 See Regs. § 1.701-2(a)(3); cf. S. Rep. No. 1622, 83d Cong., 2d Sess. 406 (1954) (referring to making  § 754 election revocable when can show an increased administrative burden to the partnership from change in activities or frequency of shifts, but not to avoid basis step-down).

436 § 754; Regs. § 1.754-1(a), (c).

437 Regs. § 1.754-1(b). If the deadline is missed, the IRS may grant an extension to file the election under its administrative discretion authorized by Regs. § 301.9100-1. See, e.g., PLRs 200802001 (extension granted when accountant inadvertently failed to file), 200838019 (same when partnership inadvertently failed to file after death of partner), 200316021 (same when accountant did not advise of availability of election), 200316006 (same when accountant inadvertently failed to file). It is, of course, foolish to rely on IRS discretion, even though it has shown some generosity in saving tax practitioners from their own malpractice. A form of election is included in the working papers for 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

438 Examples in the regulation of grounds which may be considered adequate for revoking the election include: (i) a change in the nature of the partnership business; (ii)a substantial increase in or a change in the character of the partnership's assets; and (iii) an increase in the frequency of partner retirements or shifts in partnership interests (resulting in increased administrative costs attributable to the  § 754 election). The regulation also specifies that avoiding stepping down the inside basis of partnership assets is not grounds for revoking the election. A form of request for revocation of the election is included in the working papers for 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination.

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There is, of course, a similar potential for double deduction when the partnership has unrealized losses.  Although there is an incentive for the partnership to make the election to avoid double inclusion, there is no similar incentive in the case of unrealized losses. Thus, although, the adjustment was made elective by the partnership as a matter of administrative convenience for the partnership,439 The elective aspect, of course, leaves room for abuse.440
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439 See Regs. § 1.701-2(a)(3), (d) Exs. 9 and 10.

440 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the application of the anti-abuse regulations in two such situations.

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Example: Current Distribution to a Partner with No § § 734(b)/754 Adjustment. Munn#1, Munn#2 and Propp are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp contributed land that had a basis of $60,000, and a then fair market value of $330,000, for her interest in the capital and profits; and the other two each contributed $330,000 cash. As a result, Propp has a  § 704(c) adjustment of $270,000. Oppar now (more than seven years after the Propp contribution)has the following balance sheet:

Assets	Basis	Value	
Cash	$150,000	$150,000	
Inventory	600,000	 660,000	
Land	60,000	360,000	
Building	235,000	400,000	
Other Capital Assets	245,000	200,000	
  Totals	$1,290,000	$1,770,000	
Liabilities and Capital	Tax Amount	Value	
Recourse Mortgage	$300,000	$300,000	
Munn#1 Capital	420,000	490,000	
Munn#2 Capital	420,000	490,000	
Propp Capital	150,000	490,000	
  Totals	$1,290,000	$1,770,000	

Propp receives $45,000 cash and the $200,000 Other Capital Assets in reduction of her Oppar interest from one-third to one-fifth. The partners' book capital accounts should be adjusted downward for their shares ($15,000 each) of the unrealized loss in the Other Capital Assets, to $405,000 for Munn#1 and Munn#2 and $135,000 for Propp, and, in view of the shift in interests in Oppar, should be adjusted up for their shares ($85,000 each) of the $255,000 unrealized gains in the remaining assets, to bring their capital accounts to amounts shown in the Value column, thus creating reverse  § 704(c) adjustments. Prior to the distribution, the outside basis of Propp's Oppar interest was$250,000 (including one-third of the recourse mortgage). The distribution of the $45,000 cash and the $40,000 reduction in her share of the$300,000 mortgage from 1/3  ($100,000) to 1/5  ($60,000) reduces her outside basis to $165,000. If there is no  § 754 election in effect, this $80,000 difference between her outside basis and the Oppar's inside basis in the distributed assets does not affect Oppar's inside basis in the remaining assets, so that the partners will not realize the loss until their Oppar interests are disposed of.

After the distribution, Oppar's balance sheet is:

Assets	Basis	Value	
Cash	$105,000	$104,000	
Inventory	600,000	 660,000	
Land	60,000	360,000	
Building	235,000	400,000	
  Totals	$1,000,000	$1,525,000	
Liabilities and Capital	Tax Amount	Value	
Recourse Mortgage	$300,000	$300,000	
Munn#1 Capital	405,000	490,000	
Munn#2 Capital	405,000	490,000	
Propp Capital	-110,000	245,000	
  Totals	$1,000,000	$1,525,000	

Propp's basis in the Other Capital Assets distributed is $165,000, which is $80,000 less than the inside basis to Oppar and $35,000 less than value.  If she sells the Other Capital Assets, she realizes a gain of $35,000.  Her outside basis has been reduced to zero by the $165,000 transferred basis in the Other Capital Assets, but her remaining $60,000 share of the Recourse Mortgage means that she has potential “phantom gain” in that amount, because it is included in the amount realized on any disposition of her Oppar interest. Her $270,000  § 704(c) adjustment is unchanged.  The $15,000 reduction in Munn#1's and Munn#2's capital accounts in the Tax Amount column reflects the unrealized loss in the Other Capital Assets that will never be deducted by the Oppar partners, except on liquidation of their interests.  Accordingly, the $85,000 difference between the $405,000 capital account and the$490,000 Value reflects the full reverse  § 704(c) adjustment on which they will eventually be taxed.  There is a similar reduction in Propp's capital account to $135,000 and a further reduction to the -$110,000 shown by the excess of the $245,000 distribution over the $135,000 reduced basis.  The $355,000 difference between the -$110,000 Tax Amount and the $245,000 Value reflects the sum of her $270,000 § 704(c) adjustment+ her $85,000 reverse  § 704(c) adjustment.

If instead of distributing the Other Capital Assets, Oppar sells them and distributes the proceeds, Oppar would realize a $45,000 capital loss.  The partners' shares of the loss reduce their Tax Amount capital accounts in the same manner as the notional reduction described above.  The $285,000 ($245,000 cash +$40,000 reduction in liability share) distribution would result in$50,000 gain for Propp.  Her capital account would be reduced to $245,000. Her Tax Amount capital account is reduced to -$110,000, leaving the same  § 704(c) and reverse  § 704(c) adjustments in place.

1. Partnership's Inside Basis Adjustment under § 734(b) 

The  § 754 election essentially eliminates the potential for double tax—when gain realized by the partnership and passed through to the partners duplicates the gain realized (or to be realized) by the distributee partner. It is easier to understand the application of the  § 754 adjustment in the context of sales of partnership interests,441 in part because the adjustment on sale is for the benefit of the selling partner only and seeks to adjust for differences between the purchase price and the purchaser's share of inside basis, while the adjustment for distributions changes the inside basis of partnership property for the benefit of all partners, in a way that does not compensate the distributee for the gain or lost basis that generates the adjustment. Adjustments of inside basis under a  § 754 election result in corresponding adjustments to capital accounts.442 The adjustment was made elective by the partnership as a matter of administrative convenience for the partnership,443 but, once made, is irrevocable without IRS consent.444 The elective aspect, of course, leaves room for abuse.445
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441 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of adjustments of inside basis, for the benefit of the purchaser only, to bring the purchaser's share of inside basis in line with the purchase price.

442 Regs. § 1.704-1(b)(2)(iv)(m)(4), (5).

443 See Regs. § 1.701-2(a)(3), (d) Exs. 9 and 10.

444 § 754; Regs. § 1.754-1. Examples of grounds that may be considered adequate for revoking the election include: (i) a change in the nature of the partnership business; (ii)a substantial increase in or a change in the character of the partnership's assets; and (iii) an increase in the frequency of partner retirements or shifts in partnership interests (resulting in increased administrative costs attributable to the  § 754 election). The regulation also specifies that avoiding stepping down the inside basis of partnership assets is not grounds for revoking the election.

445 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the application of the anti-abuse regulations in two such situations.

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The adjustment under  § 734(b) is triggered when an election under  § 754 applies and: (i) a distributee recognizes gain on receipt of distribution(or deemed distribution) of money in excess of basis,446 or (ii) on a distribution of property with an inside basis in excess of the (remaining) outside basis of the partnership interest so that there is “lost” basis.447 The adjustment from a current distribution resulting in distributee gain or lost basis is always an increase in inside basis measured by the gain or the lost basis, thus restoring the relation between inside and outside basis that the aggregate principle makes appropriate.448 The allocation of the basis adjustment is discussed in the next section.
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446 A distributee can only recognize loss on liquidating distribution. § 731(a)(2). See IV, A, below, for a discussion on losses in liquidating distributions.

447 § 734(b)(1); Regs. § 1.734-1.

448 § 734(b); Regs. § 1.734-1(b); see generally Cuff, “Basis Adjustments After Distributions of Partnership Assets: The Section 734/755 Regs.,”93 J. Tax'n 18 (2000); Walsh, “New Regs. Offer Guidance on Partnership Adjustment Allocations,” 65 Prac. Tax Strat. 23 (2000). See 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for a comprehensive treatment the  § 754 adjustment.

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Example: In Kind Distribution to a Partner with § § 734(b)/754 Adjustment. The facts are the same as in the example in III, C, above (Current Distribution to a Partner with No § § 734(b)/754 Adjustment), except that a  § 754 election applies.  The § § 734(b)/754 adjustment is $80,000. Because the lost basis applies to capital assets, the $80,000 inside basis adjustment is allocated only to the Land and Building; none is allocated to the appreciated Inventory.

If instead of distributing the Other Capital Assets, Oppar sells them and distributes the proceeds, the $50,000 § § 734(b)/754 adjustment will also be allocated to Land and Buildings because gain on a distribution is allocated to capital gain property.

The allocation of the adjustment is discussed in the next section and illustrated in the next example.

2. Allocating the Inside Basis Adjustment 

The allocation of the inside basis adjustment is made under § 755.449 The regulations provide a three-stage process for determining the allocation.  First, the value of each asset is determined, under a residual method process that places significant emphasis on determining the value of intangibles, implicitly including those not shown on the partnership books, when assets of the partnership are a trade or business.450 Second, the adjustment is allocated between the two classes of: (i) capital and  § 1231 property, presumably including goodwill and other  § 197 intangibles; with any gain from a distribution(or deemed distribution) of money allocated to capital gain property;451 and (ii) ordinary income property.452 Third, the adjustment for each class is allocated among the items within each class, in a manner designed to reduce the unrealized appreciation or decline in value of remaining partnership property, with any unused adjustment held in suspense for a future allocation to after-acquired property of the appropriate class instead of being allocated to properties of the other category.453
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449 § 734(c); Regs. § 1.734-1(c); § 755(a); Regs. § 1.755-1(a), (c).

450 Regs. § 1.755-1(a)(1), (2), and (5).

451 Regs. § 1.755-1(a)(1), (c)(1)(ii) (refers only to “capital gain property,” but since  § 755(b)(1) groups capital assets and  § 1231(b) property in a single class, the reference must include  § 1231(b) property).

452 Regs. § 1.755-1(a)(1), (c)(1)(i).

453 § § 754, 755, and 734: Regs. § § 1.754-1, 1.755-1, 1.734-1, 1.734-2, and 1.732-2.

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Unlike adjustments on sale of a partnership interest, where there can be positive and negative adjustments in a single category (based on a hypothetical sale of partnership assets),454 adjustments for partnership distributions in a category can only be positive or negative (with a carryover of any excess negative adjustments).455  Section 704(c) adjustments apparently do not affect the allocation.456 Any increase reflecting gain or lost basis is allocated first to appreciated property in proportion to unrealized appreciation, with any remaining increase allocated to all of the properties within the class in proportion to their fair market values.457 Thus, it is possible (although rare) for the inside basis to be increased to more than the value of the property. For current distributions, the allocations of increases will be primarily to capital gain property because the outside basis is allocated first to the basis of distributed  § 751 property, leaving less likelihood of lost basis.458
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454 Regs. § 1.755-1(b); see 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of positive and negative adjustments in computing the inside basis adjustment when a  § 754 election applies to a sale of a partnership interest.

455 § § 734(c), 755(b); Regs. § § 1.732-1(c), 1.755-1(c); see Jackel and Fessler, “The Mysterious Case of Partnership Inside Basis Adjustment,” 89 Tax Notes 529 (Oct. 23, 2000) (discusses interplay of § § 734(b), 197 and 704(c)).

456 See Regs.  § 1.755-1(c)(6) Ex. 1 (allocate adjustment on basis of unrealized  § 704(c) adjustment, but not take that adjustment into account).  For similar adjustments on sale of a partnership interest, remedial allocations under Regs.  § 1.704-3(d) are taken into account, but not other  § 704(c) adjustments. Regs. § 1.755-1(b)(1)(ii). See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion computing the inside basis adjustment for the purchasing partner when an election under  § 754 applies to a sale of a partnership interest.

457 Regs. § 1.755-1(c)(1)(i).

458 § 732(c)(1)(A); Regs. § 1.732-1(c)(1); see Regs. § § 1.732-1(c)(4), 1.755-1(c)(6) Ex. (ii).

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Because of the two-category aggregation, apparently, when the positive or negative adjustment to the category of capital gain and  § 1231 property exceeds the unrealized appreciation or depreciation in value, as the case may be, in such assets, because there are assets with unrealized changes in the opposite direction, an excess that may be attributable, for example, to nondepreciable capital loss property, may end up being allocated to  § 1231 property. None of the examples in the regulations illustrate this result. Any increase in the basis of depreciable property is depreciated as if it were new property (and not over the remaining life of the property),459 but any decrease is allocated over the remaining life of the property.460 Capital accounts are adjusted to reflect adjustments in the inside basis of partnership property under a § § 734(b)/754 election in certain circumstances to the extent they properly correspond to changes in book value.461 The same process is applied—decreases are allocated to properties with unrealized declines in value of the required character in proportion to the unrealized declines, with any remaining decreases allocated in proportion to adjusted basis,462 but with a limitation on reducing the basis of any property below zero,463 and a carryover of excess adjustment until the partnership acquires property of the required character.
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459 Regs. § 1.734-1(e)(1).

460 Regs. § 1.734-1(e).

461 Regs. § 1.704-1(b)(2)(iv)(m)(4).

462 Regs. § 1.755-1(c)(2)(ii).

463 Regs. § 1.755-1(c)(3).

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Inside basis adjustments under § § 734(b)/754 affect partners' capital accounts,464 but only to the extent needed to increase the amount at which the property is carried on the books to its fair market value.465 This means that if reverse  § 704(c) adjustments have been made in connection with the distribution, there should be no further adjustment of the capital accounts.
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464 Regs. § 1.704-1(b)(2)(iv)(m)(4).

465 Regs. § 1.704-1(b)(2)(iv)(m)(5).

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Before December 15, 1999, the basis adjustment allocation involved the same two categories of: (i) ordinary income and (ii) capital and  § 1231 assets(including gain on a money distribution466), but the allocation within classes was different.467 The former § 755 regulations required that partnership goodwill be taken into account in a  § 755 allocation, even if it was not otherwise reflected in the partnership's books.468 The initial step of allocating the increase to assets with inherent gain in proportion to the unrealized gain was also essentially the same.469 There was, however, no provision for the rare allocation when the increases exceeded the unrealized appreciation, although it is likely that goodwill would take up the slack.  There was a similar limitation on reductions in excess of basis, with a similar carryover.470
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466 Former Regs. § 1.755-1(b)(1)(ii).

467 Former Regs. § 1.755-1(a)(1)(i).

468 Former Regs. § 1.755-1(a)(1)(iv).

469 Former Regs. § 1.755-1(a)(1)(iii).

470 Former Regs. § 1.755-1(b)(3).

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Example: Allocating the § § 734(b)/754 Adjustment. The facts are the same as in the example in III, C (Current Distribution to a Partner with No § § 734(b)/754 Adjustment), and III, C, 1 (In Kind Distribution to a Partner with § § 734(b)/754 Adjustment), above. The § § 734(b)/754 adjustment is $80,000. Oppar's inside basis in the Land and Building is increased ratably by (rounded)$28,000 for the land ($300,000 Land appreciation/$465,000 total appreciation Land and Building x $80,000) to $112,000; and $52,000 for the building ($165,000 Building appreciation/$465,000 x $80,000)to $263,000. The fact that $270,000 of the Land appreciation reflects Propp's  § 704(c) adjustment, apparently, does not affect the allocation, although after the basis adjustment there is only $248,000 unrealized appreciation in the land. When the dust clears, Oppar has $60,000 unrealized appreciation in its Inventory, $385,000 unrealized capital and  § 1231 gain in its Land and Building, and Propp has $35,000 unrealized capital gain in the distributed Other Capital Assets, which, not coincidentally, exactly equals Oppar's net $420,000 ($300,000 gain Land + $60,000 gain Building - $45,000 loss Other Capital Assets) unrealized appreciation in capital and § 1231 assets before the distribution. In the process, however, Oppar has increased the basis of a depreciable  § 1231 asset, the Building, and can claim ordinary depreciation deductions over 39 years as if it represented a newly acquired commercial building.

As discussed in the examples in III, C (Current Distribution to a Partner with No § § 734(b)/754 Adjustment), and III, C, 1 (In Kind Distribution to a Partner with § § 734(b)/754 Adjustment), above, at the time of the distribution, the partners'capital accounts should be adjusted for reverse  § 704(c) allocations to the amounts shown in the Value column.  For illustrative purposes, however, the Tax Amount capital accounts have been adjusted only for the allocation of the inside basis adjustment.

After the distribution and the § § 734(b)/754 inside basis adjustments, the Oppar balance sheet is:
Assets	Basis	Value	
Cash	$105,000	$105,000	
Inventory	600,000	 660,000	
Land	112,000	360,000	
Building	263,000	400,000	
  Totals	$1,080,000	$1,525,000	
Liabilities and Capital	Tax Amount	Value	
Recourse Mortgage	$300,000	$300,000	
Munn#1 Capital	431,667	490,000	
Munn#2 Capital	431,667	490,000	
Propp Capital	-83,334	245,000	
  Totals	$1,080,000	$1,525,000	

a. Tiered Partnerships 

When the assets of a partnership that are used to make a current distribution include an interest in another partnership, the distributing partnership is referred to as the upper-tier partnership, and the partnership whose interest it owns is the lower-tier partnership. Although a  § 754 election for the upper-tier partnership permits adjusting the outside basis of the lower-tier partnership interest in the hands of the distributee, it does not allow any adjustment of the inside basis of the assets of the lower-tier partnership, unless a  § 754 election also applies to the lower-tier partnership.471 There is a similar requirement for application of  § 754 elections to both partnerships for basis adjustments when the current distribution includes an interest in the lower-tier partnership.472 Thus,  § 734(b) adjustments pass through the tiers for current (and liquidating) distributions only to the extent that  § 754 elections apply to all partnerships in the chain.
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471 § 732(b) (flush language). see Rev. Rul. 92-15, Situation 1, 1992-1 C.B. 215 (upper-tier partnership with  § 754 election in effect, adjusts inside basis of interest in lower-tier partnership when basis to distributee of other property is limited under § 732(a)(2); lower-tier partnership with  § 754 election in effect also adjusts inside basis of its assets); Rev. Rul. 87-115, 1987-2 C.B. 163 (§ 754 adjustments on sale of a partnership interest owning lower-tier partnership; only adjust inside basis of lower-tier partnership if  § 754 election applies to both); PLR 9444013 (merger of two partnerships did not affect their  § 754 elections; the resulting partnership retained the  § 743(b) basis adjustments previously made by the merged partnerships).

472 § 734(b) (flush language); see Rev. Rul. 92-15 1992-1 C.B. 215 (Situation 2 discusses the application of the § 754 election to such a transfer).

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Liability shares flow through tiers of partnerships,473 so that each partner of the upper-tier partnership include in outside basis a share of the upper-tier partnership's share of the lower-tier partnership's liabilities.  As a result, any change in a partner's interest in the upper-tier partnership is likely to result in a corresponding change in the indirect interest in the lower tier partnership, and, if a reduction, is likely to result in a distribution not only of the reduction in the share of the upper-tier partnership's liabilities, but the lower-tier partnership's liabilities as well.
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473 Regs. § 1.752-4(a); see Rev. Rul. 77-309, 1977-2 C.B. 216 (nonrecourse liabilities pass through the tiers to determine basis of limited partners for absorbing losses).

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When an upper-tier partnership transfers a  § 1.752-7 liability to a lower-tier partnership,474 the upper-tier partnership and each of its partners become  § 1.752-7 liability partners.475 If the transferred liability was one initially transferred to the upper-tier partnership by a  § 1.752-7 liability partner in the upper-tier-partnership, the transferor  § 1.752-7 liability partner remains the  § 1.752-7 liability partner for the original transfer and the other upper-tier partners become  § 1.752-7 liability partners only for any increase in built-in loss.476 Because a  § 1.752-7 liability is a  § 704(c) adjustment,477 current distributions of property other than interests in the lower-tier partnership are not likely to result in a basis reduction for a  § 1.752-7 liability partner.
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474 See II, D, 4, above, for a discussion of regulations that provide basis adjustments when a transaction separates a partner from whom a deductible obligation is assumed.

475 Regs. § 1.752-7(b)(5)(ii)(A).

476 Id.

477 Regs. § 1.752-7(c)(1)(i).

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(1) Adjusting Through the Tiers 

When  § 754 election applies to both the upper-tier and lower-tier partnerships and an inside basis increase results from gain or lost basis in a current distribution, although the adjustment to the outside basis of the lower-tier partnership is under the principles discussed above, those principles do not apply to the adjustment of the inside basis of the lower-tier partnership.  Although the IRS rationalizes the adjustment of the assets of the lower-tier partnership under § 734(b),478 the adjustment to the inside basis of the assets of the lower-tier partnership is made under the principles of  § 743(b) relating to sales or dispositions of partnership interests and is solely for the benefit of the upper-tier partnership,479 and, indirectly, its partners.
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478 See Rev. Rul. 92-15 (Situation 2), 1992-1 C.B. 215.  It is not clear why the IRS is not willing to treat the adjustment to the outside basis of the interest in the lower-tier partnership as equivalent to a “transfer” under § 743, but is willing to treat the lower tier partnership interest as a capital or  § 1231 asset regardless of the character of its assets.

479 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for discussions of the application of  § 754 adjustments on sales of partnership interests, including the application to tiered partnerships on sales and for nonrecognition transfers.

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Example: Adjustment of Inside Basis of Upper-Tier and Lower-Tier Partnership Property on Distribution by Upper-Tier Partnership. Munn, Propp and Surv are equal (one-third)partners in a partnership, Uppar. The Uppar partnership agreement satisfies the special allocation regulations.  Uppar owns a one-third interest in Lowpar, which owns an office building. The Lowpar partnership agreement also satisfies the special allocation regulations. When Lowpar was formed, Uppar contributed a dilapidated office building with a basis $100,000 less than its value, subject to a deferred compensation obligation to a former manager of Uppar (not the office building)that was not to be paid until the manager turned 65, which was 20 years in the future. After several years of operations, Uppar's outside basis in its Lowpar interest is $500,000, reflecting a $900,000 share of Lowpar liabilities, a $400,000 negative tax capital account and a $500,000 share of the tax basis of Lowpar's office building. Its share of Lowpar's net value is $1,200,000 (net of the deferred compensation obligation which, for simplicity, is assumed to be still worth $100,000)indicating that the value of Lowpar's office building is $6,300,000.

The balance sheets of Uppar and Lowpar are:
UPPAR	 	 	
Assets	Basis	Value	
Other Capital Assets	$1,300,000	$3,000,000	
Lowpar Interest	500,000	 1,200,000	
Total	$1,800,000	$4,200,000	
Liabilities and Capital	Basis	Value	
Liabilities	$2,100,000	$2,100,000	
Munn Capital	100,000	700,000	
Propp Capital	-500,000	700,000	
Surv Capital	100,000	700,000	
Total	$1,800,000	$4,000,000	
 	 	 	
LOWPAR	 	 	
Assets	Basis	Value	
Office Building	$1,500,000	$6,300,000	
Liabilities and Capital	Basis	Value	
Mortgage	$2,700,000	$2,700,000	
Deferred Compensation	-0-	100,000	
Uppar Capital	-400,000	1,100,000	
Other Partners Capital	-800,000	2,400,000	
Total	$1,500,000	$6,300,000	

Propp's outside basis in her Uppar interest is $500,000, reflecting a negative capital account of $500,000, and a  § 704(c) adjustment of $600,000 for property shown below as Other Capital Assets that were contributed more than seven years ago and including her $1,000,000 liability share ($700,000 (1/3  share of Uppar's $2,100,000 liabilities) + $300,000 (1/3  share of Uppar's $900,000 1/3  share of Lowpar's mortgage)). Propp receives Other Capital Assets with a value of $350,000 (none of which were contributed by Propp) and a basis of $305,000 in reduction of her Uppar interest from one-third to one-fifth. As a result, her liability share is reduced by $400,000, from $1,000,000 to $600,000 ($420,000 (1/5  share of Uppar's $2,100,000 liabilities) + $1,800,000 (1/5  share of Uppar's $900,000 one-fifth share of Lowpar's mortgage)) so that she has a total distribution of $750,000. The $400,000 deemed distribution from the liability reduction reduces her outside basis to $100,000, so that her basis in the Other Capital Assets is limited to that amount resulting in $205,000 of lost basis eligible for a § § 734(b)/754 adjustment. Since, by no coincidence, neither Uppar nor Lowpar have any  § 751 property, there is no deemed exchange under § 751(b). Although Propp is a  § 1.752-7 liability partner for 1/3  of the deferred compensation obligation, since it is a § 704(c) adjustment, her share is not changed by the reduction in her interest in Uppar to 1/5 .

After the distribution, the Uppar balance sheet is:
UPPAR	 	 	
Assets	Basis	Value	
Other Capital Assets	$995,000	$2,650,000	
Lowpar Interest	500,000	 1,200,000	
Total	$1,495,000	$3,850,000	
Liabilities and Capital	Basis	Value	
Liabilities	$2,100,000	$2,100,000	
Munn Capital	100,000	700,000	
Propp Capital	-805,000	350,000	
Surv Capital	100,000	700,000	
Total	$1,200,000	$3,850,000	

If Uppar and Lowpar have each made a  § 754 election that applies to Propp's distribution, under § 734(b), Uppar increases its outside basis in its Other Capital Assets by $145,000 (rounded) ($1,655,000 unrealized appreciation/$2,355,000 total unrealized appreciation) x $205,000 adjustment) and in its interest in Lowpar by $60,000 (rounded) ($700,000 unrealized appreciation/$2,355,000 total unrealized appreciation) x $205,000 adjustment), and, under  § 743(b) Lowpar also adjusts its basis in the Office Building for the benefit of Uppar by $60,000, giving Uppar additional depreciation of the $60,000 over 39 years. If a  § 754 election applies for Uppar, but not Lowpar, Uppar increases its outside basis in its Lowpar interest, but Lowpar does not increase its basis in the Office Building. If a  § 754 election applies to Lowpar, but not Uppar, no basis adjustment under  § 734(b) or  § 743(b) is made by Uppar or Lowpar.

(2) Distribution of Lower-Tier Partnership Interest 

A distribution by an upper-tier partnership of an interest in a lower-tier partnership can be a current distribution like a distribution of any other kind of property.480 The distribution is, however, an exchange that may cause the lower-tier partnership to terminate.481 When the distribution of a lower-tier partnership interest is a current distribution, that is, one that does not terminate the interest of the distributee partner's interest in the distributing upper-tier partnership, the distributee's basis in the distributed interest is generally equal to the distributing partnership's inside basis in the interest immediately before the distribution, but limited to the distributee's outside basis in the interest in the upper-tier partnership.482 When the limitation applies, an adjustment of inside basis for the upper-tier partnership is available for the lost basis, when a  § 754 election applies to the upper-tier partnership.483 An adjustment of inside basis may be available for the distributee, if a  § 754 election also applies to the lower-tier partnership, or there is a substantial built-in loss for the distributed lower-tier partnership.
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480 § 761(e) (treats distributions of partnership interests as exchanges for purposes of  § § 708 and 743 only); see Rev. Rul. 92-15 1992-1 C.B. 215 (Situation 2 discusses the application of the  § 754 election to such a transfer).

481 § 761(e); Regs. § 1.761-1(e); see PLR 8720046 (distribution of partnership by corporation in liquidation terminates the partnership;describes collateral consequences under prior regulations). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of partnership termination on sale or exchange of a more than 50% interest.

482 § 732(a). The distributee partner's outside basis in the upper-tier partnership will be reduced to zero under § 705(a)(2) when the limitation to outside basis under  § 732(a)(2) applies.

483 See Rev. Rul. 92-15, Situation 2, 1992-1 C.B. 215 (lower-tier partnership increases inside basis of its assets when basis to distributee of interest is limited under § 732(a)(2)).

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Since any reduction in the partner's share of partnership liabilities is treated as a distribution of money under § 752(b), literally, the upper-tier partnership has been relieved of its share of lower-tier partnership liabilities as part of the distribution, but since the impact of liability relief is at the partner level, the actual impact of the distribution is on the remaining partners, who should account for it in the same manner as any other liability relief.484 It would be inconsistent with the conduit and netting approach to suggest that partners in the upper-tier partnership had any tax consequences from the upper-tier partnership's being relieved of its share of lower-tier partnership liabilities.485 Again liability transfers should be netted.486 If there is a net distribution because of liability relief or other boot, or if as a result of the distribution, the distributee's share of  § 751 property changes,  § 751(b) may apply.487
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484 See Willis, Pennell & Postlewaite, Partnership Taxation, ¶ 12.01[5] (6th ed. 1997).

485 Regs. § 1.752-1(f); see Rev. Rul. 77-309, 1977-2 C.B. 216 (nonrecourse liabilities pass through the tiers to determine basis of limited partners for absorbing losses).

486 See Rev. Rul. 79-205, 1979-2 C.B. 255 (simultaneous current distributions of encumbered property; net liabilities to determine basis under § 732(a)), amplified by Rev. Rul. 87-120, 1987-2 C.B. 161 (liabilities on encumbered property distributed in liquidation of partnership always wash). See II, D, above, and 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of liability netting.

487 See Rev. Rul. 84-102, 1984-2 C.B. 119 (shift of liability on admission of new partner resulted in income to continuing partners under § 751(b), but not to new partner, because he did not receive any deemed distribution). See III, D, below, for a discussion; and 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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When an upper-tier partnership distribution is subsequent to an assumption of a  § 1.752-7 liability by the lower-tier partnership,488 the distribution by the upper-tier partnership of a lower-tier partnership interest is treated as being of the distributing partnership's share of partnership assets and liabilities including the lower-tier partnership's  § 1.752-7 liability.489 Each distributee partner is considered to be a  § 1.752-7 liability partner to the same extent as prior to the distribution.490 A distribution of a lower-tier partnership is exempt from basis reduction under Regs.  § 1.752-7(e)(3)(i) only if the partners that were  § 1.752-7 liability partners prior to the distribution continue to be  § 1.752-7 liability partners with respect to the lower-tier partnership after the distribution.491 Thus, if the interest in the distributed lower-tier partnership was originally contributed by a partner other than the distributee partner, the contributing partner should be subject to the basis reduction that applies when a  § 1.752-7 liability is distributed to another partner.492
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488 See II, D, 4, above, for a discussion of regulations that provide basis adjustments when a transaction separates a partner from whom a deductible obligation is assumed.

489 Regs. § 1.752-7(j), particularly (j)(3) and (j)(4), and (j)(5) Ex.

490 Regs. § 1.752-7(b)(5)(ii)(B).

491 Regs. § 1.752-7(e)(3).

492 Id.; see III, H, below, for a discussion of basis reduction for the  § 1.752-7 liability partner when the  § 1.752-7 liability is assumed by another partner, usually as part of a distribution.

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Like any other nonrecognition distribution in kind, the distributee should succeed to the upper-tier partnership's capital account and  § 704(c) (and reverse  § 704(c))allocations.493 In addition, the distribution of a lower-tier partnership interest can result in gain under the mixing bowl rules if the distribution involves distributing property contributed by another partner within seven years with a remaining  § 704(c) allocation, or distributing the lower-tier partnership interest to a partner who made a contribution of other property within seven years with a remaining § 704(c) allocation.494
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493 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of a transferee's succeeding to the transferor's capital account and other attributes, including  § 704(c) and reverse  § 704(c) allocations.

494 See III, E, below, for a discussion of when  § 704(c) gain is accelerated on otherwise nonrecognition partnership distributions.

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Example: Inside Basis of Upper-Tier and Lower-Tier Partnership Property for Current Distribution by Upper-Tier Partnership. The facts are the same as in the example in III, C, 2, a, (1), above, except that Uppar distributes Other Capital Assets with a basis and value of $175,000 and a portion if its interest in Lowpar (amounting to 15% of its interest in Lowpar and a 5% interest in Lowpar (in both cases rounded for ease of computation) with a value of $175,000 and an outside basis of $73,000, that is also its inside basis to Uppar.

Propp's $500,000 outside basis in her Uppar interest is reduced by $280,000 as a result of the reduction in her share of Uppar's liabilities from $700,000 (1/3  of $2,100,000) to $420,000(1/5  of $2,100,000). The adjustment of her Oppar basis for Lowpar liabilities is more complex.  The distribution reduces Uppar's share of Lowpar's liabilities by 15%, or $135,000, from $900,000 (1/3  of$2,700,000) to $765,000. Propp's 1/5  share of the $765,000 is $153,000, so that her share of Lowpar liabilities through Uppar has been reduced by $157,000 from $300,000 (1/3  of $900,000, Uppar's 1/3  share of Lowpar's $2,700,000 mortgage), for total reduction in liability share of $457,000.  On the other hand, she has taken over the $135,000 share of Lowpar liabilities as an owner of a direct interest in Lowpar, which results in a net distribution by Uppar to Propp of $322,000.

As a result, her liability share is reduced from $1,000,000 to $600,000, so that she has a total distribution of $750,000. The $400,000 deemed distribution from the liability reduction reduces her outside basis to $100,000, so that her basis in the Other Capital Assets and Lowpar interest is limited to that amount resulting in $205,000 of lost basis eligible for a § § 734(b)/754 adjustment to the inside basis of Oppar's remaining assets.  Her $100,000 outside basis is allocated, in effect, in proportion to the inside basis to Uppar, $80,000 (rounded)($305,000/$378,000) to the Other Capital Assets and $20,000 (rounded)($73,000/$378,000), to the Lowpar interest. Since, by no coincidence, neither Uppar nor Lowpar have any  § 751 property, there is no deemed exchange under § 751(b). Although she is a  § 1.752-7 liability partner for 1/3  of the deferred compensation obligation, since the  § 1.752-7 liability is a  § 704(c) adjustment, her share is not changed by the reduction in her interest in Uppar to 1/5 .

After the distribution, the Uppar balance sheet is:
UPPAR	 	 	
Assets	Basis	Value	
Other Capital Assets	$1,125,000	$2,825,000	
Lowpar Interest	427,000	 1,025,000	
Total	$1,552,000	$3,850,000	
Liabilities and Capital	Basis	Value	
Liabilities	$2,100,000	$2,100,000	
Munn Capital	100,000	700,000	
Propp Capital	-748,000	350,000	
Surv Capital	100,000	700,000	
Total	$1,552,000	$3,850,000	

If Uppar and Lowpar each have made a  § 754 election that applies to Propp's distribution, under § 734(b), Uppar increases its outside basis in its Other Capital Assets by $145,000 (rounded) ($1,655,000 unrealized appreciation/$2,298,000 total unrealized appreciation) x $205,000 adjustment) and in its Lowpar interest by $60,000 (rounded) ($700,000 unrealized appreciation/$2,355,000 total unrealized appreciation) x $205,000 adjustment), and, under  § 743(b) Lowpar also adjusts its basis in the Office Building for the benefit of Uppar by $60,000, giving Uppar additional deprecation of the $60,000 over 39 years. If a  § 754 election applies for Uppar, but not Lowpar, Uppar increases its outside basis in its Lowpar interest, but Lowpar does not increase its basis in the Office Building. If a  § 754 election applies to Lowpar, but not Uppar, no basis adjustment under  § 734(b) or  § 743(b) is made by Uppar or Lowpar.

b. Basis Adjustment Without § 754 Election: Current Distributions—§ 732(d) 

Even if a  § 754 election needed to give a transferee the benefit of a basis adjustment reflecting the purchase price (or other outside basis) for a transferee partner does not apply to the transfer, the transferee may make a  § 732(d) election,495 without partnership approval, that provides the transferee partner the benefit of the same special basis adjustment as a  § 754 election, but only if the partnership distributes the assets for which there would have been a basis adjustment for like kind property to the purchasing partner within two years of purchase.496 An in-kind distribution to a successor to a deceased partner may be one situation in which the election may apply.
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495 The  § 732(d) election is made by the distributee partner's attaching a schedule to the income tax return setting out (i) the election to adjust the basis of distributed property under  § 732(d) and(ii) the computation of the basis adjustment and its allocation of the adjustment to the distributed properties. Regs. § 1.732-1(d)(3). The election must be made in the year of the distribution if the distribution includes depreciable, depletable or amortizable property, but if not then the election can wait until the first year basis has tax significance. Regs. § 1.732-1(d)(2).

496 § 732(d); Regs.  § 1.732-1(d)(1)(i) to (iii). See IV, C, 3, a, and V, D, 2, below, for discussions of the effect of the  § 732(d) election for liquidating distributions, and IV, C, 3, b, below, for a discussion of mandatory application of the  § 732(d) election in certain circumstances.

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The adjustment is computed under  § 743(b) relating to sales or other transfers of partnership interests, and not under  § 734(b) relating to distributions.497 The amount of the adjustment is based on the excess of the purchase price over the distributee's share of the partnership's inside basis.498 The adjustment is notionally made to the inside basis of the property owned on the date of purchase, for purposes of determining the transferred inside basis to the distributee, and is allocated to all partnership properties whether distributed or not.499 If any property for which the transferee has a notional inside basis adjustment is distributed to another partner, the adjustment for the distributed property is reallocated to remaining partnership property.500 If the distribution is a current distribution, the transferee's basis generally equals the inside basis of the asset(after giving effect to the  § 732(d) adjustment).501 This provides less than complete relief for current distributions.
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497 Regs. § 1.732-1(d)(1)(iii).

498 § 743(b)(1); Regs. § 1.743-1(b), (c), and (d).

499 Regs.  § 1.743-1(g)(1) and (5) Ex. (ii).

500 Regs. § 1.743-1(g)(2) and (5) Ex. (iv).

501 § 732(a), (d).

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To the extent that the distribution includes § 751 property, or other property in lieu of the distributee's interest in  § 751 property,  § 751(b) applies first,502 as do the mixing bowl rules.503 The role of  § 732(d) is limited to determining the basis of the other property in the deemed exchange.504 The partnership is required to supply a transferee, who notifies it of a plan to make the election, with the information needed to compute the adjustment.505 Capital accounts are adjusted to reflect basis adjustments under  § 732(d) to the extent they properly correspond to changes in book value.506
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502 § 751(b).  Regs. § § 1.751-1(b), 1.732-1(d)(5). See III, D, below, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

503 § § 704(c)(1)(B), 737; Regs. § § 1.704-4, 1.737-1 to 5 and 7. See III, E, below, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

504 Regs. § 1.732-1(d)(5).

505 Regs. § 1.732-1(d)(5).

506 Regs. § 1.704-1(b)(2)(iv)(m)(3), (5).

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Example: Current Distribution with § 732(d) Election. Munn, Propp and Perch are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Perch acquired her interest from an original partner, Surv, one year ago for $160,000, when no  § 754 election was in effect. Oppar owns six properties, each with a basis of $50,000 and a value of $80,000, for a total inside basis of $300,000 and value of $480,000. The outside basis of Munn and Propp in their Oppar interests is $100,000 each, while the outside basis of Perch's interest is, of course $160,000. As a result of personal and policy differences, Oppar distributes one property to Perch reducing her interest from one-third to one-fifth. Her outside basis in the distributed property is Oppar's transferred basis of $50,000, reducing the outside basis of her Oppar interest from $160,000 to $110,000, with an unrealized loss of $30,000 compared to the $80,000 value of her one-fifth interest(1/5  of $400,000 ($480,000 - $80,000 distribution)) and a distributed property with $30,000 inherent gain ($80,000 value -$50,000 transferred inside basis). Although, in a sense, this is no worse than her position before the distribution with $60,000 potential tax gain that would increase her outside basis to $220,000 in her$160,000 share of the proceeds, the offsetting loss would be realized when the proceeds were distributed.  A  § 732(d) election does not completely solve her problem since her $60,000 adjustment ($160,000 purchase price - $100,000 share of the inside basis of Oppar's properties) would be ratable to the properties, so that her transferred inside basis in the distributed property would only be $60,000. Unless another distribution is made within two years of purchase she will never receive any advantage for the remaining  § 732(d) adjustment. All partner's capital accounts are increased for the $30,000 inherent gain in the distributed property and Perch's capital account is reduced for the $80,000 value of the distributed property.

If, instead, Oppar distributes one of the properties to each partner, Perch should be better off.  Since $10,000 of Perch's § 732(d) adjustment was allocated to each of Oppar's properties, $20,000 (2 x $10,000)was allocated to those distributed to Munn and Propp. That adjustment is reallocated to the remaining properties, presumably including the property distributed to Perch, giving Perch an additional $5,000 (1/4  of$20,000) transferred inside basis in the property she receives, increasing her distributed basis to $65,000, but she will probably never have any advantage from the rest of the  § 732(d) adjustment. Each of Munn and Propp has a $50,000 transferred inside basis in the distributed property received, measured by Oppar's inside basis unaffected by Perch's  § 732(d) election. All partners capital accounts are increased for the $90,000 inherent gain in the distributed properties and each partner's capital account is reduced by the $80,000 value of the property distributed to the partner.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

D. Non–Pro Rata Distributions in Kind—§ 751(b) 

There is no partnership concept equivalent to the corporate concept of partial liquidation or disproportionate redemption,507 presumably, because there is no need to distinguish between dividends, treated as ordinary income, and redemptions, treated as sales of the corporate stock to the corporation and capital gain or loss. Accordingly, a distribution in connection with a reduction of a partner's interest in the partnership, whether capital or profits or both, is a non–pro rata current distribution. A non–pro rata distribution, inevitably, reduces the partner's capital account relative to those of the other partners who do not receive the equivalent distribution.
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507 See Burke, “Reassessing the Administration's Proposals for Reform of Subchapter K,”86 Tax Notes 1423 (Mar. 6, 2000) (critiques some proposals for partial liquidation or redemption approach and suggests an alternate).

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Because application of the nonrecognition and transferred basis rules provides an opportunity for converting ordinary income into capital gain,  § 751(b) provides an application of an aggregate principle that is a major exception to the nonrecognition principles of  § § 721 and 731.508 Unlike § 724,509 and § 735(a),510  § 751(b) provides immediate taxation, rather than merely preserving the character of transferred property. Section 751(b), which applies a pure aggregate principle, provides exchange treatment if a partner receives more than the pro rata total share of assets with inherent ordinary income (known as unrealized receivables and substantially appreciated inventory or  § 751 property, or, more colloquially, as “collapsible assets” or “hot assets”) in exchange for receiving a lesser share in all other assets, or receives more than the pro rata total share of other assets for a lesser share of total  § 751 property.511 Although  § 751(b) applies primarily to distributions under § 731, it also applies to a boot distribution or a liability shift in an otherwise nonrecognition contribution under  § 721 that would not otherwise result in gain, because it does not exceed the basis of the partnership interest.512 The taxable exchange is between the partner receiving a distribution and the partnership (remaining partners). Any partnership  § 751 gain, apparently, affects the outside basis of the remaining partners only at the end of the year,513 although any mixing bowl gains increase outside basis immediately.514 This is consistent with the concept that the gain is recognized by the partnership as constituted after the distribution.515
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508 Regs. § 1.731-1(a)(1)(i).

509 See 710 T.M., Partnerships —Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a discussion of the extent to which  § 724 taints certain contributed property.

510 See III, B, 2, a, above, for a discussion of the more limited taint for distributed property.

511 § 751(b); Regs. § 1.751-1(b); see III, D, below, for a discussion of the complex effect of § 751.

512 See III, A, 2, b, above, for a discussion of the bifurcation approach that applies boot against partnership basis, and not as consideration for property transferred.

513 See III, A, 1, above, for a discussion of the effects of the administrative rule treats partnership income as affecting outside basis only on the last day of the partnership's tax year.

514 See III, E, below, for discussions of the basis and other effects of gain recognized in mixing bowl transactions.

515 Regs. § 1.751-1(b)(3).

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There is a similar provision for sales or other dispositions of partnership interests, also applying to a modified aggregate approach, under which the selling partner recognizes ordinary income or loss for the portion of the proceeds attributable to an allocable share of  § 751 property,516 thus, preventing conversion of what would otherwise be future ordinary income into current capital gain.517 The ordinary income or loss is computed first as if the selling partner sold the allocable share of the  § 751 property for its fair market value.518 In determining the ordinary income or loss,  § 704(c) adjustments are taken into account. Second, the balance of the amount realized (after deducting the amount applied to the deemed sale of the  § 751 property)is allocated to the outside basis of the partnership interest, to determine the gain or loss on the partnership interest.519 Thus, the amount of  § 751 income (or, very rarely loss) can exceed the overall gain (or loss) on the transaction. When the ordinary income exceeds the overall gain, there is the tax horror of ordinary income combined with capital loss that generally cannot be applied against the ordinary income realized in the otherwise unitary sale of the partnership interest.520
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516 § 751(a), Regs. § 1.751-1(a); see 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the application of ordinary income to dispositions of partnership interests.

517 See Rev. Rul. 81-241, 1981-2 C.B. 146 (payments to partners funded by interim payments on a long-term contract that were not included in income under the completed contract method are advances treated as distributions on the last day of the tax year, treated as income since receipt of the payments, which were still treated as unrealized receivables by partnership, did not increase outside basis; gain treated as ordinary under § 751(b)).

518 Regs. § 1.751-1(a)(2). See III, D, 2, below, for a discussion of how such shares should be determined when interests in capital and profits differ. Under Regs. § 1.1245-1(e)(2)(i), recapture gain is allocated to those partners who originally benefited from recaptured depreciation deductions. See 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment of allocation of depreciation recapture.

519 Regs. § 1.751-1(a)(2).

520 Of course, this same result can occur in any sale of a business, since the sale is treated as a sale of the individual assets.

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If the distributee partner receives a disproportionate distribution of either  § 751 property or other property, the distributee partner and the partnership are treated as exchanging in a taxable transaction the excess  § 751 assets for the non-§ 751 assets. This constructive exchange of assets may result in taxable gain or loss to both the distributee partner and the partnership (remaining partners). The gain or loss is either capital or ordinary depending on whether the distributee receives a disproportionate distribution of  § 751 property, or other non-§ 751 property. The balance of a distribution (i.e., that portion that is not considered to be disproportionate) is taxed under the general principles for partnership distributions. Because the  § 751 exchange is treated as occurring before the distribution, the impact is essentially the same for current and liquidating distributions, except that a partner receiving a liquidating distribution may recognize a capital loss, but a partner receiving a current distribution does not recognize loss.

Example: Ordinary Income and Capital Loss on Liquidation Distributions with § 751(b) Exchange. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has $90,000 cash, and inventory with an inside basis of $60,000 and a value of $120,000(total value $210,000). Munn's outside basis in his Oppar interest is $60,000 (as a result of a purchase when no  § 754 election was in effect). Oppar distributes $70,000 (one-third of the value of Oppar's assets)in cash to Munn in complete liquidation of his interest. The inventory is “substantially appreciated inventory,” since its fair market value ($120,000) exceeds 120% of its adjusted basis ($60,000). Consequently,  § 751(b) treats Munn as having constructively received a one-third interest in the inventory with an adjusted basis of $20,000, that is treated as being immediately repurchased by Oppar for its $40,000 fair market value, resulting in $20,000 of ordinary income. As a result of the distribution of the inventory, Munn's outside basis in his Oppar interest is reduced to $40,000 ($60,000 - $20,000). Because the remaining $30,000 in cash distributed to Munn is less than his remaining basis, Munn recognizes a $20,000 capital loss on his Oppar interest. Thus, because the liquidating distribution is bifurcated under § 721, Munn's economic loss of $10,000 ($70,000 cash - $60,000 outside basis) results in$20,000 ordinary income offset by $10,000 capital loss, the reverse of the usual tax planning goal. Oppar recognizes no gain or loss on the transaction, but does obtain a $40,000 basis in the inventory deemed to be repurchased from Munn, even if there is no  § 754 election in effect, leaving Propp and Surv to be taxed on their predistribution shares of the appreciation in the inventory.

1. Determining Gain or Loss 

The distributee-partner's gain or loss is determined by comparing the value of the share of the property (§ 751 property or other property, as the case may be) not distributed, with the basis such § 751 or other property would have if distributed (usually transferred partnership inside basis, but limited to the distributee's outside basis).521 The same process is followed for the partnership(remaining partners not including the distributee).522 The result is that a distributee who receives money or a deemed money distribution on a liability shift, recognizes ordinary income, and the other parties, usually the remaining partners, have no tax consequences because no gain is realized on money, but when the distributee receives other property the remaining partners are treated as selling the other property, and thus recognize, generally capital, gain. Of course if the distributee receives  § 751 property, the other partners recognize ordinary income, while the distributee recognizes, generally capital, gain. The partnership and the distributee-partner both receive basis adjustments for whatever property they end up with after the deemed exchange, without regard to any election under § 754, because the property is deemed purchased.523 The parties, apparently, can mitigate the effect of  § 751 by designating the specific properties within the class of  § 751 property or of other property, as the case may be, involved in the “exchange.”524
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521 Regs. § 1.751-1(b)(2)(iii). There is no gain or loss when the distributee originally contributed the property distributed. § 751(b)(2); S. Rep. No. 1622, 83d Cong., 2d Sess. 401 (1954).

522 Regs.  § 1.751-1(b)(2) and (3), (g) Ex. 2, Ex. 3 and Ex. 4.

523 Regs. § 1.751-1(b)(3)(i), (iii) and (g) Ex. 2(e)(1).

524 Regs.  § 1.751-1(b)(1) and (g) Ex. 3(c) (other property designated), Ex. 4(c) (no designation, ratable share), and Ex. 5(c) (ratable unless partners agree otherwise).

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Section 751(b) does not apply to the extent that the distributee receives  § 751 property, even if it is not a ratable share of each item of  § 751 property, since only an exchange of  § 751 property for other property is taxable.525 There is no gain or loss if property distributed was originally contributed by the distributee.526 Capital accounts are appropriately adjusted for the distributions, but not for any ordinary income or capital gain under § 751(b), since the income or gain are considered the result of exchanges by the partners in their individual capacities.
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525 § 751(b)(1); Regs. § 1.751-1(b)(1), (g) Ex. 3(c) (inventory and accounts receivable aggregated), Ex. 4(c) (same), and Ex. 5(c) (same plus cash, depreciable property and land aggregated).

526 § 751(b)(2); S. Rep. No. 1622, 83d Cong., 2d Sess. 401 (1954) (“When a partner receives a distribution of property which he contributed to the partnership, the rules of paragraph [§ 751(b)](1) shall not be applicable. The distribution is governed entirely by subpart (b). This exception permits the withdrawal of contributed property by the contributors, either with or without complete retirement from the partnership, and with the tax consequences provided in subsection (b).”)

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The balance of the distribution is treated under the general distribution rules. This means a transferred basis for property distributed that represents a ratable share of  § 751 property, or other property, as the case may be, subject to the limitation for outside basis, as adjusted for property distributed and exchanged under § 751(b). Appropriate adjustments are made to the inside basis of other property for any gain or loss recognized by the distributee that is not under § 751(b), if an election under  § 754 applies.527 Capital accounts should be appropriately adjusted for inherent gains and losses in the distributed property, and reduced by the fair market value of the distributions or deemed distributions.
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527 Regs.  § 1.751-1(g) Ex. 2(e)(2); see  McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 21.03[7] (3rd ed. 1997).

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Example: Gain or Loss on Shift in Shares of § 751 Property. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar, which is owned equally (one-third each) by Munn, Propp, and Surv, has $90,000 cash and inventory with inside basis of $60,000 and a value of $120,000. Each partner's outside basis in the Oppar interest is $100,000. Oppar distributes $12,000 in cash to Munn and Propp, and $12,000 in inventory to Surv. The inventory is “substantially appreciated inventory”since the fair market value of the inventory ($120,000) exceeds 120%of its adjusted basis ($60,000). Consequently,  § 751(b) treats each partner as having constructively received a one-third interest in the inventory distributed to Surv, with an adjusted basis to each of $2,000 and a value of $4,000. The shares of the inventory deemed distributed to Munn and Propp are treated as immediately being purchased by Oppar for their $4,000 value, resulting in $2,000 of ordinary income each. Thus, the outside basis of their Oppar interests is reduced by $10,000($2,000 for the inventory and the remaining $8,000 in cash. Surv's basis in the inventory is $10,000, $8,000 for the portion deemed purchased by Oppar from Munn and Propp and $2,000 for the portion that represents her pro rata share. Her outside basis is also reduced by $10,000, the transferred basis of the inventory, including the “purchased”inventory. All partners' capital accounts should be increased for the inherent gain in the inventory and reduced for the $12,000 total value of the distribution received. The ordinary income or gain does not affect capital accounts.

S corporation shareholders are not subject to an equivalent of  § 751 characterization of part of their gain as ordinary income, and do not include a share of corporate liabilities in their amount realized because they do not include them in basis.528 S corporation shareholders are eligible to treat up to $50,000 (or $100,000 for spouses filing a joint return) of any loss realized on the sale of stock that qualifies as  § 1244 stock as an ordinary loss.529 There is no comparable provision for partnerships.
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528 See 731 T.M., S Corporations: Operations, for a comprehensive treatment of S corporation shareholders' inability to include even guaranteed corporate indebtedness in basis.

529 § 1244(b); see 730 T.M., S Corporations: Formation and Termination, for a comprehensive treatment of use of  § 1244 stock by S corporations.

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2. Shares of Partnership Assets 

Shares of partnership assets are easy to determine for simple partnerships that have proportionate interests in profits, losses, and capital, the only kind involved in the examples in the relevant regulations.530 Such shares are not so obvious, however, when these ratios are not identical. The McKee treatise suggests that the determination should be made using capital accounts to the extent of basis, and using profit and loss shares for unrealized appreciation or depreciation in value of partnership assets.531 This approach is basically sound, but, since capital accounts represent only part of the inside basis of partnership assets, a more appropriate result is to use capital accounts plus liability shares to determine shares of asset basis, and to use profit and loss shares to determine shares of unrealized appreciation and depreciation in value of partnership assets.532 Moreover, in determining shares of unrealized appreciation and depreciation in value,  § 704(c) and reverse  § 704(c) adjustments should be taken into account.533 Since reverse  § 704(c) allocations preserve the distributee's share of unrealized appreciation or loss in  § 751 property, they may mitigate or eliminate the  § 751 exchange. If needed to reflect the economic deal, an allocation of a larger share of post-admission income could be made to a newly admitted partner, to offset the new partner's loss of the share of pre-admission unrealized income required to be allocated to the continuing partners under reverse  § 704(c) principles.534
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530 Regs. § 1.751-1(g). In Notice 2006-14, 2006-8 I.R.B. 498, the IRS noted that the current regulations have not been updated for the many statutory changes since original promulgation in 1956, and requested comments on determining shares of partnership property.  The Notice outlines several ways of determining shares, including a hypothetical sale approach combined with  § 704(c) principles that would allocate  § 751 gain to each partner on pre-distribution revaluation and generally avoid a  § 751(b) exchange, and a hypothetical hot asset sale approach that would generally would measure the  § 751(b) sale by the distributee's relinquished share of the  § 751 property.  Among others, the American Bar Association Section of Taxation, and the New York State Bar Tax Sections have submitted comments; see, e.g., “ABA Members Comment on Partnership Distribution Guidance,” 2007 TNT 82-22, and “NYSBA Tax Section Comments on Partnership Distribution Guidance,” 2006 TNT 230–8. Both reports generally support the proposed approaches and provide detail analysis of additional considerations that should be applied in the proposed regulations.  The NYSBA also suggests that consideration be given to amending § 751(b).

531 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ ¶ 16.02[3][b]and 21.03[2] (3rd ed. 1997) (the examples all involve partnerships with no liabilities). See also Willis, Pennell & Postlewaite, Partnership Taxation, ¶ ¶ 12.02[1][a]and 14.03[1] (6th ed. 1997); 720 T.M., Partnership Transactions — Section 751 Property, both with only examples with no liabilities.

532 See Regs.  § 1.743-1(d) (partner's share of adjusted basis of partnership property is share of previously taxed capital plus share of liabilities); Regs.  § 1.705-1(b) Ex. 3 (using liabilities in determining partner's share of inside basis under alternate rule).

533 Regs. § 1.751-1(a)(2). See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ ¶ 16.02[3][b], 21.03[8], and 21.04[2](3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 12.03[7] (6th ed. 1997); Utz, “Determining a Partner's Share of Unrealized Receivable at the Liquidation of a Partnership Interest,” 78 Taxes 37 (Oct. 2000)(discusses how issue is unresolved, and should take into account special allocations and other factors).

534 See Emmons and Fine, “Coping with IRS Ruling Which Applies Sec. 751 on the Admission of New Partners,”62 J. Tax'n 160 (1985).

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Example: Share of Partnership Assets. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar owns a commercial building with a basis of $150,000 and a value of $750,000, subject to a recourse mortgage of $600,000, and a condo project with a basis of $600,000 and a value of $750,000, subject to a $500,000 recourse construction loan. The basis of the commercial building is low because it has been owned and depreciated for many years. Munn, who was admitted recently when he supplied needed capital for the condo project, has a capital account of $250,000. The $150,000 appreciation in the condo project occurred after, and as a result of, Munn's capital contribution. Propp's capital account is a deficit of $250,000 and Surv's is a deficit of$350,000. The balance sheet of Oppar is:
Assets	Basis	FMV	
Commercial Building	$150,000	$750,000	
Condo Project	600,000	750,000	
Totals	$750,000	$1,500,000	
 	
Liabilities and Capital	Basis	FMV	
Mortgages	$1,100,000	$1,100,000	
Munn Capital	250,000	300,000	
Propp Capital	-250,000	100,000	
Surv Capital	-350,000	-0-	
Totals	$750,000	$1,500,000	

Although the partners share profits and losses equally, Munn's share of the unrealized appreciation is only $50,000 (1/3  of the appreciation of the condo after his admission), since the $600,000 of unrealized gain on the commercial building was allocated to Propp and Surv under reverse § 704(c) principles at the time of his admission. The outside basis for each partner is the capital account balance, plus the share of liabilities. In determining shares of the recourse liabilities in the hypothetical liquidation, each partner apparently realizes a loss of $250,000. This reduces Munn's capital account to zero, and increases Propp's deficit to $500,000 and Surv's to $600,000, which represent their respective economic risk of loss and shares of the $1,100,000 total recourse liabilities;no share is left for Munn. Accordingly, Munn's share of the Condo Project is $250,000, representing the portion of his capital account allocated to it ($200,000 plus his $50,000 share of the unrealized gain), so that his remaining $50,000 ($250,000 - $200,000 allocated to the condo) capital contribution is allocated to the commercial building. Propp and Surv's shares of the condo project are also $250,000, representing deficit capital accounts of (assumed, for simplicity) -$50,000 + their shares of the recourse construction loan ($250,000 each) + the shares of the unrealized gain ($50,000 each). Similarly, their share of the commercial building, which is “other (non-§ 751) property,” are:$50,000 for Munn, representing the balance of his capital account($50,000), and $350,000 each for Propp and Surv, representing their remaining deficits ($200,000 for Propp and $300,000 for Surv) + their shares of the recourse mortgage ($250,000 for Propp and $350,000 for Surv) and their shares of the unrealized appreciation ($300,000 each). Thus, differences in Propp's and Surv's shares of the recourse mortgages offset the differences in their capital accounts. As can be seen, it is necessary to take into account shares of liabilities as well as capital accounts (including deficits) and shares of unrealized gain to determine shares of value.

3. Section 751 Property 

Section 751 property, colloquially referred to as “hot” or “collapsible,”consists of unrealized receivables and substantially appreciated inventory items,535 neither of which terms is defined using their common meaning. Unrealized receivables are rights to payment for goods or services not previously included in income,536 and recapture property, but only to the extent unrealized gain is ordinary income.537 Inventory is any property described in § 1221(1), that is, inventory or other property held for sale to customers in the ordinary course of business, including real estate held by a dealer, even though real estate is not included in inventory,538 and any other property that would not result in capital or  § 1231 gain, e.g., accounts receivable, including unrealized receivables, as well as any other property that would meet this broad definition of inventory if held by the distributee partner (even though it is not inventory to the partnership), but excluding property actually distributed to the distributee partner, which seems to have the effect of converting property retained by the partnership that would become inventory if distributed into  § 751 property for purposes of measuring the taxable exchange.539 This broad definition of inventory, apparently, does not, however, include depreciation recapture (even though it may be an unrealized receivable), because recapture does not characterize the property, but only a portion of the gain on disposition.540
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535 § 751(b) Regs. § 1.751-1(b)(2), (d)(1); see 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the meaning of  § 751 property.

536 Regs. § 1.751-1(c)(1); see Wolcott v. Comr., 39 T.C. 538 (1962) (interests in uncompleted contracts for architectural services); Glazer v. Comr., 44 T.C. 541 (1965) (contracts for construction and sales of houses); Ledoux v. Comr., 695 F.2d 1320 (5th Cir. 1983) (rights to income for future services under management contract; seems questionable). See 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of definitions of unrealized receivables and substantially appreciated inventory.

537 § 1245 property and  § 1245 ACRS property under § 1245(a)(3) and(5);  § 1250 property under  § 1250(c) (but there is no recapture for post-1986 real property, since straight-line depreciation is required; see § 168(b)(3), although § 1(h) may tax the unrecaptured depreciation at 25%); mining property under § 617(f)(2); oil, gas and geothermal property under § 1254; farm land under § 1252(a); ordinary income nonrecapture property, e.g., franchises, trademarks and trade names under § 1253; stock in a DISC under § 992(a); and stock in foreign corporations under § 1248. Recapture items are not unrealized receivables under § 736; see § 752(c) (flush language). See V, B, 1, a, below, for a discussion of the meaning of unrealized receivables under § 736.

538 See Freeland v. Comr., 393 F.2d 573 (9th Cir. 1968), cert. denied, 393 U.S. 845 (4,000 acres of land held for sale to customers in the ordinary course of business was substantially appreciated inventory); 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of substantially appreciated inventory.

539 § 751(d)(2); Regs. § 1.751-1(d)(2)(ii). In contrast, under a 1997 amendment, all inventory, whether substantially appreciated or not, results in ordinary income or loss on sale or other taxable disposition of a partnership interest. § 751(a)(2); Regs. § 1.751-1(a). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the application of  § 751(a) to sales of partnership interests.

540 See Regs.  § 1.751-1(g) Ex. 6.

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For purposes of partnership distributions, but not for sales of partnership interests,541 inventory items are  § 751 property only if “substantially appreciated,” that is, if, in the aggregate, all inventory items have fair market value (using inventory valuation methods, not retail price) equal to 120% of the basis, without regard to whether particular distributed, or retained, items are substantially appreciated.542 Including accrual basis accounts receivable in inventory items reduces the aggregate percentage appreciation, and, therefore, reduces the likelihood that inventory items are substantially appreciated, whereas including unrealized receivables, which almost always have a zero basis, increases the percentage of appreciation.  Section 751(b) applies in the aggregate, not asset by asset. Accordingly, there is no gain on distribution of substantially appreciated inventory in exchange for traditional unrealized receivables, even though the unrealized income in the  § 751 properties exchanged may not be equal.543 A partnership is treated as owning its proportionate share of the property of a lower-tier partnership in determining whether property is  § 751 property.544
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541 § 751(a)(2); 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the difference in treatment of inventory between sales of partnership interests and partnership distributions.

542 § 751(b)(3); Regs. § 1.751-1(d); see 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of substantial appreciation. Prior to the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, inventory was substantially appreciated only if, in the aggregate, the value exceeded 10% of the value of partnership's assets (other than money).

543 Regs.  § 1.751-1(b) and (g) Ex. 3(c);see III, D, 1, above, for a discussion, and 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

544 § 751(f). The IRS has authority to extend similar principles to trusts by regulations, but no such regulations have been adopted or proposed.

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Although unrealized losses in  § 751 property can offset unrealized appreciation, reducing the amount of ordinary income on distribution, there is no provision equivalent to  § 751(b) that allows a distributee partner to treat, for example, net unrealized losses in  § 1231 property as ordinary losses on the distribution. Taxpayers have had mixed success in using self help. In one case,545 involving a withdrawal, the withdrawing partner arranged for the partnership (i) to sell his pro rata interest of one parcel of  § 1231 loss property, (ii) to specially allocate the loss to him and (iii) to distribute the proceeds to him, converting what would have been a loss on withdrawal into a  § 1231 loss;the partnership also distributed an undivided interest in another parcel of  § 1231 property, which had a transferred basis to him, so that, when he sold the interest in the parcel, he realized another  § 1231 loss. The apparent key to avoiding step-transaction problems was that the two purchasers leased the shares of the property to the partnership; they did not contribute them and become partners. Withdrawing partners who tried similar schemes in two other cases involving distribution of ordinary loss property did not fare as well. In one case,546 a purported distribution of inventory that had declined in value and was sold back to continuing business was disregarded, with the sale proceeds treated as part of the withdrawal distribution. In the other,547 a purported distribution of an undivided interest in partnership property, followed by a series of transfers resulting in contribution of the property back to the partnership was disregarded with the cash received on the sale of the property treated as a cash distribution from the partnership. Based on these cases, a distributee partner who receives a distribution in kind of loss ordinary income property that is sold may have ordinary loss on the property and  § 731 nonrecognition for any other property distributed, but only if the purchaser or the property does not contribute the property to the partnership. If the partnership needs the property it should be leased under a bona fide lease, with the purchaser retaining the benefits and burdens of ownership. This is not likely to be practical for most  § 751 property, in view of the short-term nature of such property.  A sale of, for example, loss  § 1231 property to a bona fide third party who leases it to the partnership will strengthen the claim for ordinary loss.
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545 Harris v. Comr., 61 T.C. 770 (1974).

546 Kinney v. U.S., 228 F. Supp. 656 (W.D. La. 1964), aff'd per curiam, 358 F.2d 738 (5th Cir. 1966).

547 Crenshaw v. U.S., 450 F.2d 472 (5th Cir. 1971). See V, C, 2, below, for further discussion of these cases.

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Section 751 deals solely with assets, and, apparently, ignores corresponding or offsetting payables and other obligations that have not become liabilities because they have not been taken into account for tax purposes.548 Since relief from the withdrawing partner's share of liabilities is a deemed distribution of money, it is a distribution of other (non-§ 751)property. Relief from obligations that are not liabilities should not directly affect the taxation of the distribution. It is less clear whether, if they are taken into account economically in determining the amount of the distribution,549 they should be offset against  § 751 property in determining the  § 751 exchange. Although such an offset makes sense, there is no authority for it. An alternative approach is to treat the obligations as a deferred item giving the distributee an allocable share of the partnership deduction when paid, with a corresponding distribution from the liability relief, in short an ordinary deduction and offsetting capital gain.550 It does not appear appropriate to allocate the subsequent deduction to the distributee under reverse § 704(c) principles when the partnership pays it, and the distributee is no longer a partner.551 Because a  § 1.752-7 liability is a  § 704(c) adjustment,552 application of  § 751(b) is not likely to result in a basis reduction for a  § 1.752-7 liability partner as long as the  § 1.752-7 liability remains with the partnership.  Of course, if it is distributed to another partner, the basis reduction and other consequences will follow.553
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548 See II, D, 1, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a comprehensive treatment, of the difference between such obligations and liabilities.

549 See II, D, 2, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a comprehensive treatment of transfer of deductible obligations by partnerships to partners.

550 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of such deferred treatment.

551 See I, B, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of allocations of inherent gains, losses, income and deductions to continuing partners, when a new partner is admitted.

552 Regs. § 1.752-7(c)(1)(i).

553 See III, H, below, for a discussion of basis reduction for the  § 1.752-7 liability partner when the  § 1.752-7 liability is assumed by another partner, usually as part of a distribution.

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Example: Shifts in Interests in § 751 Property. Munn and Propp are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar distributes to Propp appreciated land originally acquired for development into residential lots, with a basis of $60,000 and a value of $100,000. Munn receives a corresponding distribution of $100,000 cash. Propp's outside basis in her Oppar interest is $75,000, and Munn's is $125,000. Munn would not recognize gain, but for § 751, because the $100,000 cash is less than the $125,000 outside basis in the Oppar interest. Under § 751(b), however, Munn has exchanged a 50% interest in the land (basis $30,000)—a  § 751 asset—for “other” property—the cash. Munn recognizes ordinary income of $20,000 ($50,000 cash -$30,000 allocated basis in the land). Oppar's basis in the land is increased to $80,000 ($50,000 purchase prior to the distribution to Propp, even if no  § 754 election applies. Munn's outside basis in the Oppar interest is $45,000 ($125,000 -$30,000 basis in land deemed distributed - the remaining $50,000 cash distributed. Propp's basis is the land is $75,000, the outside basis in her Oppar interest, even though the inside basis to Oppar was $60,000 at the time of distribution since the inside basis was increased to $80,000 on the deemed  § 751(b) exchange. Even if she holds the land as a  § 1231 property, any gain realized within five years is ordinary income under § 735. The partners' capital accounts should be increased for their shares of the $40,000 gain on the lots, and reduced for the value of the $100,000 value of the distributions. Munn's  § 751(b) gain does not affect his capital account.

If Oppar had $10,000 of accounts payable that are transferred to Propp with the land, the net value of the distribution is only $90,000. Assuming Munn's cash distribution is reduced to $90,000, it makes sense to treat Munn as having only $45,000 of gain under § 751, particularly since Propp should be entitled to deduct the payables when paid, giving her an ordinary deduction and, in effect, depriving Munn of his share. Unfortunately, there does not seem to be any statutory, or other, basis for achieving this result. If the accounts payable were a  § 1.752-7 liability transferred by Munn, Munn would have a corresponding basis reduction.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

E. Mixing Bowl Transactions—§ § 704(c)(1)(B) and 737 

Because both contributions to, and distributions from, partnerships are nonrecognition transactions, some taxpayers have tried to use partnerships as devices for making nonrecognition exchanges. The simplified version involves two parties who have property they would like to trade, but that do not qualify under § 1031. Each contributes the property to a partnership, which serves as a “mixing bowl,”in which each party's ownership of the contributed property loses its identity as a result of the application of partnership entity principles. After a decent interval, the partnership dissolves and distributes the property contributed by each to the other. Regs.  § § 1.721-1(a) and 1.731-1(c)(3) contain provisions that were intended to limit this device, but the courts did not uphold them to the satisfaction of the IRS and Congress.554 Moreover, nonrecognition distributions to other partners before the  § 704(c) gain was realized could be used to avoid  § 704(c) adjustments.555 Accordingly,  § § 704(c)(1)(B) and 737 were enacted to limit these transactions,556 by providing exceptions to the general nonrecognition principle of  § 731(a)(1) for partnership distributions.  Sections 704(c)(1)(B) and 737, of course, are not limited to the simple case described above. They may apply any time: (i) contributed property, including a partnership interest, is distributed to another partner within seven years of contribution, or (ii) other property, including a partnership interest, is distributed to a contributor within seven years of contribution.557 Even though the two provisions were enacted three years apart, because of the close conceptual relation between them, it is not surprising that the regulations under both were adopted together.558
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554 See Rev. Rul. 57-200, 1957-1 C.B. 205 (treats such a transaction as taxable exchange under step transaction doctrine); but see Communications Satellite Corp. v. U.S., 625 F.2d 997 (Ct. Cl. 1980); Jupiter Corp. v. U.S., 2 Cls. Ct. 58, 83-1 USTC ¶ 9168 (1983); see 710 T.M., Partnerships —Conceptual Overview, for a discussion of how  § 707(a)(2) attacks disguised sales of property between partnerships and partners or among partners.

555 See H.R. Rep. No. 247, 101st Cong. 1st Sess. 599–600 (1989).

556 Section 704(c)(1)(B) was enacted by the Omnibus Budget Reconciliation Act of 1989, P.L. 101-239, § 7642(a); and § 737 was enacted by the Energy Policy Act of 1992, P.L. 102-486, § 1937(a). See 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of the mixing bowl provisions.

557 The original period was five years, but it was increased in 1997 to seven years. Taxpayer Relief Act of 1997, P.L. 105-34, § 1063. The current regulations still state the five-year period — see Regs.  § 1.704-4(a)(1) and (4) —but proposed regulations will change the date. REG-143397-05, 72 Fed. Reg. 46932 (8/22/07).

558 T.D. 8642, 60 Fed. Reg. 66727 (12/26/1995). See generally, Youngwood and Cerrito, “Tracing Property After Its ‘Owner’ Changes: § § 337, 704(c)(1), 737, 751, 382, 384, 1031 and 1374,”51 Tax Law. 511 (1998) (discusses difficulties of tracing, particularly when the relevant property is modified, improved or changed).

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1. Contributed Property Distributed to Another Partner—§ 704(c)(1)(B) 

Section 704(c)(1)(B) requires a contributing partner to accelerate the gain or loss under  § 704(c) when the contributed property is distributed to another partner within seven years of the original contribution, but subject to a ceiling of the amount of gain that would be allocated under  § 704(c) if the property was sold by the partnership for fair market value,559 which means that the character of the gain is determined by the character of the property to the partnership.560 Thus, the  § 704(c) gain (or loss)allocation cannot be avoided by distributing the contributed property in a nonrecognition transaction.561 Remedial allocations are taken into account,562 but it is not clear that curative allocations are. There are important exceptions for like-kind exchanges,563 and structural changes, including mergers, divisions, incorporations and other nonrecognition transfers.564 Proposed regulations, however, provide for creation of new  § 704(c) allocations in assets-over mergers.565 There is no acceleration of loss when other property is distributed within seven years to the contributing partner.
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559 § 704(c)(2)(B)(i);Regs.  § 1.704-4(a)(3) and (5) Exs. 1 and 2; see H.R. Rep. No. 247, 101st Cong. 1st Sess. 600–01 (1989); Regs. § 1.704-4(a); see TAM 9822002 (applies aggregate principle, so that U.S. corporate partner not taxed on distribution of its own stock contributed to joint venture and distributed to foreign joint venturer); Cuff, “The  § 704(c)(1)(B) Proposed Regulations,” 73 Taxes 283, 288–89 and 290–95(1995).

560 § 704(c)(1)(B)(ii);Regs. § 1.704-4(b).

561 See 1997 Bluebook, at 259–60.

562 Regs. § 1.704-4(a)(1) and (5) Ex. 3;see 710 T.M., Partnerships — Conceptual Overview, for a discussion, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment of  § 704(c) and reverse  § 704(c) adjustments.

563 § 704(c)(2); Regs. § 1.704-4(c)(1), (3), and (4) Ex.

564 Regs.  § 1.704-4(c)(2) to (6); Prop. Regs. § 1.704-4(c)(4). See III, E, 2, below, for a discussion of the application of  § 737 in restructuring transactions.

565 Prop. Regs. § § 1.704-3(a)(9); 1.704-4(c)(4)(ii)(A);and 1.737-2(b)(1)(ii). See IV, G, 2, a, below, for a discussion of the proposed regulations.

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When the contributed property is exchanged for other property in a nonrecognition transaction, the property received in the exchange is treated as the contributed property for purposes of subsequent application of § 704(c)(1)(B).566 The same principle was extended installment obligations received on an installment sale of  § 704(c) property, and for property acquired pursuant to a contract for  § 704(c) property.567 However, only two months later, in adopting the regulations relating to  § 1.752-7 liabilities,568 and adding a provision that amounts capitalized relating to  § 1.752-7 liabilities are treated as  § 704(c) items,569 Regs.  § 1.704-4(d)(1)(ii) and (iii) was stated to be “reserved,” for no apparent reason, and with no comment.570
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566 Regs. § 1.704-4(d)(1)(i).

567 T.D. 9193, 70 Fed. Reg. 14394 (3/22/05), adopting Regs.  § 1.704-4(d)(1)(ii) and (iii).

568 See II, D, 4, above, for a discussion of  § 1.752-7 liabilities.

569 Regs. § 1.704-4(d)(1)(iv).

570 T.D. 9207, 70 Fed. Reg. 20334 (5/26/05). In discussions with Tax Management editors, the IRS stated informally that a correction notice was to be issued to the effect that T.D. 9207 did not remove the regulation sections added by T.D. 9193, but no such correction notice has been issued.

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The outside basis of the contributor's partnership interest,571 the inside basis of the contributed property to the partnership, and the transferred basis to the distributee are immediately adjusted for any gain (or loss) recognized under  § 704(c)(1)(B) without the need for an election under § 754.572 Since the gain (or loss) recognized is § 704(c) gain, reflecting a difference between tax basis and book value, it does not affect the contributor's capital account.
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571 § 704(c)(1)(B)(iii);Regs. § 1.704-4(e)(1), (4) Ex.

572 § 704(c)(1)(B)(iii);Regs. § 1.704-4(e)(2), (3), and (4) Ex.

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There is also an anti-abuse rule for transactions with a principal purpose “inconsistent with the purposes of § 704(c)(1)(B),”which, of course, are defined only by example,573 but the examples state that they do not set the boundaries of what is permissible, and caution that any change in the facts may change the results.574 The first abuse example involves an attempt to avoid the then five-, now seven-year period by having the partnership retain property that would otherwise be distributed to a partner, but with all of the benefits and burdens of ownership allocated to the potential distributee, and with actual distribution immediately after the end of the period.575 To make clear that this is bad, the example states that this is all part of a plan to avoid the gain. The example makes it clear that mere delay to avoid the now seven-year period would not be inconsistent with  § 704(c)(1)(B) if there were no shifts in allocations in the meanwhile. The second example also deals with an attempt to avoid the impact of the required period between contribution and distribution. In the example, two members of an affiliated group form a partnership with a nominal outside partner, the desired distributee is admitted to the partnership after three years, and the distribution is made just over two years later. 576 The stated purpose of the scheme is to minimize the period in which the contributor would have to be in partnership with the distributee. Naturally, the example states that the scheme does not work, but this time there is no alternative statement of what would work. It is sad to think that obvious examples like these were considered necessary and appropriate. Although the regulations under  § 737 discussed in the next section have a similar anti-abuse rule577 that is cross-referenced as “being in the context of section 737,”578 the examples under that section relate to issues that do not arise under § 704(c)(1)(B), although arguably the broader anti-abuse principles illustrated may.
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573 Regs. § 1.704-4(f).

574 Regs. § 1.704-4(f)(2).

575 Regs. § 1.704-4(f)(2) Ex. 1.

576 Regs.  § 1.704-4(f)(2) Ex. 2.

577 Regs. § 1.737-4.

578 Regs. § 1.704-4.

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Example: Contributed Property Distributed to Another Partner. Propp contributes two parcels of land to a partnership, Oppar. Parcel#1 has a basis of $60,000 and a value of $300,000 and Parcel#2 has a basis of $120,000 and a value of $100,000, each of which is to be held by Oppar as  § 1231 property. Munn#1 and Munn#2 each contribute $400,000 cash. The Oppar partnership agreement satisfies the special allocation regulations. The next year, when the value of Oppar's assets has increased to $1,500,000 (including an increase in the value of Parcel#1 to $500,000) with no recognition of gain or income, Oppar distributes a one-half interest in Parcel#1 to Munn#2 in connection with the reduction of his interest from one-third to one-fifth. Propp recognizes the $120,000 (1/2  of the $240,000)  § 704(c) allocation on the contribution of Parcel#1 as  § 1231 gain. The increase in the value of Parcel#1 has no effect on her  § 704(c) allocation, since any post-contribution changes in value are properly allocated to all partners in proportion to the partnership shares. Propp's outside basis in her Oppar interest is increased from $180,000 ($60,000 basis of Parcel#1 + $120,000 basis of Parcel#2) by the $120,000 gain recognized to $300,000.  Oppar's inside basis in the portion of Parcel#1 distributed to Munn#2 is similarly increased by the $120,000  § 704(c) gain that Propp recognizes to $150,000, which also becomes Munn#2's basis in the one-half interest in Parcel#1. Propp's potential  § 704(c) gain in Parcel#1 is reduced from $240,000 to $120,000 to reflect the recognition. Her potential $20,000  § 704(c) loss in Parcel #2 is not affected by the gain recognition, so that she still has the opportunity to recognize that loss when Oppar disposes of Parcel#2. The gain recognized under  § 704(c)(1)(B) should not affect her capital account, since she was credited with the fair market values of Parcel#1 and Parcel#2 when she contributed them. On the other hand, each of Propp, Munn#1 and Munn#2 increase their capital accounts by $33,000 (1/3  of the $100,000 inherent gain in Parcel#1 and Munn#2 reduces his $400,000 capital account by the full $250,000 value of the one-half interest in Parcel#1 distributed to him.

2. Other Property Distributed to Contributing Partner—§ 737 

Section 737 deals with a problem related to  § 704(c)(1)(B) by requiring a contributing partner to recognize all or part of any unrealized pre-contribution gain when the originally contributed appreciated property is retained by the partnership, but other property not contributed by the distributee579 is distributed to the contributing partner within seven years580 of the initial contribution by the distributee.581 Without § 737, the inherent gain in the contributed appreciated property would be deferred in the transferred basis of the distributed property.582 The amount of gain recognized is the lesser of: (i) the net pre-contribution gain, that is, the aggregate net gain (reduced by any loss on contributed property) that would be realized under  § 704(c)(1)(B) if all property contributed by the distributee-contributor within seven years of the distribution (and still owned by the partnership) were distributed to another partner,583 and further reduced by any  § 704(c)(1)(B) gain recognized as a result of any related distribution of contributed property with a  § 704(c) adjustment to another partner as part of the same transaction;584 or (ii) the excess of the fair market value of the distributed property over the outside basis of the partnership interest,585 determined with adjustments from the distribution other than for the gain recognized under  § 737 for the distributed property.586 It has the same character as the precontribution gain determined by the character to the contributing partner at the time of contribution.587 The provision, thus, prevents deferring the gain on the distributed property by accelerating unrecognized gain under § 704(c), and avoids doubling the gain by adjusting the basis of the distributed property to reflect the recognized gain.588 The fair market value of marketable securities is generally treated as money for purposes of § 737.589 The fair market value of marketable securities contributed to the partnership is treated as property, however, in determining a partner's net precontribution gain under § 737(b).590  Section 737 does not apply to the extent that  § 751(b) treats a distribution as a sale or exchange of property between the distributee and the partnership.591 There is no similar exclusion for § 704(c)(1)(B), presumably because the contributing partner's share of precontribution gain is automatically reduced by any gain recognized under  § 751(b) on the distributed property.
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579 § 737(d)(1); Regs. § 1.737-2(d), (e) Ex. 1.

580 Again, the 1997 Act increased the original five-year period to seven years.

581 § 737(a)(1), (2); Regs. § 1.737-1. See H.R. Rep. No. 631, 102d Cong., 2d Sess. 68–69 (1992) (although  § 737 was enacted as part of the Energy Policy Act of 1992, it was originally part of the vetoed Revenue Bill of 1992; see H.R. Conf. Rep. No. 1018, 102d Cong., 2d Sess. 428 (1992)).

582 H.R. Rep. No. 631, 102d Cong. 2d Sess. 68 (1992). See III, B, 2, above, and IV, B, below, for discussions of the basis of distributed property.

583 § 737(b); Regs. § 1.737-1(c)(2)(i), (e) Ex. 1.

584 Regs. § 1.737-1(c)(1)(iv), (e) Ex. 2.

585 § 737(a)(1), (b). Presumably, this limitation reflects that limit on the basis of the distributed property under § 737(a)(2). See III, B, 1, a, for a discussion of the limitation.  Section 737 does not apply to the extent that  § 751(b) treats a distribution as a sale or exchange. § 737(d)(2).

586 § 737(b)(1); Regs. § 1.737-1(b)(3), (e) Ex. 2.

587 § 737(a); Regs. § 1.737-1(d), (e) Ex. 4.

588 See I, B, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of how precontribution attributes are allocated to the contributor.

589 § § 731(c)(1), 737(e); Regs. § 1.731-(2)(a). See III, F, below, for a discussion of the treatment of marketable securities as money for purposes of determining gain recognition under § 731(a).

590 Regs. § 1.731-2(g)(1)(i), (iii). See H.R. Rep. No. 826, 103d Cong., 2d Sess. 189, n.10.

591 § 737(d)(2); Regs. § 1.737-1(a)(2). See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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As for § 704(c)(1)(B), when the contributed property is exchanged for other property in a nonrecognition transaction, the property received in the exchange is treated as the contributed property for purposes of subsequent application of § 737,592 as is an amount capitalized with respect to  § 1.752-7 liabilities.593 A distribution of property previously contributed by the distributee to the partnership does not trigger gain under § 737.594 Similarly, when  § 751(b) applies,  § 737 does not, since the gain is recognized in any event.595 Unlike under § 704(c)(1)(B),596 there is no acceleration of loss or deduction as a result of a distribution of other property to the contributing partner, presumably because the partnership retains the contributed property, so that inherent loss can be deferred until it is disposed of. The denial of loss is also mitigated by the netting inherent in the definition of pre-contribution gain. The outside basis of the distributee's partnership interest is, of course, increased for the gain recognized, as is the inside basis of the contributed property.597
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592 Regs. § 1.737-2(d)(3)(i).

593 Regs. § 1.737-2(d)(3)(iv). See III, E, 1, above, for a discussion of a technical problem with Regs.  § 1.737-2(d)(3)(ii) and (iii), which at least one major law publisher has included in the old provision in Regs.  § 1.737-2(d)(3)(ii) and (iii), even though the publisher shows Regs.  § 1.704-4(d)(1)(ii) and (iii) as “Reserved.”The Federal Register, 70 Fed. Reg. 30334, 30342 (5/26/05), does not make the distinction.

594 § 737(d)(1); Regs. § 1.737-3(d).

595 § 737(d)(2); Regs. § 1.737-1(a)(2).

596 See III, E, 1, above, for a discussion of the similar issues on contributed property is distributed to another partner.

597 Regs. § 1.737-3(a), (e) Ex. 2.

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The outside basis of the distributee's partnership interest598 and the partnership's inside basis in the contributed property599 are immediately adjusted for any gain recognized under § 737, without the need for an election under § 754.600 The partnership's adjusted basis in property contributed by the distributee is increased for the gain, allocated to property with unrealized gain of the same character as the gain recognized.601 The adjustments, presumably, reduce the contributor's exposure to future allocations under  § 704(c) for the originally contributed property. The basis of the distributed property to the distributee is determined under general principles for distributions, after reflecting the gain in the distributee's outside basis.602 There are exceptions for partnership structural changes, including mergers, divisions, incorporations and other nonrecognition transfers.603 Proposed regulations, however, provide for creation of new  § 704(c) allocations in assets-over mergers.604
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598 § 737(c)(1); Regs. § 1.737-3(a), (e) Ex. 1; see Cuff, “The  § 704(c)(1)(B) Proposed Regulations,” 73 Taxes 283, 299 (1995). See 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment of the basis adjustments under § 737.

599 § 737(c)(2); Regs. § 1.737-3(b).

600 Regs. § 1.737-3(c)(4).

601 Regs. § 1.737-3(c)(3), (e) Ex. 3.

602 § 737(c)(1); Regs. § 1.737-3(b)(1).

603 Regs. § 1.737-2(a), (b), and (c); Prop. Regs. § 1.737-2(b). See III, E, 1, above, for discussion of the similar application of  § 704(c)(1)(B) in restructuring transactions.

604 Prop. Regs. § § 1.704-3(a)(9); 1.704-4(c)(4)(ii)(A);and 1.737-2(b)(1)(ii). See IV, G, 2, a, below, for a discussion of the proposed regulations.

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There is also an anti-abuse rule for transactions with a principal purpose “inconsistent with the purposes of section 737,” which, of course, are defined only by example,605 but the examples are stated not to set the boundaries of what is permissible, and caution that any change in the facts may change the results.606 The abuse example involves a transfer of property to the partnership immediately before a distribution to the contributing partner that avoids gain because of the transfer, followed by distribution of the temporarily contributed property that does not result in gain because it was contributed by the distributee.607 To make clear that this is bad, the example states that this is all part of a plan to avoid § 737.  It is sad to think that an obvious example like this was considered necessary and appropriate. The second example involves assumption by the distributee of a partnership liability also stated to be with the principal purpose of avoiding gain on the distribution, but the assumption is not considered inconsistent with  § 737 because it is a bona fide partnership liability that has substance.608 The substance is apparently that the distributee partner will in fact pay the assumed liability, but this important factor is not stated expressly. Although  § 737 has a five-, now seven-year period for determining whether gain is recognized that is similar to that of  § 704(c)(1)(B) discussed in the preceding section, so that anti-abuse examples under that section should equally apply, the  § 737 regulations cross-reference to the anti-abuse regulations under § 704(c)(1)(B), but only by narrowly referring to them as being “in the context of § 704(c)(1)(B),”and as applying “to the extent that the net precontribution gain for purposes of  § 737 is determined by reference to § 704(c)(1)(B).”609 Despite the narrowness of the language, it would not be safe to assume that the Regs.  § 1.704-4(f) examples do not apply to § 737.
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605 Regs. § 1.737-4.

606 Regs. § 1.737-4(b).

607 Regs.  § 1.737-4(b) Ex. 1.

608 Regs.  § 1.737-4(b) Ex. 2.

609 Regs. § 1.737-4(a).

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Example: Other Property Distributed to Contributing Partner. Propp contributes two parcels of land to a partnership, Oppar. Parcel#1 has a basis of $60,000 and a value of $300,000, and Parcel#2 has a basis of $120,000 and a value of $100,000, each of which is held by Propp and to be held by Oppar as  § 1231 property. Munn#1 and Munn#2 each contribute $400,000 cash. The Oppar partnership agreement satisfies the special allocation regulations. The next year, when the value of Oppar's assets has increased to $1,500,000 (including an increase in the value of Parcel#1 to $360,000) with no recognition of gain or income, Oppar distributes Parcel#3, land held by Oppar as  § 1231 property, with an inside basis of $145,000 and value of $250,000, to Propp in connection with the reduction of her interest from one-third to one-fifth. Propp recognizes the $70,000 excess of the $250,000 value of Parcel#3 over the $180,000 outside basis of her interest as  § 1231 gain, since that amount is less than the $220,000 net gain that was inherent in Parcel#1 ($240,000 gain) and Parcel#2 ($20,000 loss) when she originally contributed the parcels to Oppar. Propp's basis in Parcel#3 is $145,000, the transferred inside basis to Oppar of Parcel#3. Her outside basis in her Oppar interest increased by $70,000 to $250,000, to reflect the  § 704(c) gain she recognized, and reduced to $105,000 to reflect the $145,000 transferred basis of Parcel#3. Oppar's inside basis in Parcel#1 that Propp contributed is increased by $70,000 to $130,000 to reflect the  § 704(c) gain she recognized. Her potential  § 704(c) gain in Parcel#1 is reduced from $240,000 to $170,000 to reflect the recognition. Her potential $20,000  § 704(c) loss in Parcel#2 is not affected by the gain recognition, so that she still has the opportunity to recognize that loss when Oppar disposes of Parcel#2. She will be taxed on the $105,000 inherent gain in Parcel#3 only when she disposes of it in a recognition transaction. The gain recognized under  § 737 should not affect her capital account, since she was credited with the fair market values of Parcel#1 and Parcel#2 when she contributed them. On the other hand, each of Propp, Munn#1 and Munn#2 increase their capital accounts by $35,000 (1/3  of the $105,000 inherent gain in Parcel#3) and Propp reduces her capital account by the full $250,000 value of Parcel#3. The increase in the value of Parcel#1 has no effect on her potential  § 704(c) allocation, since any post-contribution changes in value are properly allocated to all partners in proportion to the partnership shares. To the extent, if any, that the distribution of Parcel#3, which is  § 1231 property, is allocable to reduction in her share of  § 751 gain in connection with the reduction of her Oppar interest from one-third to one-fifth, the  § 751(b) exchange would come before, and reduce, the recognition of the  § 704(c) gain.

If the distribution to Propp occurs in the sixth year after the original contribution of Parcel#1 and Parcel#2, when the value of Oppar's assets has increased to $3,000,000 (but the amounts of their capital accounts are unchanged because they have distributed all income and gain), the distribution to Propp to reduce her interest from one-third to one-fifth would be $500,000.  If she receives Parcel#3 with a value of $500,000 and an inside basis of $290,000, her  § 1231 gain recognized under § 737 is the$220,000 net gain that was inherent in Parcel#1 ($240,000 gain) net of Parcel#2 ($20,000 loss) she originally contributed to Oppar, because it is less than the $320,000 excess of the $500,000 value of Parcel#3 over the $180,000 outside basis of her Oppar interest.  Her outside basis in her Oppar interest increased by $220,000 to $400,000, to reflect the  § 704(c) gain she recognized, and reduced to $110,000 to reflect the $290,000 transferred basis of Parcel#3. Oppar's inside basis in Parcel#1 that Propp contributed is increased by $220,000 to $280,000 to reflect the  § 704(c) gain she recognized. Her potential  § 704(c) gain in Parcel#1 is reduced from $240,000 to $20,000 to reflect the recognition. Her potential $20,000  § 704(c) loss in Parcel#2 is not affected by the gain recognition, so that she still has the opportunity to recognize that loss when Oppar disposes of Parcel#2. She will be taxed on the $210,000 inherent gain in Parcel#3 only when she disposes of it in a recognition transaction. The gain recognized under  § 737 should not affect her capital account, since she was credited with the fair market values of Parcel#1 and Parcel#2 when she contributed them. On the other hand, each of Propp, Munn#1, and Munn#2 increases his or her capital account by $70,000 (1/3  of the $210,000 inherent gain in Parcel#3), and Propp reduces her capital account by the full $500,000 value of Parcel#3.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

F. Distribution of Marketable Securities—§ 731(c) 

Under § 731(c),610 the fair market value of marketable securities as of the date of distribution is considered “money,” not property, for purposes of § 731(a)(1),611 which provides nonrecognition on distributions of property.612 A distribution of marketable securities, therefore, results in gain recognition by the distributee partner to the extent that the value of the securities exceeds the partner's outside basis in the partnership interest.613 The treatment of marketable securities as money (for some purposes) reflects a concern that partners with low outside basis otherwise could delay gain recognition until they sold the marketable securities, by arranging for the partnership to buy marketable securities with money that would otherwise be distributed. Although the rationale for the provision is that marketable securities are the equivalent of money, the rationale is not consistently applied in the Code. Because the definition of “marketable securities”includes items that are clearly not the equivalent of money, the justification is questionable.614
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610 Applicable generally to distributions after Dec. 8, 1994.

611 Marketable securities are not treated as money, however, for purposes of § 731(a)(2), relating to liquidating distributions. § 731(c)(1) (referring only to § § 732(a)(2) and 737); H.R. Rep. No. 826, 103d Cong., 2d Sess. 189, n.10.

612 Other exceptions to nonrecognition include the mixing bowl provisions of § § 704(c)(1)(B) and 737. See III, E, above, for a discussion of how unrealized § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

613 § 731(c)(3)(b); Regs. § 1.731-2(a), (j) Ex. 1. See generally  Gall &  Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687 (11/12/07).

614 See Gall &  Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687(11/12/07).

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1. Amount of Gain 

The amount of the marketable securities treated as money is reduced (but not below zero) by the reduction in the net gain of the partnership's securities of the same class and issuer as the distributed securities immediately before the distribution.615 The reduction is measured by the excess of (i) the distributee's share of the net gain that would be realized if all the partnership's marketable securities held immediately before the distribution were sold 616 over (ii) the distributee's share of the net gain that would be realized immediately after the distribution (using the same values as (i)).617 Thus, the reduction reflects not only the marketable securities distributed, but also any reduction in the distributee's share of partnership gain.618
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615 § 731(c)(3)(B); Regs. § 1.731-2(b)(2), (j) Exs. 2, 3. See PLRs 200223036-200223045 (on LLC's creation of second LLC in “assets-over” transaction, in which it made distributions to some of its members in liquidation/redemption, limitation on marketable securities treated as money included only each member's share of net gain attributable to marketable securities held by divided LLC, and not resulting LLC).

616 The shares should take into account special allocations. See 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a discussion of special allocations. However, the regulations exclude any special allocations adopted with a principal purpose of avoiding the effect of § 731(c). Regs. § 1.731-2(b)(3)(ii). They specifically include any basis adjustment under § 743(b) for the distributee, and exclude gain or loss attributable to a marketable security that qualifies for one of the exceptions transferred to the distributee. Regs. § 1.731-2(b)(3)(i), (ii). See Gall &  Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687, 704(11/12/07).

617 Although § 731(c)(3)(B)(i) and (ii) provides for measuring the reduction by marketable securities of the same class and issuer as those distributed, § 731(c)(3)(B) (flush language)gives permission for the regulations to aggregate securities. Regs. § 1.731-2(b) provides for such aggregation. Accordingly, the selection of marketable securities to be distributed does not affect the amount of the reduction.

618 Regs. § 1.731-2(j) Ex. 4. The preamble to the proposed regulations stated that the provision would allow a partner to withdraw the partner's portion of appreciation in the partnership's marketable securities without recognizing gain on the transaction and that, as a result, § 731(c) applies principally when a partner's share of appreciation in marketable securities is exchanged for a share of appreciation in other partnership assets. PS-2-95, 61 Fed. Reg. 28 (1/2/96). The preamble did not comment on the effect of changes in partnership shares as a result of the distribution.

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If a distributed marketable security is either an unrealized receivable, (within the meaning of § 751(c)) or an inventory item(within the meaning of § 751(d)(2)), any gain recognized by the distributee is treated as ordinary income,619 apparently to offset the basis increase from the gain recognition.620 Because § 731(c) only applies to gain recognition by the distributee on the distribution, any loss inherent in the distributed marketable securities is not recognized.621
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619 § 731(c)(6).

620 See III, G, 2, below, for a discussion of the basis increase resulting from gain recognized under § 731(c).

621 § 731(b); Regs. § 1.731-1(b).

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Example: Amount of Gain. Propp contributes Property with a fair market value of $500,000 and an adjusted basis of $125,000 to a partnership, Oppar, for a one-third interest in capital, profits, and losses. Munn contributes $1,000,000 cash for the remaining two-thirds interest in capital, profits, and losses. The Oppar partnership agreement satisfies the special allocation regulations. Part of Munn's contribution is used to develop Property, and the rest is invested in marketable securities pending location of another suitable business opportunity. The investments include marketable securities to which none of the exceptions in § 731(c) apply, consisting of Security#1 with a basis of $200,000 and a value of $250,000, Security#2 with a basis of $150,000 and a value of $200,000, and Security#3 with a basis of $175,000 and a value of $150,000. If the three securities were sold, the net gain would be $75,000 ($50,000 gain on Security#1+ $50,000 gain on Security#2, net of $25,000 loss on Security#3). Oppar distributes Security#1, to Propp, in connection with the reduction of her interest from one-third to one-fifth. Oppar does not have any § 751 property. The distribution is not subject to mixing bowl rules.

The net gain in Security#2 and Security#3 after the distribution is $25,000 ($50,000 gain for Security#2 net of $25,000 loss for Security#3). Propp's share of the net gain before the distribution was $25,000 (1/3  of $75,000), and her share after the distribution is $5,000(1/5  of $25,000). The distribution of Security#1 is treated as a distribution of money in an amount equal to its $250,000 fair market value reduced by the $20,000 reduction in her share of the net gain in Oppar's marketable securities, or $230,000. Propp recognizes$105,000 of gain on the distribution ($230,000 distribution of marketable securities treated as money - $125,000 outside basis in Propp's partnership interest). The basis consequences of the distribution are discussed in the Example in III, F, 2, below.

2. Basis Consequences 

When gain is recognized on distribution of marketable securities under § 731(c), the basis of the distributed securities is increased (over their transferred inside basis) by the amount of the recognized gain, allocated among the distributed marketable securities in proportion to unrealized appreciation.622 When no gain is recognized, the basis of the marketable securities is the general transferred inside basis under § 732.623 Since  § 731(c) applies only for purposes of determining gain recognition by the distributee partner, the general principles for determining the distributee partner's outside basis under § 733 apply, but with no increase for gain recognized under § 731(c).624 The outside basis may, however, be adjusted for gain recognized under § 704(c)(1)(B) for a distribution of property contributed by the distributee to another partner as part of the same transaction.625 The distributee partner's outside basis is then reduced by the inside basis of the distributed marketable securities without adjustment for gain recognized on the distribution.626 If the distributee receives other property as part of the same distribution, the marketable securities are applied against the distributee's outside basis, because they are considered money. Any remaining basis applied against the transferred inside basis of the other property distributed.627 No adjustment is made to the inside basis of the distributing partnership's other property as a result of the gain recognized by the distributee, even when a § 754 election applies, because the gain is reflected in the increase in the basis of the distributed marketable securities.628 The inside basis of the partnership's other assets can be adjusted, however, under § 734 if a § 754 election applies to the distribution, for any lost basis resulting from the limitation of the outside basis of the marketable securities to the distributee's outside basis (particularly since the outside basis is not adjusted to reflect the gain).629
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622 § 731(c)(4); Regs. § 1.731-2(f)(1)(i).

623 See Gall &  Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687, 692 (11/12/07).

624 § 731(c)(5) (“Sections 733 and 734 shall be applied as if no gain were recognized, and no adjustment were made to the basis of property, under [§ 731(c)]”);Regs. § 1.731-2(f)(1)(ii).

625 Regs. § 1.731-2(g)(1).

626 § 731(c)(5); Regs. § 1.731-2(f)(1)(ii), (j) Ex. 5.

627 § 731(a)(1); Regs. § § 1.731-1(a)(1), -2(j) Ex. 6.

628 Regs. § 1.731-2(f)(2).

629 Regs. § 1.731-2(j) Ex. 6(iv). See FSA 200219008 (distribution of interests in lower-tier partnerships owning short-term debt is distribution of marketable securities; stating, confusingly, that with § 754 election in effect, adjustment under § 734(b)(1)(B) may be appropriate, apparently because of gain recognized under § 731(a)(1); because Regs. § 1.731-2(f)(2) states that there is no inside basis adjustment from gain on distribution of marketable securities, any adjustment should be for excess of inside basis of marketable securities as adjusted by the § 731(c) gain over outside basis of partnership interest, but this is not stated).

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Example: Basis Consequences. The facts are the same as in the example in III, F, 1, above. The $200,000 transferred inside basis of Security#1 is increased by the $105,000 gain to $305,000. Under § 731(c)(4), Propp's distributed basis of Security#1 is $230,000 (i.e., $125,000 [the security's adjusted basis to Oppar immediately before the distribution but limited to the adjusted basis of Propp's interest 629.1 ] plus $105,000 gain recognized). If a § 754 election by Oppar applies to the distribution, Oppar may adjust the inside basis of its remaining assets under § 734(b) to reflect the $75,000 excess of the $200,000 adjusted basis of Security#1 to the partnership immediately before the distribution over the $125,000 § 732 basis of Security#1.629.2

Each of the partners' capital accounts is increased by one-half of the $50,000 excess of the $250,000 value of Security#1 over its $200,000 basis. Propp's capital account is reduced by the$250,000 value of Security#1.

If, as part of the same transaction, Oppar distributes Property to Munn, Propp recognizes $375,000 gain on the distribution, under § 704(c)(1)(B). Accordingly, the outside basis of Propp's interest in Oppar would increase to $500,000, so that she would not recognize any gain on the distribution of Security#1. As a result, her basis in Security#1 would be its $200,000 inside basis to Oppar, and the outside basis of her Oppar interest would be reduced by $200,000 from $500,000 to$300,000.

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629.1 § 732(a). Section 732(a)(2) limits the basis to the distributee partner to the adjusted basis of the partner's interest reduced by any money distributed in the same transaction, but § 731(c)(1) does not treat marketable securities as money for purposes of § 732.

629.2 Under § 731(c)(5), § 734 is applied as if no gain were recognized under § 731(c).

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3. Marketable Securities 

“Marketable securities” are financial instruments and foreign currencies that are actively traded (within the meaning of § 1092(d)(1))630 on the date of distribution.631 A security of a class that is actively traded is a marketable security, even if transfer of the particular securities distributed is restricted for a period of time.632 Thus, stock under an investment letter or a similar restriction is, nevertheless, a marketable security, as are securities that are restricted property under § 83, presumably including forfeitable securities when an election under  § 83(b) is made.
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630 Section 1092 primarily limits deduction of losses on straddles. Section 1092(d)(1) uses the term “actively traded,” but does not define it. Accordingly, the reference should, implicitly, include Regs. § 1.1092(d)-1, defining “actively traded” as incorporated by reference. Regs. § 1.1092(d)-1(a) describes actively traded property as property for which there is an established financial market. Regs. § 1.1092(d)-1(b) includes national securities exchanges, national interdealer quotation systems, boards of trade, foreign equivalents of those markets, and interbank and interdealer markets as established financial markets. See Countryside Ltd. P'ship v. Comr. T.C. Memo 2008-3 (liquidating distribution of notes constituted distribution of nonmarketable securities because notes were not traded on exchange, and fact that their terms could be modified was not sufficient to constitute arrangement to convert notes into cash or marketable securities; deemed distribution of notes was not part of abusive transaction described in Regs. § 1.731-2(h) because examples in regulations involve distributions of marketable securities, making Regs. § 1.731-2(h) inapplicable to present case).

631 § 731(c)(2)(A); Regs.§ 1.731-2(c)(1). Although it would seem that the active-trading requirement would make marketable securities easy to value, this is not always the case. See Gall & Franklin, “Partnership Distributions of Marketable Securities,”117 Tax Notes 687, 692 (11/12/07).

632 Regs. § 1.731-2(c)(2).

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The term “financial instrument”is very broad, and encompasses most, if not all, of the types of investments.633 A long list of items specified includes stocks and other equity interests, evidences of indebtedness, options, forward or futures contracts, notional principal contracts, and derivatives.634 On the other hand, commodities (other than precious metals) are not considered marketable securities, but actively traded options, futures, and forward contracts are treated as marketable securities, whether or not they relate to commodities.635 In addition, marketable securities include: (i) interests in common trust funds, or regulated investment companies;636 (ii) any financial instrument that is readily convertible into or exchangeable for money or marketable securities;637 (iii) financial instruments where the value is determined substantially by marketable securities;638 (iv) any interest in a precious metal that is actively traded, unless the metal was produced, used or held in the active conduct of a trade or business by the partnership;639 (v) any interest in any entity if substantially all (more than 90% in value640)of the assets of the entity consist, directly or indirectly, of marketable securities, money, or both;641 and (vi) any interest in any entity that does not meet the substantially all test, but has marketable securities of at least 20% of its value, but only to the extent that the value of the interest is attributable to marketable securities, money or both.642 Value is gross value, without reduction for any liabilities encumbering or allocable to the assets, other than liabilities incurred to avoid the marketable securities provision.643
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633 See Gall &  Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687, 693–701 (11/12/07), for an extensive discussion of the various items included in the definition of marketable securities.

634 § 731(c)(2)(C).

635 See H.R. Rep. No. 826, 103d Cong., 2d Sess. 189, n.11.

636 § 731(c)(2)(B)(i) (regulated investment companies are those being offered for sale or that have outstanding any redeemable security (within the meaning of  § 2(a)(32) of the Investment Company Act of 1940). Thus, an interest in an open-ended mutual fund is treated as a marketable security even though trading in fund shares takes place exclusively through purchase-and-redemption transactions with the issuer of the fund shares. H.R. Rep. No. 826, 103d Cong., 2d Sess. 189.

637 § 731(c)(2)(B)(ii). Under § 731(c)(2)(B)(ii), an in-the-money option to buy marketable securities is treated as a marketable security inasmuch as the holder is able to readily convert it to marketable securities by exercising the option. H.R. Rep. No. 826, 103d Cong., 2d Sess. 189.  Even an option that is not in the money may be a marketable security under the next clause, which includes those where the value is determined by a marketable security.  Cf. Regs.  § 15A.453-(e)(5) (convertible debt obligation may be viewed as readily tradable unless stock into which convertible is trading at substantial (more than 20%) discount from conversion price); but cf.  Regs.  § 1.1273-2(g)(7) (convertible instrument not readily tradable because convertible into traded security).

638 § 731(c)(2)(B)(iii). A private notional principal contract that itself is not actively traded, but whose value is determined by reference to a financial instrument that is actively traded, is a marketable security (an interest in an index fund that is actively traded is a marketable security because it is included as a financial instrument). Also, privately offered stock whose value is determined by reference to actively traded stock of another class or another issuer is a marketable security. H.R. Rep. No. 826, 103d Cong., 2d Sess. 189.

639 § 731(c)(2)(B)(iv). Thus, precious metals produced, used or held in the active conduct of a trade or business by the partnership, such as a miner or manufacturer of precious metals should not be marketable securities, nor should they if held by a dealer in precious metals. See H.R. Rep. No. 826, 103d Cong., 2d Sess. 190.

640 Regs. § 1.731-2(c)(3)(i). The entire interest in such an entity will be treated as a marketable security, even if the entity holds (directly or indirectly) other assets. See H.R. Rep. No. 826, 103d Cong., 2d Sess. 190. See also PLR 200219008 (partnership distributing to its partners its interests in LLC which holds debt instruments deemed to distribute marketable securities).

641 § 731(c)(2)(B)(v). This rule prevents avoidance of gain recognition by distributing interests in such an entity that are not actively traded.

642 § 731(c)(2)(B)(vi);Regs. § 1.731-2(c)(3)(ii). Thus, an interest in an entity holding a de minimis amount of marketable securities will not be a marketable security for purposes of § 731(c). See H.R. Rep. No. 826, 103d Cong., 2d Sess. 1900.

643 Regs. § 1.731-2(c)(4).

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4. Exceptions 

Naturally, there are exceptions.644 Gain is not recognized by a distributee partner on receipt of marketable securities that the partner contributed to the partnership.645 There is also a limited exception for securities that were not marketable when acquired by the partnership, apparently to allow private placement securities to avoid gain recognition, but with significant limitations to prevent transfer of securities that are planned to become marketable, so that the exclusion applies only if the issuer had no outstanding marketable securities at that time of transfer, and the security did not become marketable within six months of the contribution (a kind of step-transaction requirement), and the security was distributed within five years of the date on which it became marketable.646 The regulations also contain an exception that does not directly appear in the Code647 for securities acquired by the partnership in a nonrecognition transaction in exchange for property other than marketable securities or money that are distributed by the partnership within five years of the later of the date of acquisition or the date the security became marketable.648 This treats the marketable security as a substitute for the contributed assets, but subject to a step-transaction requirement that the transferee not become public within six months of the contribution. A successor security rule permits a nonrecognition distribution of a marketable security acquired in a nonrecognition transaction in exchange for a security subject to one of the exceptions, but only to the extent the exchanged security would qualify, which, presumably, subjects the new marketable security to the five-year and other limitations described above.649 The five-year limits are based on administrative convenience.650 A partnership termination is disregarded in determining the application of these exceptions.651
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644 See Regs. § 1.731-2(d). See Gall and Franklin, “Partnership Distributions of Marketable Securities,”117 Tax Notes 687, 706–08 (Nov. 12, 2007), for an extensive discussion of the items that qualify for the exceptions.

645 § 731(c)(3)(A)(i);Regs. § 1.731-2(d)(1)(i).

646 § 731(c)(3)(A)(iii);Regs. § 1.731-2(d)(3). See H.R. Rep. No. 826, 103d Cong., 2d Sess. 190.

647 It should, however, be covered by § 731(c)(7), providing specific regulatory authority for regulations “necessary or appropriate” to carry out the purposes of the provision.

648 Regs. § 1.731-2(d)(1)(ii).

649 Regs. § 1.731-2(d)(3).

650 In the preamble to the final regulations, T.D. 8707, 61 Fed. Reg. 67936 (12/26/97), the IRS stated that it imposed the five-year limitation because of concerns that it would be administratively difficult to determine how the securities were acquired if a longer period were allowed.

651 Regs. § 1.731-2(g)(2). See IV, F, below, for a discussion, and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of partnership termination.

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An anti-stuffing rule disqualifies an otherwise excepted security to the extent that 20% or more of the value of the distributed security is attributable to direct or indirect contributions of marketable securities or money (other than as a result of liability shifts) to the entity to which the distributed security relates after the security was acquired by the partnership.652 This regulatory rule parallels the statutory limitation on distributions of marketable securities to the contributor, and seems to give distributions of entities receiving less than 20%contributions the advantage of the de minimis exception.
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652 § 731(c)(3)(A)(i). Regs. § 1.731-2(d)(2). See H.R. Rep. No. 826, 103d Cong., 2d Sess. 190–91. See Gall and Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687, 708–10 (Nov. 12, 2007), for an extensive discussion of the anti-stuffing rule.

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Example: Exceptions and Anti-Stuffing. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations.  Oppar contributes substantially all of its assets (less than 20% of which are marketable securities or cash) to Pubco in exchange for marketable Pubco stock in a transaction qualifying for nonrecognition treatment under § 351. As long as Oppar distributes the Pubco stock within five years of the exchange, the distribution of the Pubco stock qualifies for nonrecognition under § 731(a)(1), because it not a marketable security under the exceptions to § 731(c).  On the other hand, under the rule of administrative convenience, a distribution of the Pubco shares six years after the contribution would apparently be taxable. Similarly, a distribution by Oppar of the shares of Pubco would become taxable under the anti-stuffing rule if Oppar contributes marketable securities to Pubco that amount to 20% or more of the value of the Pubco stock when distributed.

Similarly, although the distribution of actively traded Marketco shares originally contributed to Oppar by Propp to Propp would be taxable if the value of the Marketco shares was enhanced by contribution of additional marketable securities by Oppar to Marketco that represented more than 20% of its value at the time of distribution, the anti-stuffing rule would not apply to the extent that the value of Marketco is attributable to marketable securities that Propp contributed to Marketco, because those marketable securities could have been distributed to Propp without recognition of gain even if not transferred to Marketco.

5. Distribution by Investment Partnership 

There is an important exception for investment partnerships, that is, those substantially all of whose assets (by value) consist of specified investment-type assets, but not necessarily marketable securities; and that have never been engaged in a trade or business.653 A partnership termination is disregarded in determining the application of this exception.654
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653 § 731(c)(3)(A)(iii) and (C)(i); Regs. § 1.731-2(e). See Gall and Franklin, “Partnership Distributions of Marketable Securities,”117 Tax Notes 687, 704–06 (Nov. 12, 2007), discussing and questioning the investment partnership provision.

654 Regs. § 1.731-2(g)(2). See IV, F, below, for a discussion, and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of partnership terminations.

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a. Investment-Type Assets 

The specified investment-type assets, which are similar, but not identical, to the financial instruments used to determine marketable securities, are: (i) money;655 (ii) stock in a corporation,656 but apparently not “other equity instruments”; (iii) notes, bonds, debentures, or other evidences of indebtedness,657 which appears identical to “evidences of indebtedness; (iv) interest rate, currency, or equity notional principal contracts, which is more specific than “includes ...notional principal contracts,” but is probably the same;658 (v) foreign currencies;659 (vi) interests in, or derivative financial instruments (including options, forward or futures contracts, short positions, and similar financial instruments) in, any other specified investment-type asset, which appears the same as options, forward or futures contracts, and derivatives, or in any commodity traded on or subject to the rules of a board of trade or commodity exchange, which are not financial instruments unless they relate to precious metals although actively traded options, futures and forward contracts that relate to commodities are;660 (vii) other assets specified in regulations;661 or (viii) any combination of the foregoing.662 The legislative history does not explain why these items are used for the definition.663
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655 § 731(c)(3)(C)(i)(I). Money is not used as part of the definition of marketable securities, of course, because the function of the marketable security definition is to assimilate financial instruments to money.

656 § 731(c)(3)(C)(i)(II).

657 § 731(c)(3)(C)(i)(III).

658 § 731(c)(3)(C)(i)(IV).

659 § 731(c)(3)(C)(i)(V).

660 § 731(c)(3)(C)(i)(VI).

661 § 731(c)(3)(C)(i)(VII). The regulations do not define any additional types of assets.

662 § 731(c)(3)(C)(i)(VIII).

663 See H.R. Rep. No. 826, 103d Cong., 2d Sess. 191–92.

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b. No Trade or Business 

Partnership activity as an investor, trader or dealer in the specified investment-type assets, including the receipt of commitment fees, breakup fees, guarantee fees, director's fees or similar fees that are customary in and incidental to an activity as an investor, trader or dealer does not result in the partnership's being engaged in a trade or business.664 In addition, as anticipated in the legislative history,665 the regulations provide that a partnership is not treated as being engaged in a trade or business by reason of: (i) reasonable and customary management services provided to a lower-tier investment partnership;but not management services provided to lower-tier partnerships other than investment partnerships because, as discussed below, the tiering rules treat the upper-tier management partnership as engaged in the trade or business of the lower-tier partnership,666 and (ii) reasonable and customary services provided in assisting the formation, capitalization, expansion or offering of interests in an entity in which the partnership holds or acquires a significant equity interest as long as anticipated receipt of compensation for the services does not represent a significant purpose for the partnership's investment in the entity.667
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664 § 731(c)(3)(C)(ii)(I). Regs. § 1.731-2(e)(3)(i). See also H.R. Rep. No. 826, 103d Cong., 2d Sess. 193.

665 See H.R. Rep. No. 826, 103d Cong., 2d Sess. 191.

666 Regs. § 1.731-2(e)(3)(ii).

667 Regs. § 1.731-2(e)(3)(iii). See also H.R. Rep. No. 826, 103d Cong., 2d Sess. 191.

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Under a similar look-through rule, the partnership is treated as holding a proportionate share of the assets of any lower-tier partnership and as engaging in any trade or business conducted by a lower-tier partnership,668 and a partner who contributes a partnership interest to another partnership is treated as contributing a proportionate share of the assets of the contributed partnership interest (and any lower-tier partnerships).669 Under specifically delegated authority,670 the regulations provide that the look-through rule does not apply if the upper-tier partnership does not participate in the management of the lower-tier partnership and the interest held by the upper-tier partnership is less than 20%of the total profits and capital interests in the lower-tier partnership.671 If the look-through rule does not apply to a partnership interest, then that partnership interest is treated as if it were a specified investment-type asset (i.e., it may be held by an investment partnership).672
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668 § 731(c)(3)(C)(iv)(I).

669 § 731(c)(3)(C)(iv)(II).

670 § 731(c)(3)(C)(iv) (introductory language). See H.R. Rep. No. 826, 103d Cong., 2d Sess. 191–192.

671 Regs. § 1.731-2(e)(4).

672 § 731(c)(3)(C)(iv) (flush language).

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c. Eligible Partner 

An eligible partner is one who, before the date of the distribution, did not contribute to the partnership any property other than specified investment-type assets permitted to be held by an investment partnership.673 A contribution of services to the partnership, however, will not preclude a partner from being an eligible partner.674 The taint of a partner who is not an eligible partner cannot be removed by a nonrecognition transfer,675 but should be removed by a taxable one.
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673 § 731(c)(3)(C)(iii)(I). A contribution of an interest in a lower-tier partnership will qualify as an investment-type asset if the interest meets the requirements of Regs. § 1.731-2(e)(4)(i), after the contribution. Regs. § 1.731-2(e)(2)(ii).

674 Regs. § 1.731-2(e)(2). See also H.R. Rep. No. 826, 103d Cong., 2d Sess. 192.

675 § 731(c)(3)(C)(iii)(II).

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6. Coordination with Mixing Bowl Rules 

Although, in general,  § 731(c) applies primarily for purposes of gain recognition under § 731(a), it also applies for purposes of  § 737 to allow coordination with § 737, primarily for basis purposes.676 Even though only  § 737 is referred in § 731(c), the regulations provide for coordination with  § 704(c)(1)(B) as well, and, indeed, provide for application of § 704(c)(1)(B) before § 731(c) and then application of § 737.677  Section 704(c)(1)(B) applies when contributed marketable securities are distributed to another partner within seven years of contribution, resulting in gain recognition to the contributing partner, and an increase in inside basis of the distributed marketable securities.678 Marketable securities are also taken into account in determining precontribution gain.679 This increased inside basis determines the basis used by the distributee partner to adjust outside basis and the basis of the distributed marketable securities before applying the increase for gain recognized.680
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676 Regs. § 1.731-2(a).

677 Regs. § 1.704-2(g)(1).

678 § 704(c)(1)(B)(iii);Regs. § 1.704-4(e)(1), (2). See III, E, 1, above, for a discussion of gain recognition when contributed property is distributed to another partner.

679 See H.R. Rep. No. 826, 103d Cong., 2d Sess. 189, n.10.

680 Regs. § 1.731-2(g)(1)(ii).

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The corresponding adjustment under  § 737 is more complex, reflecting that  § 731(c) applies before § 737, so that  § 737 applies only to any portion of the marketable securities not treated as money;and marketable securities, presumably those contributed by the distributee, are treated as property in determining precontribution gain,681 so that there is no reduction in potential  § 737 gain for such contributed marketable securities.  Of course, there is no recognition under  § 731(c) if the contributed marketable securities are distributed to the contributor.682 Any basis increase resulting from the § 737 portion of the transaction, including any portion of the marketable securities not treated as money, comes after determining the amount of gain attributable to the excess of the marketable securities over the distributee's outside basis.683
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681 Regs. § 1.731-2(g)(1)(iii)(A).

682 § 731(c)(3)(A); Regs. § 1.731-2(d)(1)(i).

683 Regs. § 1.731-2(g)(1)(iii)(B), (j) Ex. 7.

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Example. Coordination with § 737. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. On January 31, 20X1, Munn contributes Property#1, nondepreciable real property with a fair market value of $200,000 and an adjusted basis of $100,000 (resulting in a $100,000 § 704(c) allocation to Munn of gain) in exchange for a 25% interest in Oppar. Oppar owns a marketable security, Security#1. On February 15, 20X6, Oppar distributes Security#1, with a fair market value of $120,000 and an inside basis of $100,000, to Munn in a current distribution. As part of the same distribution, Oppar distributes Property#2 to Munn with a fair market value of $20,000 and an adjusted tax basis of $0. At the time of distribution, there has been no change in the fair market value of Property#1 or the adjusted tax basis in Munn's interest in the partnership. Munn's distributive share of the unrealized gain in Security#1 at the time of distribution was $5,000 (25% of $20,000 gain). Because Oppar has no other marketable securities, Munn's distributive share of gain in partnership securities after the distribution is zero. As a result, the distribution results in a decrease of $5,000 in Munn's share of the net gain in Oppar's securities ($5,000 net gain before distribution -zero net gain after distribution). Accordingly, the amount of the distribution of Security#1 that is treated as a distribution of money to Munn is reduced by $5,000, so that $115,000 of the distribution of Security#1 to Munn is money ($120,000 fair market value of Security#1 -$5,000 reduction). The remaining $5,000 portion of the distribution of Security#1 is treated as other property. Munn recognizes $15,000 of gain under  § 731(a)(1) on the distribution of the portion of Security#1 treated as money ($115,000 -$100,000 outside basis in Munn's partnership interest). Munn recognizes$25,000 of gain under  § 737 on the distribution of Property#2 ($20,000 value + the $5,000 portion of Security#1 that is not treated as money), because this is less than the excess of the $100,000  § 704(c) gain reduced by his zero remaining outside basis in the Oppar interest. Munn's distributed basis in Security#1 is $115,000($100,000 transferred inside basis of Security#1 + $15,000 of gain recognized by reason of § 731(c)). Munn's distributed basis in Property#2 is zero since he has no remaining outside basis in the Oppar interest. The outside basis in Munn's Oppar interest is $25,000 ($100,000 basis before distribution minus $100,000 basis allocated to Security#1 + $25,000 gain recognized under § 737), but this basis increase cannot be applied to Security#2, since the increase is ignored for this purpose.

7. Anti-Abuse Rule 

The regulations under § 731(c), which was adopted after the general anti-abuse provision,684 have their own anti-abuse provision.685 Under Regs. § 1.731-2(h), the issue is consistency with the purpose of  § 731(c) while the general anti-abuse provision seeks consistency with the intent of Subchapter K, to be determined based on the facts and circumstances.686 As in the general anti-abuse provision, the result of inconsistency is recasting the transaction. The Service can recast the transaction for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of § 731(c). Whether a tax result is inconsistent with the purpose of  § 731(c) is determined on the basis of all the facts and circumstances. The regulations list three items as potentially subject to the anti-abuse rule, which generally track the legislative history.687 Since neither the regulations nor any example illustrates the application of the anti-abuse rules, the suggestions that follow represent the author's speculations.  The first two seem to be related and involve a kind of retention-as-disguised-distribution approach; they are:(i) a change in partnership allocations, or distribution rights with respect to marketable securities, if the change in allocations or distribution rights is, in substance, a distribution of the securities;688 and (ii) a distribution of substantially all of the assets of the partnership other than marketable securities and money to some partners may be treated as a distribution of marketable securities to the remaining partners if the distribution of the other property and the withdrawal of the other partners is, in substance, equivalent to a distribution of the securities to the remaining partners.689 Both seem to involve studied nondistributions combined with arrangements that make specified partners, in effect, the owners of the marketable securities that are still held in partnership solution.  The third, the distribution of multiple properties to one or more partners at different times if the distributions are part of a single plan of distribution,690 seems to be a classic step-transaction situation.
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684 Regs. § 1.701-2. See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the general anti-abuse provision.

685 Regs. § 1.731-2(h). See Gall and Franklin, “Partnership Distributions of Marketable Securities,”117 Tax Notes 687, 710–11 (Nov. 12, 2007), for a discussion and critique of the anti-abuse rule.

686 Regs. § 1.731-2(h). See CCA 200250013 (in redemption of partner's interest, partner's assumption of partnership's assets and liabilities except for cash, other liquid assets, and a note receivable may be recast as a distribution of marketable securities to the remaining partners).

687 See H.R. Rep. No. 826, 103d Cong., 2d Sess. 195.

688 Regs. § 1.731-2(h).

689 Id. See CCA 200250013 (where in connection with a transaction ruled a disguised sale, retention by partnership of a private placement note where the subsequent sale of the note was arranged by same banker that arranged its creation and was in the business of making such private placements, the note was a marketable security applying the anti-abuse rule).

690 Regs. § 1.731-2(h).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

G. Disguised Sales 

The flexibility provided by the liberal nonrecognition principle of  § 731(a) and (b) that permits distribution of property to partners without recognition of gain by either the partnership or the distributee partner, and that permits even distribution of money to partners without recognition of gain by the distribution reducing the interest in partnership capital, distributions, profits, or losses, or any combination, tempts partners and partnerships to use those provisions to disguise a sale of property by a partnership to a partner as a separate contribution and distribution, or to disguise a sale of part (or all) of a partnership interest as a contribution by a new partner and a separate partnership distribution to the selling partner.691 Section 707(a)(2)692 was adopted in 1984 as an amendment to § 707(a), which generally provides for treatment of certain transactions between a partnership and a partner as ones with a person who is not a partner. The basic approach of  § 707(a)(2) is to authorize regulations to establish criteria to be used in identifying transactions involving both performance of services by a partner, or transfers of property in either direction between a partnership and a partner, in either case, with a related direct or indirect allocation that “when viewed together, are properly characterized” as involving partners “acting other than in ... [the] capacity as ... member[s] of the partnership” to be treated transactions under  § 707(a)(1) with a person who is not a partner.693
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691 See 1984 Bluebook, at 223–33. See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179 (Jan. 15, 2007), for an extensive discussion of, and comments on, the disguised sale regulations.

692 Added by the Tax Reform Act of 1984, P.L. 98-369, § 73(a).

693 Thus, § 707(a)(2) also covers disguised sales of property by partners to partnerships and disguised compensation by partnerships to partners.  See 710 T.M., Partnerships —Conceptual Overview, for summary discussions, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for comprehensive treatments of such disguised sales by partners and disguised compensation to partners.

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1. Disguised Sale by Partnership to Partner 

Since the statutory language relating to the disguised sales essentially beg the question of what is a disguised sale, the regulations provide the guidance. Similarly, the regulations specifically addressed to such disguised sales of property by partnerships to partners, essentially piggyback on Regs.  § 1.707-3 dealing with disguised sales of property by partners to partnerships, by providing a similar standard to determining disguised sales of property by partnerships to partners.694
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694 Regs. § 1.707-6(a). See TAM 9822002 (partner's contribution of an operating business to a joint-venture partnership in exchange for his partnership interest plus stocks and cash contributed to the joint-venture partnership by the other joint venturer is treated as a sale between the partnership and partner).

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a. Entrepreneurial Risk 

The disguised-sale-to-partnership regulations provide a flexible substance-over-form analysis to determine whether there was an attempt to disguise a sale of property to a partnership as a tax-free contribution to capital and an unrelated distribution.695 Specifically, simultaneous distributions are disguised sales if they would not have been made but for the transfer of property.696 For non-simultaneous transfers, there is a rebuttable presumption of a sale,697 adopted by the disguised sale by partnerships regulations.698 If there is a difference in amount between the contribution and the value of the property distributed that is attributable to the time between the two events, the difference is apparently imputed interest.699
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695 Regs. § § 1.721-1(a), 1.731-1(c)(3).

696 Regs. § 1.707-3(b)(1)(i), (f) Ex. 1 (allocation if distribution less than value of property); see Park Realty Co. v. Comr., 77 T.C. 412 (1981), acq. in result only (cash distribution to reimburse development expenses for land contributed to partnership are not disguised sale; cash treated as partnership distribution; case prior to enactment of § 707(a)(2)(B), but result should not be changed; see AOD 1982-067, 1982 WL 212496, distinguishing Otey in recommending acquiescence in result); TAM 9822002 (joint venture arrangement in which U.S. corporate venturer transferred its own stock and cash to joint venture, and foreign venturer transferred an operating business for an interest plus the stock and cash transferred by U.S. corporate venturer, is disguised sale, but under aggregate principle,  § 1032 protects U.S. corporate partner from gain on its own stock).

697 Regs. § 1.707-3(c)(1).

698 Regs.  § 1.707-6(d) Ex. 1.

699 Regs.  § 1.707-6(d) Ex. 1 (treats contribution subsequent to distribution as sale for the contributor's obligation to make the contribution, but does not specify the imputed interest, as such).

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Transfers of property and money within two years are presumed to be sales, and those more than two years later are presumed not to be.700 Even with this broad presumption, there is a possibility of “cherry picking”when actual and disguised sales, particularly actually selling high-basis property and leaving lower-basis property, occur within the two-year period.701 The regulations do not provide for transactions that involve installment payments, some within two years and some after two years. Perhaps there should be some weighing based on the relative amounts of payments within and not within two years. Taxpayers who want to avoid disguised sale treatment should provide only installments after two years.
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700 Regs. § 1.707-3(c), (d) and (e) Exs. 2 (applies OID and installment sale principles to deferred distribution), 4 (excludes portion of distribution of sales proceeds allocable to partnership share), 6 (disguised sale for distribution more than two years after, where distribution will be from proceeds of permanent loan committed at time of contribution, and are not dependent on future appraisal), and 8 (disguised sale when distribution more than two years apart, but shift economic benefits in meanwhile by special allocation). Regs. § § 1.707-3(c)(2), -8. See FSA 199936011 (cash payment to property contributor to adjust capital contribution to agreed percentage is disguised sale, since within two years and no facts indicate to the contrary; partnership (LLC) has cost basis in assets; anti-abuse regulations do not apply, even though transferor was tax-exempt, and LLC apparently was not). See also U.S. v. G-I Holdings Inc. (In re G-I Holdings Inc), No. 02-3082 (D.N.J. 12/14/09) (holding that partner's transfer of assets to partnership and receipt on same day of loan proceeds from partnership were properly characterized as disguised sale under § 707(a)(2)(B)(iii) when viewed together).

701 See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 181–84(Jan. 15, 2007), for a discussion of, and recommendations related to, the cherry-picking problem.

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Characterizing a contribution and distribution as a disguised sale means that the partnership recognizes gain (or loss) on the property distributed that is shared by all partners, and that the contribution is consideration for the property, not a contribution to the partnership. The disguised purchaser, of course, has a purchase price basis in the property, and a new holding period, instead of the transferred basis and tacked holding period of a nonrecognition partnership distribution. A disguised sale does not affect capital accounts, since it is not a partnership distribution.

There are disclosure requirements for transfers of property that are not treated as sales to a partner that are made within two years before or after transfers of consideration by the distributee, or the partnership's incurring liabilities transferred to the distributee with property.702
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702 Regs.  § § 1.707-3(c) and 1.707-8, requiring filing of a Form 8375.

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Example: Disguised Sale by Partnership to Partner. Munn and Propp are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn makes an additional contribution of $100,000 to Oppar on July 1, 20X2, increasing his outside basis to $300,000. On Nov. 1, 20X3, Oppar transfers to Munn property that has a basis of$30,000 and a fair market value of $110,000. Under the rules of § 1274, the imputed principal amount of an obligation of $110,000 on Nov. 1, 20X3, was $100,000 on July 1, 20X2. Since the contribution and distribution are within two years, the distribution is presumed to be a sale unless the facts and circumstances clearly establish otherwise. Thus, there is no need for the IRS to establish any advance agreement; the burden is on Oppar to show that the two transactions are unrelated. Although showing an absence of an understanding might not be sufficient to rebut the presumption, a showing that the capital contribution was made to supply permanent capital to meet a pressing long-term Oppar need might be. Similarly, a showing that the property distributed was an integral part of Oppar operations at the time of the contribution, but became surplus as a result of an unexpected event should also be enough. A combination of the two factors should be determinative in the absence of any other facts to rebut the presumption. As a result of disguised sale characterization, Oppar has gain of $80,000 on the asset transferred, and, apparently, has paid interest of $10,000. A portion of both the gain and the interest deduction should be allocated to Propp. Munn has purchased the property for $100,000, and, apparently, received$10,000 of interest.

The rebuttable presumption test is a facts and circumstances test that includes a list of 10 factors to be taken into account. The factors specified in the regulations all point toward the certainty of the distribution and disguised sale treatment. Presumably, the absence of these indicia can be used to rebut a disguised sale. In view of the emphasis on certainty, the most important factor indicating that a distribution is not part of a disguised sale is that it is subject to entrepreneurial risk.703
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703 Regs. § 1.707-3(b)(1)(ii), (2) and -3(e) Exs. 3 (deferred distribution not disguised sale when contingent on construction costs being substantially less than estimate or on leasing building), 5 (same for distribution after more than two years where distribution dependent on future appraisal), and 7 (same where no guarantee of completion or of amount of construction cost). See Va. Hist. Tax Credit Fund 2001 LP v. Comr., T.C. Memo 2009-295 (concluding, based on absence of factors, that transactions were not disguised sales; transactions were not simultaneous and subsequent transfer was subject to entrepreneurial risks of partnership's operations).

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Example: Application of Facts and Circumstances Test and Entrepreneurial Risk. Munn, Propp and Surv are equal partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations.  On August 1, 20X1, Oppar distributes land and a building with a basis of $120,000(after straight-line depreciation) and a value of $300,000 to a partner, Propp, whose outside basis is $600,000, in connection with a reduction of her Oppar interest from one-third to one-fifth. Propp refinances the distributed land and building in February 20X3, receiving $230,000 net proceeds, and contributes $230,000 to Oppar on July 1, 20X3, for a proportionate increase in her Oppar interest. Under the rules of § 1274, the imputed principal amount of an obligation of $200,000 on August 1, 20X1 was $230,000 on July 1, 20X3. The disguised sale rule provides for gain to Oppar of $120,000 (2/3  ($200,000 value of contribution/$300,000 value of land and building) x $180,000 ($300,000 value - $120,000 basis))inherent gain on distribution and an equivalent basis step-up from$120,000 transferred Oppar inside basis to $240,000 ($200,000 purchase price for 2/3  of the land and building + $40,000 transferred basis for 1/3 ) for Propp. Propp has also paid $20,000 interest to Oppar, which is, of course, allocated to its partners, including Propp. The partners'capital accounts are each increased by the $40,000 for their shares of the gain on the disguised sale of two-thirds of the land and building+ $20,000 for excess of the $100,000 value of the remaining one-third over its $40,000 allocated basis).  Propp's capital account is reduced by the $100,000 value of the one-third that is not deemed purchased. The $220,000 purchase price plus interest does not affect her capital account, except for her allocable share of the interest.

Insofar as the distribution is attributable to the land, the IRS will cheerfully invoke the disguised sale rule. It may be more reluctant to do so for the building, because Oppar may be able to defer gain under the installment method while the basis step-up provides for depreciation that is offset against ordinary income for Propp beginning in 20X1. It will, of course, insist on disguised sale treatment if the gain to Oppar is ordinary income under § § 707(b) and 1239, because Propp owns more than 50% of Oppar.

If the refinancing of the land and building by Propp was dependent on Propp's achieving improved operational results that were dependent on her changing the operations of the land and building in a way that Munn and Surv had objected to as too risky and on economic conditions, the disguised sale provision probably does not apply, even though the contribution was made within two years, because satisfying these conditions is subject to substantial entrepreneurial and economic risk. Accordingly, Propp's basis in the land and building is the $120,000 transferred Oppar inside basis, reducing her outside basis in her Oppar interest to $480,000, which is subsequently increased to $700,000, by the $220,000 contribution.  There is no interest. The capital accounts of all three partners are increased by $60,000, one-third of the $180,000 inherent gain in the land and building, Propp's is then reduced by the $300,000 value, and is, of course, increased by the $220,000 contribution.

b. Liabilities 

The legislative history indicates that assumptions of liabilities encumbering transferred property are not to be considered indicative of sale treatment, unless the liabilities are incurred in contemplation of the transfer, or are due to be paid shortly after the transfer.704 Despite the general pass-through principle for partnerships,705 the disguised-sale-of property regulations do not address tiered partnerships, even though, presumably, qualified and nonqualified liabilities should flow through.706 The disguised-sale-to-partnership regulations presume liabilities incurred within two years of the contribution of the property are incurred in anticipation of the transfer,707 which are also applied the disguised-sale-by-partnership regulations to determine whether a property distribution is a disguised sale.708 Distributions made from proceeds of borrowing within 90 days of the borrowing, but with an adjustment for the contributing partner's share of the liability, are effectively included by both sets of regulations.709 The disguised sale is limited to the share of liability transferred to the other partners for disguised sales to partnerships,710 and from the other partners for disguised sales by partnerships.711 The partner's share of recourse liabilities is determined under the  § 752 regulations,712 but the share of nonrecourse liabilities is determined solely under the profit share provision, without adjustment of  § 704(c) minimum gain,713 or excess  § 704(c) gain.714 Since the disguised sale regulations rely on the definition of liabilities under  § 752 and the related regulations, the treatment of obligations715 that are not liabilities transferred716 in the disguised sale transaction is, implicitly, left to general tax principles.717
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704 See S. Rep. No. 169, 98th Cong. 2d. Sess. 230–31 (1984); 1984 Bluebook, at 231–32; PLR 9444004 (repayment of transferred qualified liabilities as soon as possible after transfer to partnership, and reimbursement of contributing partner for certain pre-formation expenditures not reduced by transferred liabilities, is not a disguised sale); PLR 9829027 (reimbursement of pre-formation expenditures incurred within two years before transfer, including partnership organization and syndication expenditures, is not a disguised sale).

705 Regs. § 1.752-4(a).

706 See Jackel &  Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 190–91(Jan. 15, 2007), for a discussion of tiered partnership issues.

707 Regs. § 1.707-5(a)(7).

708 Regs. § 1.707-6(b)(1).

709 Regs. § 1.707-5(b), (f) Ex. 10. See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 188–90 (Jan. 15, 2007), for a discussion of issues relating to debt-financed distributions.

710 Regs. § 1.707-5(a)(1), (5)(i).

711 Regs. § 1.707-6(b)(1).

712 Regs.  § § 1.707-5(a)(2)(i) and (f) Ex. 2;-6(b) and (d) Ex. 2;see II, D, 3, a, above, for a discussion of sharing recourse liabilities.

713 Regs.  § § 1.707-5(a)(2)(ii) and (f) Ex. 1 and-6(b) and (d) Ex. 2;see II, D, 3, b, above, for a discussion of sharing nonrecourse liabilities, including the role of  § 704(c) minimum gain and excess  § 704(c) gain. See Jackel and Walsh, “Disguised Sales Revisited,”114 Tax Notes 179, 195 (Jan. 15, 2007), for a discussion of problems and authorities dealing with taxpayer attempts to manipulate the nonrecourse liability allocation rule.

714 Regs. § 1.752-3(a)(3). The Preamble explains that this rule is adopted because, applying the allocation rules approach, there would be an inverse proportion between the inherent gain and the disguised sale.  T.D. 8906, 65 Fed. Reg. 64888, 64888-89 (10/31/00).

715 See II, D, 1, above, for a discussion of the meaning of liabilities and obligations.

716 See II, D, 2, above, for a discussion of the meaning of transfer.

717 See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 191–94 (Jan. 15, 2007), for a discussion of the controversy about how those principles apply to transfers of property, including partnership interests. See 718 T.M. Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, and 560 T.M., Income Tax Basis: Overview and Conceptual Assets, for a comprehensive treatment of these issues. See Manning &  Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities,” Part One, 11 Tax Mgmt. Real Est. J. 19;Part Two, 11 Tax Mgmt. Real Est. J. 35; Part Three, 11 Tax Mgmt. Real Est. J. 51; Part Four 11 Tax Mgmt. Real Est. J. 263 (1995), for a somewhat dated discussion of those general principles.

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As is the case for a disguised sale to a partnership,718 the transfer of a qualified liability with a transfer of property to a distributee partner's assumption of or taking subject to a qualified liability is not part of a disguised sale, unless the transfer is otherwise a disguised sale, in which case, the consideration for the disguised sale is limited by the partnership's net equity in the property. 719
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718 See 710 T.M., Partnerships —Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussion of the application of the disguised sale rules to contributions of property determined to be related to distributions.

719 Regs. § 1.707-6(b)(2)(i), (ii).

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The regulations elaborate on this by excluding “qualified liabilities” when the transaction does not otherwise involve a disguised sale.720 When the transaction otherwise involves a disguised sale, the transfer of the qualified liability becomes part of the disguised sale to the extent the liability is transferred to the other partners.721 Qualified liabilities are those: (i) incurred more than two years prior to the transfer, (ii) not incurred in anticipation of the transfer, (iii) incurred to finance capital expenditures on the property,722 or (iv) incurred in the ordinary course of a trade or business transferred.723 The disguised sale by partnership rules treat all partnership liabilities incurred by the partnership more than two years before the transfer as qualified, even if they do not encumber partnership property.724
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720 Regs. § § 1.707-5(a)(5) and (f) Ex. 5;-6(b) and-6(b).

721 Regs. § 1.707-5(a)(5), (f) Ex. 6;-6(b).

722 See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 184–88(Jan. 15, 2007), for a discussion of significant issues raised by the definition of such liabilities, including possible double counting.

723 Regs.  § 1.707-5(a)(6) and (e) Ex. 4 (trade payables as qualified liabilities), Ex. 5 (qualified liability as sole consideration, no disguised sale), and Ex. 6 (where other consideration, allocation). Others are presumed part of a sale. Regs.  § 1.707-5(a)(7) and (f) Ex. 7 (liabilities incurred in anticipation of transfer). Example 8 (same with gimmick attempts with other liabilities) and Ex. 9 (another gimmick playing games with additional consideration) and -6(b). The transferor is required to disclose liabilities considered to be qualified liabilities on a Form 8275 attached to the return for the year of the transfer. Regs. § § 1.707-5(a)(7)(ii), -8, and -6(c).

724 Regs. § 1.707-6(b)(2)(iii)(B). See preamble to the regulations, 57 Fed. Reg. at 44977 (9/30/92).

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Example: Transfer of Encumbered Property to Partner. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar transfers a  § 1231 asset to Propp. On the date of the transfer, the property has an inside basis of $400,000, a fair market value of $1,000,000 and is encumbered by a nonrecourse liability of $600,000. Propp takes the property subject to the liability. Oppar incurred the nonrecourse liability six months before transferring it to Propp, and used the proceeds to purchase an unrelated asset. Accordingly, the liability should not be a qualified liability. Propp's share of the liability immediately before the transfer of the property was $300,000. Oppar is treated as having received, on the date the property is transferred to Propp, $300,000 ($600,000 liability assumed by Propp less Propp's $300,000 share of the liability immediately before the transfer) as consideration for the sale of one-half ($500,000/$1,000,000)of the  § 1231 asset to Propp. Accordingly, Oppar realizes gain of $50,000 ($300,000 -$250,000 (1/2  of the inside basis)). The gain is allocated in accordance with the partners' shares of Oppar income, taking into account any changes in shares as a result of the distribution. Oppar is also treated as having distributed to Propp, in Propp's capacity as a partner, the other one-half of the  § 1231 asset. Propp's outside basis in the  § 1231 asset is $300,000 on the half deemed purchased, and the lesser of $250,000 or the outside basis of the Oppar interest immediately before the distribution for the other half. Although Propp is deemed to receive a distribution of her one-half share of the liability, she is also deemed to make a simultaneous contribution of the same one-half share because she has assumed the liability, so that the liability transfers do not affect outside basis. The other one-half of the liability is not a partnership distribution or contribution, but the purchase price of one-half of the  § 1231 asset.

If the proceeds of the nonrecourse liability are used for capital improvements to the  § 1231 asset, it is a qualified liability. The transfer subject to the nonrecourse mortgage is not a disguised sale. Accordingly, neither Oppar nor Propp recognizes gain on the distribution, Propp's outside basis increases by the transfer of the $300,000 portion of the nonrecourse liability in excess of her predistribution share, and her basis in the  § 1231 is the lesser of Oppar's$500,000 inside basis or her outside basis, as increased.

2. Disguised Sales of Partnership Interests 

When a contribution by one partner, usually a new partner, is followed, or preceded, by a distribution to another partner, the transaction can be recharacterized as a disguised sale of a partnership interest, usually a sale of part of the interest.725 A key factor for using a distribution rather than a sale is a desire by the distributee to apply the entire basis of the partnership interest against what may be considered consideration for only part of the interest. Two of the major cases that the legislative history for the disguised sale provisions indicated an intent to overrule, Communications Satellite Corp. v. U.S. and Jupiter Corp. v. U.S.,726 involved unsuccessful IRS claims, under Regs. § 1.731-1(c)(3), of a disguised sale of a partnership interest. Nevertheless, the initial 1991 disguised sale regulations covered only disguised sales of property between a contribution partner and the partnership or between a partnership and a distributee partner.727
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725 § 707(a)(2)(B).

726 Communications Satellite Corp. v. U.S., 625 F.2d 997 (Ct. Cl. 1980) (no disguised sale by founding members who received distributions of part of their contributions when new members joined and made contributions that were under a formula designed to put the new members in the same position as if they were original members, so that the arrangement seems more like a reimbursement of a temporary investment than a sale); Jupiter Corp. v. U.S., 2 Cls. Ct. 58, 83-1 USTC ¶ 9168 (1983) (no disguised sale when funds provided by new limited partners distributed to general partner; different types of interests made it difficult to see how there was a “sale” of a partnership interest that the withdrawing partner did not own); see 1984 Bluebook, at 225–26; PS-163-84, 56 Fed Reg. 19055 (4/25/91).

727 Regs. § § 1.707-3 to-5 (disguised sale of property by the partner to the partnership), and -6 (disguised sale of property by the partnership to the partner).

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Proposed regulations dealing with disguised sales of partnership interests were issued in late 2004,728 reflecting responses to an earlier request for comment,729 and, apparently, motivated in part by the Enron scandal.  The proposed regulations, which had received significant criticism, were withdrawn in early 2009.730
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728 REG-14519-03, Section 707 Regarding Disguised Sales, Generally, 69 Fed. Reg. 68838 (11/26/04).

729 Notice 2001-64, 2001-2 C.B. 316; see Chicago Bar Comments, 2002 TNT 78-20.

730 REG-1458512-03, Withdrawal of Notice of Proposed Rulemaking, 74 Fed. Reg. 3008 (1/21/09).

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Since the proposed regulations generally followed the principles and approach of the regulations dealing with disguised sales of property by partners to partnerships and by partnerships to partners,731 since major portions of withdrawn proposed regulations not infrequently reappear in a later proposal, and since the withdrawal notice, like the preamble to the proposed regulations,732 states that until new guidance is issued, whether a transaction is a disguised sale of a partnership interest will be based on the “statutory language, guidance provided in the legislative history, and case law,” the discussion of disguised sales of partnership interests that follows will refer to the now withdrawn proposed regulations when appropriate, particularly since there is no authority that provides useful guidance on disguised sales of partnership interests.
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731 Regs.  § § 1.707-3 to -6. See 710 T.M., Partnerships — Conceptual Overview, for discussions of these regulations.

732 See preamble to REG-14519-03, 69 Fed. Reg. 68838 (11/26/04)stating that until the (now withdrawn) proposed regulations become effective, taxpayers were directed to determine the disguised sale treatment for a partnership interest by referring to the legislative history of § 707(a)(2)(B).

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The major complication in dealing with a disguised sale of a partnership interest is that a disguised sale of a partnership interest involves three parties—the partnership, the disguised seller and the disguised purchaser—in contrast to the other disguised sale situations that involve only two—the partnership and the partner that is determined to be a disguised seller or purchaser. In addition, since contributions to and distributions by partnerships are common occurrences, distinguishing between disguised sales and independent transactions requires greater care.

The proposed regulations used a convoluted definition of “sale”of a partnership interest that should not be repeated in the next version since this basic definition needed to be pieced together as a transfer of money, property or other consideration (including the assumption of a liability by a partner (purchasing partner)733 to a partnership and a transfer of consideration by the partnership to another partner,734 and is treated as a sale and not a contribution-distribution,735 only if, considering the facts and circumstances, the transfer of consideration by the partnership to the selling partner would not have been made without the transfer to the partnership by the purchasing partner, and, if not simultaneous, the subsequent transfer is not subject to entrepreneurial risks.736 In short, there is a disguised sale when there is a distribution to a partner coupled with a contribution by an existing or new partner that would not have been made without the shift in partnership interests.  When the transaction is classified a disguised sale of the partnership interest, it should be treated as a sale for all income tax purposes.737 The sale should take place on the earlier of the contribution or the distribution, when they are not simultaneous,738 with appropriate adjustments for the time value of money in the interim.
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733 The final regulations issued in 2005 concerning the assumption of partner “liabilities,” omit a provision of the proposed regulations that stated that the assumption of the § 1.752-7 liability was not an assumption for purposes of  § 707(a)(2)(B) in response to a comment suggesting that it was inconsistent with Prop. Regs.  § 1.707-5(a)(2) which takes into account all “liabilities,”even if not liabilities under § 752. Preamble, 70 Fed. Reg. 30334, 30339 (5/26/05).  See II, D, above, for a discussion of the treatment of obligations transferred by partners to partnership in a nonrecognition transactions, III, G, below, for a discussion of the effect on the contributing partner when such obligations are assumed by another partner, and IV, A, 3, below, for a discussion of the effect of such obligations when the contributing partner receives a liquidating distribution.

734 See former Prop. Regs. § 1.707-7(a)(1).

735 See former Prop. Regs. § 1.707-7(a)(2)(i).

736 See former Prop. Regs. § 1.707-7(b)(1).

737 See former Prop. Regs. § 1.707-7(a)(2)(i)

738 Former Prop. Regs. § 1.707-7(a)(2)(ii).

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a. Disguised Sale Factors 

The proposed regulations contained a list of factors that are “among”those “that tend to prove” there is a disguised sale of a partnership interest, three of which are essentially identical to those for disguised sales of property,739 properly focused on certainty of, or legally enforceable rights to, the contribution and distribution. Others focused on tracing of contributed and distributed property,740 and on negotiations between the disguised seller and the disguised purchaser,741 which seem likely to reappear.742 The negative of the factors should be evidence against finding a disguised sale, but the “among” in the proposed regulations leaves open the possibility that there is a disguised sale even when none of the listed factors is present. The proposed regulations, of course, do not provide this, or any other indication, of factors that can be relied on to show no disguised sale. The handful of IRS guidance since adoption of the disguised sale of property regulations that have addressed disguised sale of partnership interests, have all found a disguised sale.743 Accordingly, there is little available guidance on how to avoid having a disguised sale of a partnership interest.  Despite the different context, the withdrawn proposed regulations retained the presumption found in the disguised sale of property regulations discussed above that contributions and distributions within two years are part of a disguised sale, but not those more than two years apart,744 another factor that may well reappear, and that probably should be taken into account in the meanwhile.
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739 Compare former Prop. Regs. § 1.707-7(b)(2)(i), (ii), (vi) and (vii), with Regs. § 1.707-3(b)(2)(i), (ii), (ix) and (x).

740 See former Prop. Regs. § 1.707-7(b)(2)(iii),(iv), and (v). The roughly equivalent factors in the disguised-sale-to-partnership regulations focus for disguised sales of property on financing the distribution. Regs. § 1.707-3(b)(2)(iii), (iv), (v), (vi), and (vii).

741 See former Prop. Regs. § 1.707-7(b)(2)(ix) and (x). This reflects the three party nature of the disguised sale of a partnership interest and has no direct counterpart in the disguised sales of property regulations, except to the extent that those in Regs.  § 1.707-3(b)(2) can be considered to reflect direct negotiations between the partner and partnership related to the property.

742 One focused on whether the contribution or distribution is not pro rata. See former Prop. Regs. § 1.707-7(b)(2)(viii). The significance of this factor did not leap out at the author. If it reappears, perhaps there will be an explanation.

743 See TAM 200301004 (fact pattern similar to Communications Satellite, the name of which, amusingly, is redacted in all but one place; finds absence of regulations no bar to finding disguised sale, relying on statute and legislative history); TAM 200037005 (complex “reconfiguration”of a partnership into an UPREIT in which nonrecourse lender to the partnership of funds that had been loaned to the partners, ended up with an interest in the partnership, and the loans to the original partners were cancelled, was a disguised sale); CCA 200250013 (distribution of all operating assets to a withdrawing partner that assumed all partnership liabilities including a loan, the proceeds of which had been used to acquire a note issued by an LLC that used the proceeds to buy interests in a securitization trust, that was distributed to other partners treated as disguised sale of property in preference to treating it as disguised sale of partnership interest; note treated as marketable security, even though not traded, that was distributed to other partners); FSA (unnumbered, 11/12/1993) 1993 WL 1460189 (although facts impossible for the author to understand because of redactions, states that a loan and option transaction was a disguised sale of partnership interest, subject to further development of facts); 2002 NSAR 20044 (finds attempted dissolution of partnership and purported like-kind exchange of its assets was disguised sale of partnership interests, because the partners continued to operate the partnership business after the dissolution and before the exchange, so that there was still a tax partnership).

744 See former Prop. Regs. § 1.707-7(c) and (d).

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All examples in the withdrawn proposed regulations (except one illustrating the liquidation exception) illustrated the application of the disguised sale provision, and did not address considerations in determining whether there is a disguised sale; all, including the one relating to the liquidation exception, simply assumed that there were no facts or circumstances that might be contrary to the disguised sale presumption for simultaneous transfers or those within two years (the events in the two examples that were not simultaneous were within the two-year period).

The withdrawn proposed regulations contained an important exception for money (including marketable securities treated as money) transfers in service partnerships745 that were apparently exempt from the two-year presumption and the reporting requirements.746 The author hopes the IRS will not attack such transactions even though there is no other authority supporting it that he is aware of. There is also a surprisingly generous one for money (and marketable securities) distributions in complete liquidation of partnership interests,747 which are exempt from the two-year presumption but remained subject to classification as a disguised sale of partnership interest if the circumstances clearly establish a sale. Again, one can only hope that such transactions will not be attacked. There was also an exception for guaranteed payments, preferred returns and operating cash flow distributions that incorporates the similar one for disguised sales of property,748 so that its principle should apply at least until there are new proposed regulations.
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745 See former Prop. Regs. § 1.707-7(g).

746 See Preamble, 69 Fed. Reg. 68838, 68841 (11/26/04).

747 See former Prop. Regs. § 1.707-7(e) and (l) Ex. 6. This may reflect that the distributions were to continuing partners in both Communications Satellite Corp. v. U.S., and Jupiter Corp. v. U.S..

748 See former Prop. Regs. § 1.707-7(f) incorporating Regs. § 1.707-4; see 710 T.M., Partnerships—Conceptual Overview, for a discussion of the application of this exception to disguised sales of property.

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The withdrawn proposed regulations also generally followed the approach to the treatment of liabilities of the regulations for disguised sales of property.749 Reallocations of liabilities among partners were, however, not contributions or distributions as transfers of consideration unless the transaction is otherwise a disguised sale of a partnership interest.750 There is no special treatment of qualified liabilities, with the stated reason that this is because the transaction has to be otherwise a disguised sale for the liability transfer to be relevant.751 Given their close relation to the disguised-sale-of-property regulations, these principles should continue to apply.  There was, of course, an anti-abuse rule that basically applied step-transaction principles.752 The warning of this anti-abuse provision should not be ignored.
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749 See former Prop. Regs. § 1.707-7(j)and (l) Ex. 8 (nonrecourse liabilities) and Ex. 9 (recourse liabilities); see 710 T.M., Partnerships—Conceptual Overview, and 711 T.M., Partnerships—Formation and Contributions of Property or Services, for discussions of the treatment of liabilities in disguised sales of property.

750 See former Prop. Regs. § 1.707-1(j)(1).

751 See Preamble, 69 Fed. Reg. 68838, 842 (11/26/04).

752 See former Prop. Regs. § 1.707-7(j)(8). No example illustrates the application of the anti-abuse provision.

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b. The Disguised Sale 

It is easy to see a disguised sale of a partnership interest in the simple case of simultaneous transfers of the same type of consideration to the partnership by a contributor and from the partnership to the partially withdrawing partner, the sale of the partnership interest is treated as being directly between the disguised seller and disguised purchaser.  This result is easily reached without the withdrawn proposed regulations, but, of course it is confirmed by them.753 Although the withdrawn proposed regulations find a disguised sale when the transfers are simultaneous, the consideration is different, even though this classification is far from obvious.  In some ways this resembles the Communications Satellite and Jupiter cases, where the courts found no disguised sales, but the legislative history indicates an intention to overrule the courts.  Accordingly, a disguised sale is probable.  It is here that the withdrawn proposed regulations begin to become difficult and complex.  They provide that what the disguised purchaser contributes is treated as consideration for what the disguised seller receives, transferred directly between them when the consideration is the same.754 When the consideration is not the same, it is routed through the disguised purchaser. This routing properly taxes the partnership on any property received by the distributee/disguised seller from the partnership, and the distributee/disguised seller on ratable gain on the partnership interest deemed sold, but may also tax the contributor/disguised purchaser on property contributed to and retained by the partnership.755 This result of the routing is questionable and may be one of the reasons for the withdrawal. The author believes it should not be applied in the absence of the proposed regulations.
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753 See former Prop. Regs. § 1.707-7(a)(2)(ii)(B)and (l) Ex. 1 and Ex. 4 (more than one purchasing partner).

754 See former Prop. Regs.  § 1.707-7(a)(2)(ii)(B)and (l) Ex. 2 and Ex. 4 (more than one purchasing partner).

755 See former Prop. Regs. § 1.707-7(l) Ex. 3.

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In all cases, the sale occurs on the date of the earliest event.756 By an oblique reference to  § § 483 and 1274, under the withdrawn proposed regulations, and probably under general tax principles, there is apparently imputed interest in nonsimultaneous transfers.757
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756 See former Prop. Regs. § 1.707-1(a)(2)and (l) Ex. 2.

757 See former Prop. Regs. § 1.707-1(a)(2)(E). Neither of the Examples involving nonsimultaneous transfers illustrates this. Although the first, former Prop. Regs. § 1.707-7(l) Ex. 2, involves transfers only two months apart, which is less than the six-month period for original issue discount, § 1274(c), or the one-year period for imputed interest, § 483(c), the second, former Prop. Regs. § 1.707-7(l) Ex. 5, has transfers more than 10 months and more than one year apart, but treats the full future amount as the current amount.

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When property is considered transferred between the partnership and the disguised purchaser, the withdrawn proposed regulations applied the disguised-sale-of-property rules,758 even when the partnership was considered terminated.759 There are no disguised sales of partnership interest on initial formation of a partnership or as a result of deemed transfer on partnership termination,760 but presumably a disguised sale of 50% or more interest in capital and profits can result in a partnership termination.761 These sensible rules should continue to apply, even in the absence of proposed regulations.
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758 See former Prop. Regs. § 1.707-1(a)(6) and (l) Ex. 7.

759 See former Prop Regs. § 1.707-7(a)(7).

760 See former Prop. Regs. § 1.707-7(a)(8).

761 See IV, F, 1, below, for a discussion, and 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of when a sale or exchange of partnership interests may result in a termination of the tax partnership.

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For nonsimultaneous distributions that precede contributions, the disguised purchaser of a partnership interest was treated as having undertaken an obligation the date of the distribution to deliver the subsequent contribution as consideration for the distribution to the selling partner that is treated as the disguised purchase price paid by the disguised purchaser,762 presumably with gain recognized for any in-kind consideration. Although not expressly stated, the selling partner presumably recognizes gain on the partnership interest on the date of the distribution, but the purchasing partner should not recognize gain on the in-kind contribution until the property is transferred in satisfaction of the obligation. When the order is reversed, the contribution is consideration for an obligation to deliver the partnership interest, with what the disguised seller receives still routed through the disguised purchaser.763 In this case, the gain on the in-kind contribution may be realized on the date of the contribution because the partnership's obligation to make the distribution to the selling partner that the purchasing partner subsequently transfers to the partnership seems to be property rather than a deferred payment obligation that is not immediately taxable to a cash-method taxpayer. The selling partner realizes gain when the distribution is made.
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762 See former Prop. Regs. § 1.707-7(a)(2)(ii)(C).

763 See former Prop. Regs. § 1.707-7(a)(2)(ii)(D).

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When the amounts of the contribution and distribution differ, the sale price is the lesser of the two,764 with normal contribution or distribution rules applying to the excess. When the transactions are simultaneous, there is no problem of timing—the excess contribution or distribution also occurs at the same time as the sale. When the distribution is the greater amount, and is later than the sale (the date of the contribution), the consequences of the distribution under  § 731 are determined as of the date of the actual distribution.765 There is no express provision to cover when the contribution is the greater amount, but is later than the distribution (the date of the sale), but the  § 721 consequences should be delayed until the actual contribution. Since nonrecognition contributions have few significant collateral consequences, the actual date of contribution may not make much difference.
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764 See former Prop. Regs. § 1.707-7(a)(3) and (l) Ex. 2.

765 See former Prop. Regs. § 1.707-1(a)(5) and (l) Ex. 2.

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Neither the provisions of the proposed regulations, nor any of the examples, addressed how to determine what is involved in the disguised sale when there are differences in classes of partnership interest, for example general and limited partnership interests,766 differences between shares of capital and shares of profits, special allocations, or other differences. Instead, all the examples seem to assume a single class of interest with values consistent with capital accounts.767 If a disguised sale is found in such circumstances, the sale consequences should probably be confined to the interest disposed of by the distributee/disguised seller,768 and to any partnership property received that is attributable to the interest disposed of.769
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766 See Jupiter Corp. v. U.S., 2 Cls. Ct. 58 (1983).

767 See II, D, 3, and 4, for discussions of the allocation of basis among classes of interest to reflect the effect of liability shares.

768 See 718 T.M., Partnership —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the sale part of a partnership interest.

769 See III, G, 1, above, for a discussion of disguised sales of property by partnerships to partners.

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Despite the presumption that transactions more than two years apart are not disguised sales, the withdrawn proposed regulations would have required  expanded disclosure under Regs.  § 1.707-8 of contributions and distributions within seven years that are not treated as sales.770 There were similar proposed extensions to seven years of disclosures for disguised sales of property by partners,771 for liabilities incurred or assumed,772 and for disguised sales of property by partnerships.773 These expanded disclosures, including those not related to disguised sales of partnership interests disappeared with the withdrawal of the proposed regulations, with no indication of any intention to deal with them separately.
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770 See former Prop. Regs. § 1.707-7(k)and -8(a). A form of disclosure statement for a liquidating distribution is included in the working papers for 718 T.M., Partnerships—Disposition of Partnership Interests or Partnership Business; Partnership Termination.

771 See former Prop. Regs. § § 1.707-3(c)(2)and -8(a).

772 See former Prop. Regs. § § 1.707-5(a)(7)(ii)and (8), -8(a).

773 See former Prop. Regs. § § 1.707-6(c), -8(a).

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As discussed in connection with the disguised sale of property by partnerships, the treatment of obligations that are not liabilities in a disguised sale of property is unclear.774 On the other hand, when there is a disguised sale of all or part of partnership interest of a  § 1.752-7 partner,775 the results should be the same as for an actual sale—a reduction in the  § 1.752-7 liability partner's basis by the  § 1.752-7 liability reduction, and, in the case of a disguised sale of a part of the interest, a ratable reduction.776
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774 See Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179, 191–94 (Jan. 15, 2007) for a discussion of the controversy about how those principles apply to transfers of property, including partnership interests.

775 See II, D, above, for a discussion of the treatment of obligations transferred by partners to partnership in a nonrecognition transactions; III, H, below, for a discussion of the effect on the contributing partner when such obligations are assumed by another partner; and IV, A, 3, below, for a discussion of the effect of such obligations when the contributing partner receives a liquidating distribution.

776 Regs.  § 1.752-7(e)(1) and (b)(7).  See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the sale of the partnership interest of a  § 1.752-7 liability partner before satisfaction of the  § 1.752-7 liability.

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Example: Disguised Sale of Partnership Interest. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar, that is not a service partnership. The Oppar partnership agreement satisfies the special allocation regulations. Munn's Oppar interest has a current value of $200,000 and an outside basis of $100,000. Munn wants to reduce his interest to one-fifth, with a payment of$100,000 to compensate for the reduction. If Oppar distributes $100,000 as a current distribution, the distribution reduces the outside basis of his Oppar interest to zero, but does not result in gain.

If Munn sells half of his Oppar interest to Perch for $100,000, however, Munn recognizes $50,000 of gain. Perch succeeds to a ratable portion of Munn's capital account (since the special allocation regulations apply). If Munn's capital account equals his $100,000 outside basis, Perch's capital account is increased by $50,000 and Munn retains a$50,000 capital account. There is no inside basis adjustment unless a  § 754 election applies. If Oppar does not have the cash, or for any other reason, Munn or Oppar arrange a contribution by Perch of $100,000 in capital to Oppar for a one-sixth interest, with an equivalent amount distributed to Munn, he avoids the gain, if the distribution is respected. There is no real cost for Perch, because, although there is no inside basis adjustment for Perch's benefit on a contribution, even if a  § 754 election applies, Perch achieves the same result when a reverse  § 704(c) adjustment is made, since all of the inherent gain is allocated to Propp, Munn and Surv. If the transaction is a disguised sale, Perch's capital account is increased by a transfer of $50,000 from Munn's capital account, not by her $100,000 “contribution.”

If the distribution to Munn is within two years of Perch's contribution, Munn's hope to avoid disguised sale treatment was almost certain to fail under the withdrawn proposed regulations, because of the two-year presumption. In the absence of the proposed regulations, the analysis becomes one of the facts and circumstances, presumably even if there is more than a two-year gap between the transactions, but the greater the period of time, the less likely it is that a disguised sale should be determined to occur. The stated facts do not include any of the factors that were listed in the withdrawn proposed regulations as indicating a disguised sale, but if any are present, a disguised sale becomes more likely. It might be helpful, if Munn is a general partner and Perch is a limited partner, or the reverse, but if they have the same allocations of Oppar income and capital and of liabilities, the difference in class may not be enough. Even if there are differences, the principles for applying the unitary basis and allocation of liabilities to sale of a part of an interest may be able to be used to determine the interest sold.

If the value of the interest received by Perch and the value of the interest surrendered by Munn are determined on different dates, and the nature of Oppar's operations is such that the value on the second date could not be predicted on the first, the “entrepreneurial risk” should be enough to avoid a disguised sale.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  III. Current Distributions

H. Assumption of § 1.752-7 Liability by Another Partner 

When a  § 1.752-7 liability is assumed by another partner,777 usually in connection with a current or liquidating distribution,  § 704(c)(1)(B) does not apply to allow the  § 1.752-7 liability partner a deduction,778 but the assumption by any other partner results in a basis reduction (or capital loss) for the  § 1.752-7 liability partner, when still a partner, at the time of the transfer of the obligation, that is, when the  § 1.752-7 liability partner has not sold the interest or received a liquidating distribution.779 Although accelerating the deduction under the principle of Commercial Security Bank, Inc. v. Comr.,780 and the regulations providing that transfer of an obligation as part of the sale of a trade or business satisfies the economic performance requirement,781 would achieve similar results in eliminating the loss, it would also accelerate the underlying deduction for the § 1.752-7 liability partner, giving the result the regulations consider to be improper. Although this acceleration is permitted for transfers of such an obligation in connection with a trade or business, the concern is with transactions that appear to have a tax benefit, but no business purpose.
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777 See II, D, 4, above, for a discussion of the basis adjustment for the  § 1.752-7 liability partner when the  § 1.752-7 liability is assumed by another partner, usually as part of a distribution.

778 Regs. § 1.752-7(g)(1), (5) Ex. (ii).

779 Regs. § 1.752-7(g)(2), (5) Ex. (ii).

780 See Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981) (accrued interest and accounts payable of cash basis bank deductible on sale under former § 337);see 710 T.M., Partnerships — Conceptual Overview, for a discussion of the application of the Commercial Security principle.

781 Regs. § 1.461-4(d)(5).

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The  § 1.752-7 liability partner's outside basis is reduced by the “§ 1.752-7 liability reduction,”782 that is, the lesser of: (i) the excess of the  § 1.752-7 liability partner's outside basis over the adjusted value of the partnership interest,783 that is, the value of the partnership interest, as increased for the  § 1.752-7 liability partner's liability share,784 or (ii) the remaining built-in loss associated with the  § 1.752-7 liability(after adjusting for any amounts already taken into account under the  § 704(c) adjustment).785 The basis reduction eliminates the potential artificial loss from the reduction in the value in the partnership interest resulting from the  § 1.752-7 liability that, because it is not a tax liability, would not be included in the amount realized on disposition of the partnership interest. The effect is also to postpone the deduction of the remainder of the obligation until “satisfaction” of the  § 1.752-7 liability.786 If, when, and to the extent that,  the assuming partner satisfies the  § 1.752-7 liability, the deduction is allowed to the  § 1.752-7 liability partner(even though the  § 1.752-7 liability is no longer a partnership obligation), but only if the assuming partner notifies the partner of satisfaction.787 The onus is on the  § 1.752-7 liability partner to arrange for notice, on admission or otherwise.788 The character of the deduction for the  § 1.752-7 liability partner is the same as if the  § 1.752-7 liability partner had satisfied the obligation, to the extent that the assuming partner would otherwise have taken the satisfaction into account, but any excess of the  § 1.752-7 liability over that amount is a capital loss for the  § 1.752-7 liability partner at the time of satisfaction.789 The same result applies in the unlikely event the  § 1.752-7 liability is settled for less than its full amount (which is determined on an after-tax, discounted value basis), the  § 1.752-7 liability partner's deduction is limited to the amount paid in satisfaction, and the  § 1.752-7 liability partner has a belated loss on the partnership interest for the excess of the § 1.752-7 liability reduction over the deduction for the satisfaction.790
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782 Regs. § 1.752-7(g)(2), (b)(7).

783 Regs. § 1.752-7(b)(7)(i)(A).

784 Regs. § 1.752-7(b)(2).

785 Regs. § 1.752-7(b)(7)(i)(B).

786 Regs. § 1.752-7(a).

787 Regs.  § 1.752-7(g)(2) and (5) Ex. (iii), (b)(8), and (h).

788 The preamble to the final regulations rejects a suggestion that the regulations should require the partnership to give the notice. T.D. 9207, 70 Fed. Reg. 30334, 30340 (5/26/05). The preambles to T.D. 9207 and to REG-106736-00 relating to the proposed regulations are included in the working papers to 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

789 Regs. § 1.752-7(g)(2).

790 Regs. § 1.752-7(g)(2), (5) Ex. (ii).

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The partnership is not allowed any deduction or capital expenditure for the payment when the  § 1.752-7 liability is satisfied.791 Reflecting the fact that partnership assets will not be reduced to discharge the  § 1.752-7 liability, the remaining built-in loss is treated as a reduction in inside basis of partnership assets immediately after its assumption by the other partner, determined and allocated as provided under § 734(b), as if a  § 754 election applies (apparently meaning no such election is required),792 which reflects the partnership's eliminating an obligation without the effect on partnership inside basis that would have resulted from a money payment.  On the other hand, if a § 754 election applies, there may be an adjustment for any excess of the inside basis of property distributed to the assuming partner over the outside basis of the assuming partner's interest.793
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791 Regs. § 1.752-7(g)(3), (5) Ex. (ii).

792 Regs. § 1.752-7(g)(3), (5) Ex. (ii).

793 Regs.  § 1.752-7(g)(5) Ex.(ii).

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The assuming partner, of course, is not entitled to any deduction on satisfaction of the  § 1.752-7 liability to the extent of the remaining built-in loss (or, if less, the amount paid in satisfaction), but, in effect, capitalizes the payment, to that extent, into the basis of the partnership interest, and assets(other than money, inventory or receivables) distributed with the § 1.752-7 liability, or adjusts gain or loss on the partnership interest, as the case may be, computed as if the adjustment had applied at the time of the original assumption.794 These adjustments for the partnership and the assuming partner are, apparently, designed to parallel those that would apply if the  § 1.752-7 liability had not been transferred by the partnership, and must be made whether or not the  § 1.752-7 liability partner was still a partner at the time of the assumption. Although the regulations do not say it, the assuming partner should be entitled to deduct any excess of amounts paid to satisfy the  § 1.752-7 liability over the built-in loss, which is not covered by the regulation, as the appropriate result when an obligation that is not a liability is transferred in a nonrecognition transaction.795
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794 Regs. § 1.752-7(g)(4), (5) Ex. (iii). The preamble to the proposed regulations justifies this on-satisfaction adjustment as being equivalent to a cash contribution by the assuming partner to the partnership.  68 Fed. Reg. 37434, 37437.

795 Regs. § 1.752-7(g)(4). See Rev. Rul. 88-77, 1988-2 C.B. 128 (transferee deduction when satisfies obligation); Rev. Rul. 80-198, 1980-2 C.B. 113 (same); Rev. Rul. 95-74, 1995-2 C.B. 36 (same, whether obligation deductible or capitalizable; Manning and Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Two),” 11 Tax Mgmt. Real Est. J. 35, 41–42 (1995).

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There are two exceptions to the application of the rules discussed in the preceding paragraphs. Under the regulations they do not apply: (i) when the assumption of the  § 1.752-7 liability by the partnership is in connection with the contribution of a trade or business;796 or (ii) if immediately before the testing date, the sum of all  § 1.752-7 liabilities(other than those under the trade or business exception) assumed by the partnership in one or more  § 1.752-7 liability transfers is less than the lesser of 10% of the gross value of partnership assets or $1,000,000.797 Although the testing date is the date of the assumption of the  § 1.752-7 liability by another partner, the standards still seem to apply at the partnership level, and not to whether the  § 1.752-7 liability is transferred as part of a trade or business or is less than the de minimis amount.  Although using a partnership-level determination for the de minimis exception may make sense, it is less justifiable for those associated with a trade or business in view of the exclusion of such liabilities in § 358(h)(2), even though there is regulatory authority for the exclusion.
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796 See II, D, 4, b, above, for a discussion of this exception.

797 Regs. § 1.752-7(d)(2)(i).

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Example: Distribution of § 1.752-7 Liability to Another Partner. Munn, Propp and Surv have equal(one-third) shares in profits and losses of a business partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. When Oppar was formed, each of Munn and Surv contributed$2,000,000, and Propp contributed $4,000,000, but subject to deferred compensation obligations that have nothing to do with Oppar's business(so that they are  § 1.752-7 liabilities), aggregating $8,000,000, but that have a fair market value of only$2,000,000, reflecting the value of the inherent deduction and the discount for the time value of money until the deferred payments are due. Accordingly, each partner had an initial capital account of $2,000,000(since under the regulations Propp's capital account is reduced for the  § 1.752-7 liability). Her initial outside basis was $4,000,000, as the deferred compensation obligation does not offset the basis of the contributed property. If she remains a partner, this book-tax disparity will be eliminated by allocations to her under  § 704(c) of the Oppar deduction as the deferred compensation deduction is satisfied.

Oppar now has assets worth $11,880,000 including Tangible Assets, none of which are  § 751 property, with an inside basis and book value of$10,800,000, and unrealized appreciation in the Tangible Assets of$1,080,000, leaving $720,000 as a residual allocation to  § 197 intangibles, presumably, goodwill and going concern value. The inside basis and book value reflect $1,950,000 of book net income (allocated $650,000 to each), determined without deducting $350,000 paid to satisfy a portion of the deferred compensation obligation that was treated as payment of the corresponding book (but not tax) liability. The $350,000 tax deduction was allocated to Propp under § 704(c). Oppar owes bank loans and accrued liabilities of $1,200,000, and the $1,650,000 balance of the book deferred compensation obligation. Propp's capital account is now $2,650,000 including her allocable share of the Oppar income, as are those of her partners. The outside basis in her Oppar interest is now $4,700,000 ($4,000,000 contribution + $650,000 share of Oppar profits - $350,000 allocation of the deferred compensation deduction + her $400,000 share of the Oppar liabilities). The outside basis of Munn's and Surv's Oppar interests are $3,050,000 ($2,000,000 contribution + $650,000 share of Oppar profits + $400,000 share of Oppar liabilities). Even though the remaining built-in loss for the deferred compensation obligation is $1,650,000($2,000,000 on contribution - $350,000 satisfied), the value of the remaining deferred compensation obligation is $1,800,000, because the payment dates are now closer than at the time of contribution.

Accordingly Oppar's balance sheet is:
Assets	Tax	Book	Value	
Tangible Assets	$10,800,000	$10,800,000	$11,880,000	
§ 197 Intangibles	         -0-	         -0-	   720,000	
 	
Totals	$10,800,000	$10,800,000	$12,600,000	
 	
 	Tax	Book	Value	
Bank Loan &  Accr. Liab.	$1,200,000	$1,200,000	$1,200,000	
Deferred 
 Compensation	-0-	1,650,000	1,800,000	
Munn Capital	2,650,000	2,650,000	3,200,000	
Propp Capital	4,300,000	2,650,000	3,200,000	
Surv Capital	2,650,000	2,650,000	3,200,000	
 	
Total	$10,800,000	$10,800,000	$12,600,000	

Oppar makes a current distribution to Munn in connection with reducing his interest from one-third to one-fifth that consists of Tangible Assets worth $3,400,000 with a basis of$3,000,000, subject to the $1,800,000 deferred compensation obligation, including the $1,650,000 built-in loss, for a net distribution of$1,600,000 ($3,400,000 Tangible Assets - $1,800,000 deferred compensation obligation (of which $1,650,000 is the  § 1.752-7 liability)). Oppar agrees to indemnify Munn for his $400,000 share of the $1,200,000 Oppar liabilities. As a result, the outside basis of Propp's Oppar interest is increased by $80,000 to reflect the increase in her share of Oppar's $1,200,000 liabilities from one-third ($400,000) to two-fifths($480,000) as a result of Munn's reduction in his share of Oppar liabilities, and is then reduced under Regs.  § 1.752-7(g) by the $1,650,000 remaining built-in loss to $3,130,000, but, because she has not engaged in any recognition transaction, the outside basis reduction has no immediate consequences. It will, of course, increase gain or reduce loss on a subsequent taxable disposition of her Oppar interest, or reduce the basis of distributed property on a subsequent in-kind distribution. Oppar also reduces its remaining $7,800,000 ($10,800,000 - $3,000,000)basis in Tangible Assets by the $1,650,000 built-in loss (that it will now never pay) to $6,150,000 whether or not a  § 754 election applies. Munn's$3,050,000 outside basis is reduced by $400,000, his share of the Oppar liabilities, to $2,650,000 (which, not coincidentally, equals his capital account), but is not increased for the deferred compensation obligation.  Accordingly his basis in the distributed property is$2,650,000, and, when a  § 754 election applies, Oppar can increase the basis of its remaining Tangible Assets by $350,000 ($3,300,000 - $2,650,000) to $6,500,000.

When Munn pays $1,650,000 to satisfy part of the deferred compensation obligation, Propp, not Munn, is entitled to the deduction if Munn gives Propp the notice, but Munn is entitled to increase the outside basis of the Oppar interest by that amount. Again, although the regulations do not say it, if Munn pays $4,000,000 to satisfy the deferred compensation obligation, Munn should be entitled to deduct the $2,350,000 excess of amounts paid to satisfy the obligation over the $1,650,000 built-in loss. If Munn settles the deferred compensation obligation for $1,000,000, Propp's deduction is limited to $1,000,000 and she has a $650,000 increase ($1,650,000 built-in loss –$1,000,000 satisfaction deduction)  in her outside basis.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

Because of the pass-through nature of a partnership, it may be unclear whether a disposition of a partnership interest represents (i) a retirement or withdrawal from the partnership, (ii)a sale of the withdrawing partner's interest to the remaining partners or, (iii) when there is a contribution by a new partner close in time, a disguised sale to the new partner. The basic economic consequences are similar in that the withdrawing partner receives money or other consideration and terminates or reduces the interest in the partnership, but the classification can have significant tax consequences. Because of the pass-through nature of a partnership, it may be unclear whether a withdrawal transaction is a retirement from the partnership or a sale of the withdrawing partner's interest to the remaining partners under § 741.798 The Introduction of this portfolio contains a discussion of distinguishing between a withdrawal and a sale to the other partners.799
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798 See Foxman v. Comr., 41 T.C. 535 (1964), acq., aff'd 352 F.2d 466 (3d Cir. 1965) (withdrawal treated as sale based on terms of agreement); Tolmach v. Comr., T.C. Memo 1991-538, 62 T.C.M. (CCH) 1102 (payments after dissolution from continuing firm not from partners). See I, C, above, for a discussion of the effect of classifying a transaction as a sale, rather than a liquidation, of partnership interest.

799 See I, C, above, for a discussion of distinguishing partner withdrawal from sale of a partnership interest. Disguised sales of partnership interests are discussed in III, G, 2, above.

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Liquidating distributions are those that terminate the distributee partner's entire interest in a partnership, whether in one distribution or a series of distributions,800 but the interest is not liquidated until the final distribution, and each distribution in the series is treated as a liquidating distribution, not a current distribution.801 Despite the name, liquidating distributions are not made in connection with liquidation of the partnership, but to completely terminate the interest of a partner. Partnership liquidation is called termination.802
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800 § 761(d); Regs. § § 1.731-1(a)(1)(i), 1.761-1(d).

801 Regs. § 1.761-1(d).

802 Although even a termination does not necessarily mean that the partnership business has ended, only that the tax partnership has ended. See IV, F, 2, below, for a discussion of partnership termination in all its forms.

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Liquidating distributions, whether one distribution, or part of a series of deferred payments, are taxed much like current distributions, with two major differences: (i) possible loss recognition,803 and (ii) possible increase in the transferred basis of distributed property.804 Redemption and liquidating distributions in-kind for S (and C) corporations are recognition events for both the corporation,805 and the shareholder.806 Accordingly, a corporate shareholder's basis in a distributed asset equals its value;807 there is no transferred basis, and no adjustment of corporate inside basis in other property to reflect the shareholder's gain or loss.
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803 § 731(a)(2); Regs. § 1.731-1(a)(2). See IV, A, 1, below, for a discussion of when loss may be recognized for liquidating distributions.

804 § 732(b); Regs. § 1.732-1(b). See IV, C, 3, b, below, for a discussion of when the transferred basis of distributed property can be increased to reflect outside basis.

805 § § 1371(a), 336(a). But see  § 336(d) (subsidiary liquidations). See 700 T.M., Choice of Entity; 731 T.M., S Corporations — Operations; 764 T.M., Dividends — Cash or Property; 767 T.M., Redemptions; and 784 T.M., Corporate Liquidations; for comprehensive treatments of the tax effects of redemptions and liquidations, including in-kind distributions, on S and C corporations. There is an exception for certain subsidiary liquidations.  § § 332 and 337.

806 § 331. See also § § 332, 337 and 1368. See 700 T.M., Choice of Entity, 731 T.M., S Corporations: Operations, and 784 T.M., Corporate Liquidations, for comprehensive treatments of the effect of corporate liquidations on S and C corporation shareholders.

807 § § 1371(a), 334(a).

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Because of the overlap between current and liquidating distributions, most of the discussion dealing with current distributions applies to liquidating distributions, and will not be repeated in this chapter. Although the most important is the application of  § 751(b) to convert many distributions into taxable exchanges,808 also pervasive are the mixing bowl provisions,809 the treatment of marketable securities as money,810 and disguised sales of property by partnerships and of partnership interests.811  On the other hand, possible recognition of loss and increase in basis of capital and  § 1231 assets create sufficient modifications of the nonrecognition principle,812 the basis of distributed property,813 and the effect on the inside basis of partnership property when an election under  § 754 applies, to make a limited revisit to those subjects appropriate.
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808 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

809 See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

810 See III, F, above, for a discussion of the treatment of distribution of marketable securities as money in determining gain recognition.

811 See III, G, above, for a discussion of disguised sales of property by partnerships to partners, and of partnership interests when there are distributions and contributions that are considered to be related.

812 See III, A, above, for a discussion of nonrecognition of gain on property distributions, and limited recognition for money distributions in current distributions.

813 See III, B, above, for a discussion of the general transfer of the partnership's basis, holding period and character to the distributee, as well as the limitations on the transfer, in current distributions.

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Liquidation of a partnership interest, including at death,814 does not terminate the partnership for tax purposes, even if the withdrawing partner is a more than 50% partner.815 Even in a two-member partnership, the partnership continues until the final liquidating distribution,816 unless, and until, there is another terminating event.817 When an LLC redeems all but one interest, the tax partnership should continue until the terminating partner is paid out, at which point it becomes a disregarded entity.818
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814 See V, D, below, for a discussion of issues that arise on transfer of a partnership interest at death.

815 § 708; Regs. § 1.708-1(b)(2); see Pietz v. Comr., 59 T.C. 207 (1972) (partnership liquidation with all sales proceeds applied to partnership liabilities;deemed distribution under  § 752 resulted in capital loss under § § 731 and 741).

816 Regs. § § 1.708-1(b)(1)(i), 1.736-1(a)(1)(ii) and (6).

817 See Rev. Rul. 75-154, 1975-1 C.B. 186 (termination of a partnership that ceased operating when partnership was making  § 736 payments to a retired partner); PLR 7930089 (termination by incorporation of medical practice; former partner, now shareholder-employee continued § 736(a) payments individually).

818 Regs. § 301.7701-3(f)(2); Rev. Rul. 99-6, 1999-1 C.B. 432; see Darrow, “Beyond Check-the-Box: New Rulings Address Entity Conversions Resulting From Changes in Ownership,”27 J. Real. Est. Tax'n 3 (1999) (discusses issues not covered by specified situations in the ruling). See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the taxation of legal entities that are not treated as tax entities.

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Although the basic tax consequences of liquidating distributions are determined under  § § 731 to 735 and 737, and are the same as those for current distributions, with the modifications discussed above for loss recognition and possible increase in the transferred basis of distributed property,  § 736 contains special provisions for payments to a retiring partner or a deceased partner's successor in interest, which may be more conveniently collectively be referred to as withdrawing partners, primarily providing special tax treatment for the withdrawing partners for payments that are not for the interests in partnership property, that is, not liquidating distributions, called  § 736(a) payments, and for allocating payments between the two major categories.819
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819 See V, below, for a discussion of withdrawal payments under § 736.

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

A. Nonrecognition of Gain or Loss 

The distributee recognizes gain on a liquidating distribution, as for a current distribution, only if: (i) the money,820 including liability relief,821 and marketable securities822 received in exchange for the withdrawing partner's entire interest in the partnership (§ 736(b) payments), exceeds (ii) the outside basis of the partnership interest,823 which should include the distributee's share of income for the portion of the year prior to the liquidation, since the partnership's tax year terminates for the withdrawing partner on complete liquidation of a partner's interest.824
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820 Money includes a distribution of the distributee's own debt obligation to, or owned by, the partnership. See Regs. § 1.731-1(c)(2); Rev. Rul. 93-7, 1993-1 C.B. 8. See III, A, 1, above, for a discussion of the extent to which the partner's own debt obligation is treated as money.

821 See II, D, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for more comprehensive treatments, of how changes in liability allocations result in contributions by and distributions to partners.

822 See III, F, 1, above, for a discussion of marketable securities as equivalent to money in determining gain on a distribution.

823 § 731(a)(1), (c); Regs. § 1.731-1(a)(1). See II, F, above, for a discussion of how marketable securities are equated with cash in determining taxability of partnership distributions. Cf. PLR 200106009 (in determining whether gain recognized on interim distributions by S corporation of proceeds of sale of corporate assets in several transactions spread over more than one year, income for the entire year is taken into account before determining consequences of liquidating distributions during the year under  § 1367(a) and Regs. § 1.1361-1(d)).

824 § 706(c)(2)(A); Regs. § 1.706-1(c)(2)(i);see IV, E, below, for a discussion of allocating income in the year of withdrawal.

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Unlike a current distribution, the distributee may recognize a loss, but only if the property distributed consists solely825 of money, but not marketable securities,826 and § 751 property(and no other property).827 Inventory is not required to be substantially appreciated to be treated as  § 751 property.828 Allowing loss on distribution of  § 751 property prevents a basis step-up,829 which could convert capital loss into reduced ordinary income. The application of  § 751(b) in liquidating distributions is essentially the same as for current distributions.830 When § 751(b) applies, there may be ordinary income under § 751, and capital loss in the same transaction.831 Under the mixing bowl provisions, a partner may recognize gain if, within seven years of contribution, the property contributed is distributed to other partners, or if other property is distributed to the contributor.832
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825 There is no requirement that the value of other property be significant in relation to the cash, unrealized receivables and inventory distributed in order to postpone recognition of loss. See Neubecker v. Comr., 65 T.C. 577 (1975) (in dissolution of three-member law partnership, taxpayer and one other partner formed a new partnership that was a continuation, but even if termination, taxpayer who received miscellaneous office equipment and supplies with a nominal value denied loss; may also have received intangibles including goodwill); McKay v. Comr., T.C. Memo 1968-276, 27 T.C.M. (CCH) 1478 (allocates basis on liquidation of interest mostly to goodwill; partner paid well above book value when joined the partnership).

826 Section 731(c)(1) refers to § 731(a)(1), the gain recognition provision, not § 731(a)(2), the loss recognition provision. See H.R. Rep. No. 826, 103d Cong., 2d Sess. 189, n.10. Thus, any unrealized loss in marketable securities distributed is deferred in the partnership's transferred inside basis that becomes the basis to the distributee of the securities, subject to the limitation of the basis of distributed property to the distributee's outside basis. See III, B, 1, a, above, for a discussion of the limitation of the distributee's transferred inside basis of property distributed to the outside basis of the partnership interest for current distributions.

827 § 731(a)(2); Regs. § § 1.731-1(a)(2), 1.732-1(c)(3).

828 The reference to inventory in § 731(a)(2)(B) is to § 751(d), and the substantial appreciation provision is § 751(b)(3).

829 § 731(a)(2)(B). See IV, B, below, for a discussion of the possible increase in transferred basis to reflect outside basis, but not for  § 751 property.

830 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

831 § § 731(a) (flush language), 741.

832 § § 704(c)(2)(B), 737. See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

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The partnership does not recognize gain or loss for a liquidating distribution, even if the withdrawing partner does, except to the extent that there is a distribution of  § 751 property in exchange for the recipient's interest in other property or vice versa,833 but it may adjust the inside basis of partnership property to reflect the distributee's gain or loss, when a  § 754 election applies.834 Capital accounts should be increased for inherent gain or loss on distributed (and other) property, and the distributee's capital account, reduced by the fair market value of the distribution, which should equal the adjusted capital account.835
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833 § § 731(b), 751(b); Regs.  § § 1.731-1(b) and (c)(1)(ii), and 1.751-1(b)(1)(i).

834 See III, C, above, for a discussion of the application of the basis adjustment in current distributions.

835 See Regs.  § § 1.705-1(a)(3) (basis reduced, but not below zero, by distributions)and 1.704-1(b)(2)(ii) (requirement that capital accounts be maintained and affect liquidation distributions in order for special allocations to have economic effect); see II, A, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of the provisions on revaluing capital accounts in specified situations.

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The distributee partner's gain or loss is likely to be capital gain or loss on the partnership interest, but part of it may be short-term, if the interest has a split holding period.836 No portion, attributable to collectibles or depreciable real estate, is taxed at the 28% or 25% rates, respectively, that apply to gains on sales of partnership interests.837 Part of any gain may be passive income, allowing deduction of losses suspended under the at-risk or passive loss provisions, but not losses suspended for lack of basis.838
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836 See II, B, 2, above, for a discussion of how contributions can create a split holding period. Since gain attributable to  § 751 property is ordinary income on sale, contribution of  § 751 property within one year of sale is disregarded in determining the holding period of the interest. Regs. § 1.1223-3(b)(4).

837 Regs. § 1.1(h)-1(b)(2)(ii), (b)(3)(ii); see IV, A, 4, below, for a discussion why the special rates do not apply to liquidating distributions.  See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of how the special rates apply to sales of partnership interests.

838 See IV, D, below, for a discussion of these loss limitations and of when liquidation of a partnership interest allows deduction of suspended losses.

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Example: Loss on Liquidating Distribution. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $100,000. Propp receives a liquidating distribution of $50,000 in cash and inventory worth $50,000, with an inside basis to Oppar of $30,000. These amounts represent her pro rata share of  § 751 property and other property, so that there is no constructive exchange under § 751. The $50,000 cash distribution reduces Propp's outside basis to $50,000. Because Propp's basis in the inventory is limited to Oppar's predistribution inside basis of $30,000. Propp is entitled to recognize a (presumably capital) loss of $20,000 for the remaining outside basis of her Oppar interest. Any gain recognized on subsequent disposition of the inventory is, generally, ordinary income, preserving the ordinary character of the inherent gain on the inventory when distributed. Thus, to prevent conversion of ordinary income into capital gain, Propp recognizes a capital loss that is not realized economically, to be offset by corresponding ordinary income when the inventory is sold. Given the nature of inventory (and other  § 751 property), the deferral is likely to be short. Propp's capital account is eliminated, but should equal the fair market value of the distribution after appropriate adjustments for inherent gains and losses. If a  § 754 election applies, Oppar suffers a corresponding adjustment in the inside basis of capital or  § 1231 property, but has avoided the ordinary income on the distributed  § 751 property.

1. Series of Distributions 

When the withdrawing partner's interest is terminated by a series of distributions, each distribution is a liquidating distribution, not a current distribution, even though the distributee remains a tax partner until the final distribution is made,839 and recognizes gain only after total actual, or constructive, money distributions exceed the outside basis of the partnership interest.840 Thus, there is open transaction treatment,841 not installment sale treatment. Similarly, a withdrawing partner suffering a loss is not entitled to recognize the loss until the final liquidating distribution is received.842 The partnership's obligation to make the distribution is not treated as a cash equivalent, for a cash-method taxpayer, nor as an obligation requiring accrual, for an accrual-method taxpayer. An obligation to make deferred payments under  § 736 apparently is not a debt obligation representing a current distribution,843 or giving rise to potential original issue discount.844 Presumably, a liquidating distribution can be made by a partnership debt obligation that liquidates the partnership interest immediately,845 leaving the withdrawing partner as a creditor, not a partner, or, arguably, making the payments independent capacity payments under § 707(a).846 If so, gain or loss should be recognized on receipt of the debt obligation, as a closed transaction, but may qualify for deferral as an installment sale. Capital accounts should be revalued for inherent gains and losses when the withdrawing partner terminates as a partner under state law, with each liquidating distribution applied against the distributee's capital account as made.847
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839 § 761(d); Regs. § 1.761-1(d). See V, C, 3, below, for a discussion of the taxation of deferred withdrawal distributions.

840 § 731(a)(1); see V, C, 3, below, for a discussion of the allocation of a series of distributions, including contingent payments, among  § 736(a)(1) guaranteed payments,  § 736(a)(2) distributive share payments, and  § 736(b) liquidating distributions.

841 See Burnet v. Logan, 283 U.S. 404 (1931) (contingent payments on sale of stock taxed only on receipt).

842 Regs. § 1.731-1(a)(2). See also Regs. § 1.736-1(a)(6).

843 See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.3.2.

844 Cf. former Regs. § 1.483-1(b)(1)(series of distributions in corporate liquidation not subject to imputed interest); See McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.02[4][d] (3rd ed. 1997).

845 See II, C, 1, above, for a discussion of partnership loans to partners that are not distributions. Presumably, the same standards should apply in determining whether a partnership obligation is a debt obligation that is itself an immediate liquidating distribution.

846 See § 1275(a)(1); Regs. § 1.1275-1(d); Regs. § 1.483-4(b) Ex. 2 (§ 483 applies to contingent stock payments because contingent right is not debt instrument, but is deferred payment for property); Rev. Rul. 74-89, 1974-1 C.B. 125 (unstated interest under  § 483 does not apply to a series of distributions in partial liquidation, because complete liquidations are excluded); but cf. PLR 8304059 (although withdrawing partner remains a partner until last principal payment is made, interest on note given in liquidation apparently treated as independent capacity payment under  § 707(a) and § 267(e), not as guaranteed payment under § 707(c));McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.02[4][c] (3rd ed. 1997).

847 See I, A, above, for a discussion of the requirements for capital accounts, and I, B, above, for a discussion of revaluing assets on specified occasions under the special allocation regulations.

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Example: Series of Liquidating Distributions. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn withdraws from Oppar and is entitled to receive $100,000 on withdrawal, one-half payable on the date of withdrawal and the rest payable three months after the end of the year of withdrawal. Munn's outside basis is $70,000. Assuming there is no  § 751 exchange, Munn does not recognize gain on the first $50,000 distribution; the entire $30,000 gain is postponed until the second distribution. Oppar's obligation to make the second distribution is not a debt obligation subject to the original interest discount or related imputed interest rules, so that, unless interest is expressly provided, the second distribution should result in capital gain. If Munn's outside basis is $120,000, Munn recognizes the loss only when he receives the second distribution.

2. Liability Relief 

As with all partnership distributions, liquidating distributions include not only money, but any relief of partnership liabilities.848 Under § 752, a deemed money distribution attributable to recourse849 liability relief, generally, occurs when the distributee no longer bears the economic risk of loss for the recourse liability as a tax partner.850 There is controversy about when a withdrawing partner is relieved of a share of partnership liabilities,851 but the better rule is that there is immediate relief for any liabilities to be paid by the continuing partnership.852 A deemed money distribution attributable to nonrecourse debt relief generally arises when the distributee no longer shares in the liability under any of the three tiers of the regulations, which generally is when the status as a partner for tax purposes terminates.853
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848 § 752(a), (b);Regs. § 1.752-1(b), (c); Regs.  § 1.736-1(a)(2) (refers to “payments (including assumption of liabilities treated as a distribution of money under Section 752)”); Rev. Rul. 74-40, 1974-1 C.B. 159 (share of liabilities is amount realized on sale or liquidation of interest resulting in gain); cf. Zager v. Comr., T.C. Memo 1987-107, 53 T.C.M. (CCH) 230, aff'd in unpub. opin. 842 F.2d 336 (table) (9th Cir. 1988) (amounts owed by partner to partnership offset against withdrawal payment are part of  § 736 payment); Fixel v. Comr., T.C. Memo 1974-197, aff'd in unpub. opin. (5th Cir. 1975). Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.312. See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for more comprehensive treatments of liability relief in liquidating distributions.

849 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of installment sales of partnership interests.

850 Regs. § 1.752-2(a). See Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991) (relief of partnership liabilities as distribution); Rev. Rul. 79-205, 1979-2 C.B. 255; TAM 9619002 (discharge of partner's share of partnership recourse indebtedness in personal bankruptcy is partnership distribution for which partner recognizes gain to extent exceeds outside basis; not cancellation of indebtedness, because partnership was not discharged; although not stated, in effect, recourse debt was converted to nonrecourse for bankrupt partner, and reallocated to other partners).

851 See, e.g., Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (no distribution of share of liabilities to expelled partner who remained liable under local law, because expelled partner not relieved by creditor, or remaining partners; implies may be taxable later if not actually accountable for liabilities since he was no longer a tax partner, decision is questionable). See II, D, 2, above, for a discussion of when recourse liabilities are transferred.

852 See PLR 9622014 (selling partner includes guaranteed partnership liability in amount realized when purchasing partner indemnified her, even though lender refused to release her; distinguishes Weiss.

853 Regs. § 1.752-3(a)(3);see II, D, 3, b, above, for a discussion, and 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of partners' shares of nonrecourse liabilities.

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When the liquidation is made by a series of distributions, both recourse and nonrecourse liability relief may not occur until the final distribution is made, since a withdrawing partner remains a tax partner until final distribution. Thus, if part of a nonrecourse liability is allocated to the withdrawing partner as a share of partnership minimum gain, or as a share of  § 704(c) minimum gain, or as a share of remaining  § 704(c) gain, the withdrawing partner's share should continue until the final distribution, since the withdrawing partner should remain subject to  § 704(c) adjustments as long the status as a tax partner continues.854 The same may not be the case if the partnership uses one of the safe harbors, whether based on a share of expected deductions, or relation to some other item with substantial economic effect, or on the general rule based on profit shares,855 since the withdrawing partner is likely to cease sharing in these items on withdrawal under state law. If there are  § 736(a) payments that may be classified as profit shares,856 nonrecourse liabilities may continue to be allocated to the withdrawing partner. Liabilities are generally not taken into account for capital account purposes.857
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854 See II, D, 3, b, above, for a discussion of how tax partners share nonrecourse liabilities.

855 Regs. § 1.752-3(a)(3).

856 Regs. § 736(a); Regs. § 1.736-1(a); see V, B, below, for a discussion of certain withdrawal payments as distributive shares of partnership income.

857 See 710 T.M., Partnerships —Conceptual Overview, 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for discussions of why liabilities do not affect capital accounts.

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Example. Liability Relief in a Series of Liquidating Distributions. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn's outside basis in his Oppar interest is $140,000, including a $100,000 share in Oppar recourse liabilities. Munn will receive three annual distributions of cash from Oppar in complete liquidation of his interest, the first on the date of withdrawal. In addition, under the Oppar partnership agreement, the remaining partners are obligated to satisfy all Oppar liabilities. Since Munn receives a deemed distribution of the amount of the recourse liability, for which he no longer bears the economic risk of loss, under state law immediately on withdrawal, in addition to the $50,000 cash distribution, he recognizes $10,000 gain immediately, and an additional $50,000 gain on receipt of the other two distributions.

If the Oppar liability is nonrecourse, the distribution may not be immediate. If $40,000 of Munn's share of the nonrecourse liability is allocated as a share of minimum gain for nonrecourse deductions allocated prior to withdrawal, as  § 704(c) minimum gain, or as remaining  § 704(c) gain for property he contributed that remains with Oppar, the $40,000 share should continue to be allocated to Munn until final withdrawal, unless reduced by some other factor.

3. Liquidating Distribution to a § 1.752 Liability Partner 

When a liquidating distribution is made to a § 1.752-7 liability partner,858 as for an assumption of a  § 1.752-7 liability by another partner,859 the  § 1.752-7 liability partner's outside basis is reduced by the “§ 1.752-7 liability reduction,” 860 that is, the lesser of: (i) the excess of the  § 1.752-7 liability partner's outside basis over the adjusted value of the partnership interest,861 that is, the value of the partnership interest, as increased for the  § 1.752-7 liability partner's liability share,862 or (ii) the remaining built-in loss associated with the  § 1.752-7 liability(after adjusting for any amounts already taken into account under the  § 704(c) adjustment).863 The basis reduction eliminates the artificial potential loss from the reduction in the value in the partnership interest resulting from the  § 1.752-7 liability that, because it is not a tax liability, would not included in the amount realized on disposition of the partnership interest. The effect is also to postpone the deduction of the remainder of the obligation until “satisfaction” of the  § 1.752-7 liability.864 If, when, and to the extent that, the partnership satisfies the  § 1.752-7 liability, the deduction is allowed to the  § 1.752-7 liability partner(even though the  § 1.752-7 liability partner is no longer a partner), but only if the partnership notifies the partner of satisfaction.865 The onus is on the  § 1.752-1 liability partner to arrange for notice, on admission or otherwise.866 The character of the deduction is the same as if the  § 1.752-7 liability partner had satisfied the obligation to the extent that the partnership would otherwise have taken the satisfaction into account, but any excess of the  § 1.752-7 liability over that amount is a capital loss for the  § 1.752-7 liability partner at the time of satisfaction.867 The same result applies in the unlikely event the  § 1.752-7 liability is settled for less than the amount (which is determined on an after-tax, discounted value basis)—the  § 1.752-7 liability partner's deduction is limited to the amount paid in satisfaction, and the  § 1.752-7 liability partner has a belated loss on the partnership interest for the difference.
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858 See III, H, above, for a discussion of the effect of assumption of a  § 1.752-7 liability by another partner in a current distribution.

859 Id.

860 Regs. § 1.752-7(g)(2), (b)(7).

861 Regs. § 1.752-7(b)(7)(i)(A).

862 Regs. § 1.752-7(b)(2).

863 Regs. § 1.752-7(b)(7)(i)(B).

864 Regs. § 1.752-7(a).

865 Regs. § 1.752-7(g)(2) and (5) Ex. (iii), (b)(8) and (h).

866 The preamble to the final regulations rejects a suggestion that the regulations should required the partnership to give the notice. T.D. 9207, 70 Fed. Reg. 30334, 30340 (5/26/05). The preambles to T.D. 9207 and to REG-106736-00, 68 Fed. Reg. 37434 (6/24/03), are included in the working papers to 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

867 Regs. § 1.752-7(g)(2).

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Example: § 1.752-7 Liability in Liquidating Distribution. Munn, Propp and Surv are equal (one-third) partners in a capital partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. When Oppar was formed, each of Munn and Surv contributed $100,000 and Propp contributed $196,000, but subject to $96,000 of deferred compensation obligations that have nothing to do with Oppar's business. Accordingly, each had initial capital accounts of $100,000, but Propp's initial outside basis was $196,000, since the deferred compensation obligations are a  § 1.752-7 liability. Oppar has cash and other non-§ 751 property, with an inside basis and value of $540,000. It is subject to bank loans and accrued liabilities of $60,000, and the $78,000 balance of the deferred compensation obligation (§ 1.752-7 liability). Propp was allocated the $18,000 deduction under  § 704(c) when that amount of the deferred compensation was paid. Propp's capital account is$82,000 representing her share of the Oppar assets, net of the partnership liabilities and net of the $78,000 remaining deferred compensation liability. Her outside basis in the Oppar interest is $180,000, including her $20,000 share of the liabilities, and reflecting that the remaining deductible obligations do not affect her outside basis. Oppar distributes$82,000 in cash to Propp in complete liquidation of her interest, and agrees to indemnify her against any obligation on Oppar's liabilities, including the deductible obligations. Her total distribution is $102,000, including relief from her $20,000 (1/3  of $60,000) share of the liabilities. The distribution is a  § 736(b) liquidating distribution applied against her $180,000 outside basis of results in a capital loss of $78,000, representing the reduction for the deferred compensation. Since the deferred compensation is a  § 1.752-7 liability, her outside basis is reduced by the $78,000, resulting in no tax loss. When Oppar pays the deferred compensation, Propp is entitled to the deduction, but only if Oppar notifies her. Since Oppar is not entitled to the deduction, if it fails to notify Propp, it has no incentive not to notify her.

If the deferred compensation obligation is allocable to a trade or business Propp contributed, it is not a  § 1.752-7 liability. Accordingly, Propp is entitled to a (presumably capital) loss deduction on the liquidating distribution, since her outside basis is $180,000, and she only receives $102,000. Apparently, Oppar is entitled to the deduction for the deferred compensation when paid, which is allocated to Munn and Surv. Propp has converted a deferred ordinary deduction into an accelerated capital loss. If Propp is a corporation with capital or § 1231 gains that would otherwise be taxed at the same rate as ordinary income, the conversion is not a disadvantage.

4. Collectibles and Unrecaptured § 1250 Gain 

Although the sale or exchange of a partnership interest with a long-term holding period results in capital gain taxed at the basic capital gain rate, currently 15%,868 as an additional aggregate overlay, any gain attributable to collectibles and certain depreciation on real estate, taking into account special allocations, is subject to tax at 28% or 25%, respectively.869 The 2003 Act reduction in the general capital gain rate to $15% was not accompanied by any corresponding reduction in the higher rates that apply to these items.
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868 § 1(h)(1)(C), as amended by P.L. 108-27, § 301(a). See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of taxation of collectibles and unrecaptured  § 1250 gain on sale of a partnership interest.

869 § 1(h)(6), (7), and (11);Regs.  § § 1.741-1(e) and 1.1(h)-1(a), (b) and (f) Ex. 1 and Ex. 2. See 507 T.M., Income Tax Liability: Concepts and Calculation.

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Section 1(h)(5)(B) provides for pass-through treatment of “gain from the sale of an interest” (emphasis added)in a partnership, S corporation or trust, stating that gain “which is attributable to unrealized appreciation in the value of collectibles shall be treated as gain from the sale or exchange of a collectible,”and refers to applying “[r]ules similar to the rules of section 751” for the purpose, but  § 1(h)(9) authorizes “such regulations as are appropriate ... to apply this subsection in the case of sales or exchanges by pass-through entities and of interests in such entities.”870 (Emphasis added).  The regulations however, relate only to partnerships, S corporations and trusts, but use the “sale or exchange” language throughout and apply to  § 1250 capital gain (even though there is no reference to partnerships, etc. in  § 1(h)(6) relating to unrecaptured § 1250 gain).871 Since  § 731(a) provides that “any gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner,”the term sale or exchange in the regulations may be broad enough to cover liquidating, and even current, distributions.  Nevertheless, the regulations state that the regulations do not apply to “a transaction that is treated, for Federal income tax purposes, as a redemption of an interest in a partnership.” (emphasis added).872 Despite the use of a term that is not found in Subchapter K, the absence of a provision for distributions in the regulations should be conclusive unless and until the regulations are amended.
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870 Section 1(h)(10) defines pass-through entities to include in addition to those named in  § 1(h)(5)(B) (which is not cross-referenced), estates, regulated investment companies, real estate investment trusts, common trust funds and qualified electing funds defined in  § 1295 (which relates to certain passive foreign investment companies).

871 Regs. § 1.1(h)-1, adopted by T.D. 8902, 65 Fed. Reg. 57092 (9/21/00).

872 Regs. § 1.1(h)-1(b)(2)(ii), (3)(ii).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

B. Basis of Distributed Property 

Although most withdrawal distributions from pass-through entities are likely to be in money (and liability relief), they may be made in kind when a partner withdraws to continue in business on his or her own, or, particularly in family ventures, when it is appropriate to distribute assets not needed in the business, or that may be appropriately leased back. Although the distributee's basis in  § 751 property cannot exceed the transferred basis,873 the aggregate basis of other property(generally capital or  § 1231 assets)distributed as part of a liquidating distribution is increased when the partner's outside basis in the partnership interest (as reduced any money, including any net reduction in the distributee's share of partnership liabilities as a result of the distribution, or adding any contribution resulting from an excess of the liability of any encumbered property distributed,874 any marketable securities,875 and any debt obligations of the distributee,876 that are included in the distribution,877 and by the transferred basis of any  § 751 property received as part of the liquidating distribution) is greater than the transferred basis.878 Because any liability encumbering distributed property affects the outside basis of the partnership interest, both the inside basis of the distributed property and the outside basis to the distributee are determined without adjusting for the encumbrance.879
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873 § 732(c)(1)(A); Regs. § 1.732-1(c)(1)(i).

874 See III, A, 2, b, above, for a discussion of the effect of distributions of encumbered property.

875 See III, F, 1, above, for a discussion of marketable securities as equivalent to money in determining gain on a distribution.

876 See III, A, 2, a, above, for a discussion of treating the distributees own note or other debt obligation as money, not property.

877 § 732(a)(2), (c); Regs. § 1.732-1(b), (c). See Rev. Rul. 95-24, 1995-1 C.B. 14 (even though basis of bond is determined by basis to partnership, only fair market value is taken into account in determining amortizable bond premium). See 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment of the inside basis adjustment rules.

878 § 732(b); Regs. § 1.732-1(b); see III, B, 1, a, above, for a discussion of the limitation of the distributee's transferred inside basis of distributed to the outside basis of the partnership interest for current distributions.

879 Regs.  § 1.732-1 never mentions liabilities in its text or its examples, but this must be the approach. See Regs.  § § 1.736-1(b)(1) (partner's value of partner's interest in property and partnership interest to be adjusted so that both take into account the partner's share of liabilities); 1.743-1(d)(1) (transferee's share of inside basis is generally equal to share of previously taxed capital plus share of liabilities). See III, A, 2, b, above, for a discussion of the effect of bifurcated partnership approach to contributions and distributions of encumbered property.

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The exchanged basis rule that applies the remaining outside basis after deducting the basis of  § 751 property, may give the capital or  § 1231 property received as part of a liquidating distribution a basis substantially in excess of value. The effect is to postpone the distributee's gain or loss until sale of the other property received in kind, but may provide the distributee an immediate advantage when the distributed property is depreciable or amortizable.880 On the other hand, when only money and  § 751 property with a combined basis less than the distributee's outside basis are distributed in liquidation, the basis limitation allows recognition of capital loss, which is apparently viewed as less abusive than conversion of ordinary income into capital gain.881 Basis adjustments under a  § 754 election compensate for the basis distortions and loss resulting from application of these rules.882
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880 See IV, A, above, for a discussion of the effect of the excess of the distributee's basis of depreciable or amortizable property over the partnership's transferred inside basis.

881 § 731(a)(2)(B); Regs. § 1.731-1(a)(2);See IV, A, above, for a discussion of loss recognition in liquidating distributions.

882 See IV, C, below, for a discussion of these adjustments.

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All partners' capital accounts should be adjusted to reflect any unrealized gain or loss in partnership assets at the time of the liquidating distribution.883 As adjusted, the withdrawing partner's capital account, generally, should be equal to the fair market value of the liquidating distribution to satisfy the requirement of the special allocation regulations that liquidating distributions be made in accordance with capital accounts.884
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883 Regs. § 1.704-1(b)(2)(iv)(e).

884 Regs. § 1.704-1(b)(2)(ii)(b)(2); see 710 T.M., Partnerships —Conceptual Overview, 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts, and 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for discussions of how liquidation rights affect special allocations.

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Example: Basis in Excess of Value for Property Distributed in Liquidation. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn has an outside basis of $150,000 in her Oppar interest and receives a distribution of $50,000 cash, and investment real property with an inside basis to Oppar of $50,000 and a value of $150,000. After adjustment for unrealized gains and losses in Oppar's assets, Munn's capital account is $200,000. Munn does not recognize gain on the distribution, even though the $150,000 value of the investment real property exceeds his outside basis ($100,000), after deducting the $50,000 cash distributed. Munn's basis in the investment real property is $100,000, not the$50,000 transferred inside basis of the investment real estate, preserving her unrealized gain on her Oppar interest until disposition of the investment real estate. If a  § 754 election is in effect, Oppar decreases the inside basis of other capital or § 1231 property to reflect Munn's $50,000 basis step-up in the real estate. In contrast, in a current distribution, Munn would have a transferred basis in the real property equal to Oppar's inside basis of $50,000, and he would have a remaining outside basis in the Oppar interest of $50,000. There would be no adjustment of Oppar's inside basis.

If Oppar's inside basis in the investment real property is $200,000, Munn's basis is still $100,000, under the principle that limits the basis of distributed property to outside basis. This postpones his recognition of Oppar's unrealized loss until disposition as well. In this situation, Oppar's  § 754 adjustment is a $100,000 basis increase to offset the “lost” basis.

1. Allocation of Basis to Distributed Property 

When multiple properties are distributed by the partnership in a liquidating distribution, the outside basis of the partnership interest is allocated first to the transferred inside basis of any  § 751 property, but only up to the amount of the outside basis of the partnership interest.885 When the transferred inside basis of  § 751 property exceeds the outside basis, the basis reduction is allocated in the same manner as for a current distribution,886 that is, first proportionately to reduce the basis of  § 751 property that has inherent loss, then in proportion to the reduced basis of such assets,887 with any other property, of course, having a zero basis. When the outside basis of the partnership interest exceeds the transferred inside basis of  § 751 property, the excess is allocated to other property, generally capital and  § 1231 assets, even if the allocated basis exceeds the transferred inside basis of such property or even the value of the property.888 When the outside basis allocated to other property is less than the transferred inside basis, the reduction, as for a current distribution, is allocated in much the same way as described above for  § 751 property to reduce unrealized loss and then in proportion to reduced basis.889 In addition, if the property distributed is corporate stock distributed to a controlling shareholder,  § 732(f) may apply to require an adjustment of the inside basis of the corporation's assets to prevent the corporate partner's avoiding the basis limitation on the corporate stock.890 Any positive adjustment in excess of the transferred inside basis, is allocated first in proportion to unrealized appreciation in other properties with unrealized gain, and then to all other property in proportion to the fair market value of the other property (non-§ 751 property).891 If the property is a debt obligation, the basis assigned to the debt obligation is limited to its fair market value.892 A common reason for an allocation of basis in excess of value is the limitation on the basis of  § 751 property to its transferred basis, regardless of value, with the result that the appreciation in  § 751 property may be allocated to capital assets and  § 1231 property, even when it results in a basis in excess of value. The effect is preservation of the ordinary income for the distributee, offset by reduced future capital or  § 1231 gain, reduced future loss, or, possibly, increased depreciation. When the basis of distributed property is limited by the distributee's outside basis, the allocation is the same as for a current distribution.
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885 § 732(c)(1)(A); Regs. § 1.732-1(c)(1)(i).

886 See III, B, 1, a, above, for a discussion of allocating basis when the transferred inside basis is limited by the outside basis of the partnership interest.

887 § 732(c)(1)(B), (3); Regs. § 1.732-1(c)(1), (2).

888 § 732(b); Regs. § 1.732-1(b).

889 § 732(c)(1)(B), (3); Regs. § 1.732-1(c)(1), (2).

890 See III, B, 1, c, above, for a discussion of the inside basis adjustment for a controlled corporation when its stock is distributed to a controlling corporate partner.

891 § 732(c)(1)(B)(ii), (2); Regs. § 1.732-1(c)(1)(ii), (2).

892 Regs. § 1.1272-2(b)(6). If that amount is greater than the adjusted issue price of the debt obligation (its issue price adjusted for amortized original issue discount, § 1272(a)(4)), the excess may create an acquisition premium, § 1272(a)(7), that may allow a reduction in the distributee's amortization of original issue discount.  Apparently, if the fair market value is less than the inside basis (adjusted issue price) the difference may be a market discount, treated as ordinary income on disposition of the debt obligation unless the distributee makes an election to amortize it. § § 1276–78.  Similar principles, including the fair market value limit, apply for purposes of determining amortizable bond premium by the distributee. § 171(e); Regs. § 1.171-1(e)(1)(ii). See 535 T.M., Time Value of Money: OID and Imputed Interest, for a comprehensive treatment of original issue discount, market discount and bond premium.

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The distributing partnership's depreciation or amortization period and method apply to the distributed property, as if there had been no transfer,893 but other accounting aspects, such as inventory method, do not apply to the distributee or the distributed property.894 Thus, liquidation gain or loss is transferred to the distributed property and delayed until the distributed property is disposed of, or depreciated.  To the extent that the distributee's basis in the property exceeds the transferred inside basis, the excess is depreciated or amortized as new property, over the applicable depreciation or amortization period for property purchased on the date of distribution, and without regard to the partnership's method.895
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893 § 168(i)(7)(A), (B)(i); Prop. Regs. § § 1.168-5(b)(7) and-4(d)(5)(i) and (ii) (depreciation); § 197(f) and Regs.  § 1.197-2(g)(3) (amortization). See 531 T.M., Depreciation: MACRS and ACRS; and 533 T.M., Amortization of Intangibles, for comprehensive treatments of depreciation continuity.

894 See 710 T.M., Partnerships —Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussions of a partnership's ability to elect its own accounting method on contribution of an active business.

895 § 168(i)(7)(A), (B)(i); Prop. Regs. § § 1.168-5(b)(7) and-4(d)(5)(i), (ii) (depreciation); § 197(f) and Regs. § 1.197-2(g)(3).

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If the election under  § 754 applies (or if distributions are to those who have purchased an interest within two years),896 the basis of the remaining partnership properties is adjusted to reflect any amount by which the inside basis in the distributed properties was greater or less than that of the outside basis of the partnership interest.897
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896 See IV, B, 3, below, for a discussion of basis adjustments for the distributee without a  § 754 election for distributions within two years of purchase of the partnership interest by the distributee.

897 § § 734, 732(d) and (e); see Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 13.03[3] (6th ed. 1997); TAM 9734003 (does not apply  § 732(d) to prevent basis shift from longer-lived to shorter-lived assets in absence of  § 754 election).

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Example: Allocation of Distributee's Basis in Excess of Value. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $150,000, and her capital account, after adjustment for unrealized gains and losses in Oppar's assets, is $200,000. Propp receives, in liquidation of her Oppar interest:(i) appreciated inventory, representing her aggregate share of  § 751 property, with an inside transferred basis of $30,000 and a value of $100,000, and (ii) land with a basis of $20,000 and value of $60,000, on which there is a commercial building with an inside transferred basis of $10,000 and a value of $40,000 (total inside basis, $60,000, and value, $200,000). Since Propp does not recognize gain, even though the $200,000 value exceeds her outside basis of $150,000, Propp's basis in the inventory is $30,000, leaving $120,000 for the land and building, and preserving her unrealized gain. Because of the limitation of the basis of the inventory, the amount allocated to the land and building ($120,000)exceeds not only the inside transferred basis ($30,000) but also the value ($100,000). The $120,000 remaining outside basis is allocated first to the transferred inside basis, $30,000 (land, $20,000, and building, $10,000), and then to eliminate unrealized appreciation,$70,000 (land, $40,000 and building, $30,000) bringing them up to their $100,000 total value (land, $60,000 and building, $40,000). The remaining $20,000 is allocated in proportion to the values, $12,000 to the land ($60,000/$100,000 x $20,000) and $8,000 to the building($40,000/$100,000 x $20,000) for total basis of $72,000 for the land and $48,000 for the building. Although the $10,000 transferred inside basis of the building is depreciated by continuing Oppar's schedule, the $38,000 increase is depreciated as a new commercial building. Thus, the ordinary income preserved in the  § 751 property is offset by reduced future gain or increased future loss on the land and building, and increased depreciation on the building. Munn's basis increase is offset by a basis decrease for Oppar, if an election under  § 754 applies.

2. Basis Allocations in a Series of Liquidating Distributions 

Basis allocation is more complicated when a partner's interest in a partnership is liquidated by means of money and property or by property alone in a series of distributions, because each distribution in the series is a liquidating distribution without waiting for the final distribution.898 Although the regulations do not deal directly with the issue, the proper approach should be that all distributions specified for the entire series should be taken into account.  This approach is consistent with treating all distributions in the series as liquidating distributions,899 delaying loss recognition until the entire partnership interest is liquidated,900 with providing that the outside basis of the partnership interest is reduced by “any money distributed to him in the same transaction” (emphasis added),901 and with the provisions for allocating payments between  § 736(a) payments and  § 736(b) payments.902 This principle is easier to state than to apply.  When the first distribution includes all property planned to be transferred to the distributee, the outside basis should be reduced by all planned future money distributions, without adjustment for time value of money considerations because § 736 does not treat deferred obligations as debt instruments or take time value money considerations into account,903 so that the outside basis to be allocated to the property should be the outside basis as reduced for agreed future distributions of money.904 When future property distributions are contemplated, unless adjustments to basis for depreciation, amortization or otherwise can be determined at the time of the first property distribution, the outside basis probably should be applied to the property distributed in the order the transfers are made, but aggregated for distributions in the same tax year of the distributee. Even reductions in the basis of property to be distributed in the future should not be a significant issue for capital or  § 1231 assets to the extent that it is reasonably anticipated that the basis will be determined by the outside basis of the partnership interest and not the distributed transferred basis. Delaying determination of the basis of distributed property until the final distribution would require providing an estimated interim basis, or a zero interim basis, either of which would require amended returns, and some arrangement for extending the statute of limitations if the distributions are not to be completed within five years or less. If there are contingent money payments, they should handled in a manner consistent with the regulations relating to  § 736 payments.905
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898 Regs.  § 1.761-1(d) states that the basis of property distributed in a series of distributions is determined under § 732(b).

899 Regs. § 1.761-1(d).

900 Regs. § 1.732-1(a)(2).

901 Regs. § 1.732-1(b).

902 Regs. § 1.736-1(b)(5). See V, C, below, for a discussion of allocating  § 736 payments.

903 Regs.  § 1.736-1(b)(5) and (6) do not adjust for such considerations in making allocations between  § 736(a) and  § 736(b) payments or in allocating gain or loss. See V, C, 3, below, for a discussion of allocating a series of payments.

904 See IV, B, 1, above, for a discussion of allocating basis among distributed property.

905 Regs. § 1.736-1(b)(5), (6). See V, C, 3, below, for a discussion of the allocation of a series of distributions, including contingent payments, among  § 736(a)(1) guaranteed payments,  § 736(a)(2) distributive share payments, and  § 736(b) liquidating distributions.

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Example: Basis in a Series of Distributions. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in his Oppar Interest is $200,000. In 20X1, Propp receives a liquidating distribution of real estate with an inside basis of $25,000 and a fair market value of $75,000. Oppar will also distribute cash of $150,000 to Propp in $50,000 installments in each of 20X1, 20X2 and 20X3. Under the suggested approach, Propp's outside basis is considered reduced to $50,000 ($200,000 - $150,000 total cash distributions) so that the outside basis of the real estate would be $50,000. It makes no sense to allocate basis of $150,000($200,000 - $50,000 in 20X1 cash distributions) to the real estate in 20X1, and treat the 20X2 and 20X3 distributions as gain or even as reductions in the basis of the real estate.  Taking agreed cash distributions into account means that the basis result is the same as if the real estate is distributed in 20X3.

3. Section 737 in Liquidating Distributions 

When a liquidating distribution is made to a contributing partner with an allocation of gain under  § 704(c) that has not been taken into account,  § 737 applies to the distribution,906 if property other than the contributed property is distributed in kind.907 When  § 737 applies, its basis rules, presumably, apply before the general transferred basis rules.
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906 See III, E, 2, above, for a discussion of the application of the mixing bowl rules in this situation.

907 Section 737 does not apply when the contributed property is distributed to the contributor. § 737(d)(1). The previously contributed property has a transferred basis determined before taking into account any basis adjustment from application of § 737. Regs. § 1.737-3(b)(2).

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Example: § 737 in Liquidating Distribution. Propp contributes a parcel of land that has a basis of $20,000 and a value of $100,000 to a partnership, Oppar. Munn#1 and Munn#2 each contribute $100,000 cash. The Oppar partnership agreement satisfies the special allocation regulations. The next year, when the contributed property is worth $120,000 and other Oppar assets acquired with the cash have appreciated to $240,000 so that, after adjustment of the unrealized gains, each partner's capital account has increased to $120,000, Oppar distributes a purchased parcel of land with a basis of $90,000 and value of $120,000 to Propp in liquidation of her Oppar interest. Propp recognizes the $80,000 gain that was inherent in the parcel of land she originally contributed. Since that amount is less than the $120,000 value of the distributed property, Propp's basis in the distributed property is $100,000, the outside basis of her Oppar interest at the time of the liquidating distribution as increased for the $50,000 gain she recognized. The basis of the property she contributed is increased to $100,000 to reflect the gain she recognized. If a  § 754 election applies, Oppar reduces the basis in its remaining properties for the $10,000 excess of Propp's basis in the distributed property over Oppar's transferred inside basis in that property. Propp's capital account is, of course, eliminated by the distribution.

4. Anti-Abuse 

Although the basis shifts that result from the application of outside basis to distributed property may create timing advantages for the distributee partner or the remaining partners with no corresponding cost to the other partners, particularly when there is no  § 754 election, the anti-abuse regulations do not apply, but recognize the distortion as clearly contemplated by the provisions of  § 732 and by making the adjustment elective.908 This is confirmed in the anti-abuse regulations by the two examples dealing with distortions before the 1997 amendment of  § 732(b) and (c).909
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908 Regs. § 1.701-2(a)(3).

909 Regs.  § 1.701-2(d) Ex. 9 (liquidating distribution of appreciated, nonmarketable securities where no  § 754 election is made, does not violate the anti-abuse rule, even though intended that distributee partner receive a stepped-up basis in the securities giving the remaining partners a timing advantage on the inherent gain;distortion is the effect of making  § 754 elective); Regs.  § 1.701-2(d) Ex. 10 (liquidating distribution of a nondepreciable asset with built-in gain, and depreciable property with a fair market value basis, which permitted the distributee partner effectively to shift basis from the nondepreciable property to the depreciable property (generating cost recovery deductions) before the 1997 amendment, does not violate the anti-abuse rule).

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It is possible to go too far, particularly when the facts and circumstances indicate tax reduction goals, transitory arrangements, nominal partners, related parties and special allocations, with the distorting transactions part of a pre-existing plan,910 in short probably violating step-transaction and substance-over-form principles, even in the absence of the anti-abuse regulations. Two other regulations examples, similar to the ones determined not to be abusive, illustrate the anti-abuse principle.911 In one example, a partner contributes property with inherent loss to a partnership formed for the purpose by related parties, who contribute cash, used to purchase a nonmarketable security with a value and inside basis equal to the value of the contributed property. The contributor of course has a  § 704(c) allocation of the inherent loss and an outside basis of the basis, not the value of the contributed property, unless the loss is a substantial (more than $250,000) built-in loss.912 The property is leased for three years to a prospective purchaser, who has an option to purchase at the value at the time of the contribution. Three years later, but before the sale under the option, the contributor receives a liquidating distribution of the other property with an inside basis equal to the value of the contributed property, but that will have a distributed transferred basis equal to the basis of the contributed property, so that the contributor still has the original inherent loss. The sale by the partnership of the contributed loss property, realizing the loss after the contributor withdraws, results in a partnership loss that is allocated to the related partners since the  § 704(c) allocation to the contributor is no longer available. The conclusion that the transaction is abusive both under substance-over-form and step-transaction principles, as well as the anti-abuse regulation seems incontestable.913 It is hard to believe that responsible tax attorneys would sanction the arrangement, despite its resemblance to the sanctioned elective use of § 754.914 As indicated, the 2004 amendment giving the partnership a basis of only fair market value in contributed property with a substantial built-in loss, would limit this gimmick to smaller losses in any event. Since the other example depended on use of the former basis allocation rules,915 it is of no current interest except as a sad example of something the IRS felt necessary to provide in a regulation because it was uncertain that it could count on application of step-transaction and economic substance principles.916 Except on its now-dated facts, sadly, it is not even likely to reduce playing the audit lottery.
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910 Regs. § 1.701-2(a)(3).

911 Regs.  § 1.701-2(d) Exs. 8 and 11. See Notice 2002-65, 2002-1 C.B. 690 (attacks a use of straddles in pass-through entities with redemptions at FMV between closing the gain and loss legs of the straddle); Notice 2002-50, 2002-28 I.R.B. 98 (attacks a similar straddle deal using tiered partnerships and no  § 754 election); FSA 200242004 (transfer of loss property to tax partnership; sale of interest to unrelated party with no  § 754 election followed by sale of loss property by partnership, recharacterized under Regs.  § 1.701-2 as sale of assets); FSA 200134002 (complex lease stripping tax shelter with purported  § 351 contribution to create high basis and loss duplication; inter alia, attack includes violation of anti-abuse regulations, principally Regs. § 1.701-2(d) Ex. (8).

912 § 704(c)(1)(C), as added by the American Jobs Creation Act of 2004, P.L. 108-357, § 833((a) effective Oct. 22, 2004, 10 years after the 1994 adoption of the anti-abuse regulations.

913 Regs.  § 1.701-2(d) Ex. 8.

914 Regs.  § 1.701-2(d) Ex. 9.

915 See IV, B, 1, above, for a discussion of the former basis allocation rules.

916 Regs.  § 1.701-2(d) Ex. 11 (liquidating distribution to partner desiring to acquire appreciated partnership property and use the former  § 732 basis allocation rules by distributing another economically insignificant asset to shift basis to that asset, pursuant to a tax reduction plan).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

C. Effect on Partnership's Inside Basis—§ 754 and Substantial Basis Reduction 

As with current distributions, the partnership normally adjusts basis for liquidating distributions only if the  § 754 election applies.917 This can result in doubling of unrealized gain or loss, for example when a withdrawing partner realizes gain on a liquidating distribution of money that reflects, in whole or in part, unrealized appreciation in partnership assets.918 For liquidating distributions, unlike current distributions, as discussed in the next section, there is, however, a mandatory adjustment of inside basis when there is a substantial basis reduction.919
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917 § 732(a), (b). Regs.  § 1.734-1(a) and (b).  See III, C, above, for a discussion of making and revoking the election.

918 See III, C, above, for a discussion of the problem of duplicating gains or losses on distributions of property to partners.

919 § 734(a), (b), and (d).

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When an election under  § 754 applies, the inside basis of partnership assets is adjusted for a liquidating distribution to reflect: (i) the gain or loss realized by the distributee partner,920 as well as (ii) an excess of the distributee's basis for distributed property over the transferred inside basis of the distributed property.921 Thus, the partnership's inside basis adjustments may either be an increase or decrease, in contrast to current distributions where there are only increases, since no loss is recognized for a current distribution, and the distributed basis of property transferred in a current distribution is the lesser of a transferred inside basis or the outside basis of the partnership interest.922 The amount of the adjustment reflecting the gain or loss or basis difference is allocated among the inside basis of partnership assets as discussed below.923 The IRS has ruled that when the liquidation of the retiring partner's interest is made by a series of money payments the timing and amount of the inside basis adjustments under a  § 754 election are governed by the retiring partner's recognition of gain or loss.924
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920 § 734(b)(1)(A), (2)(A); Regs. § 1.734-1(b).

921 § 734(b)(2)(A), (B); Regs. § 1.734-1(b).

922 § 731(a)(2); Regs. § 1.731-1(a)(2). See III, C, above, for a discussion of adjustments of the partnership's inside basis for current distributions when a § 734(b)/754 election applies.

923 See IV, C, 2, below, for a discussion of the allocation of the inside basis adjustment.

924 Rev. Rul. 93-13, 1993-1 C.B. 126; see V, C, 3, below, for a discussion of the timing of gain and loss when there is more than one liquidating distribution.

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1. Substantial Basis Reduction 

Perceived abuses led Congress, in 2004, to require adjustment when there is a substantial basis reduction, without requiring a partnership  § 754 election.925 A substantial basis reduction occurs only in a liquidating distribution.926 There is a substantial basis reduction requiring a mandatory basis adjustment for the distributing partnership when the sum of: (i) any loss recognized by the distributee on a liquidating distribution, and (ii) the excess of the basis of distributed property to the distributee over the partnership's transferred inside basis to the partner, exceeds $250,000,927 thus, providing a practical $250,000 limit on the increase in basis for the difference between transferred inside basis and the outside basis of the partnership interest, but with the effect applied to the partnership, not the distributee partner. Although stated as a sum, it is hard to see how both can occur for a single distribution, since there can be a loss only when the distributee receives only money or  § 751 property, neither of which can have a basis greater than the transferred inside basis, and there can be basis to the distributee greater than the transferred inside basis only when the outside basis of the partnership interest (after reduction for money distributed) significantly exceeds the basis of any  § 751 property distributed. There can be a substantial basis reduction even when the distributed property is worth more than its inside basis, or more than the outside basis of the distributee's partnership interest allocated to it. On the other hand, there is no substantial basis reduction, even though distributed property is worth more than $250,000 less than its inside basis, as long as the distributee neither recognizes a loss of more than $250,000, nor enjoys a basis step-up from the transferred inside basis of more than $250,000. The IRS has provided interim guidance in the form of a Notice foreshadowing the regulations, primarily relating to reporting, concerning these adjustments.928 The Notice requires compliance with the regulation that would apply if a  § 754 election applied,929 reporting as if an election under  § 754 was in effect.930 Although the Notice does not state it, it implicitly confirms that the 2004 Act provision effectively takes the “election” out of  § 754 when there is a substantial basis reduction. The 2004 amendment to  § 734(a) requiring adjustment for partnerships with a substantial basis reduction eliminates a major source of potential abuse. As a practical matter, since one of the reasons for not making the  § 754 election is to avoid downward adjustments, the 2004 amendment to  § 734(b) comes close to eliminating the elective aspect of the  § 743(b) adjustment.
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925 § 734(a), (d).

926 § 734(d) (refers to § 734(b)(2)(A), which in turn refers to  § 731(a)(2) relating to liquidating distributions, and (B), which refers to  § 732(b) also relating to liquidating distribution). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of a similar adjustment on sale of partnership interests when there is a substantial built-in loss.

927 § 734, as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(b), effective Oct. 22, 2004. There is a parallel provision for a basis adjustment for a purchaser of a partnership interest when the partnership has a substantial (more than $250,000) built-in loss. See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the § 743 amendment.

928 Notice 2005-32, 2005-1 C.B. 895.

929 Regs. § 1.734-1(d).

930 Notice 2005-32, 2005-1 C.B. 895, § § 3 and 8 Ex. A.

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Although it is not clear whether a basis reduction for a substantial basis reduction in a liquidating distribution can pass through the tiers,931 it probably does. The statute expressly authorizes regulations to carry out the purposes of the electing partnership provision, including tiered partnerships,932 which, as indicated above, the legislative history extends to securitization partnerships, but there is no other reference to tiered partnerships. On the other hand, since there is broad authority to promulgate regulations under § 7805, this authority is probably broad enough to allow mandatory decreases in basis when the Code allows elective increases.  Although no such regulations have been proposed,  § 734(b) provides for adjustment through the tiers, albeit only if upper-tier and lower-tier partnerships have § § 734(b)/754 elections. Since the IRS interim guidance until such regulations are adopted in effect requires the same negative adjustments as if an election under  § 754 applied,933 it is not unreasonable to conclude that, for purposes of the adjustment for substantial basis reductions, an “as if” election will be imposed.
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931 See III, C, 2, a, (1), above, for a discussion of inside basis adjustments passing through the tiers when § § 734(b)/754 adjustments apply to both upper-tier and lower-tier partnerships.

932 § 743(e)(7).

933 See Notice 2005-32, 2005-1 C.B. 895.

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There is an exception from the adjustment for a substantial basis reduction for securitization partnerships.934 Securitization partnerships are those whose sole activity is issuing fixed principal securities that are serviced by the cash flow from a pool of receivables or other financial assets that convert into cash in a finite period and whose sponsor believes the pool assets are not acquired to be disposed of.935 Apparently the interest in a securitization partnership that avoided a basis adjustment for a substantial built-in loss can be sold with any loss allocated to the transferee.936 The legislative history also indicates that if a securitization partnership ceases to qualify, the general basis adjustment rule applies to the next transfer, implicitly indicating there is no adjustment for prior transfers.937 The parallel rules relating to substantial built-in losses in connection with sales of partnership interest also have an exception for electing investment partnerships.938 There is specific regulatory authority to carry out the purpose of the electing investment partnership provision, including covering tiered partnerships.939 Although there is no such express provision for securitization partnerships, the conference report indicates the same intention to prevent use of tiered partnerships to avoid the limits.940
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934 § 734(e), (f)(1).

935 § 743(f)(2).

936 § 743(f)(1).

937 See H.R. Conf. Rep. No. 755, 108th Cong. 2nd Sess. 406.

938 § 743(c) See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the application of the similar exclusion on sales of partnership interests in securitization partnership, as well as related alternative rules for investment partnerships, including the provisions for electing investment partnerships.

939 § 743(e)(7).

940 There are no special rules for distributions by investment partnerships, although the legislative history, H.R. Conf. Rep. No. 755, 108th Cong. 2nd Sess. 406, indicates that the regulatory authority to deal with tiered electing investment partnerships also applies to securitization partnerships, but Notice 2005-32, § 7, dealing with tiered investment partnerships, does not refer to securitization partnerships.

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Example: Adjustment for Substantial Basis Reduction. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $1,000,000, and her capital account is $1,250,000. Oppar distributes a commercial building that has become surplus in its business, but that Propp proposes to renovate, to Propp in liquidation of her interest. The inside basis of the commercial building is $500,000 but its value is $1,250,000. Propp's distributed basis for the commercial building is the $1,000,000 outside basis in her Oppar interest, not the $500,000 transferred inside basis. There is a substantial basis reduction, because Propp's$1,000,000 basis for the commercial building exceeds Oppar's $500,000 inside basis in it immediately before the distribution by more than$250,000, even though the commercial building has an unrealized gain of $750,000, and even though Propp's distributed basis for the property is less than its value. Oppar, therefore, must decrease the basis of its remaining capital and  § 1231 assets by the $500,000 increase in the distributed basis for the commercial building, regardless of whether a  § 754 election is in effect. As shown in the example in IV, C, 2, below, there would have been a similar adjustment if a  § 754 election applied.

2. Allocating the Inside Basis Adjustment 

Unlike current distributions, the adjustments under § § 734(b)/754 for liquidating distributions may be negative as well as positive, reflecting either loss recognized by the distributee, or any difference between the basis to the distributee and the transferred inside basis to the partnership.941 Adjustments for the gain or loss on the partnership interest, or for distributed capital or  § 1231 assets may be made only to the inside basis of capital or  § 1231 assets, while adjustments to reflect a limitation on the basis of ordinary income property, primarily  § 751 property, are allocated only to partnership ordinary income property.942
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941 § 734(b)(2); Regs. § 1.734-1(b)(2). No adjustment is made under  § 734 when a distribution of marketable securities results in gain and the distributee increases the basis of the securities by that gain. § 731(c)(5). See III, C, above, for a discussion of adjustments for current distributions.

942 § 755(b); Regs. § 1.755-1(a), (c)(1)(i).

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There may be a positive adjustment for ordinary income assets, and a negative adjustment for capital assets, or the reverse, but no positive adjustment for one capital or ordinary income asset, and negative adjustment for another.943  Section 197 intangibles, even if not shown on the books, are included,944 but the residual method does not apply.945 Positive adjustments for a class are allocated first to appreciated properties in proportion to unrealized gain, and then to all properties in proportion to fair market value.946 Similarly, decreases are allocated first to property that has declined in value in proportion to unrealized loss, then to all properties in proportion to their adjusted basis after reflecting the first allocation.947 Negative adjustments are limited to the basis of partnership property of the required character, with a carryover of any excess,948 presumably even when there is a substantial basis reduction. Negative adjustments reduce the partnership's depreciation over the remaining depreciable life of the property.949 A further complication is that when a § 754 election applies, the basis adjustment to the partnership corresponds in timing and amount to gain recognized by the withdrawing partner.950
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943 Regs. § 1.755-1(c)(2).

944 Regs. § § 1.755-1(a)(4)(iii), 1.197-2(g)(3) (providing for amortization of increase in adjusted basis of  § 197 intangibles under  § § 734(b) and 743(b). See V, B, below, for a discussion of goodwill in liquidating distributions.

945 Regs. § 1.755-1(a)(4)(iii), (6) Ex. 5. See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the application of the residual method to § 743(b)/754 adjustments to purchasers of partnership interests.

946 Regs. § 1.755-1(c)(2)(i).

947 Regs. § 1.755-1(c)(2)(ii).

948 Regs. § 1.755-1(c)(3), (4).

949 Regs. § 1.734-1(e)(2).

950 Rev. Rul. 93-13, 1993-1 C.B. 126. See V, C, 3, below, for a discussion of the timing of inside basis adjustments when there is a series of liquidating distributions.

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The partnership makes basis adjustments for any gain or loss attributable to property involved in  § 751(b) exchanges, without regard to any election under § 754.951 The two-category system may result in allocation of lost basis in, for example, depreciable  § 1250 property, that may include recapture that is a § 751 asset, to other capital assets, such as land, or vice versa. None of the examples in the regulations illustrate this result.
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951 Regs. § 1.751-1(b)(3)(i), (iii) and (g) Ex. 2(e)(1);see III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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When the partnership that makes a liquidating distribution owns an interest in another partnership, it is the upper-tier partnership in a tiered partnership arrangement, with the other partnership as a lower-tier partnership. Although a  § 754 election for the upper-tier partnership permits adjusting the outside basis of the lower-tier partnership interest in the hands of the distributee, it does not allow any adjustment of the inside basis of the assets of the lower-tier partnership, unless a  § 754 election also applies to the lower-tier partnership.952 There is a similar requirement for application of  § 754 elections to both partnerships for basis adjustments when the current distribution includes an interest in the lower-tier partnership.953 Thus,  § 734(b) adjustments pass through the tiers for current distribution only to the extent that § 754 elections apply to all partnerships in the chain.954 When the distribution of an interest in a lower-tier partnership by an upper-tier partnership is a liquidating distribution that terminates the distributee's interest in the upper-tier partnership, the outside basis of the distributed lower-tier partnership is increased to the distributee's outside basis in the upper- tier partnership if that is more than the transferred outside basis of the lower-tier partnership.955
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952 § 732(b) (flush language). See Rev. Rul. 92-15, Situation 1, 1992-1 C.B. 215 (upper-tier partnership with  § 754 election in effect, adjusts inside basis of interest in lower-tier partnership when basis to distributee of other property is limited under § 732(a)(2); lower-tier partnership with  § 754 election in effect also adjusts inside basis of its assets); Rev. Rul. 87-115, 1987-2 C.B. 163 (§ 754 adjustments on sale of a partnership interest owning lower-tier partnership; only adjust inside basis of lower-tier partnership if  § 754 election applies to both); PLR 9444013 (merger of two partnerships did not affect their  § 754 elections; the resulting partnership retained the  § 743(b) basis adjustments previously made by the merged partnerships).

953 § 734(b) (flush language); see Rev. Rul. 92-15 1992-1 C.B. 215 (Situation 2 discusses the application of the § 754 election to such a transfer).

954 See III, C, 2, a, above, for a discussion of basis adjustments for current distributions in tiered partnerships.  The same principles apply to liquidating distributions, with the modification that both positive and negative adjustments are possible.

955 See III, B, 1, and IV, B, above, for discussions of the basis of distributed property.

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A partnership that is required to decrease the inside basis of partnership property, presumably, including any decrease for a substantial basis reduction, may not allocate any of the decrease “to stock in a corporation (or any person related .  .  . to such corporation)which is a partner in the partnership.”956 Whether a person is related to a corporation for this purpose is determined under  § § 267(b) and 707(b)(1). Presumably, the related person does not have to be a corporation or the reference to related person would be redundant. Any of the basis decrease that a partnership cannot allocate to stock of corporate partners must be allocated to other partnership property.957 The partnership recognizes gain to the extent that the amount allocated to other property exceeds the basis of other property immediately before the allocation.958
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956 § 755(c), added by the American Jobs Creation Act, P.L. 108-357, § 834(a), effective Oct. 22, 2004. See H.R. Rep. No. 108-548, at 287 (2004). The legislative history indicates that the purpose of the provision is to prevent a decrease in basis of corporate partner stock, because if that stock was distributed to the corporate partner, § 1032 would protect the corporate partner from recognizing any gain on disposition of the stock. See.R. Rep. No. 108-548, at 287 (2004). See also Rubin, Whiteway, &  Finkelstein, “New Legislation Tightens Partnership Tax Rules,” 83 Taxes (May 2005).  See III, B, 1, c, above, dealing with another problem of the interplay of the partnership rules and the corporate rules, when the partnership distributes stock to a controlling corporate partner.

957 § 755(c)(2).

958 § 755(c) (flush language).

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The IRS applies an aggregate principle when a partnership owning corporate partner stock disposes of it, applying § 1032 to the corporate partner's share of any gain, but allows a basis step-up for the tax-free gain.959 As a result, a corporate partner might receive an unjustified tax-free outside basis adjustment when there is no  § 754 election in effect at the time it acquired an indirect interest in stock held by a partnership, because a portion of the gain would be allocated to it, and, even though it is tax free, would increase the outside basis of the partnership interest, that may have reflected the value of the corporate partner stock. If a  § 754 election had applied to the purchase, the inside basis adjustment would have eliminated the allocated gain and outside basis step-up. The regulations prevent this unjustified result, by, in effect, adjusting the corporate partner's outside basis to eliminate the difference between the corporate partner's share of inside basis in its stock and what the basis would have been if a  § 754 election was in effect.960
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959 Regs. § 1.1032-3(b), (c), and (e) Ex. 3. See 710 T.M., Partnerships —Conceptual Overview, for a discussion of this IRS position relating to controlling partner stock.

960 Regs. § 1.705-2.

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There is no provision for adjustments of inside basis of S corporation assets equivalent to the  § 754 adjustment. Accordingly, a purchaser of S corporation shares (or a successor to a deceased shareholder) will always be subject to interim double tax (or, rarely, double deduction) for built-in gain (or loss). As is the case for a partner when no  § 754 election applies, there is an offsetting loss (or gain) on disposition of the S corporation shares.

Example: § § 734(b)/754 Adjustment for Basis in Excess of Value for Property Distributed in Liquidation. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $150,000, and her capital account, after adjustment for unrealized gains and losses in Oppar's assets, is $200,000. Propp receives, in liquidation of her Oppar interest:(i) appreciated inventory, representing her aggregate share of  § 751 property, with an inside transferred basis of $30,000 and a value of $100,000, and (ii) a commercial building with a inside basis of $50,000 and value of $100,000. Munn's distributed basis in the inventory is the $30,000 transferred inside basis, leaving $120,000 ($150,000 - $30,000 allocated to the inventory) to be allocated to the commercial building. The $120,000 distributed basis exceeds not only the $30,000 inside transferred basis, but also the $100,000 value. Accordingly, Munn's distributed basis in the commercial building is $90,000 more than Oppar's transferred inside basis. If a § § 734(b)/754 election applies, Oppar reduces the basis of its remaining capital and  § 1231 assets by $90,000, which is the same type of adjustment that applies for a substantial basis reduction when no § § 734(b)/754 election applies. If the only qualifying asset is land held for investment, an adjustment for depreciable § 1231 property, the commercial building, is apparently shifted to a nondepreciable capital asset, the land, in effect offsetting the increase in depreciation that Propp obtains on the commercial building, to gain on the land, with no effect on depreciation, or the 25% rate for unrecaptured  § 1250 gain. If Oppar does not have qualifying property with a basis of $90,000, any excess is held in suspense until Oppar acquires qualifying property. It cannot be applied against  § 751 property, even though part of the adjustment is indirectly attributable to the$70,000 inherent gain in the inventory.

3. Basis Adjustment Without § 754 Election: Liquidating Distributions—§ 732(d) 

In liquidating distributions, unlike current distributions, the outside basis of capital and  § 1231 assets generally equals or exceeds the value of the assets under the basis rules that do not limit the distributed basis to the inside basis of the distributed property,961 as is the case for current distributions.962
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961 § 732(b); Regs. § 1.732-1(b). See IV, B, 1, above, for a discussion of the allocation of basis to distributed capital and  § 1231 assets to equal the outside basis of the partnership interest.

962 § 732(a)(2); Regs. § 1.732-1(a). See III, B, 1, above, for a discussion of the limitation of the basis of distributed property to the lesser of the transferred inside basis of the property or the outside basis of the partnership interest.

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a. Elective Application of § 732(d) in Liquidating 
 Distributions 

Even if a  § 754 election needed to give a transferee the benefit of a basis adjustment reflecting the purchase price (or other outside basis) does not apply to the transfer, the transferee may make a  § 732(d) election,963 without partnership approval, that provides the successor (or purchasing partner) the benefit of the same special basis adjustment as a  § 754 election,964 but only if the partnership distributes the assets for which there would have been a basis adjustment or like kind property to the purchasing partner within two years of purchase.965 A distribution within two years of purchase may happen if there are personal or policy differences between the purchaser and the continuing partner, but is most likely to happen when the deceased partner's interest is terminated by liquidating distributions to the successor in interest. Accordingly, the elective application of  § 732(d) to liquidating distributions is discussed as part of the discussion of tax issues for the successor.966
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963 The  § 732(d) election is made by the distributee partner's attaching a schedule to the income tax return setting out (i) the election to adjust the basis of distributed property under  § 732(d) and(ii) the computation of the basis adjustment and its allocation of the adjustment to the distributed properties. Regs. § 1.732-1(d)(3). The election must be made in the year of the distribution if it includes depreciable, depletable or amortizable property, but if not then the election can wait until the first-year basis has tax significance. Regs. § 1.732-1(d)(2).

964 Regs. § 1.732-1(d)(1)(i), (iii).

965 § 732(d); Regs.  § 1.732-1(d)(1)(i) to (iii).  See III, C, 2, b, above, for a discussion of the effect of the election in current distributions, and IV, C, 3, b, below, for a discussion of the mandatory application of the  § 732(d) adjustment in certain circumstances.

966 See V, D, 2, below, for a discussion of the successor's (and purchaser's) elective basis adjustment under  § 732(d) when there is no  § 754 election.

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b. Mandatory Application of § 732(d) in Liquidating Distributions 

The IRS may require an adjustment under § 732(d), without an election by the purchasing partner, for liquidating distributions, even if not within two years of purchase, if the fair market value of the distributed property exceeds inside basis by more than 10%,967 and has done so in regulations that apply the adjustment only when the effect would otherwise shift basis from nondepreciable to depreciable property.968 Accordingly, the mandatory application is required and not applied only as a result of audit, and is most likely to apply to liquidating distributions. It is not clear why only this case is covered, particularly since the application of the mandatory adjustment can apply to  § 751 property.969
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967 § 732(d).

968 Regs. § 1.732-1(d)(4); Rudd v. Comr., 79 T.C. 225 (1982), acq. (distributee partner's basis in partnership goodwill was mandatorily determined under § 732(d);distributee received assets including furniture and fixtures and intangibles, including use of firm name, at the time nondepreciable, with a zero inside basis upon dissolution of partnership, so that under then-§ 732(c) the entire outside basis of his partnership interest would be allocated to the furniture and fixtures, giving distributed basis in excess of value); PLR 9232022 (termination of partnership under former regulations on two-step purchase of partnership interests, where conditions of regulations for shift of basis from nondepreciable to depreciable property met required application of § 732(d) on deemed distribution of assets when second step completed); cf. TAM 9734003 (does not apply  § 732(d) to prevent basis shift from longer-lived to shorter-lived assets in absence of  § 754 election). See 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment of the application of § 732(d).

969 See Regs. § 1.732-1(d)(1)(vi). Regs.  § 1.701-2(b) Ex. 11 (two properties each with a basis of $5, one with a $5 value and the other with a $95 value distributed to a partner with a outside basis of $100, resulting in a $50 basis in each property) illustrates a case which a broader application of § 732(d) probably should cover. Section 704(c), which was amended after the adoption of the anti-abuse regulations, cures this abuse and renders the example obsolete on its facts, but the point remains that many abuses could be addressed effectively on a technical approach without resort to vague anti-abuse rules.

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The amount of the adjustment is based on the excess of the purchase price over the distributee's share of the partnership's inside basis.970 The adjustment is notionally made to the inside basis of the property owned on the date of purchase, for purposes of determining the transferred inside basis to the distributee, and is allocated to all partnership properties whether distributed or not.971 However, in a liquidating distribution, any adjustment allocated to other partnership property in which the distribute relinquishes an interest, including any property for which the transferee has a notional inside basis adjustment that is distributed to another partner,972 is reallocated to the distributed property.973 This provides complete relief for liquidating distributions.
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970 § 743(b)(1); Regs. § 1.743-1(b), (c), and (d).

971 Regs. § 1.743-1(g)(1), (5) Ex. (ii).

972 Regs. § 1.743-1(g)(2), (5) Ex. (iv).

973 Regs. § 1.743-1(g)(3), (5)Link Ex. (v).

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To the extent that the distribution includes § 751 property, or other property in lieu of the distributee's interest in  § 751 property,  § 751(b) applies first,974 as do the mixing bowl rules.975 The role of  § 732(d) is limited to determining the basis of the other property in the deemed exchange.976 The partnership is required to supply a transferee subject to a mandatory  § 732(d) adjustment with the information needed to compute the adjustment.977 Capital accounts are adjusted to reflect basis adjustments under  § 732(d) to the extent they properly correspond to changes in book value.978
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974 § 751(b). Regs. § § 1.751-1(b), 1.732-1(d)(5). See III, D, above, for a discussion of when non–pro rata current distributions involving changes in shares of ordinary income property are treated as taxable exchanges.

975 § § 704(c)(1)(B), 737; Regs. § § 1.704-4, 1.737-1 to -5. See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

976 Regs. § 1.732-1(d)(5).

977 Id.

978 Regs. § 1.704-1(b)(2)(iv)(m)(3), (5).

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Example: Mandatory Application of § 732(d) in Liquidating Distributions. Munn, Propp and Perch are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Perch acquired her interest from an original partner, Surv, five years ago for $240,000, when no  § 754 election was in effect. When Perch bought the interest, Oppar's assets were:(i) LIFO inventory with a value of $90,000 and basis of $9,000; (ii)three buildings worth $120,000 each ($360,000 total), with basis of$60,000 each (total $180,000); and (iii) three parcels of land under the buildings with a basis and value of $90,000 each (total $270,000). Surv recognized $27,000 of ordinary income on the LIFO inventory under § 751(a), and $60,000 capital gain attributable to the buildings that, presumably, included unrecaptured § 1250 gain. If a  § 754 election had been in effect, Perch's inside basis adjustment would have been$27,000 for the inventory, and $60,000 for each building. The inventory now has the same basis and value, the buildings are now worth $48,000 each (total $144,000) and are fully depreciated to a zero basis, and the land parcels are now worth $108,000 each (total $324,000), with the same $90,000 basis. Perch, whose outside basis is now $180,000, reflecting the depreciation on the buildings, receives one-third of the inventory, and one building and land parcel in liquidation of her interest. Under the general rule of § 732, Perch's transferred basis in the inventory is $3,000, $90,000 in the land and zero in the building, leaving excess outside basis of $87,000, to be allocated, under § 732(c), first $18,000 to the land and $48,000 to the building to bring basis up to value, and leaving $15,000 to be allocated to the land ($10,000) and building($5,000) in proportion to their values, but leaving each with a basis in excess of value ($118,000 for the land and $59,000 for the building), because the inventory basis is not adjusted to reflect its value. If there had been a  § 743(b) adjustment, Perch's transferred inside basis in the inventory would have been$30,000 (assuming no change in the LIFO inventory), $90,000 for the land, and $60,000 for the building (adjusting only for actual depreciation, since she did not have the advantage of the higher depreciation). Since there is a shift between depreciable and nondepreciable property, the mandatory adjustment applies, so that these amounts apparently become Perch's basis. Ironically, preventing a basis shift from nondepreciable property to depreciable property involved a shift from both to ordinary income property. All partners' capital accounts are increased for their ratable shares of the inherent gains in the distributed properties, and Perch's is reduced for the value of the properties she receives.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

D. Suspended Losses 

A partner receiving a liquidating distribution may have losses that could not be deducted because of the basis limitation of § 704(d),979 because of the at-risk limitations of § 465,980 or because of the passive loss limitation of § 469.981
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979 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the limitation of loss deductions to outside basis.

980 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the at-risk limitations, and when liquidation of a partnership interest allows deduction of suspended at-risk deductions; and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the parallel issues of when disposition of a partnership interest allows deduction of suspended at-risk deductions.

981 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the passive activity loss limitations, and when liquidation of a partnership interest allows deduction of suspended passive activity losses; and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the parallel issues of when disposition of a partnership interest allows deduction of suspended passive activity losses.

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Under § 704(d), no partner can deduct a distributive share of partnership losses that exceeds the partner's outside basis in the partnership interest immediately prior to deduction of the loss, with an unlimited carry-forward of losses not allowed in the year incurred.982 The deferred deduction is allowed if and when the basis in the partnership interest increases: (i) for subsequent income, including recognition of deferred gain on contributed property; (ii) for contributions to capital;983 or (iii) for increases in the partner's share of partnership liabilities.984
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982 § 704(d); Regs. § 1.704-1(d). See 710 T.M., Partnerships —Conceptual Overview, for a summary discussion, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of the outside basis limitation on deducting partnership losses.

983 § 705; Regs. § 1.705-1(a)(2). See I, B, above, for a discussion of allocations to account for the difference between basis and value of contributed property; cf. FSA 200207015 (S corporation shareholders may include in basis for deducting losses, increases in basis for additional shares purchased after termination of S election and before the end of the post-termination transition period).

984 § 752(a); Regs. § 1.752-1(b). See II, D, above, for a summary discussion, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for comprehensive treatments, of how partnership liabilities provide outside basis to allow deduction of partnership losses.

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A partner that is an individual (or a closely held C corporation985) may deduct losses, including a distributive share of partnership losses that do not exceed outside basis, for activities involving films, farming, oil, gas and geothermal and leasing  § 1245 property, only to the extent at risk,986 but with an unlimited carry forward.987 A partner is at risk for money or property contributed to the partnership, or for partnership liabilities for which the partner has personal liability or has pledged personal assets.988 A partner is not at risk for even recourse borrowing from a person with an interest in the partnership other than solely as creditor,989 or if protected against economic loss.990 The at-risk limitation also applies to real estate placed in service after December 31, 1986, but with an important exception for certain qualified nonrecourse financing.991 Qualified nonrecourse financing includes borrowing secured by the real property from commercial sources or government guaranteed borrowing; seller or broker financing is generally excluded, unless the terms are commercially reasonable, and on the same terms as from an unrelated person.992 All borrowing by an LLC is generally nonrecourse to the members and, thus, subject to the at-risk rules.993 Any losses that are suspended under the at-risk limitation are postponed, and can be deducted where there is an increase in an amount at risk.994 Since suspension of losses under the at-risk rules does not prevent reduction in basis for depreciation or similar allowances,995 suspended losses will be allowed when the activity is disposed of, because gain will be realized under the Tufts principle.996 Even if the gain on disposition is capital, the generally ordinary character of the suspended losses should be preserved.997 Similarly, application of the at-risk limitations does not affect capital accounts.998
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985 Section 465(a)(1)(B) defines closely held corporation as one that meets the personal holding company definition of § 542(a)(2).

986 § 465. See 710 T.M., Partnerships —Conceptual Overview, for a summary discussion; and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, and 550 T.M., At-Risk Rules, for comprehensive treatments of the issues considered in summary form in this section.

987 § 465(a)(2); Prop. Regs. § 1.465-2(b).

988 § 465(b). The at-risk amount is reduced for partnership losses and partnership distributions and increased for partnership income. § 465(b)(5); Prop. Regs. § 1.465-22(c)(2).

989 § 465(b)(3); Prop. Regs. § 1.465-8 (only capital interest or interest in net profits is noncreditor interest); see Krause v. Comr., 92 T.C. 1003 (1989) (creditors who were promoters, funded a tax defense fund and had net profits interest and liquidation interests to secure indebtedness did not have prohibited interests); Pritchett v. Comr., T.C. Memo 1989-21, 56 T.C.M. 1070 (interest in net profits of wells drilled is prohibited interest; interest in gross sales is not); Van Wyck v. Comr., 113 T.C. 440 (1999) (S corporation shareholder not at risk for funds borrowed on a recourse note from the other S corporation shareholder and loaned to corporation;other shareholder's interest not solely as creditor).

990 § 465(b)(4); Prop. Regs. § 1.465-6; see TAM 8616004 (hazard insurance, tort insurance, and subordination of incentive compensation to recovery of investment is not protection against loss, because remain subject to economic risk).

991 § 465(b)(6).

992 § § 465(b)(6)(B) and (D) and 465(c)(7)(D); Prop. Regs. § 1.465-27.

993 See generally Cash, Note, “The Application of the At-Risk Rules to Limited Liability Companies,” 14 Va. Tax Rev. 483 (1994); FSA 200043004 (limited partners allocated discharge of indebtedness income can offset an equivalent amount, without regard to amount at risk, because DOI is gross income from the activity).

994 § 465(a); Prop. Regs. § § 1.465-2(b),-11 and-12.

995 Prop. Regs. § 1.465-1(e).

996 See Comr. v. Tufts, 461 U.S. 300 (1983); Prop. Regs. § 1.465-66. See IV, A, 2, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a comprehensive treatment of how inevitable gain on such disposition allows deducting previously suspended losses.

997 Prop. Regs. § 1.465-12.

998 This follows from the requirement to reduce capital accounts to allocated losses. See Regs. § 1.704-1(b)(2)(iv) (b).

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Section 469 limits the deduction of passive activity losses and credits to the amount of passive activity income, for individuals (including as shareholders in S corporations, partners, or LLC members), estates, trusts, personal service corporations, and certain other closely held corporations.999 Suspended losses are carried forward indefinitely, until there is passive activity income,1000 but may be deducted earlier on complete disposition of the investment.1001 Income or loss is treated as derived from a passive activity if it is from a trade or business in which the taxpayer does not materially participate.1002 Nonpassive activity income, which may not be offset against passive activity losses, includes salaries and other earned income and portfolio income(which, ironically, is considered “passive” in other contexts), such as dividends, interest, annuities or royalties, including portfolio income received as a limited partner's share.1003 To the extent that passive activity losses have not been absorbed by the time of the liquidating distributions on disposition of the partnership interest, they may be deducted against any income or gain from the activity, or from any other passive activity, and to the extent not absorbed, against other income, including earned income or portfolio income.1004 Material participation requires regular, continuous and substantial involvement in operation, and, thus, may not include time spent by a venture capitalist in monitoring the operation and, possibly, in exercising controls over major expenditures.1005 The temporary regulations define material participation as: (i) more than 500 hours of activity, (ii) substantially all of the participation in the activity, or (iii) more than 100 hours, if no one else does more.1006 To limit potential abuse, the IRS has broad authority to issue regulations necessary to carry out the purposes of the provision, including “requiring net income or gain from a limited partnership or other passive activity to be treated as not from a passive activity.”1007 All rental operations are passive activities,1008 except for rental real estate activities of certain taxpayers engaged in a real property business, that is those who devote at least 750 hours of service to real property trades or business, and who provide more than one-half of their services in real property trades or businesses in which the taxpayer materially participates.1009 Limited partners have great difficulty materially participating.1010 LLC members, particularly member managers, and LLP partners probably should not automatically be considered limited partners for this purpose, and a case can be made that even nonmanager members should not, if they can meet the other tests of material participation, particularly the 500-hour test.1011 A sensible reform suggestion is to make the classification of limited partners for purposes of the passive loss rules turn on whether the taxpayer is a person whose participation in the management of the entity is limited under applicable State law.1012
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999 § 469. The definition of closely held corporation is the same as for the at-risk rules. § 469(j)(1). See 710 T.M., Partnerships —Conceptual Overview, for a summary discussion; and 549 T.M., Passive Loss Rules, for a comprehensive treatment of the issues discussed in summary form in this paragraph.

1000 § 469(a)(1)(A), (b); Regs. § 1.469-1(f)(4). See TAM 9750001 (passive loss carryovers may be used to reduce self-employment income).

1001 § 469(g); Regs. § § 1.469-2(e)(2), 1.469-2T(e). If the sale of the partnership interest generates a gain, the suspended loss is first applied against that gain. § 469(g)(1)(A)(ii); see Rev. Rul. 95-5, 1995-1 C.B. 100 (gain on distributions in excess of basis is passive gain in proportion to passive activities of S corporation or partnership); TAM 9501001 (same, specifies that character depends on activities in year of distribution).

1002 § 469(c).

1003 § 469(e)(1); see Hillman v. Comr., 263 F.3d 338 (4th Cir. 2001), rev'g and rem'g 114 T.C. 103 (2000) (S corporation shareholder not allowed to net self-charged management fees when regulations only cover netting of self-charged interest;  § 469(l)(2) is not self-executing;remand relates to alternate issue not addressed by Tax Court). Regs. § 1.469-7, relating to self-charged interest was adopted by T.D. 9013, 67 Fed. Reg. 54087 (8/21/02). The preamble states that that the self-charged rule was not extended to other self-charged items, such as management fees and salaries, because the provisions of  § 469(c)(7) relating to real estate professionals, in effect, provided adequate relief.

1004 See St. Charles Investment Co. v. Comr., 232 F.3d 773 (10th Cir. 2000), rev'g 110 T.C. 46 (1998) (S corporation that was formerly a closely held C corporation can deduct suspended passive losses against gain on disposition of passive activity assets; § 469(b), providing for such carryover only subject to the limits of § 469, trumps § 1371(b)(1), which generally prevents carryovers from C corporation years to S corporation years). See IV, A, 2, above, and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for discussions of how such liquidation or disposition ends the deferral under the passive-loss rules.

1005 See § 469(h); Regs. § 1.469-5T(b)(2);S. Rep. No. 313, 99th Cong. 2d Sess. 732–35.

1006 Regs. § 1.469-5T(a)(1), (2) and (3).

1007 Regs. § 1.469-9(g).

1008 § 469(c)(2); Regs. § 1.469-1T(e). However, a taxpayer who actively participates in the management of rental real estate can deduct up to $25,000 of his passive activity losses. § 469(i).

1009 § 469(c)(7). See Carnevale, “Prop. Regs. Do Not Relieve Real Estate Problems with PAL,” 24 Tax'n for Law. 79 (Sept./Oct. 1995).

1010 § 469(h)(2); Regs. § 1.469-5T(e).

1011 See Gregg v. U.S., 2001-1 USTC ¶ 50,169 (D. Ore. 2001) (states that limited partnership tests are obsolete for LLCs; possibly dicta); Wirtz, “Section 469: Material Participation Standards for LLC Members,” 74 Taxes 411 (1996); see also Frost, “Square Peg, Meet Round Hole: Classifying LLC Members as ‘General Partners' or ‘Limited Partners'for Federal Tax Purposes,” 73 Taxes 676, 692–95(1995); Frost, “‘Square Peg Meets Round Hole II: We Still Don't Know Whether to Classify LLC Members as ‘General Partners'or ‘Limited Partners' for Federal Tax Purposes,” 439 PLI/Tax 789 (1999); Raby and Raby, “Partners, LLC Members, and SE Tax,” 87 Tax Notes 665 (May 1, 2000) (discusses issue including what practitioners are doing).

1012 See Staff of the Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (2001).

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Example: Suspended Losses on Disposition. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn's outside basis in the Oppar interest is $30,000, Munn's amount at risk is zero, and Munn has $70,000 of losses suspended under the at-risk limitations. Munn's share of Oppar nonrecourse debt is $100,000. Munn receives a liquidating distribution for his Oppar interest of $10,000 cash. Munn's amount realized is therefore $110,000 ($10,000 cash + his $100,000 share of the nonrecourse liability), and his gain is $80,000. The gain is considered income from the activity that increases Munn's at-risk amount. The net result of the transaction is that Munn will have an $80,000 taxable gain from the liquidation of the Oppar interest, which will be capital gain except to the extent subject to § 751, and will have $70,000 of presumably ordinary loss that was previously suspended. If the loss was from a passive activity, the gain is also passive income that allows the deduction of the loss. In addition, since the sale is a complete disposition, the passive loss rules do not apply. If Munn has $70,000 of losses suspended under § 704(d), because of lack of basis and no share of liabilities, he is not entitled to deduct the loss against the $80,000 gain on the liquidation, and the remaining loss is never deductible. Presumably, he was allocated the loss initially only because of a deficit make-up obligation, but, since the sale apparently relieves him of that obligation, he will never suffer an economic loss.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

E. Closing the Tax Year 

Applying the entity principle, a partnership has its own taxable year,1013 which in turn determines when partnership income and deductions are reported. Specifically, the partner reports the partnership income for the year in which, or with which, the partnership tax year ends.1014 Although the tax year does not close for current distributions, even when they are accompanied by changes in partnership shares of capital, distributions, income, deduction, gain, loss, or liabilities,1015 it does close for a liquidating distribution that is the final distribution that completes the partner's withdrawal, and on the death of a partner.1016 This means that the withdrawing (or deceased)partner includes the allocable share of income for the portion of the year prior to the withdrawal or death, as of the date of withdrawal or death in income and in outside basis.1017 The same should be true for cash advances that are not treated as distributions.1018 The withdrawal agreement, however, apparently can allocate the income to the remaining partners.1019 The S corporation rule eliminates the problem by providing that a ratable share of corporate income is allocated to each shareholder based on the number of shares held on each day during the S corporation's tax year.1020 When the year does close, the partnership's income for the year is allocated by an interim closing of the books, unless the partnership elects proration.1021 This is the reverse of the S corporation approach of prorating annual earnings in the absence of agreement to close the books.1022
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1013 § 706(b)(1); Regs. § 1.706-1(b)(1).

1014 § 706(a); Regs. § 1.706-1(a)(1). The S corporation rule is the same. § 1366(a); Regs. § 1.1366-1(a)(1).

1015 Regs. § 1.706-1(c). Even though the books do not close, § 706(d)(1), requiring that the income for the year be allocated to reflect the varying interests, may require adjustment to reflect the change. Regs. § 1.706-1(c)(4). Prop. Regs. § 1.706-4(a)(1), REG-144689-04, 74 Fed. Reg. 17119 (4/14/09), would provide, with certain exceptions, that if a partner's interest in a partnership varies during the taxable year as a result of a disposition of an entire interest in a partnership as described in Regs. § 1.706-1(c)(2) or as a result of the disposition of less than the entire interest in a partnership, the partnership will determine the partner's distributive share of partnership items by using the interim closing method or by agreement of the partners to use the proration method. The proposed amendment would apply for partnership taxable years that begin after the date the final regulations are published, but not before taxable years beginning after Dec. 31, 2009. See 710 T.M., Partnerships — Conceptual Overview, for a discussion, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for a comprehensive treatment of retroactive allocations.

1016 § 706(c), (d);Regs.  § § 1.706-1(c)(1) and (2) and 1.761-1(d). Note that REG-144689-04, 74 Fed. Reg. 17119 (4/14/09) would amend Regs. § 1.706-1(c) to reflect § 706(c)(2)(A), which requires that the taxable year of the partnership close with respect to a partner who dies. The proposed amendment would apply for partnership taxable years that begin after the date the final regulations are published, but not before taxable years beginning after Dec. 31, 2009.

1017 § 706(c)(2)(a). Regs. § 1.706-1(c)(2)(ii). See V, D, 4, below, for a discussion of issues relating to income for the year of death.

1018 Regs. § 1.731-1(a)(1)(ii); see Rev. Rul. 94-4, 1994-1 C.B. 195 (deemed distribution resulting from shift in share of liabilities occurs at year-end to extent of share of distributive share of income for year; emphasis added). See III, A, 1, above, for a discussion of interim cash advances that are considered drawings against current-year income.

1019 See Smith v. Comr., 331 F.2d 298 (7th Cir. 1964) (allocating all income to remaining partner as part of agreement for redemption of partner is valid; before enactment of § 706(d); should still be valid, as there are no new partners or capital contributions).

1020 § 1377(a)(1); Regs. § 1.1377-1(a).

1021 § 706(c)(2)(A); Regs. § 1.706-1(c)(2)(ii). A monthly convention may be permissible. See H.R. Rep. No. 861, 98th Cong., 2d Sess. 858 (1984) (indicating that a monthly convention may be permissible in applying the 1984 amendments to  § 706(d) limiting retroactive allocation of partnership deductions); Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 205 (1995). Prop. Regs. § 1.706-4(c) and (d), REG-144689-04, 74 Fed. Reg. 17119 (4/14/09), would confirm the interim closing method as the default allocation method, and the proration method (by agreement of the partners) as the alternative. The proposed regulations would apply to partnership taxable years beginning the day after the date on which the regulations are published as final, but not before taxable years beginning after 2009. Prop. Regs. § 1.706-4(c)(2) would permit a partnership using the interim closing method to use either the calendar-day convention or a “semi-monthly convention,”while Prop. Regs. § 1.706-4(d)(2) would require a partnership using the proration method to use the calendar-day convention. These proposed regulations would apply to partnership taxable years of partnerships other than existing publicly traded partnerships that begin after the date on which the regulations are published as final, but not before taxable years beginning after 2009. See NSYBA Tax Section Comments on REG-144689-04, dated Jan. 19, 2010, for a recommendation that the final regulations—when issued—provide more flexibility in selecting and combining methods and conventions, specifically that the final regulations, among other things, (i) allow a partnership to use different methods for separate variations in partners' interests during partnership's taxable year,(ii) clarify that the proration method is available to a partnership in a taxable year in which the partnership has extraordinary items,(iii) designate the proration and interim closing methods as safe harbors rather than as exclusive methods and permit reasonable hybrid methods, and (iv) allow a partnership employing the interim closing method to use a combination of the provided conventions. See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for comprehensive treatments of the effect of closing of the tax year.

1022 § § 1366(a)(1), 1377(a); Regs. § 1.1377-1(a); see McMichael v. Comr., 99-2 USTC ¶ 50,979 (11th Cir. 1999) (S corporation shareholder remained taxable after settlement agreement, when under the agreement, there were various options as to whether he would be bought out by the other shareholders and as to the price). The allocation is based either on a strict prorating of annual income on a daily basis, § 1377(a)(1);Regs.  § 1.1377-1(a) and (c) Ex. 1, or, if all affected shareholders agree, on the actual income to the date of termination, as if it were a separate tax year. § 1377(a)(2); Regs. § 1.1368-1(g); Regs. § 1.1377-1(b) and (c) Ex. 2; cf.  Regs. § 1.1362-3(c)(6); Regs. § 1.1377-1(a); see 730 T.M., S Corporations: Formation and Termination, and 731 T.M., S Corporations: Operations, for comprehensive treatments of allocating income for the year of termination and an S corporation shareholder's interest.

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Example: Proration v. Closing of Books. Propp, Munn and Surv are members of a partnership, Oppar. Oppar and each of its partners are on a calendar year. The Oppar partnership agreement satisfies the special allocation regulations. Munn receives a liquidating distribution for his interest on June 30, 20X2. The mid-year liquidating distribution does not cause a bunching of Oppar income or loss for Munn. Although Oppar has $360,000 of taxable income for the entire calendar year 20X2, it had a $240,000 loss for the first half of 20X2, and $600,000 of income for the second half. Unless the Oppar partners agree, or have agreed, to the proration method, the share allocated to Munn is determined by closing Oppar's books as of June 30, 20X2. Under this method, Munn's share of Oppar income or loss for 20X2 is an $80,000 taxable loss (one-third of the$240,000 loss). The remaining partners are required to include of taxable income the entire $600,000 as his share of Oppar income for the period July 1 to Dec. 31, 20X2 offset by $160,000 loss for the first six months for a total of $440,000. If, on the other hand, the Oppar partners agree, or had agreed, on the proration method, Munn includes $60,000 of taxable income (one-half of the one-third of the$360,000 Oppar taxable income for 20X2 allocable to his share) as his share of Oppar's 20X2 partnership income, and the remaining partners include the other $300,000.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

F. Partnership Termination 

Section 708(a) sets forth the basic rule that, for purposes of subchapter K, “an existing partnership shall be considered as continuing if it is not terminated.”1023 Termination is a tax concept, not governed by state law principles or concepts of dissolution.1024 There is no concept of a “liquidation” of a partnership under the Code.1025 A partnership is terminated only when “no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.”1026 Accordingly, a partnership is not terminated if even a minority of its partners continue a portion of the partnership business.1027
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1023 See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the effects of partnership termination that are summarized in this section.

1024 Regs. § 301.7701-1(a). Local law governs in determining legal relationships among members of an entity, but the Code controls in determining the classification consequences of those legal relationships; Chef's Choice Produce Ltd. v. Comr., 95 T.C. 388 (1990) (dissolution of partnership under state law had no bearing on federal audit and litigation procedures commenced against partnerships); Fuchs v. Comr., 80 T.C. 506 (1983) (withdrawal of 25% partner that caused dissolution under Uniform Partnership Act, but that did not terminate withdrawing partner's right to share in some partnership income did not terminate partnership; election to reinvest condemnation proceeds had to be made by partnership). Although withdrawal of a partner generally caused dissolution under the Uniform Partnership Act (“UPA”), UPA § 31, dissociation of a partner does not dissolve the partnership under the Revised Uniform Partnership Act (1997) (“RUPA”), RUPA § 603, which has a definition of dissolution, RUPA § 801, that is closer to, but not identical with, the tax concept.

1025 Confusion is sometimes created for non-partnership tax specialists by use of the term “liquidation”of a partnership. There is no such concept in subchapter K. There is, however, the concept of a liquidation of a partner's interest in the partnership under  § § 731 and 736, but technically not a liquidation of a partnership.

1026 § 708(b)(1)(A) (Emphasis added). See, e.g., 7050 Ltd. v. Comr., T.C. Memo 2008-112 (partnership not terminated even though only activity was holding inactive foreign currency in a bank account).

1027 See Rev. Rul. 66-264, 1966-2 C.B. 248 (partnership continued when the assets of a five-person partnership were purchased at a judicial sale by a partnership comprised of three of the original five partners; did not rule on whether interests of other partners were sold or liquidated); Neubecker v. Comr., 65 T.C. 577 (1975) (partnership continued, when two, apparently junior, partners in a three-person partnership formed a new two-person partnership at a new location, leaving office and the bulk of the assets with the third partner); but see Sloan v. Comr., T.C. Memo 1981-641 (although treat old partnership as continuing while one of three partners is being paid out, apparently treat new partnership of the other two with a third partner as not a continuation, when the new entity did not acquire assets and assume liabilities of the old partnership); Foxman v. Comr., 41 T.C. 535 (1965), acq., aff'd, 352 F.2d 466 (3d Cir. 1965) (also held two minor income-producing properties).

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Although, under the entity approach that generally applies to transfers of partnership interests, a disposition of a partnership interest should have no effect on the partnership or remaining partners, under a reversion to an aggregate principle, a partnership terminates on:(i) sale or exchange of 50% or more interest in the capital and profits of the partnership within any 12-month period,1028 or (ii) sale of all other partnership interests to one remaining owner or a single new owner.1029
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1028 § 708(b)(1)(B); Regs. § 1.708-1(b)(2).

1029 § 708(b)(1)(A); Regs. § 1.708-1(b)(1).

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Liquidating distributions to all partners except one, or a sale of all partnership interests to one person, whether or not a partner, immediately terminates the partnership,1030 because the definition of a 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, within the meaning of this title, a trust or estate or a corporation ... .”1031 Although not expressly stated, it takes at least two persons to form a partnership.1032 Thus, partnership mergers, regardless of form, terminate all the merging partnerships unless one is considered the continuing partnership.1033 Similarly, incorporation of the partnership terminates it, unless the incorporation takes the “assets-over”form of transfer of the partnership's assets to the corporation, but the corporate stock is retained by the partnership.1034
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1030 Regs. § 1.708-1(b)(1). See Rev. Rul. 99-6, 1999-1 C.B. 432 (partnership, usually an LLC, becomes a disregarded entity when it has only one member); but see  Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir. 1982) (husband-wife partnership continues until business wound up, even though agreement stated terminated on death); Haines v. U.S., 76-1 USTC ¶ 9222 (N.D. N.J. 1976) (farming partnership did not terminate at end of year of death of partner who made land available to partnership, when heirs to land, through corporations, became partners and continued to make land available;no loss on “abandonment” of improvements that were partnership assets; cf. Rev. Rul. 99-5, 1999-1 C.B. 434 (disregarded entity, usually an LLC, becomes a partnership when it adds one or more members);Regs. § 301.7701-3(f)(2).

1031 § 7701(a)(2). There is a substantially identical definition in  § 761(a) in Subchapter K.

1032 Regs.  § § 301.7701-1(a)(4) (a business entity with only one member is either classified as a corporation or is disregarded), 301.7701-3(f)(2). See, e.g., Rev. Rul. 99-5, 1999-1 C.B. 434 (disregarded entity, usually an LLC, becomes a partnership when it adds one or more members); Rev. Rul. 99-6, 1999-1 C.B. 432 (partnership, usually an LLC, becomes a disregarded entity when it has only one member).

1033 See IV, G, 2, below, for a discussion of the forms of partnership mergers, including a discussion of the effects of partnership termination.

1034 See IV, G, 5, c, below, for a discussion of the effects of incorporation.

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A liquidating distribution to one member of a two-person partnership, or the sale of the partnership interest to the other does not terminate the partnership while the withdrawing partner or a successor continues to share in partnership profits or to receive payments under § 736(a),1035 even though no longer a partner for state law purposes. Even though payments continue to a retired partner under § 736, a partnership can terminate if all business activities terminate.1036
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1035 Regs. § 1.708-1(b)(1)(i), (ii); see Skaggs Est. v. Comr., 75 T.C. 191 (1980) (in community property state, since estate's partnership interest is subject to probate, even though the agreement stated the partnership terminated on death, the estate shared in partnership results until the business wound up); Haines v. U.S., 76-1 USTC ¶ 9222 (N.D. N.J. 1976) (farming partnership did not terminate at end of year of death of partner who made land available to partnership until then;heirs to land, through corporations, became partners and continued to make land available; no loss on “abandonment of improvements”that were partnership assets). See IV, F, 2, below, for a discussion of the continuation of a two-person partnership as long as payments to the withdrawing partner continue.

1036 See Rev. Rul. 75-154, 1975-1 C.B. 186 (even after partnership terminated, former partners entitled to deduct retirement payments to previously retired partner).

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1. Sale or Exchange 

A partnership terminates when “within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.”1037 The sales or exchanges must be of at least 50% of both capital and profits; a sale of, for example 60% of capital and only 40% of profits is not a terminating event.1038
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1037 § 708(b)(1)(B). The 12-month period is any period of 12 consecutive months; not a calendar year or the partnership taxable year, and the sales can be by more than one partner. Regs. § 1.708-1(b)(2). See PLR 9440017 (transfer of a 49% interest in a partnership (P) followed by a transfer of a 1% interest in P which occurs at least one year and one day after the original transfer does not terminate P); PLR 9529037 (sales of partnership interests that occur one year and one month apart are not aggregated for purposes of determining whether the partnership has terminated).

1038 Regs. § 1.708-1(b)(2). See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the meaning of capital and profits interests.

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A liquidating distribution to a more than 50% partner does not terminate the partnership,1039 nor does a contribution to a partnership, even if the new partner has a more than 50% interest.1040 On the other hand, a nonrecognition exchange, such as a contribution to a corporation, or to another partnership is an exchange that may trigger a termination,1041 as is distribution of a partnership interest (whether by a corporation or a partnership or otherwise),1042 presumably including a partnership current or liquidating distribution.1043 Transfers in partnership divisions and mergers raise special issues of partnership termination.1044
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1039 Regs. § 1.708-1(b)(2). See Rev. Rul. 66-264, 1966-2 C.B. 248 (partnership continued when the assets of a five-person partnership were purchased at a judicial sale by a partnership comprised of three of the original five partners; did not rule on whether interests of other partners were sold or liquidated); Neubecker v. Comr., 65 T.C. 577 (1975) (partnership continued, when two, apparently junior, partners in a three-person partnership formed a new two-person partnership at a new location, leaving office and the bulk of the assets with the third partner); but see Sloan v. Comr., T.C. Memo 1981-641, 42 T.C.M. (CCH) 1606 (although treat old partnership as continuing while one of three partners is being paid out, apparently treat new partnership of the other two with a third partner as not a continuation, when the new entity did not acquire assets and assume liabilities of the old partnership).

1040 Regs. § 1.708-1(b)(1)(ii); see Rev. Rul. 75-423, 1975-2 C.B. 260 (no termination when new partner contributed cash for a 60% interest in partnership profits and capital).

1041 Regs. § 1.708-1(b)(2); see Evans v. Comr., 54 T.C. 40 (1970), acq., aff'd, 447 F.2d 547 (7th Cir. 1971) (contribution to a controlled corporation terminated tax partnership); Rev. Rul. 81-38, 1981-1 C.B. 386 (same); Rev. Rul. 87-110, 1987-2 C.B. 189 (transfer in a reorganization, but not if an “F” Change-in-Identity reorganization); Long v. Comr., 77 T.C. 1045 (1981) (§ 1031 exchange of partnership interests (before enactment of  § 1031(a)(2)(d))resulted in a termination). But cf. PLR 8819083 (contribution of 99% interest in profits and capital of partnership to new holding partnership with identical interests did not terminate existing partnership;no significant change in ownership).

1042 § 761(e).

1043 See FSA 200219008 (lower-tier partnership terminates on distribution of partnership interests by upper-tier partnership to its partners). A corporate dividend or redemption has the same effect. See PLR 8529097 (partnership terminated on transfer of 99% partnership interest to liquidating trust (prior to General Utilities repeal); FSA 200132009 (partnership terminates on sale of 50+% partnership interest owned by husband and wife to an S Corp. owned by only the husband; there are no attribution rules under § 708).

1044 See IV, G, 1 and 2, below, for discussions of partnership terminations in partnership divisions and mergers, respectively.

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When a distribution results in a disguised sale, the transaction should be treated as a sale or exchange for purposes of partnership termination, but only to the extent of the interest deemed sold.1045 Otherwise, when a liability transfer results in a sale or exchange for purposes of characterizing the transaction, the transfer of the partnership interest probably should not be characterized as a sale or exchange for purpose of partnership termination.1046 The definitions of transferred and exchanged basis property, which treat property in which the basis to the transferee is determined “in whole or in part” by the basis to the transferor or of the transferred property,1047 should provide substantial support for this position, particularly in light of the specific provisions relating to a disguised sale of a partnership interest.
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1045 Prop. Regs. § 1.707-7. See III, G, 2, a, above, for a discussion of when nonrecognition contributions may be converted into taxable sales of all or part of a partnership interest.

1046 See O'Brien v. Comr., 77 T.C. 113 (1981) (nonrecourse liabilities treated as distribution under  § 752 on abandonment; not as a sale of partnership interest);Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 16.01[7](6th ed. 1997); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 12.03[1][e] (3rd ed. 1997).

1047 § 7701(a)(43), (44); see 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for discussions of the transferred and exchanged basis.

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Example: Termination on Disguised Sale or Exchange. Munn, Propp and Surv are partners in a partnership, Oppar. Munn contributed$600,000 and Propp contributed $400,000, representing 100% of the Oppar capital, so that Munn has 60% of Oppar's capital and Propp has 40%, but they have only 40% and 262/3 % interests in profits, respectively, with Surv being entitled to the remaining 331/3 %. The Oppar partnership agreement satisfies the special allocation regulations. On Nov. 12, 20X1, Munn sells his Oppar interest (60% of capital, but only 40% of profits)to Perch. Despite the sale of 60% of capital, there is no termination because there was no sale of 50% of profits. On January 12, 20X2, Ides is admitted to the partnership for a $250,000 contribution that gives her a 162/3 % interest in capital and 131/3 % interest in profits. Even though there has been shift of more than 50% of profits and capital, a contribution is not a sale or exchange. On June 30, 20X2, Ides receives a $250,000 cash distribution in connection with a reduction of her interest to 20% of capital and 111/11 % of profits, which has the effect of increasing Ides' share to 20% of capital and 131/3 % of profits. Oppar and its partners are unable to rebut the presumption that Ides' contribution and the distribution to Propp are not part of a disguised sale of one-half of Surv's Oppar interest to Ides. Accordingly, Propp's disguised sale of 20% of capital and 131/3 % of profits, combined with Munn's sale of 60% of capital and 40% of profits, now mean that 80% of capital and 531/3 % of profits have been sold within 12 months, even though in separate transactions to separate purchasers, so that Oppar has terminated. The other consequences to Propp and Ides of the disguised sale are discussed in the example in IV, F, 2, below.

2. Effect of Termination 

When the partnership is terminated, there is a deemed transfer of the assets from the “old” partnership to the “new”partnership, followed by a transfer of the interests in the new partnership to the partners of the old (an “assets-over” transaction).1048 There is normally no recognition of gain or loss on the deemed contribution and distribution.1049 This results in a transferred basis and tacked holding period in the assets of the “new” partnership. It should also result in a carryover of the attributes of liabilities, including any discount or premium and any potential deduction.1050 There is, however, no revaluation of capital accounts.1051
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1048 Regs. § 1.708-1(b)(4). The current regulations were adopted in 1997. T.D. 8717, 62 Fed. Reg. 25498 (5/9/97) (subsequently redesignated by T.D. 8925, 66 Fed. Reg. 715 (1/4/01)); generally effective for terminations occurring after May 8, 1997. The prior regulations involved an assets-up form of a deemed distribution and recontribution of the partnership's assets and liabilities, with all of the collateral consequences. See Schachat and Mahoney, “A Step Towards Simplification:The Final  Section 708(b)(1)(B) Regulations,” Tax Mgmt Memo, Spec. Ed. 1997-7: Corp. Tax and Bus. Plan. Rev. S-179 (7/21/97).

1049 § § 721, 731; see IV, G, 2, below, for a discussion of the effects of transfers to effect a partnership merger. See also 710 T.M., Partnerships — Conceptual Overview for discussions of the general nonrecognition principle for partnership contribution and distributions, respectively; cf. PLR 9719015 (similar result on partnership merger).

1050 See, e.g., Philadelphia and Reading Corp. v. U.S., 602 F.2d 338 (Ct. Cl. 1979) (transferee in  § 351 transaction entitled to amortize mining development expenditures made by transferor).

1051 Regs. § § 1.704-1(b)(2)(iv)(l), 1.704-3(a)(2). See T.D. 8717, 62 Fed. Reg. 25,498–99 (5/9/97).

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The analysis for the outside basis and holding period of the partnership interests of the continuing partners is more complex. Although the outside basis of interests in the “new” partnership is the same as that of the old, because it is received as a liquidating distribution,1052 the holding period for the partnership interests is, apparently, based on the holding period of the partnership assets, which means a split holding period—a tacked holding period to the extent attributable to capital assets and  § 1231 property, but a new holding period to the extent attributable to  § 751 property.1053 When a two-person partnership terminates on sale by one partner to the other, or any partnership on sale by all partners to a third party, the IRS takes an inconsistent approach that the transaction is a sale of the partnership interest by the terminating partner(s), but a purchase of an undivided interest in partnership assets by the acquiring partner.1054 Thus, the purchaser has no need for a  § 754 election to receive a purchase price basis in the assets.
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1052 § 732(b);Regs. § 1.732-1(b).

1053 § 735(b);Regs. § 1.1223-3(a). See II, B, 2, above, for a discussion of the effect of a split holding period. See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 12.05[2][g] (3rd ed. 1997) (discussion under old regulations that should continue to apply, although not clearly stated).

1054 Regs. § 1.708-1(b)(1)(i). See Rev. Rul. 99-6, 1999-1 C.B. 432. Rev. Rul. 67-65, 1967-1 C.B. 168 (surviving partner purchasing deceased partner's interest deemed to purchase ratable share of assets; does not tack partnership holding period under § 735). See IV, G, 5, b, for a discussion of the collateral effects of this position.

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The most important effect of the current approach is that the deemed contribution does not create any new  § 704(c) amounts,1055 and does not start a new seven-year period for purposes of the mixing bowl provisions.1056 The proposed regulations that create new  § 704(c) gain in assets-over mergers,1057 should not apply to partnership terminations, because there are no new partners in a partnership termination. Termination does, however, start a new depreciation period for all of the partnership's depreciable tangible assets,1058 but not for intangible assets amortized under § 197.1059 The difference is that  § 168(i)(7) is statutory, while the rules on intangibles are regulatory.1060 The result is the successor partnership must depreciate the adjusted basis of tangible assets at the time of termination as newly acquired and placed in service on the termination date, while it can continue to amortize  § 197 and other intangibles using the same rates and schedules as the terminated partnership. Some partnerships limit sales and exchanges by partners to prevent this adverse effect. On the other hand, qualified property, 50% bonus depreciation property, or New York Liberty Zone property placed in service by the terminated partnership during the taxable year of termination may be eligible for the additional first year or “bonus” depreciation under  § 168(k) or § 1400L.1061 The termination: (i) does not trigger investment tax credit recapture,1062 (ii) does not trigger application of  § 731(c) (relating to marketable securities),1063 (iii) allows carryover of special basis adjustment under  § 743(b) in assets of the terminated partnership; and (iv) is not a distribution of the interests in the new partnership that is a sale or exchange terminating the new partnership.1064
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1055 Regs. § § 1.704-3(a)(3)(i), 1.704-4(c)(3), and 1.708-1(b)(4) Ex.(iii).

1056 Regs. § § 1.704-4(a)(4)(ii), 1.737-2(a); see III, E, above, for a discussion of provisions that prevent avoidance of the  § 704(c) allocation of the inherent gains to the contributor. Under the old approach,  § 704(c) applied to the extent that the assets deemed recontributed had a value different from the outside basis of the partnership interests that determined the new inside basis. See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 202.2.2.1 (1995); McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 12.05[2][f](3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 16.02[3] (6th ed. 1997). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the effects of partnership termination.

1057 See IV, G, 2, b, below, for a discussion of the proposed regulations on new  § 704(c) allocations in assets-over partnership mergers.

1058 § 168(i)(7). See Preamble to PS-5-96, 61 Fed. Reg. 21985 (5/13/96). In addition to citing § 168(i)(7), which provides that the MACRS depreciation carryover rules for nontaxable  § 721 or § 731 transactions do not apply to a termination, the preamble cites various anti-churning rules. The anti-churning rules became unimportant by 1997, because most personal property placed in service before 1987 was depreciated over a five-year recovery period, and, therefore, was fully depreciated by 1997, and residential rental property and nonresidential real property placed in service after 1986 is not subject to the anti-churning rules. See § 168(f)(5)(B)(i).

1059 § 197(b)(2) (provides for continuing transferor's amortization in nonrecognition transactions; no exclusion for partnership terminations);Regs. § 1.197-2(g)(2), (k) Ex. 16(ii) (new partnership inherits recovery period following partnership termination).

1060 See Preamble to PS-5-96, 61 Fed. Reg. 21985 (5/13/96);Evans, “Terminating Partnership Terminations,” 90 Tax Notes 1397, 1401–07 (Mar. 5, 2001).

1061 As added by the 2002 Job Creation and Worker Assistance Act, P.L. 107-147, § § 101, 301(a), and modified by the 2003 Jobs and Growth Tax Relief Reconciliation Act, P.L. 108-27, § 201. In general, to use the special depreciation provisions, the depreciable property must: (1) be of a specified type; (2) be used in the New York Liberty Zone in a trade or business of the taxpayer, if applicable;(3) have its original use commence with the taxpayer after certain specified dates; (4) be acquired by the taxpayer by purchase within a specified time; and (5) be placed in service by specified dates. Regs.  § 1.1400L(b)-1(c)(2) to (6). For this purpose, the property is treated as placed in service on the date it was deemed contributed to the successor partnership, so that the new partnership, not the terminated partnership, claims the deduction. Regs. § § 1.168(k)-1T(b)(5)(iii), (f)(1)(ii) and (g)(2); 1.1400L(b)-1(c)(5)(ii) and (6) and (g)(ii).

1062 Preamble, T.D. 8717, 62 Fed. Reg. 25498, 25499 (5/9/97).

1063 Regs. § 1.731-2(g).

1064 Regs. § 1.761-1(e).

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Separate partnership returns are required for the periods before and after termination.1065 The partnership termination occurs as of the day of the terminating event, so that operations through that date are chargeable to the old partnership.1066 The partnership elections for the “old” partnership do not carry over to the “new” partnership,1067 giving the partners a fresh start for otherwise irrevocable elections, like the  § 754 election, although an existing  § 754 election should allow § § 734(b)/754 adjustments that result from the transaction that caused the termination.1068 This also provides the trap that the parties may overlook the requirement to make new elections for any elections that the parties wish to continue, which is, of course, particularly troublesome if crucial deadlines pass. Even though the terminated partnership is deemed to become a new partnership, it retains its EIN,1069 but, because there is no equivalent provision for retaining its tax year, it presumably must adopt a new taxable year.1070
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1065 Regs. § 1.708-1(b)(3), (4); Notice 2001-5, 2001-1 C.B. 327 (both terminating and new partnership file short period returns;both use same employer identification number); see FSA 200132009 (return filed for partnership that terminated on sale of more than 50% that did not separate pre- and post- termination periods, nevertheless started running of statute of limitations).

1066 Regs. § 1.708-1(b)(3); § 706(c)(1); Regs. § 1.706-1(c)(1), (2).

1067 Regs. § 1.704-3(a)(2).

1068 See Rev. Rul. 86-73, 1986-1 C.B. 282 (existing election under  § 754 applies to new partner who purchased more than 50% interest on deemed distribution resulting from termination; “new”partnership must make new election).

1069 Regs. § 301.6109-1(d)(2)(iii).

1070 See 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for discussions of partnership tax years.

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The date of termination, and consequent closing of the tax year, varies with the event giving rise to the termination. When all partnership interests are transferred to, or become owned by a single owner as a result of liquidation of all other interests, the termination should be on the date when there is only one “partner.”1071 When a partnership terminates on a merger, division (only when there is no continuing partnership), or incorporation, the termination occurs on the date of the transaction, which may vary with the form of transaction.1072
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1071 Regs. § 1.708-1(b)(1). Although Regs.  § 1.708-1(b)(3)(i) states that the date of termination is the date on which the winding up of the partnership affairs is completed for purposes of § 708(b)(1)(A), since there is no “winding up” of the business where the business is continued with a single owner, it should not modify the result in the example in Regs. § 1.708-1(b)(1)(i).

1072 Regs. § 1.708-1(c)(2), Regs. § 1.708-1(d)(1), and Rev. Rul. 84-111, 1984-2 C.B. 88. See IV, G, 1, b; IV, G, 2, c;and IV, G, 3, below, for discussions of tax return requirements for continuing and terminating partnerships, as well as new partnerships in partnership divisions, partnership mergers, and partnership incorporations, respectively.

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Example: Effect of Partnership Termination. Munn, Propp and Surv each have one-third interests in profits and losses of a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp contributed appreciated land and a commercial building for one-half of Oppar's capital. Munn contributed cash to be used to renovate the property Propp contributed for the other one-half of Oppar's capital. Surv, who contributed no property, is the active manager of the project. Oppar continues Propp's depreciation life and method for the building, but, of course, starts a new life for the capitalized renovations. After five years, during which Oppar distributed all income, Munn sells his interest to Perch#1, and, within 12 months, Surv sells her interest to Perch#2, who takes over her management duties, with the consent of Propp and Perch#1. Because Oppar is terminated on Surv's sale, “old” Oppar is considered to have contributed all of its property to “new”Oppar in a nonrecognition transaction under § 721. Accordingly, the termination has no effect on the inside basis of “new” Oppar's assets, or on any adjustment of inside basis for Perch#1, if a  § 754 election applied. Perch#2 is entitled to an inside basis adjustment if “old” Oppar had a  § 754 election in effect on the date of Surv's sale, but “new” Oppar must make a new  § 754 election for any subsequent adjustments. Indeed, all of “old” Oppar's elections cease to be effective on the termination, so that “new”Oppar gets a fresh start, but also must make new elections for any it wishes to continue. The termination has no effect on Propp's capital account or remaining allocation under § 704(c), nor does it begin a new seven-year period for purposes of the mixing bowl rules. Accordingly, a distribution of part of the contributed property more than seven years after the original contribution, but less than seven years after the termination does not result in gain to Propp under the mixing bowl rules. On the other hand, “new” Oppar begins a new depreciation period for its remaining basis in the commercial building. If the property contributed by Propp was a  § 197 intangible that Propp had been properly amortizing, Oppar continues Propp's amortization period, as does “new” Oppar.

If Surv does not sell her interest until more than 12 months after Munn's sale, Oppar does not terminate. Its basis, depreciation, amortization and elections continue unchanged, except for any inside basis adjustments for Perch#1 and Perch#2 under a  § 754 election.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  IV. Liquidating Distributions

G. Structural Changes 

Partnerships, like corporations, may be restructured in a variety of ways to meet changing business needs, or to reflect changes in the relationships of the participants. The following sections discuss the tax consequences of dividing, merging, incorporating, recapitalizing, and changing the state law form of tax partnerships. All these forms of restructuring involve partnership distributions as an integral part of the transaction, mostly liquidating distributions, but some divisions and recapitalizations may only involve current distributions. Although all of these restructurings are generally nonrecognition transactions, there are important collateral consequences, some significant ones of which depend on the exact legal form adopted to effectuate the restructuring,1073 with many of the most important consequences turning on when in the restructuring process the distribution is made. Because tax partnerships may be organized under a variety of state law legal forms, ranging from traditional general partnerships to limited liability companies, their restructurings are subject to a variety of state statutes.1074 There has been a tendency in recent years for the statutes to allow mergers not only of entities governed by the specific statutes, but with other forms of unincorporated entity, conversions from one form of entity to another, or even into corporations.1075 Few, if any, provide for statutory divisions.
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1073 See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259(2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form; suggests a specific election to choose assets-up or assets over results, regardless of form).

1074 See Ely, Grissom and Houser, “State Tax Treatment of Limited Liability Companies and Limited Liability Partnerships,” 106 Tax Notes 1557(Feb. 2, 2005). Most states have statutes that permit only professionals, such as doctors, lawyers and accountants, to use a special form of incorporation that provides limited liability for the acts of other members of the organization but continues to impose unlimited liability for the professional's own acts and those of others acting under his or her direction.

1075 See, e.g., Revised Uniform Partnership Act (1997)(“RUPA”) § § 905-908; Del. Rev. Unif. Part. Act (“Del. RUPA”) § § 15-902 and 15-905; Revised Uniform Limited Partnership Act (1976 with 1985 amendments) (“RULPA”) (no provision);Revised Uniform Limited Partnership Act (2002) (“Re-RULPA”) § § 1106–1113);Del Lim. Part. Act (“Del LPA”) § § 17-211 and 17-212 Uniform Limited Liability Company Act (1996) (“ULLCA”) § § 904–907;Revised Limited Liability Company Act (2006) (“RULLCA”) § § 1001–1005, 1014–1015; Del. Lim. Liab. Co. Act (“Del. LLCA”) § 18-209;Del. Gen. Corp. (“Del. GCL”) § 263 (allows mergers of corporations with partnerships and LLCs).

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1. Partnership Divisions 

Partnership divisions for state law and tax purposes almost always involve formation of one or more new unincorporated entities that will end up with part of the assets of the original unincorporated entity, and that usually will have some but not all of the partners or members of the old entity as owners of each of the new entities. From a tax standpoint, the general nonrecognition of gain or loss on liquidating (or current) distributions in kind makes it easy to arrange for partnership divisions or separations.1076 Although the special allocation provisions can permit tax partners to achieve many of the practical effects of a separation, subject of course to the limitations imposed by those rules,1077 formal division into two or more tax partnerships is often better than a special allocation, particularly when there is partner dissension.1078 At least two members of the prior partnership must be members of each resulting partnership for there to be a partnership division;1079 distributions to a single partner are simply distributions in liquidation of the partner's interest.1080
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1076 The current regulations on partnership divisions were adopted by T.D. 8925, 66 Fed. Reg. 715 (1/4/01), generally following the proposed regulations set forth in REG-111119-99, 65 Fed. Reg. 1572 (1/11/00). The preambles to the regulations and to the proposed regulations, which also relate to partnership mergers, are included in the working papers.

1077 See 710 T.M., Partnerships —Conceptual Overview, for a discussion, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of the requirements and limitations of special allocations.

1078 See generally Sowell, “Partnership Mergers and Divisions,” 542 PLI/Tax 1195 (2002);Sloan, Lipton, and Frediani, “Final Regulations under  Section 708 Provide Expanded Guidance on Partnership Mergers and Divisions—Part 1, 531 PLI/Tax 895(2002), Part 2, 531 PLI/Tax 931 (2002); Wregglesworth, “Slicing, Dicing and Combining Partnerships: A Look at the Proposed Regulations on Partnership Mergers and Divisions,” 41 Tax Mgmt. Memo. 35(2000); Kalinka, “Proposed Regulations Concerning Partnership Mergers and Divisions Provide Guidance and Some, But Not Enough, Flexibility,”78 Taxes 15 (Aug. 2000).

1079 See Regs. § 1.708-1(d)(4)(iv);Preamble to Final Regulations, T.D. 8925, 66 Fed. Reg. 715 (1/4/01).

1080 § 731, 732.

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None of the traditional judicial corporate doctrines limiting separations—business purpose, continuity of interest, continuity of business, or step transactions—have apparently been applied to partnership divisions, and it is hard to see why they should.1081 There is no partnership equivalent of the traditional corporate issues of avoiding treatment of accumulated earnings as dividends, or of avoiding corporate-level gain recognition. In addition, most of the potential for conversion of ordinary income into capital gain is eliminated by § 751,1082 with the mixing bowl provisions1083 and § 7351084 providing backstop. When tax planners find devices that are beyond the author's imagination, the anti-abuse rules may well provide the substitute basis for attack.
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1081 See Goodman, “Corporate and Partnership M& A Tax Laws: Is It Time Merge Subchapters C and K?,” 95 Tax Notes 1497, at 1507–11 (2002)(brief history of partnership mergers and divisions, and discussion of possible relevance of judicial corporate doctrines, such as business purpose, to partnerships).

1082 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1083 See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1084 See III, B, 2, a, above, for a discussion of how  § 735 taints certain distributed property.

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The partnership division regulations use a complex series of definitions. In the partnership division regulations: (i)the “prior partnership” is the pre-split partnership, under local law, (ii) a “resulting partnership” is any partnership that, under local law, has at least two partners from the prior partnership, (iii) the “divided” partnership, is the prior tax, not necessarily local law, partnership when it is a continuing partnership, and (iv) a “recipient partnership”is any partnership that receives assets from the divided partnership.1085 There is an implicit fifth definition:(v) the “continuing partnership” is the one in which partners who owned 50% or more of the capital and profits interest in the prior partnership,1086 own 50% or more of the capital and profits interests in the divided partnership, and, if more than one partnership could meet the definition of continuing partnership, the continuing partnership is the one that has the greatest net fair market value of the assets (after liabilities), and it is treated as having transferred assets and liabilities to the recipient partnerships. Accordingly, there may be no “divided” continuing partnership, so that all resulting partnerships are new tax partnerships. When a partnership splits into more than two separate parts, it is likely that none will have partners who had more than 50% of the prior partnership, and, although both partnerships could qualify when there is an exact equal split, neither can have the greater fair market value of net assets, so that neither is the continuing partnership. If there is no continuing partnership, the prior partnership becomes a resulting and recipient partnership even when it remains the same state law entity.1087
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1085 Regs. § 1.708-1(d)(4).

1086 See IV, F, above, for a discussion of when a partnership terminates such that it is no longer a continuing partnership.

1087 Not all IRS personnel understand this. In a recent equal division of a partnership, when the prior partnership requested a new EIN as required by the regulations, Regs.  § 1.708-1(d)(2)(i) and (5) Ex. 1, the IRS refused to give one, and insisted that it continue using its prior EIN. See IV, G, 1, c, below, for a discussion of the need for new EINs and other collateral consequences of partnership divisions.

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a. Distribution and Contribution of Partnership Assets (Assets-Up) 

Although the prior regulations apparently treated the assets of any new partnership that is not considered the continuing partnership as having been distributed to its partners by the continuing or prior partnership and contributed by them to the new partnership,1088 the current regulations treat this as one of two acceptable approaches to partnership division, labeling it as the “assets-up” form.1089 Specifically, in an assets-up division:(i) the divided partnership distributes assets, subject to partnership liabilities, in a manner respected under state law to some or all of its partners in partial or complete liquidations of their interests in the partnership, that is, as current or liquidating distributions;(ii) the distributee partners immediately contribute the distributed assets to one or more recipient partnerships in exchange for interests in the recipient partnerships. The distributions may result in gain recognition if they result in changes in shares of  § 751 property. The assets-up form, however, is recognized only if the parties actually follow the form—when the prior partnership distributes assets to some or all of its partners under state law, and the distributed assets are contributed by the distributees to a recipient partnership that does not receive any other assets of the prior partnership, thus blending an approach that respects form, with one that indicates a strong preference for a specific approach.1090 If the prior partnership is a continuing partnership, the distribution is a current distribution or a liquidating distribution.1091 When there is no continuing partnership, and the prior partnership does not dissolve under local law, any retained assets are treated as transferred, under the assets-over form, to a resulting partnership that, apparently, is not the recipient partnership in the assets-up transaction.1092 The possibility that the interim holding of the assets by the partners may be a continuation of the partnership, particularly when the assets constitute a business,1093 is ignored.1094
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1088 See former Regs. § 1.708-1(b)(ii) Ex.; PLR 8852004 (finds distribution and contribution even though facts state transfer is from old partnership to new partnerships); Cooney v. Comr., 65 T.C. 101 (1975) (payments to withdrawing partners were  § 736(a) payments).

1089 Regs. § 1.708-1(d)(2)(ii), (5) Ex. 2.

1090 See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,”44 San Diego L. Rev. 259 (2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form;suggests a specific election to choose assets-up or assets-over results, regardless of form).

1091 Regs. § 1.708-1(d)(3)(ii)(A), (5) Ex. 2 (assets-up form respected) and Ex. 3 (assets-up form not respected because some assets transferred directly by prior partnership to recipient partnership).

1092 Regs. § 1.708-1(d)(3)(ii)(B), (5) Ex. 7 (assets-up form respected when no continuing partnership).

1093 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the tax concept of “partnership”that does not require that the arrangement be a partnership under state law, but only that it be a joint business or investment operation.

1094 See Regs.  § 1.708-1(d)(5) Ex. 7; T.D. 8925, 66 Fed. Reg. 715 (1/4/01); Preamble, REG-111119-99, 65 Fed. Reg. 1572 (1/11/00).

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Assets-up divisions can be combined with assets-over divisions.1095 The preamble indicates that when interests in the divided partnership are received by other than a partner who contributed  § 704(c) property, gain may be triggered under the mixing bowl provisions.1096 If the assets-up form is followed, the capital accounts should be based on fair market values at the date of contribution, and not on the capital accounts in the divided partnership.1097 Since the assets-up form results in a basis in the assets to the new partnership measured by the outside basis of the partnership interests in the prior partnership,1098 there should be a new application of § 704(c),1099 and, under a 2004 amendment to § 704(c), if any partner has a built-in loss in its assets, the inside basis is fair market value and the built-in loss is allocated only to the contributing partner.1100 Similarly,  § 1.752-7 liabilities may be transferred and new  § 1.752-7 liabilities may be created, although nothing in the final regulations addresses this issue directly.1101 The distribution of assets presumably involves a potential  § 751 exchange.1102 The partner's capital account in the recipient partnership should reflect the valuation of the assets at current value,1103 while those in the divided partnership should reflect the revaluation resulting from the distributions to the partners in the recipient partnership.1104
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1095 See Regs.  § 1.708-1(d)(5) Ex. 7.

1096 § 704(c)(1)(B) or § 737. See III, E, 1, above, for a discussion of how the mixing bowl rules accelerate the taxation of  § 704(c) gain on distributions of contributed property to others, or of other property to the contributor.

1097 Regs. § 1.704-1(b)(2)(iv)(e).

1098 See IV, B, above, for a discussion of how the basis to the distributee of property received in a liquidating distribution may be higher or lower than the transferred inside basis to the partnership.

1099 See I, B, above, for a discussion of  § 704(c) gain or loss.

1100 § 704(c)(1)(C), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(a), effective Oct. 22, 2004.

1101 See Regs. § 1.752-7(b)(4)(ii), (5)(ii), and (e)(3)(ii) Exs. 4 and 5 (deal only with assets-up divisions).

1102 § 751(b). See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1103 Regs. § 1.704-1(b)(2)(iv)(d).

1104 Regs. § 1.704-1(b)(2)(iv)(e), (f).

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b. Transfer of Partnership Assets (Assets-Over) 

The default, and apparently preferred, form of division, is the “assets-over” form. Specifically, the assets-over form: (i) treats the divided (continuing) partnership as transferring assets to the recipient partnership(s), (ii) in exchange for interests in the recipient partnership (even though the divided(continuing) partnership is the sole owner of the interests), and(iii) distributing the resulting interests in the recipient partnership to some or all of its partners,1105 who receive the interests as current or liquidating distributions. When there is no continuing partnership, reflecting the termination of the divided partnership,1106 the distributions are liquidating distributions to all partners.1107 The dividend partnership's transitory ownership of all the interests in the recipient partnership —which would mean the recipient partnership, having only one owner, is not a tax partnership — is ignored.1108 There may be transfers of  § 1.752-7 liabilities, and new ones may be created. The capital accounting for the partners in the recipient partnership should be the same as for any partnership contribution of property — revaluation of partnership assets and new capital accounts for the recipient partnerships based on valuing the transferred property at current values.1109 The capital accounting for all partners in the divided partnership should reflect revaluation of the partnership interests in the recipient partnership and all other assets, with inherent gains and losses allocated, and with the value of the distributed partnership interests applied against capital accounts, at fair market value, for the partners receiving the interests in the divided (continuing) partnership.1110
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1105 Regs. § 1.708-1(d)(3)(i)(A).

1106 See IV, F, 2, above, for a discussion of the effects of partnership termination.

1107 Regs. § 1.708-1(d)(3)(i)(B).

1108 Regs.  § 1.708-1(d)(5) Ex. 3 to Ex. 6.

1109 Regs. § 1.704-1(b)(2)(iv)(d).

1110 Regs. § 1.704-1(b)(2)(iv)(e),(f). See I, A, above, for a summary discussion, and 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts, for more comprehensive treatments of revaluation of capital accounts.

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The IRS selected the assets-over form as the default pattern for partnership divisions because, at least at the time, the assets-over form appeared to provide more favorable tax treatment for taxpayers and the government.1111 The assets-over form applies when no specific form is used — for example, because the form of the transaction is a division in which the continuing partnership is not deemed to survive for federal tax purposes.1112
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1111 In the preamble to REG-111119-99, 65 Fed. Reg. 1572 (1/11/00), the IRS stated that the assets-over form would not trigger gain for any partner under  § § 704(c)(1)(B) and 737, and that  § 732 would not cause partnership assets to lose basis in the transaction. But see Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,”44 San Diego L. Rev. 259, at 278–95 (2007) (questions policy justifications).

1112 Regs. § 1.708-1(d)(3)(i), (5) Ex. 3 to Ex. 6.

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Since the recipient partnerships in the assets-over form have the same inside basis in their assets as the divided (continuing)partnership, the collateral effects should be the same as for a partnership termination — that is, continuity of basis and tacked holding period for the transferred assets, no change in the outside basis of the partnership interest, but most important no new  § 704(c) amount.1113 Although partners' outside basis of the interests in the recipient partnerships should be the same as their outside basis in the prior partnership,1114 their holding period may become a split holding period because the divided partnership's holding period in the partnership interest of the recipient partnership is a tacked one determined by the nature of the assets contributed,1115 and the holding period of distributed property to a distributee partner is determined by the holding period to the partnership.1116 Under the 2004 amendment to § 704(c), if any property transferred to a recipient partnership has a built-in loss, the inside basis is fair market value and the built-in loss is allocated only to the partners in the recipient partnership who had interests in the property that has the built-in loss in the divided (continuing)partnership.1117
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1113 § § 732, 735;Regs.  § § 1.704-3(a)(3)(i) and -4(c)(3) and 1.708-1(b)(4) Ex. (iii). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the collateral effects of a partnership termination.

1114 § 732. See III, B, 1, and IV, B, 1, above, for discussions of the basis of distributed property.

1115 § 1223(1); Regs. § 1.1223-3.  See II, B, 2, above, for a discussion, and 710 T.M., Partnerships — Conceptual Overview, for a more comprehensive treatment; of the holding period of a partnership interest.

1116 § 735(b). See III, B, 2, above, for a discussion of the holding period of distributed property.

1117 § 704(c)(1)(C), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(a), Oct. 22, 2004.

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To the extent that this allocation of the built-in loss is not possible, the mixing bowl rules will presumably require current adjustment for the built-in loss. The mixing bowl rules may be triggered unless the contributor has an interest in the recipient partnership that holds the contributed property, and does not receive any other distribution.1118 Since a partnership division involves a distribution of partnership property, indirectly in the form of the interest in the recipient partnership in an assets-over division, and directly, in an assets-up division, there may be adjustments under a  § 754 election when the outside basis of a distributee partner differs from the inside basis of the property or partnership interest distributed, but only if both the distributing partnership and the recipient partnership have  § 754 elections in effect.1119 There also may be gain recognition as a result of liability shifts.1120 Although there is no express provision for netting liability increases and decreases in the division,1121 netting should apply.1122
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1118 § 704(c)(1)(B) or § 737; Regs. § § 1.704-4(c)(4), 1.737-2(b)(2).

1119 § 734(b) (flush language). See III, C, and IV, C, above, for discussions of the adjustments of a partnership's inside basis as a result of distributions when a  § 754 election applies.

1120 § 752(a), (b). See III, A, 2, b, and IV, A, 2, above, for discussions of how shifts of liability shares can result in gain recognition.

1121 See Regs. § 1.752-1(f), (g) Ex. 2.

1122 See Regs. § 1.752-1(f); Rev. Rul. 79-205, 1979-2 C.B. 255; PLR 8852004 (applies Rev. Rul. 79-205 separately to contribution and distribution). See III, F, 5, a, above, for a discussion of the effect of liability shifts in changes of partnerships from unlimited liability entities to limited liability entities, or the reverse; and III, F, 5, b, above, for a discussion of similar issues in change of a partnership into a disregarded entity.

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On the other hand, it is not clear that the assets-over form involves exchanges that trigger § 751.1123 There are no shifts in shares of  § 751 assets on the transfers to the recipient partnerships, and, classifying the partnership interests in the recipient partnerships as  § 751 property or other property would be difficult to say the least. The look-through rule for purposes of § 751, by its terms, treats the upper-tier partnership as owning its proportionate share of the property of the lower-tier partnerships; it does not characterize the interest in the lower-tier partnership as  § 751 property. On the other hand, in view of the attention to tiered partnerships in recent years, the lack of direct authority is telling.1124 The controversy from the extension of the mixing bowl rules to partnership mergers,1125 suggests that, if there is to be an application of  § 751 in partnership divisions, the issue should be handled by regulations.
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1123 Cf. Regs.  § § 1.731-1(c) (specifically refers to  § 751 in connection with distributions of property), 1.732-1(e) (same), and 1.743-1(g) (same).

1124 The partnership merger and division regulations, Regs.  § 1.708-1(c) and (d), do not even mention § 751.

1125 See Rev. Rul. 2004-43, 2004-2 C.B. 842 (stated results similar to those in the proposed regulations, but was withdrawn in response to comments suggesting that the results were contrary to the regulations and should not be retroactive); Rev. Rul. 2005-10, 2005-1 C.B. 492 (withdraws Rev. Rul.  2004-43). At the same time, the IRS issued Notice 2005-15, 2005-1 C.B. 527, announcing the intention to implement the principles of the ruling, effective Jan. 19, 2005; REG-143397-05, 72 Fed. Reg. 46932 (8/22/07) (the proposed regulations foreshadowed in Notice 2005-15 appeared approximately two years later, but are to be retroactive to date of announcement in Notice 2005-15). In response to comments received and other information gleaned, the IRS and Treasury announced in Notice 2009-70, 2009-34 I.R.B. 255, that further study of certain aspects of the application of § 704(c) was necessary before the regulations could be finalized. The notice invited comments (due no later than Feb. 22, 2010) on a variety of issues relating to § 704(c) layers and other issues with respect to tiered partnerships and partnership mergers and divisions.★ The proposed regulations are discussed in 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination.

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Because the inside basis of the recipient partnership in the assets-over form continues the inside basis of the divided(continuing) partnership, there should be no new  § 704(c) allocations, but there may be new reverse  § 704(c) allocations.1126 Proposed regulations1127 that provide for creation of new  § 704(c) gain for the transferor partnership in a merger,1128 expressly state that  § 737 and the proposed regulations do not apply to “divisive transactions.”1129 The proposed regulation states that  § 737 does not apply to the transfer by a “transferor” partnership to a “transferee” partnership of all the  § 704(c) contributed by a partner when an interest in the transferee partnership is distributed as part of the same plan to the contributor.1130 This narrow phrasing obviously leaves open the application of the mixing bowl rules to the extent that the contributor does not maintain an interest in the partnership to which some or all of the property with a  § 704(c) adjustment is transferred. The proposed regulation goes on to state that a subsequent transfer of the contributed property with the  § 704(c) adjustment of another partner that was also a partner of the transferor partnership is subject to  § 737 to the same extent as a distribution by the transferor partnership would have been.1131 The phrasing is puzzling since there is no reason why  § 737 would also apply to a distribution by the “transferee” partnership to a partner who was not a partner in the transferor partnership. Since the preamble to the proposed regulations does not even mention the exception for “divisive” transactions, there is always a possibility that regulations may be proposed to extend the principles of the merger regulations to partnership divisions, but, in view of the tangled history of the proposed regulations, it is highly unlikely that any such regulations will be effective before they are adopted, or, at least proposed.1132 On the other hand, the preamble to the final partnership merger and division regulations states that to the extent that, in a partnership division, each partner's overall interest in each partnership property does not change, a partnership division should not create new  § 704(c) property or  § 737 net precontribution gain, but that this result is not necessarily appropriate where a division is non–pro rata as to the partners, where some property is extracted from or added to the partnerships in connection with the division, or where new partners are added to the ownership group in connection with the division.1133
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1126 The proposed regulations relating to new  § 704(c) allocations assume that there are also reverse  § 704(c) allocations. See Prop. Regs.  § 1.704-4(c)(4)(ii)(F) Ex. 4, and (f); 1.732-2(b)(1)(ii)(f) Ex. 4, and(f).

1127 See REG-143397-05, 72 Fed. Reg. 46932 (8/22/07).

1128 See id. See IV, G, 2, a, above, for a discussion of the application of the proposed regulations to mergers.

1129 Prop. Regs. § 1.737-2(b)(2). It is interesting that the reference is not to “division of a partnership,” which is the title of the regulations that are the subject of this section. There is, of course, no cross-reference to those regulations, which, together with the errors discussed in IV, G, 2, a, above, suggest that the drafters of the proposed regulations may be experts in the mixing bowl rules, but do not understand partnership mergers and divisions.

1130 Prop. Regs. § 1.737-2(b)(2)(i). Again note that the terminology is not consistent with the careful definitions discussed in IV, G, 1.

1131 Prop. Regs. § 1.737-2(b)(2)(ii).

1132 As described in the preamble to the proposed regulations, Rev. Rul. 2004-43, 2004-2 C.B. 842, originally stated results similar to those in the proposed regulations, but was withdrawn in response to comments suggesting that the results were contrary to the regulations and should not be retroactive. Rev. Rul. 2005-10, 2005-1 C.B. 492. At the same time, the IRS issued Notice 2005-15, 2005-1 C.B. 527, announcing the intention to implement the principles of the ruling, effective Jan. 19, 2005.

1133 T.D. 8925, 66 Fed. Reg. 715, 718 (1/4/01). It also states that the IRS and Treasury intend to study this issue and request comments.

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Example: Effect of Form of Division. Munn, Propp, Ides, and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn and Propp are each 30% partners, and Ides and Surv are each 20% partners. Oppar owns four parcels of investment real estate:
 	Basis	Value	
Parcel#1	$300,000	$450,000	
Parcel#2	400,000	450,000	
Parcel#3	150,000	300,000	
Parcel#4	300,000	300,000	
Total	$1,150,000	$1,500,000	

The outside basis of the Oppar interests are:Munn, $360,000; Propp, $360,000; Ides $240,000; and Surv, $190,000. Although the others all contributed cash equal to their outside basis, and have capital accounts of the amount of cash contributed, Surv contributed $40,000 cash and Parcel#3 then worth $200,000, which has a tax basis $150,000, so that Surv has a  § 704(c) adjustment of $50,000, and a book value capital account of $240,000. As a result of disagreements, Ides and Surv want to go their separate ways, with Parcel#3 and Parcel#4.

The simplest division form is for Oppar to transfer the two parcels to Newpar, and distribute the interests in Newpar to Ides and Surv in liquidation of their interests using the assets-over form. Newpar has a transferred basis in the two parcels, and Ides and Surv end up with the same outside basis in their Newpar interests that they had in their Oppar interests. Oppar is the divided and continuing partnership, because its partners owned 60% (more than 50% of the divided partnership), and (although not essential on these facts)it retains the assets with the greater value. Its basis in the retained parcels is not affected, nor is the outside basis of Munn and Propp. Since Surv continues to be a partner in Newpar, the partnership owning Parcel#3, her  § 704(c) allocation should continue, and should not be increased to reflect the $100,000 appreciation while the Oppar owned Parcel#3. Surv does not recognize any gain under  § 704(c)(1)(B) or § 737, since Parcel#3 has not been distributed to another partner and the distribution of the Newpar interest should not be considered a distribution of other property to her. Since the basis of Parcel#3 and Parcel#4 totals $450,000, but the combined outside basis of Ides' and Surv's Oppar interests is only $430,000, Oppar is entitled to increase the basis of its remaining properties under § 734(b), but only if Newpar makes a  § 754 election that will result in a corresponding reduction in the inside basis of its properties—Parcel#3 and Parcel#4, under § 734(b). If Parcel#3 is held for sale to customers, Munn and Propp recognize ordinary income under  § 751(b) because they, in effect, relinquish shares of Parcel#3, a  § 751 asset (substantially appreciation inventory) for their increased shares in Parcel#1 and Parcel#2, and Ides and Surv recognize capital gain for relinquishing shares of other property for  § 751 property. The income and gain recognized increase the basis of the Oppar properties and Parcel#3. Oppar should revalue its assets and allocate the inherent gains to the partners, before reducing Ides' and Surv's capital account by the value of the interests in Newpar. Newpar should use the values of Parcel#3 and Parcel#4 to establish its book values and the capital accounts of Ides and Surv.

The parties can choose to follow the assets-up form by having Oppar distribute Parcel#3 and Parcel#4, but, if they do, the exact form of the distribution changes the tax consequences. If Parcel#3 is distributed to Surv, its basis is increased to $190,000, while the basis of Parcel#4 distributed to Ides is reduced to $240,000. If a  § 754 election applies for Oppar, it is entitled to increase the inside basis of its retained properties (under  § 734) for the net $20,000 lost basis. Since these amounts become the transferred basis of the parcels to Newpar, there is no requirement that Newpar make the  § 754 election for Oppar to be entitled to the adjustment. On the other hand, there is a risk that Surv and Ides have  § 704(c) allocations for the difference between basis and value of Parcel#3 and Parcel#4, and that they begin new seven-year periods under  § § 704(c)(1)(B) and 737 for these Parcels. If Parcel#3 is held for sale, Ides also has a  § 751(b) exchange, involving ordinary income and Surv has more capital gain. The capital accounting for both Oppar and Newpar should be essentially the same as for the assets-over form.

If, instead, Oppar distributes undivided interests in Parcel#3 and Parcel#4 to Ides and Surv, who then contribute the undivided interests to Newpar, Surv recognizes $25,000 gain under § 704(c)(1)(B) on the half-interest in Parcel#3 distributed to Ides, increasing the inside basis of the half-interest in Parcel#3 to $100,000 and the outside basis of her Oppar interest to $215,000. Surv's transferred basis in her half-interest in Parcel#3 is $75,000, and in Parcel#4 is $150,000, but since her outside basis is only $215,000, there is a $10,000 decrease. Since neither parcel has unrealized depreciation, the decrease is allocated in the proportion to their adjusted basis, one-third to Parcel#3 and two-thirds to Parcel#4. The results are the same for Ides, except that with the increase in the basis of the half-interest in Parcel#3 to $100,000, there is a $10,000 decrease, allocated 40% to Parcel#3 and 60% to Parcel#4. The § 751(b),  § 754 and capital account results are essentially similar to those for a distribution of individual parcels.

c. Collateral Consequences 

Any liability increases and decreases in the division are netted,1134 with outside basis adjusted to reflect any net increases and decreases. Although not discussed in the regulations, there may be gain recognition when there are changes in shares of § 751 property, and there is also a distribution resulting from a net decrease in liabilities,1135 but a reverse  § 704(c) allocation may avoid this gain.1136 The divided partnerships do not recognize depreciation recapture,1137 but there may be investment tax credit recapture in the assets-up form.1138 The partnership's depreciation period and method continue as if there had been no transfer,1139 except for any increases in basis, which are depreciated as new property1140 but other accounting aspects, such as inventory method, do not continue.1141
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1134 Regs. § 1.752-1(f) and (g) Ex. 2; see Regs.  § 1.752-5(a) (effective date). See 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of how shifts and liability shares can result in gain recognition.

1135 § 751(b). See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1136 Cf. Regs.  § 1.708-1(c)(5) Ex. 5 (similar result for a sale of a partnership interest as part of a merger).

1137 See § § 1245(b), 1250(b); Regs. § § 1.1245-4(c), 1.1250-3(c).

1138 § 47(b); Regs.  § 1.47-3(f)(1)(ii)(d) (one of the four conditions for qualification of a transaction as a mere change in form of conducting a trade or business is that the basis of the property in the hands of the transferee be determined by the basis to the transferor partnership).

1139 § 168(i)(7); see 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of continuity of depreciation in partnership contributions. See IV, F, 2, above, for a discussion of the different rule that applies when a partnership terminates.

1140 § 168(i)(7)(A), (B)(i); Prop. Regs. § 1.168-5(b)(7),-4(d)(5)(i) and (ii) (depreciation); § 197(f) and Regs.  § 1.197-2(g)(3) (amortization).

1141 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of partnership accounting elections.

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Both the assets-over and the assets-up division forms essentially continue the  § 1.752-7 status of existing  § 1.752-7 liabilities and § 1.752-7 liability partners, to the extent of the remaining built-in loss as long as the relevant interest in the recipient partnership to which the  § 1.752-7 liability is transferred is distributed to the  § 1.752-7 partner. However, such divisions may create new § 1.752-7 liabilities, or  § 1.752-7 partners, for any increase in the amount of  § 1.752-7 liabilities prior to the division.1142 If there is a shift is  § 1.752-7 liabilities as a result of either form of division, because the relevant interest in the recipient partnership to which the  § 1.752-7 liability is transferred is not distributed to the  § 1.752-7 partner, the basis reduction under Regs.  § 1.752-7(e) applies to the  § 1.752-7 liability partner.1143
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1142 Regs.  § 1.752-7(b)(4)(ii) (terminations), (5)(ii) (tiered partnerships), and (e)(3)(ii) Ex. 4 (partnership division).

1143 Regs.  § 1.752-7(e)(3)(ii) Ex. 5 (shift, partnership division). See III, H, above, for a discussion of basis reduction for the  § 1.752-7 liability partner when the  § 1.752-7 liability is assumed by another partner.

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The partnership interest of any partner who does not remain with one of the divided partnerships is considered liquidated,1144 which presumably means that the partner has received a liquidating distribution that may include  § 736(a) payments as well as  § 736(b) payments.1145 Although the regulations do not require it, the division agreement should deal with this, as well other issues, including making or not making  § 754 elections. This emphasizes the importance of careful advice and drafting of the division agreement and other relevant documents, which, if one lawyer represents the partnerships, without separate counsel for the partners, raises the familiar conflict, confidentiality and disclosure issues.1146
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1144 Regs. § 1.708-1(d)(1).

1145 See V, A, and V, B, below, for a discussion of the effect of  § 736 in classifying liquidating distributions between payments for the interest in the partnership and payments that are distributive shares or guaranteed payments.

1146 A form of representation letter dealing with withdrawal from the partnership that can be adapted to deal with this issue is included in the working papers.

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Naturally, there is an anti-abuse provision, albeit a narrow one, that states that if the division is part of a larger transaction, and the result is inconsistent with the form, the IRS can recast it in accordance with the substance.1147 The principle is illustrated by an example in the partnership merger regulations which contain a virtually identical anti-abuse statement.1148 The example involves a merger of two partnerships and a division of the merged partnership, which transfers the just-acquired assets of the merging partnership to a recipient partnership, and distributes the interests in the recipient partnership to two of the original partners in the merged partnership as a complete liquidating distribution for interests in the merged partnership.1149 When the dust clears, one of the original partners in the merged partnership and the two partners in the merging partnership own interests in the merged partnership that has only its original assets and the two distributees own interests in the recipient partnership that owns the historic assets of the merging partnership. The example states that even though the transaction follows forms that the regulations state will be respected for mergers and divisions, since together they are a larger transaction that has the effect of an exchange of interests in the merging partnership for interests in the merged partnership, which was stated to be the original desire of the distributee partners, it will be recast as a taxable exchange of those interests. Interestingly, the partnership division anti-abuse provision does not directly refer to the example, even though the larger transaction was a combination of a merger and a division.
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1147 Regs. § 1.708-1(d)(6).

1148 Regs. § 1.708-1(c)(6)(ii).

1149 Id.

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Because a partnership continues until no part of the partnership business is conducted in partnership form,1150 more than one partnership could be considered a continuation of the pre-split partnership.1151 Only those partnerships whose partners had more than 50% of the capital and profits of the prior partnership, however, are considered to be continuing partnerships.1152
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1150 § 708(b)(1); Regs. § 1.708-1(a). See IV, F, 1, above, for a discussion, and 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of partnership terminations.

1151 § 708(b)(2)(B). See PLR 9350035 (split-off of a project to a new partnership); PLR 9015016 (seven continuing partnerships with same owners in same proportions); PLR 8244124 (split as part of family settlement; each partnership entitled to make qualified reinvestment under  § 1033 for share of condemnation proceeds received by old partnership).

1152 § 708(b)(2)(B); Regs. § 1.708-1(d)(4)(i), (5) Exs. 1 and 4.

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All resulting partnerships that are continuing partnerships continue the prior tax elections of the prior partnership,1153 but other resulting partnerships have a fresh start on tax elections, and must affirmatively make any elections that they wish to continue, although an existing  § 754 election should allow § § 734(b)/754 adjustments that result from the transaction.1154 Resulting partnerships are not affected by post-split elections of any other resulting partnership (including the divided or any other continuing partnership).1155 The prior partnership terminates when none of the resulting partnerships is a continuing partnership.1156 All resulting partnerships, except the divided partnership (which files a full-year return that does not include the income of the resulting partnerships after the division),1157 need new EINs, start new tax years with the division, and report the division.1158 Each recipient partnership's depreciation period and method continues, as if there had been no transfer,1159 but other accounting aspects, such as inventory method, do not continue.1160
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1153 Regs. § 1.708-1(d)(2)(ii).

1154 See Rev. Rul. 86-73, 1986-1 C.B. 282 (existing election under  § 754 applies to new partner who purchased more than 50% interest on deemed distribution resulting from termination; “new” partnership must make new election).

1155 Regs. § 1.708-1(d)(2)(ii).

1156 Regs. § 1.708-1(d)(1). See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the resulting tax consequences.

1157 The return is to “state that the partnership is a continuation of the prior partnership and shall set forth separately the respective distributive shares of the partners for the periods prior to and including the date of the division and subsequent to the date of division.” Regs. § 1.708-1(d)(2)(i).

1158 Regs. § 1.708-1(d)(2)(i), (5) Ex. 1; see PLR 199944016 (after division of LLC taxed as a partnership of part of its operating assets to a new LLC, while retaining interest in another LLC, with distribution of interests in new LLC to members, both old LLC and new LLC are continuations of old LLC; prior ruling to old LLC applies to new LLC); cf. FSA 200132009 (return filed for partnership that terminated on sale of more than 50% of interests that did not separate pre- and post-termination periods, nevertheless started running of statute of limitations).

1159 § 168(i)(7); see 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of depreciation of contributed property.

1160 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of a partnership's ability to elect its own accounting method on contribution of an active business.

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Example: Consequences of Division. The facts are the same as in the example in IV, G, 1, b, above. Under the assets-over form, Oppar is the divided and continuing partnership, because its partners owned 60% (more than 50%) of the divided partnership and (although not essential on these facts) it retains the assets with the greater value. As the continuing partnership, its elections remain in effect and its taxable year continues, for Munn and Propp, although, of course, Oppar's tax year terminates for Ides and Surv when the division occurs. Newpar is a resulting partnership and a recipient partnership. It has a fresh start on elections, including the  § 754 election. Its first tax year begins on the date of the distribution. The collateral results are the same for the assets-up form, as the principal difference in the forms is the effect on the basis of the assets transferred to a recipient partnership and the related § § 704(c)(1)(B)/737 mixing bowl,  § 751 ordinary income exchange, § § 734(b)/754 inside basis adjustments, and potential  § 704(c) consequences for Surv and Ides discussed in the example in IV, G, 1, b, above.

2. Partnership Mergers 

Partnership mergers for tax purposes can occur under state partnership laws governing the variety of unincorporated forms that qualify as tax partnerships, many of which provide for unincorporated entity mergers, much as they do for corporate mergers, or by practical mergers in the form of transfers of assets of, or interests in, one partnership (merged partnership) to another (resulting partnership). The partnership merger regulations were adopted at the same time as the partnership division regulations discussed in the preceding section.1161 When two or more partnerships combine, the transaction is technically a termination of each of the partnerships, unless the partners of one end up with more than 50%ownership of the capital and profits of the resulting partnership.1162 If more than one partnership can meet the test because of overlapping partners, the resulting partnership is the one with the largest net value of assets.1163
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1161 See T.D. 8925, 66 Fed. Reg. 715 (1/4/01), generally following the proposed regulations set forth in REG-111118-99, 65 Fed. Reg. 1572 (1/11/00). The preambles to the regulations and to the proposed regulations, which also relate to partnership divisions, are included in the working papers.

1162 § 708(b)(2)(A). See IV, F, 1, above, for a discussion of when a tax partnership terminates.

1163 Regs. § 1.708-1(c)(1), (5) Ex. 1;see IV, G, 2, c, below, for further discussion of the effects of partnership terminations in mergers; see generally Sowell, “Partnership Mergers and Divisions,” 542 PLI/Tax 1195 (2002);Sloan, Lipton, and Frediani, “Final Regulations under  Section 708 Provide Expanded Guidance on Partnership Mergers and Divisions—Part 1, 531 PLI/Tax 895(2002), Part 2, 531 PLI/Tax 931 (2002); Wregglesworth, “Slicing, Dicing and Combining Partnerships: A Look at the Proposed Regulations on Partnership Mergers and Divisions,” 41 Tax Mgmt. Memo. 35(2000); Kalinka, “Proposed Regulations Concerning Partnership Mergers and Divisions Provide Guidance and Some, But Not Enough, Flexibility,”78 Taxes 15 (Aug. 2000).

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None of the traditional judicial corporate doctrines limiting corporate mergers and other reorganizations—business purpose, continuity of interest, continuity of business, or step-transaction—have apparently been applied to partnership mergers, and it is hard to see why they should.1164 There is no partnership equivalent of the traditional corporate issues of avoiding treatment of accumulated earnings as dividends, or of avoiding corporate-level gain recognition. In addition, most of the potential for conversion of ordinary income into capital gain is eliminated by § 751,1165 with the mixing bowl provisions,1166 and § 735,1167 providing backstop. When tax planners find devices that are beyond the author's imagination, the anti-abuse rules may well provide the substitute basis for attack.
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1164 See Goodman, “Corporate and Partnership M& A Tax Laws:Is It Time Merge Subchapters C and K?,” 95 Tax Notes 1497, at 1507–08 (2002).

1165 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1166 See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1167 See III, B, 2, a, above, for a discussion of how  § 735 taints certain distributed property.

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a. Transfer of Partnership Assets (Assets-Over) 

Although the prior regulations and rulings apparently treated the merger as taking the form of a transfer of assets from the merged partnership(s) to the resulting partnership,1168 in a nonrecognition transfer, with a nonrecognition distribution of the resulting partnership interests in the resulting partnership to partners of the merged partnerships in liquidation of their interests,1169 the current regulations treat this as one of two approaches to mergers, and label this approach the “assets-over”form.1170 It is the default, and apparently preferred, form of partnership merger, and applies whenever the form of merger does not specifically follow the assets-up form,1171 thus, blending an approach that respects form, with one that indicates a strong preference for a specific approach.1172 The IRS selected the assets-over form as the default pattern for partnership mergers because it usually provides favorable tax treatment for taxpayers and the government.1173
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1168 Former Regs. § 1.708-2(i); Rev. Rul. 77-458, 1977-2 C.B. 220 (merger of 10 partnerships with same partners); Rev. Rul. 68-289, 1968-1 C.B. 314 (merger of three partnerships with the same partners). Both Rev. Rul. 77-458 and Rev. Rul. 68-289 were clarified by Rev. Rul. 90-17, 1990-1 C.B. 119 (resulting partnership in a merger does not terminate, even if interest of 50% or more in resulting partnership distributed by merging partnerships).

1169 § § 731, 732(b).

1170 Regs. § 1.708-1(c)(3)(i), (5) Ex. 2.

1171 Regs.  § 1.708-1(c)(5) Ex. 3(ii); see Preamble, T.D. 8925, 66 Fed. Reg. 715 (1/4/01) (relies in part on administrative convenience); cf. Rev. Rul. 84-111, 1984-2 C.B. 88 (providing three forms for incorporating a partnership:assets-over, assets-up, and interest-over).

1172 See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259(2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form; suggests a specific election to choose assets-up or assets-over results, regardless of form).

1173 Preamble to REG-111119-99, 65 Fed. Reg. 1572 (1/11/99). See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259, at 278–95 (2007) (questions policy justifications).

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Specifically, the assets-over form: (i) treats the merged (transferor) partnership as transferring its assets to the resulting (transferee) partnership, (ii) in exchange for interests in the recipient partnership (even though the merged (transferor)partnership is the sole owner of the interests), and (iii) distributing the interests in the resulting (transferee) partnership to all of its partners, (iv) who receive the interests as liquidating distributions.1174 Since the inside basis for the assets transferred to the merged and resulting partnership in the assets-over form is the same as the inside basis for the assets of the merged(and terminated) partnership, the collateral effects should be the same as for a partnership termination.1175 Under the 2004 amendment to § 704(c), if any merged partnership has a built-in loss in its assets, the inside basis is fair market value and the built-in loss is allocated only to the partners in such merged partnership.1176 The possibility that the interim holding of the interests in the transferee partnership, by the transferor partnership, cannot qualify as a partnership, because of only one owner, is ignored.
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1174 Regs. § 1.708-1(c)(3)(i).

1175 See IV, F, 2, above, for a discussion of those collateral effects for partnership terminations that should apply to partnership mergers.

1176 § 704(c)(1)(C), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(a), effective on the date of enactment, Oct. 22, 2004.

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The merged partners' capital accounts in the resulting (transferor) partnership should equal their respective capital accounts in the merged partnership, as adjusted for revaluation of their capital accounts,1177 while the capital accounts of the partners in the resulting (transferee) partnership should reflect similar revaluation.1178 Although the outside basis of the interests in the resulting transferee partnership should be the same as their outside basis in the merged transferor partnership,1179 their holding period may become a split holding period because the merged transferor partnership's holding period in the partnership interest in the resulting transferor partnership is a tacked one determined by the nature of the assets contributed,1180 and the holding period of distributed property to a distributee partner is determined by the holding period to the partnership.1181
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1177 Regs. § 1.704-1(b)(2)(iv)(d), (e), and (f).

1178 Regs. § 1.704-1(b)(2)(iv)(f).

1179 § 732. See III, B, 1, and IV, B, above, for discussions of the basis of distributed property.

1180 § 1223(1); Regs. § 1.1223-3.  See II, B, 2, above, for a discussion of split holding periods.

1181 § 735(b). See III, B, 2, b, above, for a discussion of the holding period of distributed property.

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Both the assets-over and the assets-up merger forms essentially continue the  § 1.752-7 status of existing  § 1.752-7 liabilities and § 1.752-7 liability partners, to the extent of the remaining built-in loss as long as the relevant interest in the resulting (continuing) partnership to which the  § 1.752-7 liability is transferred is distributed to the  § 1.752-7 partner.  However, such mergers may create new  § 1.752-7 liabilities, or  § 1.752-7 partners, for any increase in the amount of  § 1.752-7 liabilities prior to the merger.1182
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1182 Regs. § 1.752-7(b)(4)(ii) (terminations), and (5)(ii) (tiered partnerships), and (e)(3)(ii) Ex. (partnership merger).

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The assets-over merger form should not trigger gain under  § § 704(c)(1)(B) and 737, or a basis adjustment under § 732,1183 Although the preamble to the proposed partnership merger and division regulations did not say so expressly, the merger should be an occasion for revaluation and new reverse  § 704(c) allocations, since there are contributions by new partners.1184 Proposed regulations,1185 however, provide for creation of new  § 704(c) gain or loss in assets-over mergers for the partners of the merged partnership, with a new seven-year period.1186 The proposed regulations are complex and confusing, in part because they do not use the same terminology that is used in the partnership merger regulations.1187 They are also hard to understand without careful study of the examples, which are not only complex and confusing, but, in some cases do not apply the principles of partnership mergers correctly.
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1183 Preamble, REG-111119-99, 65 Fed. Reg. 1572 (1/11/00). The proposed regulations discussed in this paragraph confirm this. Prop. Regs. § § 1.704-4(c)(4), 1.737-2(b)(1). See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1184 See Regs. § 1.704-1(b)(2)(iv)(f).

1185 See REG-143397-05, 72 Fed. Reg. 46932 (8/22/07). The preamble to REG-143397-05 is included in the working papers. In response to comments received and other information gleaned, the IRS and Treasury announced in Notice 2009-70, 2009-34 I.R.B. 255, that further study of certain aspects of the application of § 704(c) was necessary before the regulations could be finalized. The notice invited comments (due no later than Feb. 22, 2010) on a variety of issues relating to § 704(c) layers and other issues with respect to tiered partnerships and partnership mergers and divisions. The proposed regulations are discussed in 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

1186 Prop. Regs. § § 1.704-3(a)(9), 1.704-4(c)(4)(ii)(A), and 1.737-2(b)(1)(ii). As described in the preamble to the proposed regulations, Rev. Rul. 2004-43, 2004-2 C.B. 842, originally stated results similar to those in the proposed regulations, but was withdrawn in response to comments suggesting that the results were contrary to the regulations and should not be retroactive. Rev. Rul. 2005-10, 2005-1 C.B. 492. At the same time, the IRS issued Notice 2005-15, 2005-1 C.B. 527, announcing the intention to implement the principles of the ruling, effective Jan. 19, 2005.

1187 The proposed regulations define a transferor partnership that is, apparently, the same as the merged(terminated) partnership, and a transferee partnership, which is, apparently, the same as the resulting partnership. Prop. Regs. § § 1.704-4(c)(4)(i), 1.737-2(b)(1)(i). The discussion of the proposed regulations will use the merger regulations designations, with the proposed regulations designations in parentheses.

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Under the proposed partner's distributive share regulations, the new  § 704(c) gain or loss applies to differences between the value and the basis of the assets of the merged partnership, but not to the extent such difference represents a precontribution  § 704(c) allocation to the merged (transferor) partnership, as to which the original seven-year period continues to apply.1188 There is also additional new  § 704(c) gain or loss, if the resulting (transferee) partnership merges with another partnership and becomes the merged (transferor) partnership in the later merger.1189 The same result does not apply to any difference between the basis and value of the assets of the resulting (transferee) partnership that is properly recorded as a reverse  § 704(c) allocation to the resulting partners in the resulting (transferee) partnership.1190 Thus, only partners of the merged (transferor) partnership have exposure for new  § 704(c) allocations resulting from the merger; partners of the resulting partnership have no exposure as a result of reverse  § 704(c) allocations resulting from the merger. Accordingly, when property transferred by the merged (transferor) partnership is distributed to a partner in the resulting (transferee) partnership more than seven years after an original contribution with a  § 704(c) allocation, but less than seven years after the merger, only the new  § 704(c) gain, measured by the appreciation since original contribution, is taxed to the partners of the merged (transferor) partnership.1191
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1188 Prop. Regs. § § 1.704-4(c)(4)(i)(A), 1.737-2(b)(1)(ii).

1189 Prop. Regs. § § 1.704-4(c)(4)(ii)(D), 1.737-2(b)(1)(ii)(D).

1190 Prop. Regs.  § § 1.704-4(c)(7) and (4)(ii)(F) Ex. 4; 1.737-2(f) and (b)(1)(ii)(F) Exs. 1 and 4.

1191 Prop. Regs. § 1.704-4(c)(4)(ii)(A), (B), and (F) Ex. 1.

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The new  § 704(c) gain is allocated among the partners of the merged(transferor) partnership as if they owned an undivided interest in the property using any reasonable method, including taking into account interim revaluations on the admission of a new partner or, presumably, any other revaluation.1192 Example (2), which is supposed to illustrate this principle, originally contained an error that apparently resulted from juggling numbers to deal with admission of a new partner to the partnership that is supposed to be the merged(transferor) partnership, and which is so under state law but the error has been corrected.1193 Post-merger revaluations may reduce the new  § 704(c) gain, and are allocated first to new  § 704(c) gain and then to original  § 704(c) gain,1194 but apparently pre-merger revaluations can have similar effect.1195 There is an exception for mergers of partnerships with identical ownership of book capital and identical ownership of each item of income, gain, loss, deduction, and credit, shares of distributions and liabilities for both partnerships, with a de minimis exception for 97% overlap in each of the above.1196
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1192 Prop. Regs. § 1.704-4(c)(4)(ii)(B), (C), and (F) Ex. 2.

1193 72 Fed. Reg. 62608 (11/6/07). See Jones, “Young Guns and the Administrative Burden of Mergers and Mixing Bowls,” 117 Tax Notes 489 (Oct. 29, 2007).

1194 Prop. Regs. § 1.704-4(c)(4)(ii)(C)(1).

1195 Prop. Regs.  § 1.704-4(c)(4)(ii)(F) Ex. 3 (in the example, a pre-merger revaluation on admission of the new partner reduced original  § 704(c) gain, which, in turn increased new  § 704(c) gain).

1196 Prop. Regs.  § 1.704-4(c)(4)(ii)(E) and (F) Ex. 5.

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The proposed regulation does not deal with distribution of appreciated property of the merged (transferor) partnership to a former partner of the merged partnership (partnership) who could have received the property without triggering new  § 704(c) gain under  § 704(c)(1)(B) or § 737 in the absence of the merger, but since it is the merged partnership's contribution to the resulting partnership and the addition of its partners to the potential distributees that raises “mixing bowl” issues, there should be no triggering for distributions to the “old”partners.1197
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1197 It is probably too much to hope that the final regulations will deal favorably with this.

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The parallel provision for distributions of other property to partners in the merged (transferor) partnership for new  § 704(c) gain are similar.1198 The rules relating to original  § 704(c) gain and subsequent mergers are similar, but there is no reference to revaluation or adjustments for losses.1199 Indeed, since essentially the same facts are used as in the examples under § 704(c)(1)(B), the results are more or less mirror images. No gain is required to be recognized by a partner who originally contributed property to the resulting (transferee) partnership more seven years before a distribution of the transferred property by the merged (transferor) partnership with original  § 704(c) gain and new  § 704(c) gain, notwithstanding reverse  § 704(c) gain.1200 The gain to the distributee is limited to the lesser of net precontribution gain, or the excess of the value of the distributed property over the outside basis of the partnership interest.1201 The net precontribution gain for a partner in the merged (transferor) partnership is the sum of the original § 704(c) gain, and an allocable share of the new  § 704(c) gain, when a distribution of property is received within seven years of the original contribution.1202 There is an almost identical exception for substantially identical ownership mergers.1203
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1198 Presumably because loss is not recognized under § 737;see III, E, 2, above, for a discussion of how unrealized § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1199 Prop. Regs. § 1.737-2(b)(1)(ii).

1200 Prop. Regs. § 1.737-2(e), (b)(1)(ii) Exs. 1 and 4.  Although Ex. 1 cross-references the similar one under Prop. Regs.  § 1.704-4(c)(4)(ii)(F) Ex. 1, it does not bother to indicate that the former partners of the merged (transferor) partnership recognize gain.

1201 § 737(a), (b);Regs. § 1.737-1(b), (c); Prop. Regs.  § 1.737-2(b)(1)(ii) Ex. 2. As was the case for Prop. Regs.  § 1.704-4(c)(4)(ii)(F) Ex. 2, the stated facts do not support the analysis.

1202 Prop. Regs. § 1.737-2(b)(1)(ii)(A), (B) and (F) Ex. 3.

1203 Prop. Regs. § 1.737-2(b)(1)(ii)(E), (F) Ex. 5.

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The proposed regulations discussed above, as foreshadowed in Notice 2005-15,1204 are retroactively effective for distributions of property after January 15, 2005, if the property was contributed in a merger after May 3, 2004.1205 Interestingly, other amendments made by the proposed regulations to change references in the remainder of the mixing bowl regulations to conform to the extension of the gain recognition period from five to seven years, are effective August 9, 2007, even though they effectuate statutory amendments changing the period to seven years that were generally effective June 7, 1997.1206
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1204 As described in the preamble to the proposed regulations, Rev. Rul. 2004-43, 2004-2 C.B. 842, originally stated results similar to those in the proposed regulations, but was withdrawn in response to comments suggesting that the results were contrary to the regulations and should not be retroactive. Rev. Rul. 2005-10, 2005-1 C.B. 492. At the same time, the IRS issued Notice 2005-15, 2005-1 C.B. 527, announcing the intention to implement the principles of the ruling, effective Jan. 19, 2005.

1205 Prop. Regs. § § 1.704-4(g); 1.737-5.

1206 See Taxpayer Relief Act of 1997, P.L. 105-34, § 1063(a). See III, E, above, for a discussion of the change in the gain recognition period from five to seven years.

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If a partner in one of the merged partnerships does not wish to join the resulting partnership, a sale of the withdrawing partner's interest to the resulting partnership will be respected if the right form is followed.  The merger agreement, however, must specify that the resulting (continuing) partnership is purchasing the exiting partner's interest in the terminating partnership and the amount paid for the interest, and the withdrawing partner must consent to sale treatment.1207 This avoids having the consideration received by the terminating partner considered received by (and taxed to) the continuing partners. The sale should be a sale for all purposes, such that: (i) the continuing partners in the resulting partnership will have available to them any appropriate basis adjustment under a  § 754 election,1208 and (ii) if the sale is of more than 50% in capital and profits of the otherwise resulting partnership, the partnership will terminate.1209 Presumably, in all other cases in which a partner in a merged partnership does not continue, the partnership distribution provisions, including § 736, apply.1210 The references to the merger agreement and the different treatment of the continuing partners emphasize the importance of careful advice and drafting of the merger agreement and other relevant documents, which if one lawyer represents the merged (transferor) partnership, or even the resulting (transferee), without separate counsel for their partners, raises the familiar conflict, confidentiality and disclosure issues.1211
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1207 Regs. § 1.708-1(c)(4), (5) Ex. 5. T.D. 8925, 66 Fed. Reg. 715 (1/4/01); REG-111119-99, 65 Fed. Reg. 1572 (1/11/00) (indicate special rule designed to avoid possible deemed sale of assets when surviving partnership provides consideration).

1208 See III, C, and IV, C, above, for discussions of the election that permits adjustment to inside basis to reflect the purchase price (and of mandatory adjustment when the partnership has a substantial built-in loss).

1209 See IV, F, 1, above, for a discussion of when a sale of partnership interests terminates the tax partnership.

1210 Regs.  § 1.708-1(d)(1) (similar provision for partnership divisions); see V, C, 3, below, for a discussion of the consequences of payments, including deferred payments, to a withdrawing partner.

1211 A form of representation letter dealing with withdrawal from the partnership that can be adapted to deal with this issue is included in the working papers.

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Example: Assets-Over Merger. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. They share equally in profits and losses. Oppar has $90,000 of nonrecourse liabilities. Each partner's capital account is $80,000, so that their outside basis is $110,000. There are no  § 704(c) allocations. Oppar's assets and liabilities at the time of the merger are:
Asset	Basis	Value	
Nondepreciable Capital Assets	$150,000	$90,000	
Collectibles	180,000	240,000	
Unrealized Receivables	-0-	120,000	
Total	$330,000	$450,000	
Liabilities and Capital	 	 	
Nonrecourse Borrowing	$90,000	$90,000	
Munn Capital	80,000	120,000	
Propp Capital	80,000	120,000	
Surv Capital	80,000	120,000	
Net	$330,000	$450,000	

Thus, Oppar's net worth is $360,000 ($450,000 asset value - $90,000 liability).

Munn, Propp and Ides have equal (one-third)shares in profits and losses of another partnership, Techpar. The Techpar partnership agreement satisfies the special allocation regulations. Munn's and Propp's capital account and outside basis are $100,000 each (representing cash contributions that were used for capitalized improvements to a “Black Box”), and Ides's capital account is $100,000, but her outside basis is zero, representing her contribution of the Black Box, so that Ides has a  § 704(c) allocation of $100,000. After successful research on the Black Box, its value is $720,000.

Because the Black Box can be useful in Oppar's business, Munn and Propp have decided to merge the two partnerships. Despite its greater value, they follow the simplest procedure, an assets-over transfer of the Black Box to Oppar, on June 30, 20X1. As a result, Oppar's net worth increases to $1,080,000; Munn and Propp each have a one-third interest in Oppar ($360,000 — $120,000 for Oppar's premerger net worth and $240,000 from Techpar's value). Propp has a one-ninth interest ($120,000 for Oppar's pre-merger net worth), and Ides a two-ninths interest ($240,000 from Techpar's value). Since Propp and Munn together own more than 50% of Oppar, it is technically a continuation of both Techpar and Oppar. Since the value of Techpar's assets is more than Oppar's, Techpar is the resulting tax partnership, even though it transferred its assets to Oppar and terminated under state law. The partners' capital accounts are: Munn and Propp, $180,000 each, representing the sum of their capital accounts in Oppar and Techpar; Surv, $80,000, her Oppar capital account; and Ides, zero, her Techpar capital account.

Under the proposed regulations, each of the partners in Oppar has a  § 704(c) allocation of $20,000 (1/3  of $60,000 appreciation ($240,000 value - $180,000 basis) of the Collectibles, and a second  § 704(c) allocation of the$60,000 decline in value ($90,000 value - $150,000 basis) in the Nondepreciable Capital Assets, since they are deemed to contribute these assets to the resulting partnership, Techpar. Ides has a $100,000 § 704(c) allocation for the Black Box, and the three partners in Techpar each have a $206,667 § 704(c) allocation for the Black Box (1/3  of ($720,000 value - $100,000  § 704(c) allocation to Ides)). If the Collectibles are distributed to Ides within seven years of the merger, the former partners of Oppar, apparently including not only Surv, but also Munn and Propp who were also premerger partners in Techpar, will recognize their shares of up to $20,000 gain on distribution under § 704(c)(1)(B). Arguably, the same result would apply to a distribution of the Collectibles to Munn or Propp, but this should not be the case to the extent as with their premerger interests in Oppar. Similarly, if an interest in the Black Box is distributed to Surv within seven years of the merger, Surv recognizes up to $20,000 gain under  § 737 on the distribution. The continuing partners of Techpar do not recognize any gain under § 704(c)(1)(B) on the distribution of the Black Box, because  § 704(c) gain does not include reverse  § 704(c) allocations to partners of the resulting partnership. Of course, if the Black Box distribution is within seven years of Ides' original contribution to Techpar, she will recognize up to $100,000 of her original  § 704(c) gain, but not if the distribution is more than seven years after the original contribution, even if it is within seven years of the merger, as the merger does not start a new seven-year period for prior  § 704(c) gain.

b. Distribution and Contribution of Partnership Assets (Assets-Up) 

The other recognized form of merger, the “assets-up”form, however, is recognized only if the parties actually follow the form.1212 The merged partnership must distribute its assets to its partners, under state law, in liquidation of their interests, and the distributed assets must be contributed by the distributees to a recipient partnership that does not receive any other assets of the prior partnership.1213 Specifically, in an assets-up merger, the merged (transferor) partnership: (i) distributes assets subject to partnership liabilities, in a manner respected under state law to all of its partners in partial or complete liquidations of their interests in the partnership, (ii) who receive the assets as distributees in liquidating distributions, and (iii) the distributee partners immediately contribute the distributed assets to the resulting(transferee) partnerships, (iv) in exchange for interests in that partnership.1214 The result is that the inside basis to the resulting partnership is determined by the outside basis of the interests of the partners in the merged partnership, except that, under the 2004 amendment to § 704, if any merged partnership has a built-in loss in its assets, the inside basis is fair market value and the built-in loss is allocated only to the partners in such merged partnership.1215 The possibility that the interim holding of the assets by the partners may be a continuation of the partnership, particularly if they constitute a business,1216 is ignored.1217 The distributions may result in gain recognition if they result in changes in shares of  § 751 property.
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1212 Regs. § 1.708-1(c)(3)(ii); see Preamble to T.D. 8925, 66 Fed. Reg. 715 (1/4/01). The terminating partnership must distribute its assets in such a manner that the partners are the owners of the assets under state law, even though state law generally does not control partnership tax consequences. See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259(2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form; suggests a specific election to choose assets-up or assets-over results, regardless of form).

1213 Regs. § 1.708-1(c)(3)(ii), (5) Ex. 3 (assets-up form respected).

1214 Regs. § 1.708-1(c)(3)(ii).

1215 § 704(c)(1)(C), as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(a), effective Oct. 22, 2004.

1216 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the basic definition of a tax partnership.

1217 See Regs. § 1.708-1(c)(3)(ii), and (5) Ex. 3; T.D. 8925, 66 Fed. Reg. 715 (1/4/01).

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The preamble indicates that when interests in a merged partnership are received by other than a partner who contributed § 704(c) property, gain may be triggered under the mixing bowl rules.1218 In addition, of course, new  § 704(c) gain or loss may be created for any difference between the inside basis of the property to the resulting (transferee)partnership and the basis of the contributed property to the partners of the merged (transferor) partnership as distributees.1219 Similarly, new  § 1.752-7 liabilities may be created, although nothing in the final regulations addresses this issue directly.1220 Accordingly, it is difficult to see why the parties would want to use the assets-up form, unless there are significant increases in the basis of partnership assets, most likely, because partners had purchased interests when there was no  § 754 election in effect.
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1218 § 704(c)(1)(B) or § 737. See Preamble, REG-111119-99, 65 Fed. Reg. 1572, 1575–76(1/11/00). See III, E, above, for a discussion of how unrealized § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1219 See IV, B, above, for a discussion of the basis of distributed property received in liquidating distributions, and I, B, above, for a discussion of  § 704(c) gain or loss.

1220 See Regs. § § 1.752-7(b)(4)(ii), (5)(ii), and (e)(3)(ii) Ex. 3 (deals only with assets-up merger).

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Example: Assets-Up Merger. The facts are the same as in the Example in IV, G, 2, a, above, except that Techpar distributes the Black Box to its partners, who then contributes it to Oppar; the combination is an assets-up merger. The principal difference is that the Black Box has a transferred basis measured by the $200,000 outside basis of Munn's and Propp's interests in Techpar, not by the $200,000 inside basis to Techpar, even though it is the same amount. One-third of Techpar's inside basis was lost on the distribution to Ides, who has zero basis. New  § 704(c) allocations and new mixing bowl periods are triggered. Accordingly, it is difficult to see why they would use the assets-up approach. Since an assets-up merger creates new  § 704(c) allocations, the proposed regulations, which relate only to assets-over mergers, properly do not apply.

The regulations do not, however, respect the form when the partners of the merged partnership contribute their partnership interests to the resulting partnership, an interests-over form, but will treat the transaction as an assets-over transaction,1221 because of alleged complications in applying § § 704(c)(1)(B) and 737 to the partners of the merged partnership.1222
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1221 Regs.  § 1.708-1(c)(5) Ex. 4. See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,”44 San Diego L. Rev. 259, 292–94 (2007) (suggests that rejection of interests-over form is inconsistent with Rev. Rul. 99-6, 1999-1 C.B. 432, which respects a purchase by one person of all of the interests as an interests-over transaction; does not discuss that this result is for seller only and that assets-up approach used for purchaser). See IV, G, 5, a, below, for a discussion of Rev. Rul. 99-6.

1222 Preamble, REG-111119-99, 65 Fed. Reg. 1572, 1573 (1/11/00).

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c. Collateral Consequences 

Any liability increases and decreases in the merger are netted,1223 with outside basis adjusted to reflect any net increases and decreases. Although not discussed in the regulations, there may be gain recognition when there are changes in shares of § 751 property, and there is also a distribution resulting from a net decrease in liabilities,1224 but a reverse  § 704(c) allocation may avoid this gain.1225 The merged partnerships do not recognize depreciation recapture,1226 but there may be investment tax credit recapture in the assets-up form.1227 The partnership's depreciation period and method continue as if there had been no transfer,1228 except for any increases in basis, which are depreciated as new property,1229 but other accounting aspects, such as inventory method, do not.1230 Naturally, there is an anti-abuse provision, which applies step-transaction and similar principles when the merger is part of a larger transaction, for example a disguised exchange of partnership interests.1231
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1223 Regs. § 1.752-1(f), (g) Ex. 2; see Regs.  § 1.752-5(a) (effective date). See 710 T.M., Partnerships — Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of how shifts and liability shares can result in gain recognition.

1224 § 751(b). See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1225 Cf. Regs.  § 1.708-1(c)(5) Ex. 5 (similar result for a sale of a partnership interest as part of a merger).

1226 See § § 1245(b), 1250(b); Regs. § § 1.1245-4(c), 1.1250-3(c).

1227 § 47(b); Regs.  § 1.47-3(f)(1)(ii)(d) (one of the four conditions for qualification of a transaction as a mere change in form of conducting a trade or business is that the basis of the property in the hands of the transferee be determined by the basis to the transferor partnership).

1228 § 168(i)(7); see 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of continuity of depreciation in partnership contributions. See IV, F, 2, above, for a discussion of the different rule that applies when a partnership terminates.

1229 § 168(i)(7)(A), (B)(i); Prop. Regs. § 1.168-5(b)(7),-4(d)(5)(i) and (ii) (depreciation); § 197(f) and Regs.  § 1.197-2(g)(3) (amortization).

1230 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of partnership accounting elections.

1231 Regs. § 1.708-1(c)(6). See IV, G, 1, c, above, for a discussion of the anti-abuse provision, which involves a division combined with a merger.

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Because a partnership continues until no part of the partnership business is conducted in partnership form,1232 the resulting partnership can be a continuation of more than one of the merged partnerships,1233 but only the one whose partners have more than 50% of the capital and profits of the prior partnership may be the resulting partnership, and if more than one meets that standard, the partnership that contributes the greatest amount of the net assets continues, files a full-year return, and retains its EIN,1234 even if in form another partnership is the resulting one under state law.1235 When none of the merged partnerships had partners who control more than 50% of the capital and profits interests of the resulting partnership, all of the merged partnerships terminate and the resulting partnership is a new entity.1236 All merged partnerships except the resulting(transferee) partnership, file short-year returns for the period ending with the merger,1237 with distributive shares taking into account the changes in partners' interests.1238 Unlike partnership divisions,1239 there is no explicit provision in the partnership merger regulations relating to tax elections of the merged partnerships, but, presumably, only the tax elections of the resulting(transferee) partnership, if any, continue, and if not, the resulting partnership that is not a resulting partnership will have a fresh start on tax elections, and will have make affirmatively any that it wishes to continue, although an existing  § 754 election should allow § § 734(b)/754 adjustments that result from the division transaction.1240 The collateral consequences are the same as for any partnership termination.1241
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1232 § 708(b)(1); Regs. § 1.708-1(a).

1233 Regs. § 1.708-1(c)(1), (5) Ex. 2.

1234 § 708(b)(2)(B); Regs. § 1.708-1(c)(1), (2). The return must “state that the resulting partnership is a continuation of such merging or consolidating partnership, shall retain the employer identification number (EIN) of the partnership that is continuing, and shall include the names, addresses, and EINs of the other merged or consolidated partnerships.” Regs. § 1.708-1(c)(2).

1235 Regs.  § 1.708-1(c)(5) Ex. 2(i).

1236 Regs. § 1.708-1(c)(1). Regs.  § 1.708-1(c) generally deals with the forms of partnership mergers and consolidations and is generally effective for transactions after Jan. 3, 2001.

1237 Regs. § 1.708-1(c)(1), (2) and (5) Ex. 1; cf. FSA 200132009 (return that did not separate pre- and post-termination periods filed for partnership that terminated on sale of more than 50% of the partnership interests, nevertheless started running of statute of limitations). The regulations do not address the rare situation where two or more partnerships that could be continuing partnerships contribute exactly the same net value. There is no provision for coin-toss or other tie-breaker.

1238 § 706(c). See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a discussion of the rules requiring that allocation of income reflect the partners' varying interests during the taxable year.

1239 Regs. § 1.708-1(d)(2)(ii). See IV, G, 1, c, above, for a discussion of the similar need for new partnership elections following a partnership division.

1240 See Rev. Rul. 86-73, 1986-1 C.B. 282 (existing election under  § 754 applies to new partner who purchased more than 50% interest on deemed distribution resulting from termination; “new” partnership must make new election).

1241 See IV, F, 2, above, for a discussion, and 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of such collateral effects of partnership terminations.

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Example: Collateral Consequences.  The facts are the same as in the example in IV, G, 2, a, above. Oppar terminates on the transfer. Accordingly, its tax year ends on June 30, and it must file a final return for the period ending then. The shares of Oppar's $90,000 liability for its nonrecourse borrowing are Munn and Propp $30,000 (one-third) each, Ides $20,000(two-ninths), and Munn $10,000 (one-ninth). As a result of her smaller share, Propp has a liability distribution of $20,000, but, since $20,000 is less than her $90,000 outside basis ($80,000 capital account +$10,000 liability share), she does not recognize gain. All inherent gains and losses of both Oppar and Techpar should be allocated to their premerger partners under reverse  § 704(c) allocations. Accordingly, since Propp should continue to have a $40,000 share of the unrealized receivables under a reverse  § 704(c) allocation,  § 751(b) should not result in a deemed exchange, even though she received a deemed distribution as a result of the reduction in her share of liabilities. Similarly, $420,000 unrealized appreciation in the Black Box is allocated ratably to Munn, Propp and Ides. Ides also, of course, continues to have a $100,000  § 704(c) allocation, but the seven-year period for purposes  § § 704(c)(1)(B) and 737 continues to date from the formation of Techpar.

3. Incorporating the Going Partnership 

There may come a time in the life of a partnership business when the parties decide to incorporate the business as a whole.1242 Although at one time, a significant reason for incorporating was achieving limited liability for all participants, with the general availability of unincorporated limited liability entities, this is more likely to be a reason for changing the state law form than for incorporating.1243 Similarly, unlimited life and centralization of management can be, and now frequently are, achieved by using the LLC (limited liability company), limited partnership or LLP (limited liability partnership) forms now available in virtually every state,1244 particularly in view of the freedom of contract embodied in all of them, ranging from significant for general partnerships(and LLPs) to what is sometimes referred to as “contract as deity” for Delaware LPs and most LLCs.1245 Although the rules for pensions and profit sharing plans are now substantially similar for corporations and tax partnerships, there are a few remaining fringe benefit and other considerations that may favor incorporation.1246 A more significant reason is likely to be raising capital, particularly public capital, since an unincorporated business entity that is publicly held is automatically taxed as a corporation,1247 but a state-law corporation may be preferred because it is a better understood form for publicly held entities by investors and by the courts, particularly the Delaware courts. Although the regulations allow significant liquidity to be provided without becoming publicly traded,1248 being publicly traded provides greater liquidity for owners. Of course, the double taxation of corporate profits, compared with the pass-through aspect of partnership taxation, including the ability to pass-through losses, may provide a significant counterweight even with a 15% tax rate on dividends and capital gains. While S corporations can provide some of these benefits, the limitations on S corporation qualification even after several liberalizations, and the inability to use special allocations, to increase outside basis for entity-level debt (even where a shareholder guarantees the debt) and to make nonrecognition distributions of S corporation assets to shareholders, make the S corporation form not particularly attractive to a tax partnership.1249
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1242 See 700 T.M., Choice of Entity, for a comprehensive treatment of the considerations in choosing among the various available forms of state law legal entities and tax entities.

1243 See IV, G, 5, c, below, for a discussion of the tax consequences of such changes.

1244 See Ely, Grissom and Houser, State Tax Treatment of Limited Liability Companies and Limited Liability Partnerships, 106 Tax Notes 1557 (Feb. 2, 2005). See 710 T.M., Partnerships — Conceptual Overview, for a discussion of the prior Kintner regulations that might have required actual incorporation to achieve these goals.

1245 See RUPA § 103(mostly restraints on limiting fiduciary duties); RULPA § 1005(incorporates RUPA); Re-RULPA § 110 (fewer restraints); Del. LPA § 17-1101(contract as deity; only limit is good faith and fair dealing); ULLCA § 103(fewer restraints on limiting fiduciary duty); RULLCA § 110 (contract as demi-deity; only a few more restraints); Del. LLCA § 18-1101(contract as deity).

1246 See Hibschelweiler and Kopin, “LLCs Are Generally—But Not Always—The Right Choice,” 58 Tax'n Acct. 159 (1997) (suggests some rare instances, where partnership treatment may be less favorable than S corporation or even C corporation treatment); But see, e.g., Schwidetzky, “Is It Time to Give the S Corporation a Proper Burial?,” 15 Va. Tax Rev. 591 (1996) (favors allowing virtually tax-free liquidations of existing S corporations). Nevertheless, 1996 legislation liberalized the S corporation provisions.

1247 § 7704. Although only certain publicly held partnerships can avoid classification as corporations by satisfying the exceptions for investment partnerships, § 7704(c), or grandfathered partnerships, § 7704(g), those exceptions are not relevant if the decision to incorporate is undertaken for other reasons. See 710 T.M., Partnerships — Conceptual Overview, for a discussion of these exceptions.

1248 Regs. § 1.7704-1; see 710 T.M., Partnerships —Conceptual Overview, for a discussion of these arrangements.

1249 See 730 T.M., S Corporations: Formation and Termination, for a comprehensive treatment of these and other aspects of S corporation taxation.

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When the partners decide that the business should be transferred to a corporation for tax purposes only, they can “check the box.”1250 The election is considered to be a transfer of all of the partnership's assets to the association(corporation) and a distribution of the corporate stock by the partnership to the partners, that is, the assets-over form of incorporation.1251 When a state law corporation is preferred for any of the reasons discussed above, there is no regulation equivalent to those for partnership mergers and divisions, so that the partnership and its partners must rely on a ruling, that antedates the partnership merger and division regulations for the very similar tax consequences.1252 Rev. Rul. 84-111 holds that the parties can choose among: (i) a transfer of assets by the partnership followed by a partnership liquidation (equivalent to the “assets-over” form of partnership mergers and divisions); (ii) a liquidation of the partnership followed by a transfer of the assets by the partners to the corporation (equivalent to the “assets-up” form of partnership mergers and divisions), or (iii) a transfer of all of the partnership interests to the corporation(equivalent to the “interests-up” form of partnership mergers and divisions that is not recognized as a valid form for those transfers); with the collateral results under  § 351 controlled by the form, assuming the transfer qualifies under § 351. The holding period of the corporation's assets and of the corporate shares should also follow the form.1253
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1250 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the election available to unincorporated business entities to be taxed as corporations by filing a form.

1251 Regs.  § 301.7701-3(g)(1)(i) (partnership)and (iv) (disregarded entity). The preamble indicates that form still controls for actual incorporations. See T.D. 8844, 64 Fed. Reg. 66580 (11/29/99). It retains its EIN. Regs. § 301.6109(h)(1). See IV, G, 3, a, below, for a discussion of the assets-over form. See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259(2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form; suggests a specific election to choose assets-up or assets-over results, regardless of form).

1252 Rev. Rul. 84-111, 1984-2 C.B. 88 (providing three forms for incorporating a partnership: Situation 1—assets-over, Situation 2—assets-up, and Situation 3—interests-up).

1253 See 710 T.M., Partnerships —Conceptual Overview, for discussions of the holding period of partnership interests and of distributed property, respectively.

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In most cases there is no assignment of income issue on transfer of even cash-method receivables or payables in connection with an incorporation of a partnership business, but the IRS may assert that there is assignment of income when receivables or similar items are transferred that are unrelated to the partnership's income or operations.1254 An incorporating partnership that qualifies under  § 351 does not recognize depreciation recapture regardless of form,1255 but there may be investment tax credit recapture in the assets-up and interests-up forms.1256 The partnership's depreciation period and method continue as if there had been no transfer,1257 but other accounting aspects, such as inventory method, do not.1258 The partnership terminates on incorporation, and is required to file a final return,1259 but the date of termination depends on the form of incorporation, as discussed below for each form.
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1254 See Hempt Bros. Inc. v. U.S., 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S. 826 (1974) (transferee corporation must report as ordinary income receivables transferred by cash-method partnership, and has zero basis in inventory when predecessor partnership improperly expensed costs); Rev. Rul. 80-198, 1980-2 C.B. 113 (transferee in  § 351 transaction entitled to deduct accounts payable of cash-method transferor); but see Rooney v. U.S., 305 F.2d 681 (9th Cir. 1962) (reallocate to corporation expenses incurred by shareholders for growing crops transferred to corporation before harvest).

1255 § § 1245(b), 1250(b); Regs. § § 1.1245-4(c), 1.1250-3(c).

1256 § 47(b); Regs.  § 1.47-3(f)(1)(ii)(d) (one of the four conditions for qualification of a transaction as a mere change in form of conducting a trade or business is that the basis of the property in the hands of the transferee be determined by the basis to the transferor partnership).

1257 § 168(i)(7); see 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of depreciation continuity.

1258 See 711 T.M., Partnerships —Formation and Contributions of Property or Services, for a comprehensive treatment of a partnership's choice of method of accounting.

1259 See IV, F, above, for a discussion of when a tax partnership terminates and the collateral consequences of termination.

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If the requirements of  § 351 are not met by the partners, and the transaction cannot be arranged to qualify for nonrecognition as an acquisitive  § 351 transaction,1260 the transaction should be a taxable sale of partnership assets by the partnership or the partners, or of the partnership interests,1261 depending on the form followed.1262 If the transfer of partnership assets is to a corporation that the partnership or its partners do not control immediately after the transfer, so that § 351 does not apply, the transfer is equivalent to a taxable sale of partnership assets or interests.1263
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1260 See IV, G, 3, d, below, for a discussion of acquisitive  § 351 transactions, sometimes called “National Starch” transactions.

1261 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the effect sales of partnership assets or interests.

1262 See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,”44 San Diego L. Rev. 259 (2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form;suggests a specific election to choose assets-up or assets-over results, regardless of form).

1263 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the tax consequences of such taxable dispositions.

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Although Rev. Rul. 84-111 refers to a transfer of liabilities as well as assets, it describes only the basis consequences. It does not deal with the consequences of boot, from an excess of liabilities over basis or otherwise.1264 When the inside basis of the partnership's assets differs from the aggregate outside basis of the partnership interests, the method chosen may affect the corporation's basis in the partnership's assets. Moreover, although Rev. Rul. 84-111 refers to § 751, since it does not specify that any of the assets is  § 751 property, it does not discuss any  § 751 consequences. Although incorporation of a partnership with liabilities involves either a deemed distribution of each partner's share of the liabilities, or a transfer of that share, as discussed below, the incorporation, generally, should not result in recognition of ordinary income, regardless of form, unless the liabilities exceed the aggregate basis of the assets, that is, unless there is boot under § 357.1265 Nevertheless, there is a risk that the IRS may take a contrary position, particularly in an interests-up incorporation.
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1264 See 710 T.M., Partnerships —Conceptual Overview, and 711 T.M., Partnerships —Formation and Contributions of Property or Services, for discussions of the bifurcation approach to transfers of assets between partners and partnerships.

1265 See Manning, “The Service Corporation—Who Is Taxable on Its Income? Reconciling Assignment of Income Principles,  § 482 and § 351,”37 U. Miami L. Rev. 657, 662–68 (1983).

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When it qualifies, the corporation may elect to be taxed under Subchapter S.1266 Although the incorporation transaction generally terminates the partnership,1267 a partnership transferring its assets to a new state law corporation can also presumably remain alive as a holding entity, but if it does, the transferee corporation cannot qualify as an S corporation.1268 When the transferee corporation is a C corporation that is a qualified small business under § 1202, any appreciation in value prior to incorporation cannot qualify for the 50% exclusion of gain; only subsequent appreciation can qualify.1269 Regardless of the form of incorporation, stock of a C or S corporation that is a small business corporation as defined in  § 1244 is eligible for ordinary loss of up to $50,000 ($100,000 on a joint return), measured by the basis, not the value, of the partnership assets or interest contributed, in any year when realized, although as practical matter the loss is only likely to be realized in one year.1270
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1266 See e.g., PLR 200328021 (failure of LLC to make election is inadvertent; allowed to make late election); PLR 200215027 (corporate separation involving state law mergers that elect to be taxed as corporations and that elect S corporation status after separation). See 730 T.M., S Corporations: Formation and Termination, for a comprehensive treatment of entities eligible to be S corporations.

1267 See IV, F, 2, above, for a discussion of the collateral consequences of the termination.

1268 § 1361(b)(1)(B);see 730 T.M., S Corporations: Formation and Termination, for a comprehensive treatment of why a holding partnership disqualifies an S corporation.

1269 § 1202(i)(1). Qualified small business stock can be held by a partnership or other pass-through entity. § 1202(g). See 760 T.M., Small Business Corporation Stock — Special Tax Incentives, for a comprehensive treatment of the 50% exclusion under § 1202, including this limitation.

1270 See 760 T.M., Small Business Corporation Stock — Special Tax Incentives, for a comprehensive treatment of  § 1244 stock issued to partnerships, for partnership interests, or otherwise.

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a. Transfer of Partnership Assets (Assets-Over) 

A transfer of partnership assets to a newly created corporation (assets-over form) qualifies for nonrecognition under  § 351 (except to the extent boot is received), when the partners (or the partnership)are in control of the corporation, that is, if they have 80% ownership.1271 Specifically, the assets-over form: (i) treats the partnership as transferring its assets to the resulting (transferee) partnership, (ii) in exchange for corporate shares, and (iii) distributing the corporate shares to all of its partners, (iv) who receive the interests as liquidating distributions.1272 The partnership recognizes gain or loss that is passed through to the partners on any transfer for boot. The transfer of liabilities is boot only to the extent that aggregate liabilities transferred exceed the aggregate basis of the assets transferred, or if any liabilities are transferred with a tax avoidance purpose.1273
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1271 Rev. Rul. 84-111, 1984-2 C.B. 88. See § 368(c), defining control. See 700 T.M., Choice of Entity, for a comprehensive treatment of the requirements for a nonrecognition transfer.

1272 Rev. Rul. 84-111, Situation 1. See PLR 8538094 (in giving favorable ruling on incorporation of partnership involving transfer to two corporations (essentially following Rev. Rul. 84-111, without citing it), and withdrawal by some partners, expressly refuses to rule on the  § 736(a) consequences of liquidating distributions in kind to partners withdrawing).

1273 § 357; Regs. § § 1.357-1, -2.

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Since  § 751 applies only to transfers of partnership interests and partnership distributions, it does not apply to a transfer of partnership assets, so that the general nonrecognition provision of  § 351 controls. The transferee corporation, generally, has a transferred basis and tacked holding period for the assets, and succeeds to the tax consequences of payment of liabilities and other obligations, but there is no general carryover of, or succession to, other tax attributes, such as accounting methods. Under the 2004 amendment to § 362(e),1274 the transferee corporation's basis in the assets contributed is reduced for any built-in net loss in the partnership's assets transferred.1275 The mixing bowl rules do not apply to an assets-over form of partnership incorporation.1276
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1274 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the 2004 amendment to § 362(e).

1275 § 362(e).

1276 Regs. § § 1.704-4(c)(5), 1.737-2(c). See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

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The transferor partnership's basis in the corporate shares is an exchanged basis equal to the inside basis of the assets transferred, reduced by the liabilities transferred, and its holding period is tacked to the extent attributable to capital assets or  § 1231 property, but not to the extent attributable to other assets.1277 The partnership's inside basis in the corporate shares becomes the partners' basis in the shares when distributed in liquidation, subject to the effect of each partner's outside basis (as reduced for the deemed distribution from the partner's being relieved of a share of partnership liabilities on the transfer).1278 Similarly, the partners' holding period for the corporate shares is the partnership's holding period in the property transferred, which may result in a split holding period to the extent of partnership ordinary income assets; the holding period of the partnership interests is irrelevant.1279
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1277 See II, B, 2, above, for a discussion of the same issue in determining the holding period of a partnership interest.

1278 See III, B, 1, and IV, B, above, for discussions of the transferred basis of distributed property.

1279 See III, B, 2, b, above, for a discussion of the application of  § 735(b) to provide a carryover holding period for distributed property without regard to the holding period of the partnership interest.

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In view of the status of the corporation as an entity, although the corporation succeeds to the potential recapture,1280 or collectibles gain,1281 the corporate shares are capital assets not subject to any taint. Of course, if the corporation elects to be an S corporation, the shareholders will be subject to look-through recapture or collectibles gain, when the S corporation realizes them.1282 Similarly, since  § 704(c) applies only to partners and partnership recognition, any  § 704(c) allocations to partners disappear, although, of course the corporation will realize the gain, and will pass it through to its shareholders if it is an S corporation.
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1280 § § 1245(b), 1250(b); Regs. § § 1.1245-4(c), 1.1250-3(c).

1281 § § 1(h)(6)(B), 1223(1); Regs. § 1.1(h)-1(a).

1282 Regs. § 1.1(h)-1(a), (b).

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The transfer of the liabilities from the partnership to the corporation is a deemed distribution by the partnership to its partners, reducing their basis in the partnership interests that may result in gain to any partners whose shares of liabilities exceed basis.1283 Although the partners recognize pass-through income or gain to the extent the partnership receives boot, including an excess of total liabilities transferred over the total basis of the assets transferred, in view of the  § 357 provision that liability transfers are not boot, unless the total liabilities exceed total basis, the corresponding deemed distribution of each partner's share of partnership liabilities under  § 752 should not result in recognition under § 751(b), even when the partners' interests in capital and profits are not in the same proportions.1284 The deemed distribution is not, however, matched by any partner's receiving a disproportionate share of  § 751 property or other property.
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1283 § 752(b); Regs. § 1.752-1(e); see IV, A, 2, above, for a discussion of the taxation of liability relief as a cash liquidating distribution.

1284 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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When the transfer of partnership assets is subsequent to an assumption of a  § 358(h) liability by the partnership (which is substantially the same as a  § 1.752-7 liability that is defined by reference to § 358(h)(3)),1285 the basis of the corporate stock received by the partnership is immediately reduced (but not below the fair market value of the stock), by the amount of the  § 358(h) liability, and the partners' outside bases in their partnership interests are reduced by the same amount, even if the reduction brings the basis below fair market value, and, if the reduction is more than the outside basis, the partner recognizes gain on the partnership interest.1286 Since the basis reduction is of the corporate stock, it apparently does not affect the transferred basis of the partnership assets contributed to the corporation. Since the purpose of § 358(h), and its partnership equivalent,1287 is to prevent artificial loss, the reduction apparently does not result in gain when it exceeds basis. The immediate basis reduction is appropriate for transfers to C corporations, because the potential deduction is transferred to the corporation, so that there is no deferred deduction for the partnership or its partners. S corporations have a situation closer to partnerships, but the corresponding regulations for them apparently have not been proposed.
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1285 Regs. § 1.358-7(d).

1286 § 358(h); Regs. § 1.358-7(b), (e) Ex. 2.

1287 See II, D, 4, above, for a discussion of how the regulations reduce a partner's outside basis when a transaction separates a partner from whom a deductible obligation is assumed before the obligation is satisfied.

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The partnership does not terminate until the corporate shares are distributed.1288
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1288 Rev. Rul. 84-111, Situation 1, 1984-2 C.B. 88.

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Example: Assets-Over Form of Partnership Incorporation. Munn, Propp and Surv have equal(one-third) shares in profits and losses of a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn's mother and Propp contributed $100,000, and Surv contributed$50,000 to Oppar. Oppar has $110,000 of recourse liabilities, which are allocated disproportionately, because of the different capital accounts, $20,000 each to Munn and Propp and $70,000 to Surv. Accordingly, Propp's outside basis is $120,000 ($100,000 capital + $20,000 liability share, and Surv's is also $120,000 ($50,000 capital + $70,000 liability share. Munn's outside basis is $90,000 because he inherited his mother's estate, which successfully established a $30,000 valuation discount($100,000 capital - $30,000 discount + $20,000 liability share). The inside basis of Oppar's assets is $360,000, the value is $480,000, and Oppar's net worth is $370,000. Oppar's balance sheet is:
Assets	Basis	Value	
Nondepreciable Capital Assets	$195,000	$135,000	
Collectibles	165,000	255,000	
Unrealized Receivables	 -0- 	90,000	
Totals	$360,000	$480,000	
 	 	 	
Liabilities and Capital 
 Recourse Liabilities	$110,000	$110,000	
Munn Capital	100,000	140,000	
Propp Capital	100,000	140,000	
Surv Capital	50,000	90,000	
Totals	$360,000	$480,000	

Oppar incorporates its business by transferring its assets (assets-over form) to a C corporation, Ceeco, in exchange for Ceeco shares, worth $370,000, that are distributed ratably to its partners: Ceeco shares worth $140,000 to each of Propp and Munn and $90,000 to Surv. Neither Oppar nor any of its partners recognizes gain or loss on the transfer under  § § 351 and 357, since the liabilities transferred do not exceed the basis of the assets transferred;  § 751 does not apply to an assets transfer. Ceeco's basis in the assets is the same as Oppar's inside basis, under § 362, and it has a tacked holding for the capital assets and collectibles, but not for the receivables. Oppar's basis of the Ceeco shares, under § 358, is $250,000, the $360,000 total inside basis of the assets transferred, reduced by the $110,000 liabilities transferred. Oppar's holding period of the Ceeco shares is split—a tacked holding period for the 81+% ($390,000/$480,000) of the shares attributable to the capital assets and the collectibles, and a new holding period for the 18+%($90,000/$480,000) attributable to the receivables. Oppar terminates only when the Ceeco shares are distributed to its partners.

The transfer of the Oppar liabilities is also a distribution to the partners reducing their outside basis by $20,000 to $100,000 for Propp; by $20,000 to $70,000 for Propp; and by $70,000 to $50,000 for Surv, but since the distribution does not exceed any partner's outside basis, none recognize gain. Even though the deemed distribution is disproportionate to their outside basis and profits interests, it should not result in income or gain under § 751(b), since there is no corresponding disproportionate (or other) distribution of  § 751 property to any partner. Each partner's basis in the Ceeco shares is the same as the outside basis of their Oppar interest, and each partner's holding period for the shares is the same split holding period as Oppar's; their long-term holding period in their Oppar interests in irrelevant. No portion of the shares is subject to any higher rate for the collectibles gain. Oppar, of course, terminates when the Ceeco shares are distributed.

b. Distribution and Contribution of Partnership Assets (Assets-Up) 

When the order of the transactions involved in incorporating the partnership business is reversed, with the assets first distributed, subject to partnership liabilities, in liquidation to the partners, and then contributed by them to the corporation (assets-up form), the corporation's basis in the assets is determined by the partners' outside basis in the partnership interests, not the partnership's inside basis—the same as the differences between an assets-over and an assets-up form of partnership merger or division.1289 Specifically, in an assets-up incorporation, the partnership: (i) distributes its assets subject to partnership liabilities, to all of its partners in partial or complete liquidations of their interests in the partnership (but there is no requirement that the distribution be respected under state law), (ii) who receive the assets as distributees in liquidating distributions, and (iii)the distributee partners immediately contribute the distributed assets to the corporation, (iv) in exchange for its shares.1290 The partnership apparently terminates on the distribution,1291 even though, technically, the assets continue to be part of a business operation during the interim between distribution and contribution.1292
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1289 See IV, G, 1 and 2, above, for discussions of partnership divisions and mergers, respectively.

1290 Rev. Rul. 84-111, 1984-2 C.B. 88.

1291 See IV, F, 2, above, for a discussion of the collateral consequences of partnership termination.

1292 See 710 T.M., Partnerships —Conceptual Overview, and 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for comprehensive treatments of how hard it is terminate a partnership without absolutely complete termination of business operations.

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The distribution of the partners' shares of assets and liabilities is entitled to nonrecognition under  § 731 for both the partnership and the partners.1293 The distributions may, however, result in gain recognized under the mixing bowl rules, if it includes property contributed to the partnership within seven years of the distribution.1294 Each partner's share of partnership assets should be determined by the partner's capital account, plus liability share in allocating the inside basis of the assets, and by profit or loss share, in allocating inherent gain or loss in the assets.1295 Thus, each partner should receive a ratable share of the gross value of the assets, but should receive them subject to the partner's share of partnership liabilities. The liability shares are not necessarily proportionate to shares of capital or profits or losses,1296 but the transfer of the liabilities is essentially a wash, because the deemed distribution from the reduction in the partner's share of partnership liabilities is netted against the deemed contribution from taking over the same liability share individually. Because each partner receives a ratable share of each asset, there is no exchange under § 751(b).1297
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1293 See IV, A, above, for a discussion of how, and to what extent, partnership liquidating distributions qualify for nonrecognition.

1294 Regs. § § 1.704-4(c)(5), 1.737-2(c). See IV, E, above, for a discussion of provisions that prevent avoidance of the  § 704(c) allocation of the inherent gains to the contributor.

1295 See III, D, 2 above, for a discussion of the effects of these factors under § 751. The same concepts should apply under the mixing bowl rules.

1296 See II, D, 3, above, for a discussion, and 714 T.M., Partnerships — Allocation of Liabilities; Basis Rules, for a comprehensive treatment of how these liability shares are determined.

1297 See III, D, above, for a discussion, and 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive treatment of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

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The partner's basis for the distributed property, however, is determined by the outside basis of the partnership interest(including the liability share and any gain under the mixing bowl rules), which may differ significantly from the share of inside basis when a transferee partner has acquired a partnership interest when no  § 754 election applied.1298 Thus, there may be significant change from the inside basis of the assets distributed to the aggregate basis of those assets for the partners individually, or even shifts in basis among the various kinds of assets, even when there is no net change, even though neither the partnership nor the partners recognize gain or loss on the distribution.1299 The partners' holding period of the assets distributed is the same as the partnership's holding period; the holding period of their partnership interest is irrelevant.1300
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1298 See III, C, above, for a discussion of the effect of the entity principle in creating differences from the general equality between inside and outside basis under the aggregate principle.

1299 See III, C, and IV, C above, for discussions of adjusting the inside basis of property received in a liquidating distribution to reflect the distributee's outside basis.

1300 See III, B, 2, b, above, for a discussion of the application of  § 735(b) to provide a carryover holding period for distributed property without regard to the holding period of the partnership interest.

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The partners' basis in the corporate shares received on the contribution of the assets is the same as their basis in the assets transferred, and they may have a split holding period based on the nature of the assets transferred.1301 In addition, when the share of partnership liabilities exceeds outside basis—reflecting a negative capital account (or a purchaser who succeeded to a capital account greater than the net purchase price net of liabilities transferred), there may be gain under § 357(c), which treats an excess of liabilities transferred over the aggregate basis of property transferred as boot. If the assets transferred by any partner have a built-in loss, under the 2004 amendment to § 362(e), the transferee corporation has a downward adjustment to basis for the net built-in loss, unless both the transferor partner and the transferee corporation elect to adjust the basis of the corporate stock.1302 When the interest transferred is held by a  § 1.752-7 liability partner, the consequences should be the same basis adjustment and other consequences as for a transfer of a partnership interest in a  § 351 transaction.1303 When the transfer of former partnership assets includes the assumption of a  § 358(h) liability,1304 the basis of the corporate stock received by the partner is immediately reduced (but not below the fair market value of the stock), by the amount of the  § 358(h) liability.1305 Since the basis reduction is of the corporate stock, it apparently does not affect the transferred basis of the partnership assets contributed to the corporation. Since the purpose of § 358(h), and its partnership equivalent, is to prevent artificial loss, the reduction apparently does not result in gain when it exceeds basis.
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1301 See II, B, 2, above, for a discussion of the principle that tacking applies only to capital and  § 1231 assets.

1302 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the  § 362(e) amendment.

1303 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of these adjustments in transfers to controlled corporations.

1304 See II, D, 4, above, for a discussion of regulations that provide basis adjustments when a transaction separates a partner from whom a deductible obligation is assumed for the potential allocation of the deduction under  § 704(c) before the obligation is satisfied.

1305 § 358(h); Regs. § 1.358-7(b), (e) Ex. 2.

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Example: Assets-Up Form of Partnership Incorporation. The facts are the same as in the example in IV, G, 3, a, above, except that Oppar distributes its assets ratably to its partners, who contribute them to Ceeco. Despite the differences in their capital accounts, all partners' shares of each asset are equal, because the allocation to Surv of $70,000 of the recourse liability (compared with $20,000 to each of Munn and Propp) makes up for her lower capital account. Surv, of course, receives her $160,000 in value of the Oppar assets, subject to her $70,000 share of partnership liabilities, while the other two are subject only to $20,000 liabilities each, so that her net value is $50,000, while the other two receive assets with a net value of $100,000. The reduction in partnership liability shares and the increase in individual liabilities on the distribution wash.

Since each of Propp's and Surv's $120,000 outside basis is equal to one-third of the $360,000 inside basis of Oppar's assets, their basis for their respective shares of each asset is zero for the receivables, $65,000 for the capital assets, and $55,0000 for the collectibles. Munn's outside basis ($90,000) is less than his share of Oppar's inside basis of these assets ($120,000). Because his basis in the receivables is zero, the $30,000 reduction is allocated first to reduce the basis of his share of capital assets from his$65,000 share of the Oppar inside basis to its $45,000 value. The remaining $10,000 reduction is allocated to the capital assets and the collectibles (both capital assets) in proportion to their inside basis, as adjusted: $4,500 ($45,000/$100,000) to the capital asset and $5,500 ($55,000/$100,000) to the collectibles), leaving him with a basis of $40,500 for the capital assets and $49,500 for the collectibles.

Since each partner's basis in the assets transferred is greater than the liabilities transferred, there is no boot and no gain recognized on the transfer under  § § 351 and 357.  Section 751 does not apply, because the partners are transferring assets subject to partnership liabilities, in exchange for corporate shares. Similarly, there are no  § 704(c) allocations for the corporate shares. Each partner has a basis in the Ceeco shares equal to the basis of the assets transferred net of the liabilities transferred: $70,000 for Munn ($90,000 - $20,000), $100,000 for Propp ($120,000 - 20,000); $50,000 for Surv ($120,000 -$70,000). Their holding period is the same split holding period as for the assets-over form—a tacked holding period for the 81+%($390,000/$480,000) of the shares attributable to the capital assets and the collectibles, and a new holding period for the 18+% ($90,000/$480,000)attributable to the receivable. Because of the reduced basis, as a practical matter, the parties would probably avoid this form. The assets-up form is desirable, primarily when there are transferee partners with an outside basis greater than their shares of inside basis, usually because no  § 754 election applied to the acquisition of their interest.

Ceeco receives the assets with a transferred basis equal to the total basis to the partners, which is $30,000 less than in the assets-over incorporation because of Munn's basis reduction. It has a tacked holding period for the capital assets and collectibles, but not for the receivables.

c. Transfer of Partnership Interests (Interests-Up) 

When the partners transfer their interests to the corporation (interests-up form), the result is a mixture of the two preceding situations. Specifically, in an interests-up incorporation, the partners: (i) contribute their interests in the partnership to the corporation, (ii) in exchange for its shares, (iii) which immediately terminates the partnership (iv) so that the corporation holds the partnership's assets as a distributee in a liquidating distribution.1306 Accordingly, the corporation has an exchanged basis in the assets determined by the basis of the partnership interests (not reduced for liabilities), with a possible shift in basis among the various categories of assets, even if there is no net change,1307 and tacked holding period. Under the 2004 amendment to § 362(e)(2), the basis of the partnership interest is apparently reduced for any net built-in loss in determining the basis of the partnership assets to the corporation.1308 Since the partnership terminates, there should be no adjustment of the inside basis of the assets under the 2004 amendment to § 743(b).1309
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1306 Rev. Rul. 84-111, Situation 3, 1984-2 C.B. 88.

1307 See III, B, and IV, B, above, for discussions of how the basis of distributed property is determined and allocated.

1308 § 362(e).

1309 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the 2004 amendment to § 743(b).

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The partners' basis in their corporate shares is measured by their basis in their partnership interests, reduced for liabilities transferred, but a split holding period is imposed to the extent the partnership interest is attributable to  § 751 property, implicitly extending the  § 751(a) gain characterization rule to a complete aggregate approach.1310 The mixing bowl rules do not apply to an interests-up form of partnership incorporation.1311
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1310 PLR 9537013 (interests-up incorporation; no tacking for shares attributable to interests in § 751 assets that are not capital or  § 1231 assets;arguably means that would allow tacking from recapture). See II, B, 2, above, for a discussion of the effect of a split holding period.

1311 Regs. § § 1.704-4(c)(5), 1.737-2(c). See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

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When a partner's share of liabilities transferred exceeds the basis in the partnership interest, there may be gain under both the partnership principles of  § § 752 and 741, and the corporate principles of § 357(c).1312 Under corporate principles, the boot is allocated in proportion to the fair market value of the property transferred.1313 The same approach should apply under partnership principles as well. When there is boot,  § 751(a) treats the gain as ordinary income to the extent allocable to the partner's share of  § 751 property, with the balance allocated to the partnership interest, possibly producing, generally capital gain, but no loss. The allocable share of corporate stock should not, however, result in ordinary income under § 751(a), even though that section provides for ordinary income on receipt of money or property, with no reference to  § 351 or any other nonrecognition provision. The nonrecognition provision of § 351 should control.1314
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1312 See Rev. Rul. 80-323, 1980-2 C.B. 124 (limited partner recognizes gain under  § 357(c) when transfers limited partnership interest with liabilities in excess of basis in transaction under § 351).

1313 See Rev. Rul. 68-55, 1968-1 C.B. 140 (realized gain or loss computed on asset-by-asset basis, boot allocated in proportion to fair market values); Rev. Rul. 85-164, 1985-2 C.B. 117 (holding period also allocated ratably so that all shares have split holding period).

1314 See Manning, “The Service Corporation—Who Is Taxable on Its Income? Reconciling Assignment of Income Principles,  § 482 and § 351,”37 U. Miami L. Rev. 657, 662–68 (1983).

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It is a closer question whether the portion of liabilities allocable to  § 751 property should be taxable when liabilities transferred do not exceed the basis of the partnership interest. There is a strong argument that it should not because  § 752(d) provides that “liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships,” presumably, incorporating  § 357 which treats liabilities transferred as boot only if they exceed the total basis of the assets transferred, or are transferred with a tax avoidance purpose. The regulations, however, provide that the “the reduction in the transferor's share of partnership liabilities is treated as an amount realized under section 1001,”and do not refer to  § 357 or any other nonrecognition provision. Accordingly, it is not unlikely the IRS will seek to apply § 751(a), but in view of the statutory language, it probably should not prevail. When the interest transferred is held by a  § 1.752-7 liability partner, the consequences should be the same basis adjustment and other consequences as for a transfer of a partnership interest in a  § 351 transaction that is not part of incorporating the partnership.1315
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1315 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of these adjustments in transfers to controlled corporations.

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Example: Interests-Up Form of Partnership Incorporation. The facts are the same as in the example in IV, F, 3, a, above, except that each partner contributes the Oppar interest (interests-up form) to Ceeco, for Ceeco shares worth $140,000 each for Munn and Propp, and $90,000 for Surv. None of the partners recognize gain or loss under  § § 351 and 357, as the basis of the partnership interest each transfers is greater than the liabilities transferred. Accordingly, they should not recognize gain under § 751, even though some portion of the liability transfer may be allocable to the receivables, which are  § 751 property. Although a literal-minded IRS agent may argue to the contrary, as discussed above, the argument should not prevail. The basis of the Ceeco shares to each partner is the same as the outside basis of the Oppar interest reduced by the liability share, $70,000 for Munn, $100,000 for Propp and $50,000 for Surv, exactly the same as in the assets-over and assets-up forms of incorporation. The partners would also generally be able to tack the holding period of their Oppar interests to their Ceeco shares, except, applying the aggregate principle, for the 18+%($90,000/$480,000) attributable to the $90,000 of  § 751 property, the receivables.

Since Oppar terminates, or becomes a disregarded entity (if an LLC) when Ceeco acquires all the interests, Ceeco's basis is determined by the outside basis to it of the interests, $330,000(including the liabilities transferred). This is $30,000 less than the inside basis of the Oppar assets because of Munn's lower basis resulting from the discounted estate tax value, but is the same total basis as for an assets-up incorporation. For this reason, as a practical matter, the parties would probably not use this form. The allocation of the basis reduction is probably slightly different from an assets-up transaction, because, as the holder of all partnership interests, Ceeco should allocate the entire $30,000 reduction to the nondepreciable capital assets (instead of having to allocate $4,950 to the collectibles as Munn was required to do), but since it pays tax on all gains at the same rate as ordinary income the allocation is probably not important. Ceeco has a tacked holding period for the capital asset and the collectibles, but a new holding period for the receivables.

d. Acquisitive § 351 Transaction 

A transfer of a partnership to a corporation normally cannot qualify for nonrecognition unless it qualifies under § 351 as a transfer to a corporation in which the partners have 80% control, since only corporations can be parties to corporate reorganizations.1316 Because of the step-transaction doctrine, a partnership or other unincorporated entity cannot participate in a tax-free corporate reorganization by the simple expedient of incorporating, followed by a reorganization involving the newly created controlled corporation. Instead, the transaction is viewed as a taxable exchange of the assets by the partnership to the acquiring corporation for its stock.1317 On the other hand, if the incorporation has independent significance, a subsequent reorganization, although close in time to the incorporation, may qualify for favorable treatment.1318 Thus, the issue remains a factual one. Incorporation prior to sale negotiations is likely to permit a subsequent reorganization to qualify. Although incorporation after sale negotiations have started is not necessarily fatal, it makes reorganization qualification risky at best, is almost certain to be challenged by the IRS, and involves costly litigation even if the taxpayer is ultimately successful.
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1316 § 368(b); Regs. § 1.368-1(a).

1317 See West Coast Marketing Corp. v. Comr., 46 T.C. 32 (1966) (where land transferred to corporation when sale was imminent, exchange of stock of new corporation for stock of acquiring corporation was not a valid reorganization;no business purpose for forming new corporation); Rev. Rul. 70-140, 1970-1 C.B. 73 (transfer of additional property to existing controlled corporation followed by exchange of stock of controlled corporation for stock of acquiring corporation did not qualify under § 351); Rev. Rul. 54-96, 1954-1 C.B. 111 (creation of new subsidiary followed by immediate exchange of stock of new subsidiary for stock of the acquiring corporation does not qualify as a stock-for-stock reorganization under § 368(a)(1)(B)); Rev. Rul. 70-225, 1970-1 C.B. 80 (attempted corporate separation followed by transfer of stock of controlled in a reorganization does not qualify as a valid reorganization under § 368(a)(1)(D)).

1318 See Weikel v. Comr., T.C. Memo 1986-58 (incorporation followed by “B” reorganization found to be valid notwithstanding pending negotiations for sale to Johnson &  Johnson that occurred within six months of incorporation; incorporation had business purpose if sale did not go through, and the negotiations were still in progress and tentative).

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A partnership or other unincorporated entity may, however, participate in an acquisitive  § 351 transaction that has many of the practical benefits of a tax-free corporate reorganization when the transferee is a corporation that is not controlled by the partnership or its partners, if the other assets of the corporation are contributed at the same time, so that all contributors collectively have control, since control is a group issue—the group of transferors, not each individual transferor, is used to determine control.1319 The remaining stock must be issued for transfers of property directly to the issuing corporation, not to a subsidiary.1320 Thus, a transaction in which an individual transferred property to a corporation while three corporations simultaneously transferred all their assets to the same corporation is a  § 351 transaction for the individual, and is an assets-for-stock reorganization under § 368(a)(1)(C) for the corporations, because the individual and the transferring corporations collectively controlled the transferee corporation.1321 A transaction involving a transfer of assets by an existing corporation to a new one does not qualify if the new corporation is viewed as a mere reincorporation of the transferor corporation,1322 but does qualify if the new corporation's creation has independent significance.1323 Thus the same transaction may be a  § 351 transaction for a partnership or its partners, and a corporate reorganization for others.
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1319 § 368(c); Rev. Rul. 59-259, 1959-2 C.B. 115; Regs.  § 1.351-1(a)(3) (in underwriting, public included in control group).

1320 See Rev. Rul. 84-44, 1984-1 C.B. 115 (transaction does not qualify under  § 351 for corporate transferor of some of its assets to the acquiring corporation, when the remaining stock of the acquiring corporation was issued in a subsidiary merger under  § 368(a)(1)(D) of an unrelated corporation into the subsidiary because the assets of the second corporation were transferred to the subsidiary, not the issuing corporation).

1321 See Rev. Rul. 68-357, 1968-2 C.B. 144 (transfer of property by individual to a corporation when three other corporations transfer all their assets to the same corporation is a  § 351 transaction for the individual, and an assets-for-stock reorganization under  § 368(a)(1)(C)  for the corporations, since individual and transferring corporations collectively controlled transferee corporation); PLR 200049026 (creation of corporation by transfers of appreciated property for less than about 20% of stock combined with reverse subsidiary merger of another corporation for the remaining shares qualifies under  § 351 for transferors of property;and reverse subsidiary merger for other shareholders, both groups of shareholders included in control group); PLR 200136023 (apparently more of the same).

1322 Rev. Rul. 68-349, 1968-2 C.B. 143 (transaction did not qualify under  § 351 when individual transferred distributed the stock of the transferee corporation to its shareholders in liquidation).

1323 Rev. Rul. 76-123, 1976-1 C.B. 94 (change of state of incorporation is enough); see also Rev. Rul. 69-516, 1969-2 C.B. 56 (change of place of incorporation followed by a reorganization of surviving corporation qualifying under § 368(a)(1)(C)); Rev. Rul. 96-29, 1996-1 C.B. 50 (Situation 1 permits change of state of incorporation followed by public offering of majority of stock; Situation 2 permits change of state of incorporation followed by acquisition of an additional business); FSA 200042004 (transfer of assets by parent to new subsidiary for stock and boot with simultaneous sale by other members of the control group followed by merger of an unrelated corporation into the new subsidiary for more than 80% of the subsidiary's stock constituted both a  § 351 transaction for parent and statutory merger under  § 368(a)(1)(A) for the unrelated corporation; control requirements satisfied).

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In the so-called “National Starch”transaction (because a well-known transaction involved a corporation with that name), some shareholders transferred less than controlling stock to an acquiring corporation in exchange for acquiring corporation stock, while the acquiring corporation's corporate parent transferred cash to the acquiring corporation (to be used by it to purchase the remaining acquired business or assets) in exchange for the remaining acquiring corporation stock; the transaction qualified under § 351.1324 Under the rulings, the same result follows if a partnership transfers its assets to a corporation for corporate shares and an acquiring corporation or other person transfers other assets to the same corporation for the rest of its shares. Similarly a transaction may qualify if one of the transferors of assets is an individual,1325 or if an acquiring corporation transfers less than substantially all of its assets.1326 As with many of the provisions of Subchapter C, the requirements are a mixture of complying with extremely technical requirements, and satisfying substance-over-form and step-transaction considerations.1327
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1324 See Rev. Rul. 84-71, 1984-1 C.B. 106 (transfer by shareholders of target corporation of less than controlling stock to acquiring corporation in exchange for Ack stock(that is not nonqualified preferred stock) while the acquiring corporation's corporate parent transfers cash to the acquiring corporation (to be used by it purchase the remaining Tarr stock) in exchange for the remaining Ack stock qualifies under § 351), revoking Rev. Ruls. 80-284, 1980-2 C.B. 117, and 80-285, 1980-2 C.B. 119.

1325 See Rev. Rul. 68-357, 1968-2 C.B. 144.

1326 See PLR 200049026 (creation of corporation by transfers of appreciated property for less than about 20% of stock combined with a reverse subsidiary merger for shares of another corporation qualifies under  § 351 for transferors of property; the shareholders of the merging corporation were included in control group); PLR 200136023 (apparently more of the same).

1327 See 758 T.M., Transfers to Controlled Corporations: In General; and 759 T.M., Transfers to Controlled Corporations: Related Problems, for more comprehensive treatments of the issues and techniques summarized in this paragraph.

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Example: Acquisitive § 351 Partnership Incorporation. Munn, Propp and Surv have equal(one-third) shares in profits and losses of a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn's mother and Propp contributed $100,000, and Surv contributed$50,000 to Oppar. Oppar has $110,000 of recourse liabilities, which are allocated disproportionately, because of the different capital accounts, $20,000 each to Munn and Propp and $70,000 to Surv. Accordingly, Propp's outside basis is $120,000 ($100,000 capital + $20,000 liability share), and Surv's is also $120,000 ($50,000 capital + $70,000 liability share). Munn's outside basis is $90,000 because he inherited his mother's estate, which successfully established a $30,000 valuation discount($100,000 capital - $30,000 discount + $20,000 liability share). The inside basis of Oppar's assets is $360,000, the value is $480,000, and Oppar's net worth is $370,000. Oppar's balance sheet is:
Assets	Basis	Value	
Nondepreciable Capital Assets	$195,000	$135,000	
Collectibles	165,000	255,000	
Unrealized Receivables	-0- 	90,000	
Totals	$360,000	$480,000	
 	 	 	
Liabilities and Capital	 	 	
Recourse Liabilities	$110,000	$110,000	
Munn Capital	100,000	140,000	
Propp Capital	100,000	140,000	
Surv Capital	50,000	90,000	
Totals	$360,000	$480,000	

Oppar wishes to combine its business in a joint venture with Ceeco, in which Munn, Propp and Surv will manage the joint operation. Ceeco insists that the joint venture Jointco be a corporation, because it wants to include Jointco on its consolidated return. Accordingly, Oppar transfers its assets (assets-over form)to Jointco, in exchange for Jointco shares, worth $370,000, that are distributed ratably to its partners: Jointco shares worth $140,000 to each of Propp and Munn and $90,000 to Surv. These Jointco shares will be 18% of the outstanding Jointco shares. At the same time, Ceeco will transfer the assets of its Oppar division to Jointco and contribute cash to expand the combined business in exchange for 82% of the outstanding Jointco shares. On these facts, the transfer by Oppar to Jointco should qualify as a nonrecognition transaction under § 351, with the same tax consequences as an incorporation of Oppar using the assets-over form. At the other extreme, if Ceeco transferred all of its assets to Jointco for 99.5%of the Jointco shares that it distributed to its shareholders in liquidation, with Oppar receiving .5% of the Jointco shares, the transaction would probably be a taxable sale of the Oppar assets for the Jointco shares. Where the line is to be drawn is a matter of professional judgment.

4. Recapitalization 

The IRS analyzes a recapitalization in which a general partnership interest is converted into a limited partnership interest, or the reverse, as a transfer of the general partnership interest in exchange for the limited partnership interest under § 721, with the outside basis continued under § 722.1328 The ruling expressly holds that there is no sale or exchange for purposes of gain recognition or partnership termination under § 708,1329 and that there is a tacked holding period for the partnership interests received.1330 It also holds that there may be gain recognition if there are changes in liability shares that result in deemed distributions.1331 The IRS approach is essentially an application of the entity principle.
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1328 Rev. Rul. 84-52, 1984-1 C.B. 157; see Rev. Rul. 95-55, 1995-2 C.B. 313 (follows Rev. Rul. 84-52, and applies same principles on conversion of general partnership into registered limited liability partnership); Rev. Rul. 95-37, 1995-1 C.B. 130 (same for conversion of partnership into an LLC taxed as a partnership); PLR 200345007 (reclassifying units, adding classes of units, making various classes convertible into other classes, and conversions do not result in gain or loss provide there are no changes in liability shares as a result of any reclassifications or conversions);follows Rev. Rul. 84-52).

1329 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of when a transfer of a partnership interest terminates the partnership.

1330 See II, B, 2, above, for a discussion of tacking of holding period.

1331 Regs. § 1.1223-3(c)(2)(ii);see II, D; III, A, 2;and IV, A, 2, above, for discussions how liability reductions are treated as cash distributions.

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A direct nonrecognition exchange of partnership interests is not a possibility because  § 1031(a)(2)(D) specifically excepts partnership interests from the types of property that may qualify.1332 The ruling was issued shortly before  § 1031(a)(2)(D) was added, and is not affected by the amendment.1333 In a companion ruling,1334 the IRS held that a partner has a single, apparently unallocated, basis for all partnership interests, general and limited, owned by the partner,1335 and applied the liability allocation rules in several situations involving sale of interests in a limited partnership; in effect allocating all recourse liabilities solely to the general partnership interest, subtracting out the liabilities in allocating basis between general and limited partnership interests, and treating the recourse liability share transferred with the general partnership interest.1336 Accordingly, when a general partnership interest is converted into a limited partnership interest, the partner apparently receives a deemed distribution of any liabilities applicable to the converted general partnership interest,1337 to be applied against the basis of the entire limited partnership interest, plus any retained general partnership interest (including any share of liabilities).1338
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1332 Section 1031(a)(2) excludes property held primarily for sale, securities, partnership interests, trust certificates and choses in action.

1333 See S. Rep. No. 169, 98th Cong., 2d Sess. (1984); 1984 Bluebook, at 244, 246 (1984)(refers to exchanges of interests in different partnerships).

1334 Rev. Rul. 84-53, 1984-1 C.B. 159. 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).

1335 See McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ ¶ 4.01[b]and 6.01.

1336 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of this aspect of Rev. Rul. 84-53. See also Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 12.01[1][b].

1337 See IV, A, 2, above, for a discussion of liability reductions are treated as cash distributions.

1338 See Willis, Pennell & Postlewaite, Partnership Taxation, ¶ ¶ 7.01[a]and 13.02[4][b].

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Example: Recapitalization and Liability Shift. Munn, Propp and Surv have equal (one-third)shares in profits and losses of a general partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn and Propp contributed $150,000, and Surv, who is a talented executive, made no capital contribution, receiving a profits-only interest. The Oppar partnership agreement allocates all profits and losses equally. Oppar borrowed $600,000 on a recourse mortgage from CountriBanc, to construct a commercial building; $300,000 of the liability is allocated to Surv, and only $150,000 each is allocated to Munn and Propp, because when, on a hypothetical liquidation, the loss of $900,000 is allocated equally $300,000 to each of Munn and Surv, it creates a deficit of$150,000 ($300,000 - $150,000 capital) for Munn and Propp and$300,000 ($300,000 - zero) for Surv. Each partner's outside basis is $300,000. The commercial building needs major renovations, but Munn, who is nearing retirement, does not wish to be exposed to personal liability on the increased loan, and the lender, acting as is all too typical, refuses to release him from personal liability on the refinancing loan. Munn is not ready to retire, and, in any event, with the renovation, Oppar cannot afford to liquidate his interest. Munn, Propp and Surv reorganize Oppar as a limited partnership, Limpar, with Munn as a limited partner and Propp and Surv as general partners. Although the reorganization does not relieve Munn of liability on the existing recourse mortgage, his personal liability terminates when it is paid off as part of the refinancing to a new $1,000,000 mortgage, which CountriBanc, as a typical bank, does not find troublesome. The conversion of Oppar to Limpar is treated as an exchange by Munn of his Oppar general partnership interest for his Limpar limited partnership interest, and by Propp and Surv of their Oppar general partnership interests for the Limpar general partnership interests. Although arguably not a direct part of that transaction, the refinancing is a distribution to Munn of his $150,000 share of the original recourse mortgage, which reduces his outside basis to $150,000, and increases Propp's and Surv's outside basis to $450,000 each. At the same time each increases the outside basis of the Oppar interest to $650,000 for one-half of the$400,000 increase in the refinanced recourse mortgage loan, none of which is allocated to Munn, because that was the point of the conversion. The result would be the same if, under local law, the conversion to Limpar automatically released Munn from personal liability on the recourse mortgage.

5. Changing the Legal Form of a Tax Partnership 

A tax partnership can change from one form of state law unincorporated entity to another without affecting its tax status. When it changes from a multiple owner state law entity to one with only a single owner, it changes its tax status from partnership to disregarded entity, with significant tax consequences.

a. Changing the State Law Form of a Tax Partnership 

Most state unincorporated entity statutes have provisions allowing the conversion of the entity into any other form of unincorporated entity.1339 Converting an entity treated as a partnership for tax purposes from one state law form of organization to another form of unincorporated entity — for example, from a partnership to an LLC — is not a taxable event.1340 The conversion does not result in the termination of the partnership's taxable year, and the new state law entity is not required to obtain a new taxpayer identification number.1341 The conversion can have collateral tax effects; for example, if it results in a shift in liabilities, there may be a distribution.1342
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1339 See, e.g., RUPA § § 901–904, 908; Del. RUPA § § 15-901, 15-903 and 15-905; RULPA, no provision; Re-RULPA § § 1101–1105, 1113; Del LPA § § 17-217 and 17-219; ULLCA § § 901–903, 9077; RULLCA § § 1006–1009, 1014–1015; Del. LLCA § 18-214, 18-216; Del. Gen. Corp. (“Del. GCL”) § 265 (allows conversion of partnerships and LLCs to corporations).

1340 Rev. Rul. 84-52, 1984-2 C.B. 157 (general partnership to limited partnership); Rev. Rul. 95-55, 1995-2 C.B. 313 (conversion of law firm general partnership to registered limited liability partnership; the IRS noted that the partnership must continue to use the same method of accounting, unless it secured IRS consent to a change); Rev. Rul. 95-37, 1995-1 C.B. 130 (conversion of partnership into an LLC taxed as a partnership); PLR 9350013 (conversion of law firm general partnership to LLC). Before (and after) the check-the-box regulations, the IRS has applied Rev. Rul. 84-52 to a variety of conversions. See PLR 199935065 (LLCs into limited partnerships to satisfy lenders on replacement properties in a  § 1031 exchange); PLR 9618021 (general partnership to LLC), PLR 9525058 (general partnership law firm to LLC; considers collateral issues, including not tax shelter and self-employment tax); PLR 9443024 (limited partnership to LLC); PLR 9432018 (general partnership to LLC; LLC is continuing partnership); PLR 9350013 (conversion of law firm to LLC;considers effect on cash method including effect on whether any members become limited entrepreneurs). See also PLR 9630012 (conversion of general partnership in one state to limited liability partnership in another). See IV, F, 4, above, for a discussion of a similar result when a general partnership interest is converted into a limited one, or the reverse.

1341 See Rev. Rul. 95-37, 1995-1 C.B. 130.

1342 See Rev. Rul. 84-53, 1984-1 C.B. 159 (effects of liabilities when same partner has general and limited partnership interests and sells part of interest); Rev. Rul. 80-323, 1980-2 C.B. 124 (limited partner recognizes gain under  § 357(c) when transfers limited partnership interest with liabilities in excess of basis in transaction under § 351). See also Rev. Rul. 95-37, 1995-1 C.B. 130 (conversion of partnership into an LLC); Rev. Rul. 84-102, 1984-2 C.B. 110 (shift of liability in connection with admission of new partner resulted in income to existing partners under § 751(b)); PLR 200414013 (no gain on conversion of general partnership to LLC when general partners will jointly and severally guarantee partnership's long-term (and apparently only) debt, remaining jointly and severally liable; result should be the same if each guaranteed only a ratable share of debt); PLR 9719015 (one of a series of apparently identical rulings on complex merger of several LLCs resulted in some shifts in liabilities treated as distributions, particularly when result of transaction was that liabilities changed from recourse to nonrecourse or reverse). See IV, F, 2, above, for a discussion of a similar result when a general partnership interest is converted into a limited one, or the reverse.

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Example: Change in Form and Liability Shift. Munn, Propp and Surv have equal (one-third)shares in profits and losses of a general partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn and Propp contributed $150,000, and Surv, who is a talented executive, made no capital contribution, receiving a profits-only interest. The Oppar partnership agreement allocates all profits and losses equally. Oppar borrowed $600,000 on a recourse basis to construct a commercial building; $300,000 of the liability is allocated to Surv, and only$150,000 each is allocated to Munn and Propp, because when, on a hypothetical liquidation, the loss of $900,000 is allocated equally $300,000 to each of Munn and Surv, it creates a deficit of $150,000 ($300,000 -$150,000 capital) for Munn and Propp and $300,000 ($300,000 -zero) for Surv. Each partner's outside basis is $300,000. Munn, Propp and Surv convert Oppar to an LLC, do not provide a deficit make-up in the LLC operating agreement, and refinance the mortgage to one that is recourse only to the LLC. Since there is no minimum gain, no  § 704(c) minimum gain, and no  § 704(c) gain, nonrecourse liabilities are allocated in accordance with profit shares, unless a safe harbor is provided. Thus, the mortgage liability is allocated equally ($200,000) to each partner, resulting in a shift of $100,000 from Surv to Munn and Propp. If, as a result of intervening tax losses, Surv's outside basis is less than $100,000, she will recognize gain. Since, under partnership law, if the mortgage is not refinanced, the partners remain personally liable for it, they continue to have economic risk of loss, the mortgage remains a recourse liability, and there is no liability shift on conversion. Capital accounts and § 704(c) allocations, of course, are not affected by a change in state law form that does not change the tax entity.

b. Partnership to Disregarded Entity 

A partnership, particularly an LLC, becomes a disregarded entity when it has only one member.1343 If one member purchases the interests of all of the other members, the IRS takes an inconsistent approach that the transaction is a sale of partnership interests under  § 741 by each of the other members with appropriate gain or loss recognition,1344 preceded by a distribution of all of the assets to the selling members for purposes of determining basis and holding period of the assets for the acquirer.1345
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1343 Regs. § 301.7701-3(f)(2); Rev. Rul. 99-6, 1999-1 C.B. 432; see Darrow, “Beyond Check-the-Box: New Rulings Address Entity Conversions Resulting From Changes in Ownership,”27 J. Real. Est. Tax'n 3 (1999) (discusses issues not covered by specified situations in the ruling).

1344 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the character of gain or loss and other collateral consequences of sale of a partnership interest.

1345 See Rev. Rul. 99-6, Situation 1, 1999-1 C.B. 432; McCauslen v. Comr., 45 T.C. 588 (1966) (purchaser of interest of other partner in a two-person partnership, starts new holding period for assets attributable to purchased interest; deemed purchased, not distributed in liquidation of purchased interest with tacked holding period); Rev. Rul. 67-65, 1967-1 C.B. 168 (surviving partner purchasing deceased partner's interest deemed to purchase ratable share of assets; does not tack partnership holding period under § 735).

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When all members sell their interests to a third party, the sellers report gain or loss on sale of their partnership interests under  § 741 and the purchaser acquires the LLC's assets by purchase for purposes of determining the basis and holding period of the assets. Although the ruling does not say so expressly, the reference to  § 741 presumably means the seller's gain or loss is capital gain except to the extent that  § 751 or the pass-through of collectibles gain applies.1346 The ruling does not deal with the situation when the LLC redeems all but one interest, but the partnership should continue until the terminating partner is paid out.1347
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1346 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.; see also Abrams, “Doing the McCauslen Two-Step,” 1 Bus. Ent. 18(Nov./Dec. 1999) (challenges appropriateness of deemed asset distribution).

1347 Regs. § 1.708-1(b)(1)(i)(a);see IV, F, above, and V, below, for a discussion of the continuation of even a two-person tax partnership when there are deferred withdrawal payments. See also Darrow, “Beyond Check-the-Box: New Rulings Address Entity Conversions Resulting From Changes in Ownership,” 27 J. Real. Est. Tax'n 3 (1999).

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Example: Partnership to Disregarded Entity. Munn, Propp and Surv have equal (one-third) shares in profits and losses of a general partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has no liabilities. Munn's capital account is $100,000, but his outside basis is $80,000 because he inherited his interest from an estate that successfully claimed valuation discounts, when no  § 754 election was in effect. Propp's capital account and outside basis are $100,000, and Surv's are $50,000. The net value of Oppar's assets is $340,000, all of which are capital assets held for more than one year, and the aggregate inside basis is $250,000. Munn purchases Propp's and Surv's Oppar interests for $130,000 and $80,000, respectively (reflecting the difference in their capital accounts), resulting in a termination of Oppar. Propp and Surv each realizes $30,000 (Propp, $130,000 - $100,000 and Surv, $80,000 - $50,000) of capital gain on the sale of the Oppar interest. Although under the general rule of § 735, a partner has a tacked holding period for Oppar assets distributed in liquidation, Munn is only entitled to a tacked holding period of his interest for the assets attributable to his interest. Thus, he has a long-term holding period for his $80,000 basis in the one-third share of the Oppar assets attributable to his Oppar interest (even though the transferred basis is $100,000, in effect, equal to his capital account). He is deemed to have purchased the other two-thirds of the assets, even though Propp and Surv have sold their Oppar interests; Munn starts a new holding period for two-thirds of the Oppar capital and  § 1231 assets. There would be no tacking, in any event, for any  § 751 and other ordinary income assets held by Oppar.

c. Unincorporated Tax Partnership Entity to 
 Corporation 

Most state unincorporated entity statutes also allow an unincorporated entity to convert to a corporation A formless conversion of a state law unincorporated entity classified as a partnership for federal tax purposes into a state law corporation (i.e., where the entity converts to a corporation without any formal transfer of assets), which under the federal tax classification regulations is bound to have association status, is treated as an assets-over transaction.1348 Thus all of the tax consequences are the same as for an incorporation of a partnership that expressly follows the assets-over form as described in IV, G, 3, a, above.  By using a formless conversion statute, the partners forego the opportunity to use either the assets-up form,1349 or the interests-up form.1350 They remain free to obtain any benefits of using these alternative forms by forgoing the convenience of the formless conversion statute, and following the relevant forms of actual incorporation.1351
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1348 Rev. Rul. 2004-59, 2004-1 C.B. 1050.

1349 See IV, G, 3, b, above, for a discussion of the tax consequences of the assets-up form.

1350 See IV, G, 3, c, above, for a discussion of the tax consequences of the interests-up form.

1351 See Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,”44 San Diego L. Rev. 259 (2007) (critiques approach that uses form to determine tax consequences as providing disparate treatment for economically equivalent transactions and creating tax incentives that may conflict with business considerations in choice of form;suggests a specific election to choose assets-up or assets-over results, regardless of form).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  V. Withdrawal Payments—§ 736

It is common for partners or shareholders who withdraw from a partnership or corporate business on death, retirement or otherwise to have their interests redeemed, for a single payment, or a series of payments.1352 Such redemptions are commonly provided for in buy-sell agreements or buy-sell provisions of partnership agreements, LLC operating agreements or shareholder agreements. In the absence of agreement, a partner in a general partnership (including an LLP)has a right to have the interest liquidated, although one dissociating wrongfully may be liable for any damages caused by early withdrawal.1353 Partners, general and limited, in limited partnerships, have more limited rights to have their interests redeemed,1354 as do members of LLCs.1355 Structural changes, including mergers and divisions, may also be occasions for withdrawal.1356 There is no general right of redemption in a corporation, even in a P.A.1357 The tax consequences of withdrawal payments are the subject of this chapter.
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1352 § § 731, 736; Regs. § § 1.731-1, 1.736-1 and 1.761-1(d).

1353 See, e.g., RUPA § 602(c); Del. § 602(c).

1354 See, e.g., RULPA § 1105 and RUPA § 602(c); Re-RULPA § § 602 and 704;Del. § 17-604.

1355 See, e.g., ULLC § 701(a) (dissociated member entitled to payment for interest at end of specified term of the LLC); RULLCA § 603, 502; Del. Lim, Liab. Co. Act § 18-603 (member may not resign prior to liquidation, except as provided in limited liability company agreement).

1356 See Whitman &  Ransom v. Comr., T.C. Memo 2005-172 (partners who withdrew when law firm merged with another and received agreed liquidating distribution had terminated their interests so that when successor partnership zeroed out their negative capital account balances, it was not a § 736 payment). See IV, G, 1, b, and IV, G, 2, a, above, for discussions of withdrawals by partners in partnership divisions and mergers, respectively.

1357 See, e.g., Corlett, Killian, Hardemon, McIntosh and Levi, P.A. v. Merritt, 478 So.2d 828 (Fla. 2d DCA 1985) (no requirement that shareholder in a P.A. practice with the firm; no right to compel redemption). But cf. A.W. Chesterton Co. Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997) (minority shareholder had fiduciary duty, based in part on implicit agreement, at time of the Subchapter S election, not to upset S election, not to transfer shares to destroy S election at least in absence of business purpose, even though corporation declined to exercise its first refusal right; transfer enjoined).

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There are other ways for a withdrawing partner to terminate the interest. The remaining partners may purchase the deceased or retiring partner's interest for a lump sum or a series of payments. Because of the pass-through nature of a tax partnership, it is often difficult to determine whether a transaction in which a withdrawing party receives payment for the interest is a liquidating distribution or a sale.1358 The purchasing partners have a purchase price basis in the interest of the withdrawing partner, but the inside basis of the partnership's assets is not adjusted unless a  § 754 election applies or there is a substantial built-in loss.1359 Even when a transaction is expressly structured as a liquidating distribution, it may be recharacterized as a disguised sale if new or existing partners make contributions determined to be related to the distribution.1360 A sale of the partnership interest to a third party has the same consequences for the withdrawing partners as a sale to the other partners.
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1358 § 741; Regs. § 1.741-1.  See I, C, above, for a discussion of distinguishing between distributions or withdrawal and sales of partnership interests to the remaining partners. See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the tax consequences of sale of a partnership interest.

1359 § 743(a), (d);Regs. § 1.743-1; see Notice 2005-32, 2005-1 C.B. 895.

1360 § 707(b)(2)(B). See III, G, above, for a discussion of disguised sales of partnership interests.

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The withdrawal may trigger a decision that the partnership be terminated, and its business or assets sold or collected, with the proceeds distributed as liquidating distributions to all partners.1361 Even when the tax partnership is formally dissolved under state law, and its business or assets are sold, it may not be terminated if two or more of the prior partners purchase the assets and continue the business.1362
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1361 § 708(b)(1); Regs. § 1.708-1(b)(1). See IV, F, above, for a discussion of partnership termination.

1362 § 708(b)(1)(A); Regs. § 1.708-1(b)(1)(i). See Rev. Rul. 66-264, 1966-2 C.B. 248 (partnership continued when the assets of a five-person partnership were purchased at a judicial sale by a partnership comprised of three of the original five partners;did not rule on whether interests of other partners were sold or liquidated); Neubecker v. Comr., 65 T.C. 577 (1975) (partnership continued, when two, apparently junior, partners in a three-person partnership formed a new two-person partnership at a new location, leaving office and the bulk of the assets with the third partner).

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Section 736 applies to payments by the partnership in liquidation of the entire interest of a retiring or deceased partner who has ceased to be a partner under local law, voluntarily or involuntarily,1363 but remains a partner for tax purposes until all withdrawal payments are made.1364 When the withdrawal is a result of death, or, rarely, disability, of the withdrawing partner, there is no liquidating distribution if the successor “continues as a partner in its own right under local law.”1365 The reference to local law dates to the original promulgation of the Subchapter K regulations,1366 so that it does not even reflect the general replacement of the Uniform Partnership Act then in effect by the Revised Uniform Partnership Act or proliferation of forms treated as tax partnerships including, principally, LLCs that have different concepts of when a partner or member ceases its status.1367 In addition, it does not reflect that some tax partners are not partners under local law, particularly ineligible persons and assignees.1368 It seems clear that when the interest of such tax partners is terminated,  § 736 should apply.  Nevertheless, it is wise when the application of  § 736 is desired, for tax partners in LLCs and other entities to take the appropriate steps under the governing documents and local law to terminate their status. Similarly, ineligible persons and assignees who are not partners under local law should take steps equivalent to those required under local law to manifest their intent, including notice to the entity and any other persons who have any relation to the partnership or the tax partnership interest.1369
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1363 See Holman v. Comr., 66 T.C. 809 (1976), aff'd, 564 F.2d 283 (9th Cir. 1977) (two partners expelled from a law partnership taxed on amounts for their respective shares of unrealized receivables as ordinary income under § 736(b)(2); not capital gain under § 731); Milliken v. Comr., 72 T.C. 256 (1979), aff'd in unpub. opin.(1st Cir. 1979) (§ 736 applies even if the taxpayer's expulsion was wrongful under state law; remedy was for an accounting;he could not force a continuation as a partner); In re LaBrum &  Doak LLP, 222 Bankr. 749 (Bankr. E.D. Pa. 1998) (state law determined that a partnership in bankruptcy is entitled to allocate a  § 467 tax recapture liability to retired partners who had received the benefit of the recapture before retirement).

1364 Regs. § 1.736-1(a)(1). See Scott v. Comr., T.C. Memo 1997-507, 74 T.C.M.(CCH) 1157 (taxpayer introduced no evidence that he remained a partner after Dec. 31; under Mississippi law, he retired from the partnership on Dec. 31); Fensel v. U.S., 617 F. Supp. 22 (W.D. Pa. 1985) (taxpayer who quit working in partnership business and received no income thereafter, was still a partner until sold interest in a later year; no theft loss for share of income in meanwhile since he did not discover loss until later).

1365 Regs. § 1.736-1(a)(1)(i). See, e.g., RULPA § 705; Re-RULPA § 704, RULLCA § 504 Del. LLCA, § 18-705, all of which give the executor or personal representative the power to exercise certain partner or member rights for purpose of settling the estate or administering the property. See also Holdeman v. Epperson, 857 N.E.2d 583 (Ohio 2006) (successor to LLC member has right to be admitted as member even though operating agreement provided only for status as a transfer for limited purpose of setting the estate or administering property; does not discuss what limit means).

1366 T.D. 6175, 1956-1 C.B. 111.

1367 See, e.g., RUPA § 701; Del. RUPA § 701, RULPA § 1105 (de facto reference to RUPA § 701), Re-RULPA § 602, Del. LPA § § 17-603; ULLCA § 603;RULLCA § 603; Del LLCA § 18-603.

1368 See, e.g., Rev. Rul. 77-332, 1977-2 C.B. 484 (non-CPA principals in accounting firm not eligible to be partners under state law are tax partners); Nichols v. Comr., 32 T.C. 1322 1959)(doctor and nonphysician wife who managed office are tax partners); Evans v. Comr., 50 T.C. 40 (1970), aff'd, 447 F.2d. 547 (7th Cir. 1971) (corporate assignee of economic interest that was not partner because other partner did not know of, or consent to, assignment was tax partner). See 710 T.M., Partnerships —Conceptual Overview, for a comprehensive treatment of the definition of tax partner.

1369 Cf. Rev. Rul. 93-80, 1993-2 C.B. 239 (abandonment requires taking all steps necessary to abandon including written notice to the partnership).

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Payments for purposes of  § 736 are not limited to money, but include distributions of property,1370 and, of course, relief from liabilities.1371 Although usually, the distribution from the relief from partnership liabilities will occur at the time the partner withdraws under local law, this is not always the case, particularly when the remaining partners do not expressly indemnify the withdrawing partner for partnership liabilities.1372 When liabilities are discharged in connection with a partner's withdrawing from a partnership, whether the partnership continues or terminates, the liability relief should be a liquidating distribution under § 736, but the courts are not always careful in their analysis when the principal issue is whether a loss is capital or ordinary.1373
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1370 See V, C, 4, below, for a discussion of  § 736 distributions of property in kind.

1371 § 752(b) (decrease in a partner's share of partnership liabilities treated as a distribution of cash); Regs. § 1.752-1(c);Regs.  § 1.736-1(a)(2) (“payments(including assumption of liabilities treated as a distribution of money under  § 752) ...to a withdrawing partner.”); see Rev. Rul. 74-40, Situations 2 and 3, 1974-1 C.B. 159 (relief from nonrecourse liability is part of distribution, even if no money distributed); Zager v. Comr., T.C. Memo 1987-107, aff'd in unpub. opin. (9th Cir. 1988) (partnership's retention of partner's share of partnership receivables and depreciable property as offset against amounts owed by partner to partnership constitutes  § 736 payment); Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991) (payables not yet deducted included as liabilities treated as  § 736 payment; taxpayer failed to argue, until too late, that the obligations were not liabilities;no consideration of who should be entitled to deduction for payables and when).

1372 See Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992) (no distribution of share of liabilities to expelled partner who remained liable under local law, because expelled partner not relieved by creditor or remaining partners); Richardson v. Comr., 76 T.C. 512 (1981), aff'd, 693 F.2d 1189 (5th Cir.1982) (existing partners did not receive a deemed cash distribution to the extent that they established that existing partnership liabilities remained their sole and personal obligations). See also Austin v. U.S., 461 F.2d 733 (10th Cir. 1972) (husband whose interest in partnership terminated as part of divorce proceedings in which wife received all partnership assets and assumed all partnership liabilities realized gain equal to the excess of the share of liabilities over his adjusted basis for his partnership interest); cf. Gardner v. Comr., T.C. Memo 1987-420, aff'd in unpub. opin. (6th Cir. 1989) (limited partner relieved of share of partnership nonrecourse liabilities and received distribution when forfeited partnership interest for failure to make required capital contribution).

1373 See Stilwell v. Comr.,  46 T.C. 247 (1966) (partner who withdrew from a two-person partnership and received nothing except other partner's agreement to pay all partnership debts, and to indemnify withdrawing partner, is not entitled to ordinary loss; received deemed distribution of share of liabilities); Pietz v. Comr., 59 T.C. 207 (1972) (when all proceeds of sale of partnership assets applied to liabilities, so that partners received no cash or property, loss was capital; liability relief was capital; did not refer to § 736); O'Brien v. Comr., 77 T.C. 113 (1981) (when 10% partner in a real estate partnership that had substantial nonrecourse indebtedness, withdrew by giving notice of abandonment of his partnership interest, the taxpayer realized a capital loss on the transaction pursuant to § § 731, 742 and 752, without mentioning § 736). All of these cases clearly resulted in capital, not ordinary, loss and all should have been treated as liquidating distributions under  § § 731 and 736, although the only consequence of determining that  § 736 applies in this context is that, if  § 736 applies, its timing rules control.

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When one partner in a two-person partnership withdraws, the partnership does not terminate when  § 736 applies to liquidating distributions,1374 because the tax partnership still has two partners, the one continuing to operate the business and the withdrawing, but not withdrawn, partner. Since the ambiguity whether one partner in a two-person partnership is receiving a liquidating distribution or making a sale to the remaining partner is particularly great, parties desiring the application of  § 736 should be very careful to make the status as a liquidating distribution express. The partnership may, however, be terminated for other reasons, for example if the remaining partner incorporates the business or discontinues it.1375
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1374 Regs.  § 1.736-1(a)(1)(i) and (a)(6), and § 1.708-1(b)(1)(ii).

1375 See Rev. Rul. 75-154, 1975-1 C.B. 186 (termination); Flood v. U.S., 133 F.2d 173 (1st Cir. 1943) (same); Rev. Rul. 83-155, 1983-2 C.B. 38 (same for payments by corporation succeeding to partnership business); GCM 39054, Nov. 24, 1981 (same; background for Rev. Rul. 83-155;expressly follows Rev. Rul. 80-198, 1980-2 C.B. 113); PLR 9419015 (payments for unrealized receivable made after conversion of partnership to corporation, to withdrawn partners are guaranteed payments under § 736(a)(2); follows Rev. Rul. 83-155, effect on retired partner not stated); cf. PLR 8304059 (withdrawal payments to all limited partners other than trust established by limited partner and limited partnership interest of general partner, in cash and partnership notes guaranteed by the general partner, apparently, treated under § 707(a), although  § § 707(c) and 736 also referred to); PLR 7930089 (termination by incorporation of medical practice; former partner, now shareholder-employee, continued  § 736(a) payments individually).

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Section  § 736 is a classification provision, not a taxing provision. Reflecting that the withdrawing partner remains a tax partner until the final distribution, it divides partnership withdrawal payments between those: (i) under  § 736(a) that are, in effect, deductible by the partnership and income to the withdrawing partner, and (ii) those under  § 736(b) that are considered payments for the withdrawing partner's interest in partnership property, so that the payments are usually nondeductible to the partnership and capital gain to the withdrawing partner.1376  Section 736(a) payments are, in turn, characterized as either:(i) a distributive share of partnership income (§ 736(a)(1)), or (ii)guaranteed payments under  § 707(c) (§ 736(a)(2)).1377 Similarly,  § 736(b) payments are liquidating distributions that have to be divided between those under § 751,1378 and the balance. Despite the statutory order, since all payments, fixed or contingent, are  § 736(b) payments to the extent of the value of the partner's allocable share of the value of partnership assets, including goodwill and other  § 197 intangibles not recorded on the books,1379 other than those receivables and unstated goodwill treated as  § 736(a) payments,1380 the value of partnership assets must be determined before any payments can be designated  § 736(a) payments. In substance, § 736(a) takes payments to which it applies out of the general provisions for liquidating distributions, and provides special tax consequences. Although liquidating distributions that are not  § 736(a) payments are traditionally referred to as  § 736(b) payments, they are simply liquidating distributions governed by the nonrecognition and basis principles discussed above.1381 The regulations under  § 736 do, however, add specific detail to those principles, particularly when there are deferred liquidating distributions.
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1376 Accordingly, characterizing the payments involves potentially significant conflicts among the partners. When the partnership attorney, in effect, represents all partners, there should be informed written consent to the conflict and other ethical issues. A form of representation letter dealing with similar issues at the withdrawal stage is included in the Working Papers.

1377 See V, B; and V, C, below, for detailed discussions of the taxation of  § 736(a) and  § 736(b) payments; see 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for discussions of the meaning and taxation of guaranteed payments, and of the complex rules for allocating partnership results.

1378 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1379 Regs. § 1.736-1(b)(1).

1380 See V, B, 2, below, for a discussion of the special treatment of these items for service partnerships.

1381 See IV, A and B, above, for a discussion of the nonrecognition and substituted basis principles that apply to liquidating distributions.

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Section 409A provides that amounts deferred under a nonqualified deferred compensation plan are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met.1382 The IRS has stated in interim guidance that  § 409A may apply to an arrangement between a partner and a partnership for the deferral of compensation under a nonqualified deferred compensation plan, but excludes from § 409A treatment an arrangement that provides for  § 736 payments, unless the arrangement provides for payments that qualify under § 1402(a)(10).1383  Section 1402(a)(10) excludes from self-employment tax payments to a retired partner under a written plan of the partnership providing for periodic payments (to continue at least until a partner's death) to retired partners generally or to a class of partners, if: (i) the partner rendered no services for the partnership business during the taxable year of payment, (ii)the other partners have no obligations with respect to retirement payments except under the plan, and (iii) the partner's share of partnership capital has been paid to the partner in full before the partnership's taxable year of payment.1384 Although the reference to  § 1402(a)(10) seems to be treated as a narrow exception, the arrangement described is a not uncommon arrangement for professional partnerships.1385 The preamble to the final regulations notes that commentators question the exception for  § 1402(a)(10) and states that the IRS still believes the exception is appropriate, but also states that until further guidance, taxpayers may treat the legally binding right to the payments excludible under  § 1402(a)(10) as arising on the last day of the partner's taxable year before the partner's first taxable year in which such payments are excludible under § 1402(a)(10), and the services for which the payments are compensation as performed in the partner's first taxable year in which such payments are excludible from SECA tax under § 1402(a)(10), so that the time and form of payment of such amounts generally may be established, including through an election to defer by the partner, on or before the final day of the partner's taxable year immediately preceding the partner's first taxable of receipt of such payments, which effectively means the year before retirement. The interim relief ceases to apply if after initial exclusion, the amounts become taxable in another year, for example if an amount paid in one year has been excluded from SECA tax under § 1402(a)(10), and an amount paid in a subsequent year has not been excluded from SECA tax under  § 1402(a)(10) because, for example, the partner performed services in that subsequent year.1386
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1382 § 409A, added by the American Jobs Creation Act of 2004, P.L. 108-357, § 885(a), generally effective for amounts deferred after 2004. Note that the IRS will not issue rulings or determination letters regarding the income tax consequences of establishing, operating, or participating in a nonqualified deferred compensation plan. See Rev. Proc. 2010-3, 2010-1 I.R.B. 110, § 3.01(43). See 385 T.M., Deferred Compensation Arrangements, for a comprehensive treatment of § 409A.

1383 Notice 2005-1, Q& A-7, 2005-1 C.B. 274. The notice asks for comment on the applicability of  § 409A to arrangements subject to § 736, whether there should be a distinction between payments subject to § 736(a) and (b); the coordination of the timing rules of Regs.  § 1.736-1(b)(5) with the rules of  § 409A for nonqualified deferred compensation plans; and whether there should special rules in applying  § 409A to disguised compensation, under § 707(a)(2)(A).

1384 § 1402(a)(10); Regs. § 1.1402-17.

1385 See Rev. Rul. 79-34, 1979-1 C.B. 285 (exclusion applies to payment based on a percentage of partnership profits for the year earned, even though part not paid until next year); GCM 37701 (background on Rev. Rul.  79-34).

1386 Preamble, II.G, T.D. 9431, 72 Fed. Reg. 19234, 19244 (4/17/05); see Preamble, II.E, REG-158080-04, 70 Fed. Reg. 57930, 57937 (10/4/05)(states that taxpayers can continue to rely on the Notice 2005-1, Q& A-7(which relates to § 736));Schwartz, “Section 83(b), Section 409A and Subchapter K,” 772 PLI/Tax 657, 705–07 (2007).

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U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  V. Withdrawal Payments—§ 736

A. Payments for Interest in Partnership—§ 736(b) 

Retirement distributions that are for the withdrawing partner's interest in partnership property are  § 736(b) payments,1387 so that the value of partnership property must be determined before any payments can be classified as  § 736(a) payments. Since partnership property includes  § 751 property,  § 736(b) payments are liquidating distributions that are, implicitly, further divided into payments (or distributions): (i)for  § 751 property, including substantially appreciated inventory and unrealized receivables in capital partnerships,1388 and (ii)those for other partnership property,1389 including goodwill and other similar amortizable  § 197 intangibles for capital partnerships and for service partnerships in which the partnership agreement provides for payment for goodwill.1390
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1387 § 736(b); Regs. § 1.736-1(b).

1388 Unrealized receivables are  § 736(a) payments for general partners in service partnerships. § 736(b)(2), (3). See V, B, 1, a, below, for a discussion of the treatment of unrealized receivables in service partnership.

1389 Regs. § 1.736-1(b)(2); see Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.4.3.2. See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1390 § 736(b)(2)(B); Regs. § 1.736-1(a)(2), (b)(1) and (3), and (7) Ex. 3. See IV, A and B, above, for discussions of the general taxation of liquidating distributions.

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Payments for an interest in partnership property—§ 736(b) payments—result in gain to the withdrawing partner to the extent that money,1391 including liability relief, exceeds the outside basis of the partnership interest,1392 but with no deduction for the remaining partners, as the payments represent a liquidating distribution for the withdrawing partner's interest in partnership capital,1393 including net unrealized gain or loss. Since the withdrawing partner's outside basis in the partnership interest includes a share of partnership liabilities,1394 the deemed distribution from liability relief is usually a wash.
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1391 Money includes marketable securities(see III, F, above, for a discussion of the treatment of marketable securities as money for purposes of recognizing gain under  § § 731(a)(1) and 737) and the distributee's own obligation (see III, A, 2, a, above, for a discussion of treating the distributee's obligation as money when distributed to the obligor).

1392 § 731(a); Regs. § 1.731-1(a).  The withdrawing partner may elect to recognize gain ratably over a series of payments. See V, C, below, for a discussion of allocating payments for purposes of recognizing income and gain. The withdrawing partner recognizes loss only when the distribution consists only of money and of  § 751 property with an inside basis less than the distributee's outside basis in the partnership interest, after reduction for the money distributed, and in a series of distributions only when the last distribution is received, presumably, because until then the total amount to be received is not known. § 731(a)(2); Regs. § § 1.731-1(a)(2), 1.736-1(b)(6). See IV, A, above, for a discussion of recognizing gain or loss for liquidation distributions, including a series of distributions.

1393 Regs. § 1.736-1(a)(2); see Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.5.1; McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.01[4][a](3rd ed. 1997). Regs. § 1.1(h)-1, providing for look-through of gain, does not apply to partnership redemptions. See Preamble, T.D. 8902, 65 Fed. Reg. 57092, 57093 (9/21/00).

1394 Regs. § 1.736-1(b)(1).

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The valuation placed by the partners upon a withdrawing partner's interest in partnership property in an arm's-length agreement is generally recognized, because of the adverse interests between the partners with respect to the characterization of payments to the withdrawing partner.1395 The withdrawing partner generally desires a larger amount of the liquidating payments to be assigned to the interest in partnership property, other than  § 751 property, that are capital gain or loss, while the remaining partners generally prefer an allocation to ordinary property, or to  § 736(a) payments. If they do not agree or the agreement is not the result of arm's-length bargaining, the IRS or the courts will do it.1396 The withdrawing partner's gain (or loss) is capital gain or loss on the partnership interest, except to the extent attributable to  § 751 property—unrealized receivables and substantially appreciated inventory.1397 The partnership recognizes no gain or loss in connection with a  § 736(b) payment.1398 Because of the special treatment of unrealized receivables for service partnerships,1399  § 751 applies only to the service partnership's substantially appreciated inventory.1400 For partnerships where capital is a material income-producing factor, there is no special treatment of unrealized receivables.1401
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1395 Id.

1396 See Champlin v. Comr., T.C. Memo 1977-196 (valuation of interest in partnership property when parties did not allocate payments between  § 736(a) and (b) payments based on a “careful examination of the record and all the factors affecting the negotiations between the parties.”); Quirk Est. v. Comr., T.C. Memo 1988-286, aff'd, 928 F.2d 751 (6th Cir. 1991) (value and character of retiring partner's interest determined, even though such issues were the subject of litigation in state court; values on partnership's financial statements adopted because taxpayer failed to produce contrary evidence).

1397 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1398 § 731(b); see IV, A, above, for a discussion of the taxation of liquidation distributions.

1399 See V, B, 1, a, below, for a discussion of the treatment of unrealized receivables for service partnerships.

1400 See III, D, 3, above, for a discussion of the meaning of substantially appreciated inventory.

1401 Regs. § 1.736-1(b)(3). See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition current and liquidating distribution.

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There is no partnership deduction for  § 736(b) payments, which are liquidating distributions by another name. Similarly, except to the extent applicable to  § 751 property,1402  § 736(b) payments do not affect the inside basis of partnership assets, unless a  § 754 election applies.1403 Any special basis adjustments that applied only to the basis of assets attributable to the withdrawing partner under § 743, stay with the partnership assets for the benefit of the continuing partners.1404 In short, the discussion in IV, above, describes the tax consequence of  § 736(b) payments.
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1402 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1403 See IV, C, above, for a discussion of the application of the  § 754 election to liquidating distributions.

1404 Regs. § 1.734-2(b)(1).

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When goodwill is a  § 736(b) asset,1405 it must be valued. The value placed on goodwill “by an arm's-length agreement of the partners, whether specific in amount or determined by a formula” will generally be considered correct.1406 Although the regulations rely on the adverse position of the parties in respecting their agreement, the relative positions of the parties have changed since the regulations were adopted. The nondeductibility of payments for goodwill created a strong incentive for partnerships to treat goodwill as a  § 736(a) payment, but that incentive has been reduced by the amortizability of goodwill, and has been by limited by the confining of deductible unspecified goodwill to service partnerships.1407
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1405 Regs. § 1.736-1(b)(3). See V, B, 1, b, below, for a discussion of when goodwill is not a  § 736(b) asset for service partnerships.

1406 Regs. § 1.736-1(b)(3).

1407 See V, B, below, for a discussion of the 1993 amendment making the changes.

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The tax advantage to the partnership of current deduction over later amortization has usually exceeded the spread between ordinary income and capital gain for a withdrawing partner, but not for successors to a deceased partner, as long as there is an estate tax providing a step-up in basis at death,1408 because the estate of a deceased partner does not have a stepped basis in rights to  § 736(a) payments,1409 but does for the balance of the partnership interest.1410 With the reduction in the capital gains rate to 15%, increasing the relative disadvantage to a withdrawing partner, the planning advantage to the continuing partners is less clear. Prior to 1993,1411 goodwill payments were nondeductible, creating a strong incentive for partnerships to classify payments as  § 736(a) payments, while the withdrawing partner had a lesser incentive to object since the difference usually was only between the ordinary income and capital gain rate, allowing the partnership in some cases to increase the payment to compensate the withdrawing partner, and come out ahead.1412
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1408 For a successor to a deceased partner, the stake is the difference between ordinary income and, generally no tax, because of the step-up in basis at death. § 1014. The stake becomes the same as for a partner withdrawing during life, if carryover basis applies. See V, D, below, for a discussion of this and other issues that arise on transfer of a partnership interest at death.

1409 § § 753, 1014(c).

1410 Reduced by the deduction under § 691(c).

1411 Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, § 13262(a). See H.R. Rep. No. 111, 103d Cong., 1st Sess. 781–83 (1993); McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.04[1](3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.02[1] (6th ed. 1997).

1412 The partnership agreement of the author's law firm at the time of his withdrawal (1980) contained an express provision to the effect that the withdrawal payments provided were based on an assumption that they were  § 736(a) payments, and might be modified if that assumption proved inaccurate.

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The regulations require that “partnership gross value” for purposes of § § 734(b)/754 adjustments be made by determining the value of the partnership as a going concern,1413 but give no further guidance as to how this is to be done.1414 Any excess of partnership gross value over the value of assets other than  § 197 intangibles is assigned to  § 197 intangibles, with a separate facts and circumstances determination for  § 197 intangibles than goodwill and going concern value, so that goodwill and going concern value have a zero value when there is no excess.1415 If the excess is not enough to cover the value of the other  § 197 intangibles, the excess is allocated first to  § 197 intangibles that are covered by the flush language of § 751(c), which basically covers recaptures and similar items.1416 Any remaining excess is allocated to goodwill and going concern value.1417 These determinations of the values allocated to other  § 197 intangibles and to goodwill do not provide for the allocation of the § § 743(b)/754 adjustment; they are determinations of the value of partnership assets. The determination of the inside adjustment for partnership assets is determined under the general principles for allocations for distributions.1418
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1413 Regs. § 1.755-1(a)(4)(iii).

1414 In contrast, the regulations dealing with § § 743(b)/754 adjustments on sale of a partnership interest have detailed provisions for grossing up the purchase price of the interest. Regs. § 1.755-1(a)(4)(i), (ii). See IV, C, above, for a discussion of how the adjustment is determined and allocated.

1415 Regs. § 1.755-1(a)(5)(i), (6) Ex. 1.

1416 Regs. § 1.755-1(a)(5)(ii), (6) Ex. 3. Since most of the recapture items should have been included in the value determined for the underlying assets, presumably this has the effect of allocating the value of the other  § 197 intangibles first to the ordinary income potential.

1417 Regs. § 1.755-1(a)(5)(iii), (6) Ex. 2. The regulations include goodwill that would not qualify under § 197, but it is not clear what this is. Although self-created goodwill is not amortizable, § 197(c)(2), it should still qualify under § 197.

1418 See III, C, 2, and IV, C, 2, above, for discussions of allocations of inside basis adjustment when a § § 734(b)/754 election applies.

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Although amortizable  § 197 intangibles are generally limited to those purchased, otherwise nonamortizable intangibles can become amortizable as a result of inside basis when a § § 734(b)/754 election applies or  § 754 otherwise applies,1419 and remedial allocations can be made even for nonamortizable intangibles.1420 The anti-churning rules, which are designed to prevent amortization of intangibles transferred to related parties, apply to such basis step-ups.1421 The  § 197 regulations apply an aggregate principle that treats each partner, whether a contributing, continuing, or distributee, as acquiring a ratable interest in the basis step-up, under a  § 754 election, of an otherwise nonamortizable intangible asset. Thus, the basis step-up reflecting gain recognized by the distributee partner becomes amortizable to the extent allocated to partners who are not related to the contributing partner, but not to the extent allocated to the contributing partner and related persons. When there is a series of liquidating payments, any step-up in basis for amortizable  § 197 intangibles (or other assets) under a  § 754 election occurs only as payments are made and the distributee recognizes the gain.1422
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1419 Regs. § 1.197-2(g)(3), (k) Exs. 14 to 17 and 31; see H.R. Conf. Rep. 213, 103d Cong., 1st Sess., 686-87 (treats basis step-up under  § 754 as acquisition of  § 197 intangible); PLR 9715008 (basis step-up on purchase by remaining partners of interest of withdrawing partners allocable to  § 197 intangibles treated as newly acquired intangible); cf. Frontier Chevrolet Co. v. Comr., 116 T.C. 289 (2001), aff'd 329 F.3d 1131 (9th Cir. 2002) (noncompete in connection with redemption of 75% shareholder is  § 197 intangible, because in connection with acquisition of indirect interest in a trade or business);Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ S15.04[5](2003 Cum. Supp. No. 2); Jackel and Fessler, “The Mysterious Case of Partnership Inside Basis Adjustment,” 89 Tax Notes 529(Oct. 23, 2000) (discusses interplay of § § 734(b), 197 and 704(c)).

1420 Regs. § 1.197-2(g)(4).

1421 See Regs. § 1.197-2(h)(12), (k) Exs. 18, 19, and 28 to 30;see 533 T.M., Amortization of Intangibles, for a comprehensive treatment of the application of the anti-churning rules to  § 754 adjustments.

1422 See Rev. Rul. 93-13, 1993-1 C.B. 126 (§ 734(b) adjustments made only as distributee recognizes gain); see V, C, 3, below, for a discussion of the timing of gain or loss recognition when a withdrawing partner receives deferred payments.

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Example: Amortization of § 197 Intangibles under § § 734(b)/754 Adjustment. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar's retail and franchising operation has grown rapidly and is worth considerably more than the value of its tangible and recorded intangible assets. This goodwill or going concern value is self-created, having been developed with deductible human resources and advertising expenses. Oppar is an accrual-method partnership that has no unrealized receivables and its inventory is not substantially appreciated. Munn has decided to retire. Under a buy-sell agreement formula, based on earnings, Munn is entitled to a payment of $1,000,000. His outside basis is $900,000, including a $400,000 share of Oppar liabilities, representing a capital account of $500,000. His capital account should be adjusted to $1,000,000, as should the capital accounts of Propp and Surv. In the revaluation, the partners determine that $600,000 of the book-up should be allocated to goodwill and going concern value. Munn recognizes $500,000 of gain on receipt of the $1,000,000 payment and the relief of his $400,000 share of liabilities. If a § § 734(b)/754 election applies, $200,000 of the basis increase is allocable to his share of the goodwill and going concern value. Since Propp and Surv are considered to have acquired their shares of this amortizable  § 197 asset from Munn who is not a related person, Oppar may amortize the $200,000 over 15 years. There is no basis adjustment for the remaining $400,000 of goodwill, since it is self-created. Accordingly it cannot be amortized for tax purposes.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  V. Withdrawal Payments—§ 736

B. Distributive Share or Guaranteed Payments—§ 736(a) 

Section 736(a) applies to all payments to a withdrawing partner that are not considered to be for the partner's interest in partnership property.1423 Moreover, for service partnerships, those in which capital is not a material income-producing factor, payments for a share of certain assets—unrealized receivables, and goodwill when the partnership agreement does not specify a payment for goodwill—are also  § 736(a) payments.1424 Naturally,  § 736(a) does not define when capital is a material income-producing factor.  The sparse legislative history1425 indicates that the determination is made under present and prior law and refers to  § 401(c)(2) (relating to determining earned income of self-employed individuals and including only income from businesses in which personal services are a material income-producing factor),1426  § 911(d) (relating to the earned income exclusion for U.S. persons living abroad and referring to wages, salaries, professional fees and compensation for personal services),1427 and former  § 1348(b)(1)(A) (relating to the former maximum tax on earned income, which adopts, by reference, the first two).1428 In case trying to draw a principle out of the cited sources is not confusing enough, the conference report also states that capital is not material when the primary source of income is fees, commissions, or other compensation for personal services —an unacknowledged variation on § 911(d).  The report also states that the practice of a profession by a doctor, dentist, lawyer, architect, or accountant,1429 is not a business in which capital is material, even though a professional may have a substantial investment in capital equipment.  Aside from knowing that the obvious professions are not businesses where capital is material, it is difficult to even begin to figure where the line should be drawn.
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1423 § 736(b); Regs. § 1.736-1(a)(2). See V, A, above, for a discussion of the treatment of  § 736(b) payments to the retiring partner and the partnership, including the application of § 751 and the  § 754 election.

1424 § 736(b)(2), (3). See Holman v. Comr., 66 T.C. 809 (1976), aff'd, 564 F.2d 283 (9th Cir. 1977); Milliken v. Comr., 72 T.C. 256 (1979), aff'd in unpub. opin.(1st Cir. 1979).

1425 H.R. Rep. No. 213, 103d Cong., 1st Sess. 697–98 (Conference Report).

1426 This is the mirror image of the § 736(b)(3)(A) standard.

1427 It also provides that, for a trade or business in which capital is a material income-producing factor (undefined in the Code or regulations), only 30% of the earnings can be considered earned.  This qualification is of no relevance under § 736(b)(3). Regs. § 1.911-3(b)(2).

1428 It provides exclusions relating to certain distributions from qualified plans that probably have no relevance to § 736(b)(3).

1429 Compare the list for personal service corporations under  § 441(i) (limitation of tax year of personal service corporations, implicitly including  § 269A (reallocating income if tax-avoidance purpose) and  § 448(b)(2) (limitation on cash method of accounting)) that includes the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting as personal services. Regs. § § 1.441-3(d)(2), 1.448-1T(e)(4). Regs. § 1.448-1T(e)(4)(ii), (iii), and (iv) also defines the fields of health, performing arts and consulting, respectively. Most of the businesses and professions on this broader list probably should be classified as ones in which capital is not a material income-producing factor.

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There is no step-up in basis at death for rights to  § 736(a) payments, because they are classified as income in respect of a decedent (“IRD”).1430 If a partnership making  § 736(a) payments terminates before the payments are completed, a successor, apparently, can deduct the payments, under § 162(a), not § 736(a).1431
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1430 § § 753, 1014(c). See V, D, below, for a discussion of this and other issues that arise on transfer of a partnership interest at death.

1431 See Rev. Rul. 75-154, 1975-1 C.B. 186 (former partners entitled to deduct, under § 162, retirement payments to previously retired partner even after partnership terminated); Flood v. U.S., 133 F.2d 173 (1st Cir. 1943) (same); Rev. Rul. 83-155, 1983-2 C.B. 38 (same for payments by corporation succeeding to partnership business); GCM 39054, Nov. 24, 1981 (same; background for Rev. Rul. 83-155;expressly follows Rev. Rul. 80-198, 1980-2 C.B. 113 (transferee in  § 351 transaction entitled to deduct accounts payable of cash-method transferor)); PLR 9419015 (payments for unrealized receivables made to withdrawn partners after conversion of partnership to corporation are guaranteed payments under § 736(a)(2); follows Rev. Rul. 83-155;effect on retired partner not stated); cf. PLR 8304059 (interest on deferred withdrawal payments to all limited partners (other than trust established by limited partner and limited partnership interest of general partner), in cash and partnership notes guaranteed by the general partner, apparently, treated under  § 707(a) as paid in a nonpartner capacity, although  § § 707(c) and § 736 also referred to).

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Section 736(a) payments are treated as either a distributive share of partnership income, if determined by partnership income, or as a guaranteed payment, if not.1432 The classification determines the character and timing of the tax results of the payments.1433
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1432 § 736(a)(1), (2); Regs. § 1.736-1(a)(3); see Wallis v. Comr., T.C. Memo 2009-243 (10/27/09) (Tax Court ruled that payments for partner's “units” were guaranteed payments taxed to partner as ordinary income, noting that: (1) each partner received same number of units each year for services rendered to partnership regardless of size of partner's partnership interest and without regard to partnership's income; and (2) units were not treated as part of partner's respective shares of partnership income or partnership property and were not reflected in partners' respective capital accounts); PLR 9649007 (payments subject to limits based on income of partnership are distributive share; character determined by character of partnership income, including ratable share of U.S.-source income and foreign-source income); Pollack, Amdur &  Bellows, Partnership Buy-Sell Agreements, § 203.4.3.1 (1995); McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.01[4](3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.01 (6th ed. 1997).

1433 See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments of the timing the income and deduction for guaranteed payments.

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Section 736(a) payments treated as guaranteed payments are ordinary income deductible by the partnership,1434 since the  § 707(c) capitalization provision does not apply to  § 736(a)(2) payments.1435 Since a liquidating distribution can hardly be considered made in an independent capacity, payments based on gross income, probably should be considered guaranteed payments, but the result is unclear. Guaranteed payments do not affect capital accounts.1436
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1434 Regs. § 1.736-1(a)(3)(i), (4). See II, C, 2, above, for a discussion of guaranteed payments.

1435 Regs. § § 1.736-1(a)(4), 1.707-1(c).

1436 Regs. § 1.704-1(b)(2)(iv)(o).

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A payment treated as a distributive share of partnership income is included in income of the withdrawing partner under § 702, and the distributive shares of the remaining partners are reduced accordingly.1437 The character of a partner's distributive share of partnership income depends upon the character of the partnership's income.1438 The distributive share represented by the payment is reported under the normal partnership allocation rules,1439 and the payment itself under the normal liquidating distribution rules.1440 Distributive shares flow through the capital account.1441
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1437 Regs. § 1.736-1(a)(4). See PLR 7939099 (when payments to a retired partner as a distributive share of partnership income was converted to payment fixed by a formula when the remaining partners terminated the firm's business and the partnership, the revised payment became a guaranteed payment, deductible by the payors under § 162(a)).

1438 Although the reference to the term “payment” as a distributive share might imply that a  § 736(a)(1) payment is taken into account only when paid, Regs. § 1.736-1(a)(5), since  § 736(a) only characterizes the payment or allocation, with the tax accounting determined under the principles of § 702(a). See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.06 (3rd ed. 1997); Willis, Pennell & Postlewaite, Partnership Taxation, ¶ 15.06(6th ed. 1997); see 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of the pass-through of partnership items to partners.

1439 Regs. § 1.736-1(b)(4);see 710 T.M., Partnerships — Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for a comprehensive treatment of how partnership results are allocated.

1440 Regs. § 1.736-1(b).

1441 Regs. § 1.704-1(b)(2)(iv)(b).

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Since withdrawing partners receiving either distributive shares or guaranteed payments include the amounts in income based on the partnership's tax year and method of accounting,1442 the difference is that the character of a distributive share is determined by the nature of the partnership's income (with corresponding reductions in the remaining shares of partnership results),1443 while a guaranteed payment is always ordinary income to the withdrawing partner(and deductible or capitalizable by the remaining partners).1444 Thus, there is likely to be a significant difference only when the partnership has a major portion of its income from tax-advantaged sources, such as capital gains or tax-exempt income, another item for bargaining and drafting of the partnership or withdrawal agreement.
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1442 § 706(a); Regs.  § 1.706-1(a) (distributive share); § 707(c);Regs.  § 1.707-1(c) (guaranteed payments).

1443 § 702(b); Regs. § 1.702-1(a), (b). Specified items of partnership income and deduction are taken into account separately by each partner in determining the distributive share of partnership income or loss.  § 702(a)(1) to (7); Regs.  § 1.702-1(1) to (6). Other items of partnership income, gain, loss, deduction and credit are taken into account separately to the extent provided by regulations. § 702(a)(7); Regs. § 1.702-1(a)(8). Finally, each partner takes into account the share of the taxable income or loss of the partnership other than those items that are required to be separately stated. § 702(a)(8); Regs. § 1.702-1(a)(9). See also Rev. Rul. 2008-39, 2008-31 I.R.B. 252 (where upper tier partnership's(UTP) activities consist solely of owning other partnerships whose trading constitutes trade or business, management fees paid by UTP are not deductible under § 162;such fees are passed through to UTP's partners as separately stated § 212 expenses). See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for more comprehensive treatments, of determining and allocating shares of partnership income.

1444 Regs. § 1.707-1(c).

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1. Service Partnerships 

A further complication is that payments by professional and other service partnerships—those for which capital is not material, whatever that means outside the professions—two classes of partnership assets that would otherwise be for a partner's share of partnership property,1445 are, nevertheless, treated as  § 736(a) payments.1446 These are: (i) traditional unrealized receivables, not including recapture items, and (ii) “goodwill.”The apparent rationale for this treatment is that it is difficult, particularly in service partnerships, to distinguish between payments for property and payments in the nature of unfunded retirement benefits.1447 Although the payments for unrealized receivables would be ordinary income in any event, the result is that the remaining partners receive a deduction for payments as made, offset by income only when the receivables are collected.1448
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1445 Indeed, they are considered  § 736(b) payments to the extent of the inside basis of these items. Regs. § 1.736-1(b)(2). By their nature, however, the inside basis of these items to partnerships is rarely above zero.

1446 § 736(b)(2); Regs. § 1.736-1(b)(2).

1447 Regs. § 1.736-1(a)(2).

1448 See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § § 203.3.2.1 and 203.3.2.2.

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a. Unrealized Receivables 

Particularly in service partnerships, unrealized receivables—amounts due from customers or clients for work completed or in progress—often constitute a major portion of the value of the firm.1449 Recapture items are not unrealized receivables under § 736.1450 The rationale, if any, for the special treatment of traditional unrealized receivables is hard to discern, except that it has the effect of clearly making the receivables IRD, but if that is the goal it would have made more sense to limit it to decedents and to state the result in § 753.1451 The special treatment, however, provides a timing advantage for the continuing partners, who often can deduct the  § 736(a) payments before the corresponding income is collected.1452
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1449 See, e.g. Esler v. Comr., T.C. Memo 1988-17, 56 T.C.M. (CCH) 41 (payments to a partner withdrawing from a law firm that were intended to compensate the partner for income, accounts receivable, and work in progress retained by the firm, and for the goodwill he helped build through his past services were  § 736(a) payments); Ware v. Comr., 906 F.2d 62 (2d Cir. 1990), aff'g T.C. Memo 1989-165, 57 T.C.M. (CCH) 105 (fee of law firm client that withdrawing partner originally claimed was an unrealized receivable; payment to (actually collection of half of fee by) a withdrawing partner was ordinary income).

1450 § 752(c) (flush language). See 720 T.M., Partnership Transactions — Section 751 Property, for a comprehensive look at the treatment of recapture items.

1451 § 753; see V, D, 4, below, for a discussion of the effect of classifying this and other partnership items as income in respect of a decedent.

1452 See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.3.2.

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Payments for substantially appreciated inventory and, presumably recapture items are payments for property that are § 736(b) payments, but taxed under § 751(b), with the offsetting advantage for the partnership only when the inventory or other ordinary income property is disposed of, or the property is depreciated.1453
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1453 § 736(a), (b)(2)(A); Regs. § 1.736-1(b)(2), (4) and (7) Ex. 1 and Ex. 4. § § 736(b)(2), 751(c); See H.R. Rep. No. 111 103d Cong., 1st Sess. 782–83 (1993); Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991) (payments allocated to unrealized receivables are ordinary income); Tolmach v. Comr., T.C. Memo 1991-538, 62 T.C.M. (CCH) 1102 (payments are  § 736(a) guaranteed payments even if attributable to goodwill where agreement allocated specified amount to goodwill even though report in settled litigation allocated 80% to goodwill;  § 736(b) sets ceiling of reasonable value, not floor); Cooney v. Comr., 65 T.C. 101 (1975) (withdrawal was liquidation of interest, not sale, but ambiguous agreement allocated them to goodwill).

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Example: Liquidating Payments for Unrealized Receivables. Munn, Propp and Surv are equal(one-third) partners in a service partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar, has:(i) $90,000 cash, (ii) cash-method receivables of $222,000, with an inside basis of zero, and (iii) supplies that were properly deducted when acquired, but are worth $9,000. Munn's outside basis in his Oppar interest is $30,000. Oppar distributes $107,000 in cash to Munn in complete liquidation of his interest. The supplies are “substantially appreciated inventory,” since sale would produce ordinary income and the fair market value exceeds 120% of the zero adjusted basis. Consequently,  § 751(b) treats Munn as having constructively received a one-third interest in the supplies with an adjusted basis to him of zero, that is treated as being immediately repurchased by Oppar for its $3,000 value. Even though $74,000 of the payment is allocated to his pro rata share of the receivables, it is treated as ordinary income as a guaranteed payment under § 736(a), and not as a deemed sale under § 751(b). Accordingly, although Oppar steps up its basis in the supplies, it does not adjust its basis in the receivables. It should be entitled to a deduction for the guaranteed payment, when made, and should be able to deduct the “purchased” supplies just as it would for supplies purchased from others. It takes the receivables into account when collected, whether in the year of Munn's withdrawal or later. Thus, it deducts the payment to Munn, even though some of the corresponding income may not be realized until later tax years. Since the remaining $30,000 in cash distributed to Munn equals his outside basis, Munn does not realize any capital gain.

b. Unspecified Goodwill 

Section 736 gives the partners in service partnerships significant flexibility to determine whether distributions to general partners are to be treated as: (i)736(a) payments, in effect, deductible to the remaining partners and taxable as guaranteed payments or partnership income to the withdrawing partner; or (ii) payment for the withdrawing partner's interest in partnership property, usually including goodwill, under § 736(b), in effect, capital gain to the withdrawing partner, and nondeductible to the remaining partners, except as affected by § 751,1454 or capital recovery as depreciation or amortization. Classifying unspecified goodwill payments as  § 736(a) payments eliminates the need to value partnership goodwill, with the benefit to the partnership of not having to capitalize that value and amortize it over 15 years under  § 197 (and only if the anti-churning rules of  § 197(j) do not apply).1455 The flexibility to treat goodwill under  § 736(a) now applies only to payments to general partners in service partnerships.1456 At least some LLC members, particularly managers in manager-managed LLCs and probably all members in member-managed LLCs should qualify,1457 as should almost all partners in LLPs, since LLPs generally operate under the same partnership acts as general partnerships, with the only difference being limited liability obtained by filing an appropriate document, which protects the limited liability partners only against contract and vicarious tort liability,1458 but limited partners in a limited partnership probably cannot.1459 A sensible reform suggestion is to make the distinction between general and limited partners for purposes of  § 736 turn on whether the withdrawing partner was subject to self-employment tax, rather than relying on state law limits on the right to participate in management.1460 The interesting question is whether the courts or the IRS will, as they should, adopt this sensible standard without legislation.
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1454 § § 736, 702 and 707(c); Regs. § 1.736-1; see Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § § 203.5.1 and 203.5.2 (1995). See V, A, above, for a discussion of the treatment of  § 736(b) payments to the retiring partner and the partnership, including the application of  § 751 and the  § 754 election.

1455 § 197(a), added by Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, § 13261(a), the same provision that amended § 736(b). McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.04[2] (3rd ed. 1997). See V, A, above, for a discussion of capitalizing and amortizing goodwill that has not been recorded on the partnership books.

1456 § 736(b)(3). The same flexibility was available to a partnerships prior to the enactment of  § 736(b)(3) by the Revenue Reconciliation Act of 1993, § 13262, effective Jan. 5, 1993.

1457 See ULLCA § § 404(a),(c); RULLCA § § 407(a), (b); Del. LLCA § 18-402.

1458 RUPA § § 101(5), 306(c), and 1001;Del RUPA § § 15-101(8), 15-306(c) and 15-1001.

1459 RULPA § § 302, 403; Re-RULPA § § 302, 403; Del. ULPA § § 17-302, 17-403. See Frost, “‘Square Peg, Meet Round Hole: Classifying LLC Members as ‘General Partners'or ‘Limited Partners' for Federal Tax Purposes,” 73 Taxes 676, 695 (1995); Frost, “‘Square Peg Meets Round Hole II: We Still Don't Know Whether to Classify LLC Members as ‘General Partners' or ‘Limited Partners' for Federal Tax Purposes,”439 PLI/Tax 789 (1999); cf. Rev. Proc. 95-10, 1995-1 C.B. 501 (effectively equates member-managers with general partners for classification purposes under the Kintner regulations).

1460 See Staff of the Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (2001), at 281–82.

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A payment for a withdrawing partner's share of partnership goodwill, even in a service partnership is a  § 736(b) payment to the extent of the partnership's inside basis in goodwill,1461 or when the partnership agreement1462 specifically provides for payments with respect to partnership goodwill.1463 When neither of these limitations apply, the payment is a  § 736(a) payment.1464 It is frequently ambiguous whether an agreement provides for goodwill payments, but the courts have interpreted quite literally the requirement that the partnership agreement provide for payment to a withdrawing partner for the interest in goodwill for the payment to qualify for  § 736(b) treatment.1465 When the agreement provision is ambiguous, the courts apply contract interpretation techniques with unforeseeable results.1466 At the other extreme, at least one court has enforced an agreement labeling a payment as a guaranteed payment, even though the facts strongly indicated that it was for professional goodwill.1467 Although  § 736(b)(2) refers to the “partnership agreement,” since partnership agreement includes any modification agreed to by all the partners or adopted as provided in the partnership agreement,1468 a provision in the withdrawal agreement for a specific partner should suffice.1469 The author hopes that readers of this Portfolio will only have to deal with whether an agreement is adequate for clients who come to you in a transaction on which another lawyer gave the advice.
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1461 Regs. § 1.736-1(b)(3).

1462 See V, C, 1, below, for a discussion of the meaning of “partnership agreement.”Although it is probable that an agreement providing for goodwill must be made before the time for filing the partnership return for the year of withdrawal, it may be possible to change the character of later payments by an amendment made before the filing of the partnership return for later payments.

1463 § 736(b)(2)(B); Regs. § 1.736-1(b)(3).

1464 Id.

1465 See, e.g., Smith v. Comr., 37 T.C. 1033 (1962), aff'd, 313 F.2d 16 (10th Cir. 1962) (premium over book value paid to expelled partner in service partnership not explicitly designated as goodwill was  § 736(a) payment); Banoff & Jackel, “Sales, Exchanges and Other Dispositions of Partnership Interests,” 531 PLI/Tax 311, 385–91 (2002).

1466 See Comr. v. Jackson Investment Co., 346 F.2d 187 (9th Cir. 1965), rev'g and rem'g 41 T.C. 675 (1964) (payment referred to as “guaranteed payment or a payment for ‘goodwill’”determined to be for goodwill because agreement elsewhere referred to it as a payment for goodwill); Jacobs v. Comr., T.C. Memo 1974-196, 33 T.C.M. (CCH) 349 (payment in liquidation of interest was for goodwill, where agreement provided that partner forfeited interest in receivables).

1467 See Spector v. Comr., 641 F.2d 376 (5th Cir. 1981) (payment to retiring accountant immediately following merger of his practice with continuing partnership not for goodwill when agreement characterized it as guaranteed payment even though never rendered services to continuing partnership; apply rule of Comr. v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 757 (1967) to hold taxpayer to his agreement).

1468 § 761(c); Regs. § 1.761-1(c). The modification can even be adopted after the end of the tax year as long as it is agreed before the time for filing the partnership return, without extensions, generally by April 15 of the next year. Although the agreement can be written or oral, an oral agreement is a guarantee of trouble.

1469 See Comr. v. Jackson Investment Co., 346 F.2d 187 (9th Cir. 1965), rev'g and rem'g 41 T.C. 675 (1964) (provision in withdrawal agreement).

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Example: Unspecified Goodwill. Munn, Propp and Surv are equal (one-third) partners in a law firm, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has $90,000 cash (working capital), and cash-method receivables and work in process of $111,000, with an inside basis of zero. Munn's outside basis in his Oppar interest is $30,000. Oppar distributes $150,000 in cash to Munn in complete liquidation of his interest, $30,000 as his capital account, and the balance based on an earnings formula. No amount is allocated specifically to the receivables or to goodwill, although the earnings of the firm indicate that there is significant goodwill and going concern value, as implied by the significant excess of the remaining $120,000 payment over Munn's $37,000 share of the receivables. Since the Oppar agreement does not designate any portion of the payment as being for goodwill, the entire excess is a  § 736(a) payment, taxed as ordinary income to Munn and currently deductible by Oppar. The $37,000 allocable to the receivables is not treated as an exchange under § 751(b), but is deductible when paid as a  § 736(a)(2) guaranteed payment, as is the $83,000 balance allocable to unspecified goodwill and other factors. Thus Propp and Surv, in effect, pay for Munn's interest in goodwill out of pre-tax dollars. The $30,000 allocable his capital account is a § 736(b) liquidation distribution with no gain or loss, since it equals Munn's outside basis. Since the $83,000 excess is deductible, it does not affect capital accounts or provide a basis for revaluing Oppar's assets. If the agreement specifies an amount for goodwill, Munn should be able to treat that portion as capital gain, but Oppar would only be able to amortize it over 15 years. Oppar should revalue its assets and capital accounts to reflect the value of the goodwill.

c. Deductible Obligations 

Accounts payable and similar obligations of a cash-method partnership or other obligations that have not been taken into account for tax purposes should not be considered liabilities at least until paid.1470 If the deductible obligations are transferred to the withdrawing partner the right to the deduction goes with the transfer of the obligation.1471 If they are not transferred, but taken into account economically in determining the amount of the liquidating distribution, apparently, they reduce any ordinary income to the withdrawing partner on any  § 736(a)(2) guaranteed payment for unrealized receivables, since  § 736(b) payments come first.1472
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1470 See II, D, 1, above, for a discussion of the tax meaning of liability for partnership (and other) purposes; Manning and Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part One),” 11 Tax Mgmt. Real Est. J. 19, 22–25 (1995). But cf. Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991) (payables not yet deducted included as liabilities; taxpayer failed to argue, until too late, that the obligations were not liabilities; no consideration of who should be entitled to deduction for payables and when).

1471 See II, D, above, for a discussion of the transfer of the right to the deduction with a transfer of the obligation.

1472 See V, B, 2, b, below, for a discussion of a different analysis for capital partnerships.

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Example: Liabilities and Deductible Obligations in Service Partnerships. Munn, Propp and Surv are equal (one-third) partners in a service partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has cash, furniture and fixtures, including its library, with a basis and value of $90,000, and cash-method receivables of $180,000, with an inside basis of zero. It is subject to a $60,000 bank loan for purchase of its assets and for working capital, and accounts payable for $18,000 of deductible obligations that can be deducted only when paid. Munn's capital account is $30,000, representing his share of the Oppar assets, and his outside basis in the Oppar interest is $50,000, including his share of the bank loan. Oppar distributes$64,000 in cash to Munn in complete liquidation of his interest (in effect, adjusting his capital account for $54,000—$60,000 as his share of the receivables, net of $6,000, as his share of the payables), and agrees to indemnify him against any obligation on the bank loan or payables. His total distribution is $84,000, including relief from his $20,000 (1/3  of $60,000) share of the bank loan. The indemnity against the payables should not be taken into account since they are not liabilities for tax purposes. $30,000 of the payment is allocated to his interest in Oppar's assets, and the remaining $54,000 is a  § 736(a) payment for his interest in the receivables, taxable as ordinary income. This amount is less than his $60,000 share of the receivables as a result of an offset against the payables. Although, arguably, Munn should have ordinary income on his full share of the receivables, and should be entitled to deduct his share of the payables when paid, there is no provision equivalent to  § 751 for giving him the deduction. Accordingly, reducing his ordinary income for the obligations that reduced the amount of his payment has more or less the same net result, although there may be timing differences between the payment of the income and the payment of the deductible obligations.

2. Capital Partnerships 

In a partnership in which capital is material, payments for (or distributions of) the withdrawing partner's share of goodwill, whether or not specified in the partnership agreement, and for unrealized receivables are liquidating distributions under § 736(b). To the extent attributable to unrealized receivables, they will be ordinary income under § 751(b), and to the extent attributable to goodwill, they will be capital gain. Since the classification is of partnerships, not partners, payments to service partners in a capital partnership that represents a marriage of money and sweat are  § 736(b) payments attributable to even unspecified goodwill, not  § 736(a) payments.

a. Section 736(a)Payments in Capital Partnerships 

Given the need to recognize goodwill as a partnership asset in making adjustments under  § 734(b) and otherwise,1473 this leaves little scope for  § 736(a) payments outside of service partnerships. The regulations, which have not been amended since 1993, refer to payments in the nature of “mutual insurance,1474 which seems to refer to payments of unfunded deferred compensation, as well as unspecified goodwill. Accordingly payments in excess of the value of the withdrawing partner's share of the value of partnership property, which should include any share of the value of goodwill, whether specified or not,1475 should be  § 736(a) payments whether or not the parties designate the excess amount as “mutual insurance”or unfunded deferred compensation, even in capital partnerships,1476 since similar payments may be deductible even for corporations.1477 Obviously, it is better if the withdrawal agreement or the partnership agreement specifically labels the payments as  § 736(a) payments, but such designation will probably be respected only if the allocation to goodwill is reasonable.1478 In addition, even though an obligation to make deferred partnership liquidating distributions apparently is not a debt obligation representing a current distribution,1479 or subject to the imputed interest original issue discount rules,1480 a provision for such interest should be a  § 736(a)(2) guaranteed payment, as should be any provision for deferred payments that are in excess of the value of the interest at withdrawal.1481
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1473 See V, A, above, for a discussion of the determination of, and allocations to, goodwill.

1474 Regs. § 1.736-1(a)(2).

1475 Cf. Frontier Chevrolet Co. v. Comr., 116 T.C. 289 (2001), aff'd 329 F.3d 1131 (9th Cir. 2002) (noncompete in connection with redemption of 75% shareholder is  § 197 intangible, because in connection with acquisition of indirect interest in a trade or business).

1476 See Willis, Pennell & Postlewaite, Partnership Taxation, ¶ 15.04[1] (6th ed. 1997); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.04[1] (3rd ed. 1997).

1477 See Manning, Corporate Buy-Sell Agreements, § 206.

1478 Regs. § 1.736-1(b)(3).

1479 See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.3.2.

1480 Cf. former Regs. § 1.483-1(b)(1) (series of distributions in corporate liquidation not subject to imputed interest); see McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.02[4][d](3rd ed. 1997).

1481 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.02[4][c](3rd ed. 1997). See V, C, 3, below, for a discussion of the effect classification of implicit increases in deferred payments to reflect the deferral as  § 736(a) payments.

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Example: § 736(a) Payment in Capital Partnership. Munn, Propp, and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar conducts an accrual-method retail business. Although Propp and Surv, the active managers, have received guaranteed payments for their services, all partners recognize that these payments were designed primarily to provide them with cash to live on, and do not represent a fair measure of the value of their services. Their shares of Oppar profits are intended to provide the remainder of their compensation. As a result of policy disputes, it is clear that one of them must go. Surv is willing to withdraw, but insists on payment of $50,000 more than her capital account, as adjusted for unrealized gains and losses in the Oppar assets, which includes$300,000 for goodwill based on an outside appraisal. She claims that the amount represents an expected increase in profits, particularly if she is allowed free rein in management. Munn and Propp are willing to pay her that amount to induce her to withdraw. The $50,000 should be a  § 736(a)(2) guaranteed payment. If the withdrawal agreement provides that it is “in recognition of her past efforts for which her guaranteed payment and distributive share did not provide full compensation,” the implicit classification as a  § 736(a)(2) guaranteed payment should be accepted. If Surv successfully insists that it be designated in the agreement as “in recognition of going concern value and goodwill based on future prospects that have not been reflected in earnings,” the implicit designation as goodwill should make it a  § 736(b) payment that should result in additional amortizable § 197 goodwill despite the appraisal. If, as a compromise, both phrases are incorporated in the withdrawal agreement, the ambiguity will, most likely, lead to litigation, in which the pre-1993 implicit bias in favor of treating it as a  § 736(a) payment should not apply. If the withdrawal agreement provides for payment of her withdrawal amount over five years with interest at 2% above the applicable federal rate, the interest payments should be  § 736(a)(2) guaranteed payment. If there is no such express designation, but there is evidence that the originally agreed payment was increased to reflect the deferral, the increased amount should also be a  § 736(a)(2) guaranteed payment.

b. Deductible Obligations 

Although  § 751(b) ensures that the distributee is taxed on ordinary income for a share of unrealized receivables and similar items, there is no statutory or regulatory provision allowing an offset for equivalent unrealized deductions on accounts payable and similar obligations,1482 or preserving the right to a share of unrealized deductions. Nevertheless, under general tax principles, since the payables and similar obligations are not considered to be liabilities at withdrawal, so that the withdrawing partner is not entitled to an immediate deduction, even though, economically, the reduction in the withdrawal payment to reflect the obligations may be the equivalent of payment.1483 Although it might make sense to keep obligations that are not liabilities at withdrawal open and consider additional distributions to the withdrawing partner when paid — giving the distributee additional gain, reduced loss, or a basis adjustment in property distributed in kind, with a simultaneous offsetting deduction for the constructive payment of a share of the deductible item1484 —that approach is probably not administratively feasible. Permitting the remaining partners to deduct the payments is contrary to reverse § 704(c) principles, since the portion of the obligation taken into account in determining the amount of the distribution is properly allocable to the withdrawing partner,1485 but seems to be a reasonable administrative compromise. Since the deductible obligations are not transferred, but only taken into account in determining the payments to the withdrawing partner, the acceleration of deduction on transfer of a trade of business under the economic performance regulations should not apply.1486
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1482 See II, D, 1, above, for a discussion the difference between such obligations and liabilities.

1483 See Manning and Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Two),” 11 Tax Mgmt. Real Est. J. 35, 42 (1995).

1484 See Rev. Rul. 80-198, 1980-2 C.B. 113, Rev. Rul. 75-154, 1975-1 C.B. 186; Flood v. U.S., 133 F.2d 173 (1st Cir. 1943); Rev. Rul. 83-155, 1983-2 C.B. 38; GCM 39054, Nov. 24, 1981; see V, B, 1, c, above, for a discussion of a different analysis for service partnerships. Cf. Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981) (treating such obligations as paid in a sale of business).

1485 See I, B, above, for a discussion of allocations of inherent gains, losses, income and deductions to continuing partners, when a new partner is admitted.

1486 Regs.  § 1.461-4(d) and (g)(1)(ii)(C) (economic performance occurs when purchaser assumes liability in connection with a trade or business transfer) do not apply; see II, D, above, for a discussion of effect of the transfer of obligations that are not liabilities in connection with a distribution. Similarly, since the deductible obligations are not debt instruments, the principles of Regs. § 1.1001-1(g), in effect, closing the transaction, should not apply.

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Example: Liabilities and Deductible Obligations in Liquidating Distributions. Munn, Propp and Surv are equal (one-third) partners in a capital partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has cash and other non-§ 751 property, with an inside basis and value of $360,000, and LIFO (substantially appreciated)inventory with an inside basis of $18,000 and value of $180,000. It is subject to bank loans and accrued liabilities of $60,000, and has deferred compensation and other obligations for which economic performance has not occurred of $18,000 that can only be deducted when paid. Munn's capital account is $106,000, representing his share of the Oppar assets(including the basis of the LIFO inventory) net of the liabilities, and his outside basis in the Oppar interest is $126,000, including his share of the liabilities. Oppar distributes $154,000 in cash to Munn in complete liquidation of his interest (in effect, adjusting his capital account for $48,000—$54,000 as his share of the LIFO reserve or inventory appreciation, net of $6,000 for his share of the deductible obligations), and agrees to indemnify him against any obligation on the liabilities or deductible obligations. His total distribution is $174,000, including relief from his $20,000 (1/3  of$60,000) share of the liabilities. The indemnity against the payables should not be taken into account since they are not liabilities for tax purposes. Since  § 751(b) comes first, Munn realizes $54,000 ordinary income on the deemed sale of his share of the LIFO inventory with a basis of $6,000 (applied against his outside basis) for $60,000. Oppar increases its inside basis in the inventory to $72,000 to reflect the deemed purchase, even when no  § 754 election applies. The remaining $114,000 of the distribution ($174,000 -$60,000 sale price of the LIFO inventory) is a  § 736(b) liquidating distribution applied against his outside basis of $120,000 ($126,000 - $6,000 transferred basis of the LIFO inventory) and results in a capital loss of $6,000 representing the reduction for the deductible items. When Oppar pays the deductible items, it should be entitled only to a deduction of $12,000, representing Propp and Surv's share. Munn should be entitled to deduct his $6,000 share, and should also have$6,000 capital loss, representing Oppar's discharge of his obligation. This is the result that would apply if the deferred deductions could be offset against the  § 751(b) income, but there is no statutory sanction for such an offset. Even if the proper result is reached following this analysis, Munn may not be able to offset the capital gain against the capital loss, in view of the different tax years.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  V. Withdrawal Payments—§ 736

C. Allocating § 736 Withdrawal Payments 

The basic function of  § 736 is not to provide for the tax treatment of withdrawal payments, but to provide for their classification. Once classified, the tax principles governing the payments are determined under other provisions1487—§ 702 for those classified as distributive share under § 736(a)(1);1488  § 707(c) for those payments classified as guaranteed payments under § 736(a)(2);1489 and  § § 731 and 751 for liquidating distributions under § 736(b).1490
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1487 Regs. § 1.736-1(b)(4), (b)(1).

1488 See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for discussions of how partnership operations as taxed to the partners.

1489 See 710 T.M., Partnerships —Conceptual Overview, and 712 T.M., Partnerships —Taxable Income; Allocation of Distributive Shares; Capital Accounts, for discussions of the treatment of fixed payments to service providers as ordinary income instead of a share of partnership income.

1490 See IV, A, and III, D, above, for discussions of the taxation of liquidating distributions in general and the effect of the characterization provision of § 751.

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1. Agreement 

The partners' valuation of a withdrawing partner's interest in partnership property in an arm's-length agreement generally is recognized, because of the adverse interests between the partners with respect to the characterization of withdrawal payments as being for the interest in partnership property to the extent of its value, including goodwill and similar  § 197 intangibles, so that any payment in excess of that agreed value is a  § 736(a) payment.1491 There are apparently few constraints on the agreement of the parties as to the allocation of the payments between  § 736(a) and § 736(b) payments. There is no Code provision, as there is for special allocations, requiring that the allocations have substantial economic effect or not have a tax-avoidance purpose.1492 The regulations only state that “generally” the partners'agreement will be respected, but the agreement may not be respected when there is no arm's-length dealing, for example, in family partnerships.1493 If the partners do not value the withdrawing partner's interest in partnership property, however, the IRS or the courts may do so.1494 Since liability adjustments are payments,1495 the relevant value of the partner's interest in partnership assets should be a gross value, not a valuation of the partner's equity or capital account.
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1491 Regs. § 1.736-1(b)(1).

1492 Compare  § 736 and Regs.  § 1.736-1(b)(1) with § 704(b)(2) and Regs.  § 1.704-1(b)(1)(i) and (2)(i); see McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.02[5] (3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.02[2](6th ed. 1997); Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements, § 203.3.2.

1493 Regs. § 1.736-1(b)(1), (4); McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.02[2] (3rd ed. 1997).

1494 See Champlin v. Comr., T.C. Memo 1977-196 (liquidation agreement became part of partnership agreement; finds liquidation, not sale of interest based on a “careful examination of the record and all the factors affecting the negotiations between the parties”). See also Quirk Est. v. Comr., T.C. Memo 1988-286, 55 T.C.M. (CCH) 1188 aff'd, 928 F.2d 751 (6th Cir. 1991) (value and character of retiring partner's interest determined, even though such issues were the subject of litigation in state court; values on partnership's financial statements adopted, because taxpayer failed to produce contrary evidence).

1495 See IV, A, 2, above, for a discussion of the treatment of liability shifts in liquidating distributions.

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Example: Effect of Agreement. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. When Munn withdraws, he is entitled to a cash payment of $100,000 based on a reasonable formula based on earnings. The parties the parties reasonably agree Oppar's assets are worth only $90,000, including § 197 intangibles. Munn's outside basis in his Oppar interest is $85,000. Munn recognizes$5,000, presumably capital, gain on the Oppar interest. The remaining$10,000 should be a guaranteed payment under § 736(a). If a  § 754 election applies, Oppar reduces the inside basis of its assets to reflect the gain, but not the guaranteed payment, which is deductible.

2. Ordinary Losses 

There is no provision equivalent to  § 751 for allowing a withdrawing partner a share of unrealized ordinary losses on withdrawal. Thus, applying the entity principle, if a partnership has inventory that has declined in value below its cost (but cannot be written down),1496 or  § 1231 property that is worth less than basis, so that sale would produce ordinary loss, any loss resulting from a liquidating distribution that is less than the withdrawing partner's outside basis produces capital loss. If the withdrawing partner's share of loss property can feasibly be distributed to the loss partner and sold while it is still ordinary income property the loss can be transferred, assuming the withdrawing partner's outside basis is sufficient to allow the partnership's high basis to carry over. Maintaining the character is easy for  § 751 property, because  § 735 preserves the character of even loss property, but may be more difficult for § 1231 property. The distributee must establish that the distributed property qualifies as  § 1231 property based on post-distribution activities. When the share of loss property cannot feasibly be distributed—because it is property the partnership needs, because the withdrawing partner's share is only a portion of the loss asset, or otherwise—the difficulties are often insuperable.
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1496 See Thor Power Tool v. Comr., 439 U.S. 522 (1979) (no deduction for write-down of inventory of obsolete parts and tools, even though proper under generally accepted accounting principles, when the taxpayer did not reduce price, and continued to sell some).

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Taxpayers have had mixed success in using self-help. Thus, a distribution of loss inventory followed by its resale to the partnership was, predictably, disregarded on step-transaction grounds, so that the withdrawing partner realized capital loss.1497 Similarly, a distribution of an undivided interest in loss  § 1231 property, followed by a series of steps that resulted in the undivided interest being transferred to one of the remaining partners and recontributed to the partnership also failed.1498 A more ingenious, or luckier, partner did succeed in getting ordinary  § 1231 loss treatment when the share of the loss property was not recontributed to the partnership, but leased to it by the purchaser.1499
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1497 See Kinney v. U.S., 228 F. Supp. 656 (W.D. La. 1964), aff'd per curiam, 358 F.2d 738 (5th Cir. 1966).

1498 See Crenshaw v. U.S., 450 F.2d 472 (5th Cir. 1971).

1499 See Harris v. Comr., 61 T.C. 770 (1974).

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Example: Ordinary Loss for Withdrawing Partner. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp's outside basis in her Oppar interest is $100,000. Propp receives a liquidating distribution of $50,000 in cash and inventory worth $30,000, with an inside basis to Oppar of $50,000. These amounts represent her pro rata share of § 751 property, and other property, so that there is no constructive exchange under § 751. The $50,000 cash distribution reduces Propp's outside basis to $50,000. Since the inventory has a transferred basis to equal to $50,000, because her outside basis equals Oppar's inside basis, her loss on sale of the inventory at its $30,000 value is ordinary. If the sale is directly or indirectly to Oppar, however, the distribution and sale are likely to be collapsed into a cash distribution of $80,000, resulting in capital loss on the Oppar interest. The same result should follow if the property distributed is a  § 1231 asset, for example, improved land previously used in Oppar's business that has become surplus, because Oppar has closed the business operation previously conducted there. Since there is no provision preserving the character of the real estate, Propp will have to demonstrate some use in her trade or business to prevent the property's being converted to investment property. If only an undivided interest in the surplus real estate is distributed to Propp any sale to Oppar, an Oppar partner, a person related to an Oppar partner, or even a third party who contributes the property to Oppar is likely to be viewed as a sale of Propp's Oppar interest, producing capital loss. On the other hand, if Propp leases the undivided interest to Oppar on arm's-length terms, and then sells the property, the leasing should preserve the  § 1231 character of the property, and the sale should avoid step-transaction problems, if the purchaser continues leasing indefinitely.

3. Deferred Payments or Distributions 

When partnership liquidity problems make it appropriate to arrange to make the payments to the withdrawing partner over a period of time, the distributee remains a tax partner until the final payment is made, and complex rules for allocation of the payments come into play.1500 Withdrawing partners generally recognize gain only when the total amount of  § 736(b) payments exceeds the outside basis of the partnership interest,1501 and loss only when all liquidating distributions have been received, since the loss is not fixed until then.1502
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1500 Regs. § 1.736-1(b)(5), (6).

1501 Regs. § § 1.731-1(a)(1), 1.736-1(b)(6).

1502 Regs. § 1.731-1(a)(2).

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Each installment is allocated between  § 736(a) and  § 736(b) payments.1503 Since  § 736(b) payments are measured by the value of the withdrawing partner's interest in partnership assets at the date of withdrawal, any allowance, express or implied, for deferral of  § 736(b) payments is appropriately allocable to  § 736(a) payments since it reflects the time value of money, which is properly reflected as ordinary income to the withdrawing partner and ordinary deduction for the partnership. On the other hand, there is no requirement —as there is for sales of property — that an interest factor be included in characterizing the payments,1504 so that an arm's-length agreement that ignores the time value of money in fixing withdrawal payments, perhaps by placing a value on the partnership interest that is on the high side, should be respected.
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1503 Regs. § 1.736-1(b)(5).

1504 See § 1274; Regs. § 1.1274-2.

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Fixed payments are generally allocated ratably to the overall amounts of the two kinds of payment—§ 736(b) and  § 736(a) payment, but fixed payments received are first allocated to the  § 736(b) share.1505 Contingent payments are also allocated first to  § 736(b) payments, to the extent there are no fixed payments, or fixed payments are not sufficient, with the remaining(or all) treated as  § 736(a) payments—as guaranteed payments or distributive share as appropriate.1506 This allocation system delays the withdrawing partner's ordinary income, but also delays the partnership's deduction.1507 In a service partnership, payments for receivables and unspecified goodwill are  § 736(a)(2) guaranteed payments, and not payments for a share of partnership property. In contrast, when there are sales of partnership interests for deferred payments, the installment method generally applies to the gain on the partnership interest, but not to any amount attributable to  § 751 property.1508
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1505 Regs. § 1.736-1(b)(5)(i), (7) Ex. 1. The possible receipt of additional amounts does not convert a fixed payment into a contingent one.

1506 Regs. § 1.736-1(b)(5)(ii). See Quirk Est. v. Comr., T.C. Memo 1988-286, 55 T.C.M. (CCH) 1188, aff'd, 928 F.2d 751 (6th Cir. 1991) (dispute as to value of assets did not convert fixed amount for assts into contingent payments).

1507 Regs. § 1.736-1(b)(5).

1508 See Rev. Rul. 89-102, 1989-2 C.B. 100 (installment method does not apply to portion of proceeds of sale of partnership interest attributable to [substantially] appreciated inventory; presumably would now apply to all inventory); CCA 200722027 (same for unrealized receivables). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of sales of partnership interests, including installment sales.

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The distributee and all remaining partners can agree to the allocation of the payments and, thus, change the timing of the withdrawing partner's ordinary income, and gain or loss, and accelerate the partnership's deduction, but they may not allocate more (and, presumably, not less) than the fair market value of the withdrawing partner's share of partnership property to  § 736(b) payments.1509 Similarly, payments apply against the distributee's outside basis first, and loss is delayed until the final payment,1510 unless the distributee elects ratable inclusion of gain or loss when all  § 736(b) payments are fixed.1511 Although  § 751(b) may apply to a portion of the  § 736(b) payments, the regulations do not address the allocation of the  § 736(b) payments between  § 751 property and other property. Given that the ratable inclusion election does not apply to  § 736(b) payments attributable to  § 751 property,1512 and the general approach of  § 751(b) to treat the  § 751 exchange first,1513 the first  § 736(b) payments are allocable to the  § 751(b) exchange.1514 There is, however, apparently no constraint on the parties' agreeing to accelerate  § 736(a) payments before § 736(b) payments, presumably because the  § 736(a) payments are likely to be ordinary income, which can allow the partnership to accelerate the deduction for any express or implicit allowance for the time value of money. Because the amount of the  § 736(b) payment is determined by the value of the distributee's share of partnership property at the date of withdrawal, the  § 751(b) exchange should include a ratable share of  § 751 property unless the parties otherwise agree. Nevertheless, if a  § 754 election applies, the basis adjustment to the partnership corresponds in timing and amount with gain recognized by the withdrawing partner.1515 This, of course, means that the partnership and distributee normally have adverse interests in any negotiation to change the default allocation and timing rules.
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1509 Regs. § 1.736-1(b)(5)(iii);Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.05[4](6th ed. 1997); McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ ¶ 22.02[4][a]and 22.05[4] (3rd ed. 1997).

1510 Regs. § 1.731-1(a)(2).

1511 Regs.  § § 1.736-1(b)(6) and (7) Exs. 1 and 2, 1.731-1(a)(1), 1.731-1(a)(2).

1512 Regs. § 1.736-1(b)(6).

1513 See III, D, above, for a discussion of the application of  § 751 to create a taxable exchange in an otherwise nonrecognition distribution.

1514 Regs. § 1.751-(b)(3)(iii); See Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements § 203.4.4.2 (1995).

1515 Rev. Rul. 93-13, 1993-1 C.B. 126.

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Example: Allocating Deferred Liquidating Distributions. Munn, Propp and Surv are equal (one-third)partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar has $90,000 cash and investment (capital gain) property, including goodwill, with inside basis of $60,000 and a value of $120,000 (total basis, $150,000, value$210,000). Each partner's outside basis in the Oppar interest is $50,000. Munn is to receive $8,000 per year for 10 years, plus 10% of Oppar net income over the same period, in liquidation of his Oppar interest.$7,000 (one-tenth of Munn's share of the value of Oppar's assets)of each fixed payment is a  § 736(b) payment, and the balance is a  § 736(a)(2) guaranteed payment, taxable as ordinary income. The contingent payments are  § 736(a)(1) distributive share payments, taxable as allocable shares of Oppar income. Unless Munn elects otherwise, the first $50,000 payments are return of his outside basis, deferring his $20,000 gain until the eighth and subsequent payments. If a  § 754 election applies, Oppar adjusts the inside basis of its capital and  § 1231 property, for Munn's$20,000 gain only in the eighth through tenth years as Munn recognizes gain. The election does not affect the  § 736(a) payments. Even though Munn's payments for his share of Oppar property are made over 10 years, no portion of the payments is taxed, and deducted, as interest under the OID or imputed interest rules, although the classification as part of the  § 736(a) payments has a similar effect. The  § 736(a) guaranteed payment and distributive share are, presumably, the partners' adjustment to recognize the time value of money, and other values of Munn's contribution to Oppar that are not reflected in the value of Oppar's property, including goodwill, so that a portion of the  § 736(a) payments implicitly recognizes the interest element of the deferred payments.

The agreement of all partners can change the allocation between  § 736(a) and § 736(b) payments, for example, by providing all of the payments are  § 736(b) payments until the payments total $70,000 (the first seven years), and then all fixed payments are  § 736(a) payments. They could presumably also make the first $30,000 fixed payments  § 736(a) payments and the last $70,000  § 736(b) payments. They probably cannot make all the fixed payments  § 736(a) payments, leaving only the contingent payment up to $70,000 as  § 736(b) payments, since there can only be  § 736(a) payments after payment for the share of partnership property has been provided.

Munn can elect to allocate his outside basis over the payments, in which case, $5,000 of each fixed payment is return of basis, $2,000 represents Munn's capital gain on his Oppar interest, with the remaining $1,000 is still a  § 736(a)(2) guaranteed payment. The entire amount of each contingent payment is a  § 736(a)(1) distributive share payment, characterized by Oppar's income. If a  § 754 election applies, Oppar adjusts the inside basis of its capital and  § 1231 property, by Munn's$2,000 each year, instead of waiting until the eighth and subsequent years.

If Munn's fixed payment is only $6,000, and the contingent payment is 15% of Oppar's income, the full amount of each fixed payment is a  § 736(b) payment, as is each contingent payment until Munn receives a total of $10,000 in contingent payments. Any excess contingent payments are a  § 736(a)(1) distributive share. Munn treats the first $50,000 of fixed and contingent payments as return of his outside basis, the next $20,000 as gain on his Oppar interest. If Munn elects to allocate his basis, Munn recognizes $1,000 capital gain on each fixed payment and additional gain on each contingent payment that is a  § 736(b) payment, until he has recognized the $20,000 gain on his Oppar interest. If a  § 754 election applies, Oppar adjusts its inside basis as Munn recognizes gain. The parties, apparently, cannot agree that any fixed payments are  § 736(a) payments.

If Oppar's assets are cash and fixed assets with a basis and value of $30,000, and substantially appreciated inventory with a basis of $18,000 and a value of $180,000; and each partner's outside basis is $36,000, the  § 751(b) exchange apparently comes first out of the  § 736(b) payments. If this is so, the first $60,000 of the fixed payments (the first eight years and part of the ninth year with $8,000 fixed payments, and, presumably all fixed payments with $6,000 fixed payments) are part of the  § 751(b) exchange. Thus, in effect, 10% ($18,000 inventory basis/$180,000 value) of each payment is a recovery of Munn's outside basis and the rest is ordinary income. This means $6,300 of ordinary income under  § 751(b) in each of the first eight years and $3,600 in the ninth year (total $55,000) when the fixed payments are $8,000, and $5,500 each year when the fixed payments are $6,000. The parties can, apparently, agree to alter these amounts by putting the  § 736(a) payments first or last, or in some other pattern.

If Oppar is a service partnership with cash and fixed assets having a basis and a value of $30,000, and unrealized receivables of $180,000 with a zero basis (total basis, $30,000, value$210,000; and each partner's outside basis is $10,000, $1,000 of each payment is a  § 736(b) payment, the $6,000 allocable to the unrealized receivables is a  § 736(a)(2) guaranteed payment, and the remaining $1,000, as well as all contingent payments, is a  § 736(a) guaranteed payment, and the contingent payments are representing unspecified goodwill, implicit interest, mutual insurance, or whatever. If the fixed payment is only $6,000, $1,000 is the  § 736(a) payment, and the$5,000 balance, plus, apparently, the first $1,000 of the contingent payment is for unrealized receivables, with the balance of the contingent payments for the rest of the  § 736(a) categories, for whatever difference that may make. The parties can, apparently, agree to alter these amounts by putting the  § 736(a) payments first or last, or in some other pattern.

4. Section 736 Distributions in Kind 

Although the use of the word “payments”in  § 736 could be read to indicate that  § 736(a) applies only to cash payments, the better reasoning is that it applies to any distributions in liquidation of a partner's interest.1516 Indeed, since a  § 736(b) payment is clearly a  § 731 liquidating distribution as is confirmed by the numerous references in the  § 736 regulations to  § § 731 and 732,1517 every case and example dealing with property in a liquidating distribution is a case or example of a  § 736(b) payment in kind.1518 Moreover, since  § 736 is a characterization provision, to deal with  § 736(a) payments, it inherently relies on  § § 702 and 707(c), neither of which are not limited to money any more than  § § 731 and 732. In short, there is no more reason to conclude that property cannot be a  § 736 payment than to conclude that property must be a  § 731 distribution. The paucity of authority may have reflected the difficulty of dealing with possible gain recognition on distributions in kind for  § 736(a) payments.1519 The IRS has recently faced up to the issue in ruling that gain is recognized on use of property for guaranteed payments.1520 One interesting thing about the ruling is that it does not cite any of the long-standing authority that paying compensation or expenses with property results in gain.1521
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1516 There is indirect regulatory support for this interpretation. The original proposed  § 736 regulations excluded distributions of property. Former Prop. Regs. § 1.736-1(a)(2), 20 Fed. Reg. 5854, 5871 (8/12/55). This language was dropped from the final regulations. See McKee, Nelson, &  Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.06 (3rd Ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.06[1] (6th ed. 1997).

1517 Regs. § 1.736-1(a)(2), (b)(1), (b)(6) and (b)(7) Exs. 1 and 2 (all refer to § 731);Regs.  § 1.736-1(a)(2) (refers to § 732).

1518 See IV, A and B, above, for a discussion of liquidating distributions, including those dealing with distributions of property.

1519 See PLR 8538094 (expressly refuses to rule on the  § 736(a) consequences of liquidating distributions in kind to partners withdrawing when the partnership incorporates).

1520 See Rev. Rul. 2007-40, 2007-25 I.R.B. 1426 (gain recognized on property distributed in satisfaction of guaranteed payment; it is not a distribution under § 731).

1521 See, e.g., International Freighting Corp. v. Comr., 135 F.2d 310 (2d Cir. 1943) (gain recognized on transfer of corporate stock to employees as bonus); U.S. v. Davis, 370 U.S. 65 (1962) (gain recognized on transfer of appreciated stock to ex-wife in divorce property settlement; before enactment of § 1041).

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Another concern may have been difficulty in allocating property distributions between  § 736(a) and  § 736(b) payments.1522 Although a sensible rule might be to allocate any property distributions first to  § 736(b) payments and any money distributions first to  § 736(a) payments, the regulations do not do so, and, arguably the ratable allocation provisions may be considered inconsistent with this suggestion.1523 On the other hand, the permission for the parties to change the allocation by agreement provides a practical solution for parties who are well advised,1524 but also opportunities for planning, for example, by allocating loss property to guaranteed payments.1525 As discussed in the next paragraph, there should be no gain on distribution of property for distributive share payments. Accordingly, the only relevance of the valuation of the property distributed even for  § 736(a) payments seems to be for gain (or loss) recognition for guaranteed payments and for capital accounting.1526
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1522 See IV, B, 2, above, for a discussion of some of practical problems of allocating basis for the distributee when there is a series of payments.

1523 Regs. § 1.736-1(b)(5)(i), (ii).

1524 Regs. § 1.736-1(b)(5)(iii).

1525 See Rev. Rul. 2007-40, 2007-25 I.R.B. 1426.

1526 Regs. § 1.704-1(b)(2)(iv)(e), (f).

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Since  § 736(a)(1) distributions represent shares of partnership income, and are properly charged to the withdrawing partner's capital account, it is the allocation, not the distribution, that is the income recognition event. Under this approach, the distribution is applied against the capital account and outside basis without regard to source. Thus, distributions that represent  § 736(a)(1) distributive share payments, should similarly be credited to the capital account and outside basis, and in-kind distributions applied against them in the same manner as any other in-kind distributions, whether labeled  § 736(b) payments, or simply nonrecognition distributions under § 731. The tax consequences get even more complicated (as can be imagined), if unrealized receivables are distributed.1527
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1527 See V, B, 1, a, above, for a discussion of the treatment of unrealized receivables in service partnerships.

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On the other hand, since  § 736(a)(2) guaranteed payments are fixed in amount and do not go through the capital account, the partnership recognizes gain on distribution of appreciated property for such obligations,1528 but loss may be limited under  § 704(b) or § 267. When there are both money and property distributions, the property distributions should be allocated first to  § 736(b) payments(liquidating distributions), and any agreement of the partners so providing should be respected.1529 Since there is no direct authority on point, however, there can be no guarantee that the IRS will respect the agreement. The tax consequences are substantially different where property other than money constitutes a payment to a withdrawing partner under § 736, depending on which assets constitute  § 736(b) amounts, and which constitute  § 736(a) amounts.
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1528 See Rev. Rul. 2007-40; McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 13.03[5] (3rd ed. 1997); but see Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.06[4] (6th ed. 1997).

1529 See Rev. Rul. 2007-40;Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 15.06[4](6th ed. 1997); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 22.06[1][b] (3rd ed. 1997).

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The special treatment of traditional unrealized receivables as  § 736(a) payments can create theoretical problems, when withdrawing general partners of a service business receive shares of such receivables in kind as part of continuing a portion of the business after withdrawal. If the distribution of the receivables is considered a payment, the effect is immediate income for the withdrawing partner and the partnership, and an immediate deduction for the continuing partners measured by the value of the receivables.1530 There is no sound policy reason for such a result. The better approach is to treat the withdrawn receivables as part of an exchange under § 751(b). At least to the extent that the receivables distributed in kind represent the withdrawing partner's share, it is hard to see them as a “payment” for that share. An alternative approach is to treat the fees as income to the partnership, simultaneously distributed to the withdrawing partner when collected,1531 but this inappropriately keeps the withdrawing partner a tax partner until the last collection, and requires reporting of all collections by the departing partner on the partnership return.
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1530 See McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships, ¶ 22.06[2][b] (3rd ed. 1997).

1531 See Ware v. Comr., 906 F.2d 62 (2d Cir. 1990), aff'g T.C. Memo 1989-165, 57 T.C.M. (CCH) 105 (fee of law firm client that withdrawing partner originally claimed was an unrealized receivable; payment to (actually collection of half of fee by) withdrawing partner was ordinary income).

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Example: § 736 Distributions in Kind. Munn, Propp and Surv are partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar's balance sheet is:
Assets	Basis	Value	
Cash	$80,000	$80,000	
Capital Asset #1	 5,000	 75,000	
Capital Asset #2	 10,000	 80,000	
Capital Asset #3	 25,000	 5,000	
Total	$120,000	$240,000	

Capital	Basis	Value	
Munn Capital	$40,000	$80,000	
Propp Capital	40,000	80,000	
Surv Capital	 40,000	 80,000	
Total	$120,000	$240,000	

Propp's capital account and outside basis are$40,000. If Propp receives $80,000 cash in liquidation of her interest, she recognizes $40,000 of capital gain, but if she receives Capital Asset #2, she defers the gain and has a transferred and exchanged basis of $40,000 in Capital Asset #2. If a  § 754 election applies, Oppar reduces the inside basis of its other capital assets to reflect Propp's gain, or Propp's basis increase in Capital Asset #2.

If the Oppar partnership agreement provides that Propp is to receive $80,000 in cash and Capital Asset #3 in liquidation of her interest, and the facts indicate that the extra $5,000 in value does not represent goodwill or other asset value, $80,000 of the liquidating distribution is a  § 736(b) payment and the remaining $5,000 must represent a  § 736(a)(2) guaranteed payment, even in a capital partnership. If the partners agree, and the agreement is respected, as it should be, that $5,000 of the cash represents the § 736(a)(2) payment, Propp recognizes $5,000 ordinary income on the  § 736(a)(2) guaranteed payment, with Oppar receiving an equivalent deduction. Propp also recognizes $35,000 gain on receipt of the balance of the cash, and receives Capital Asset #3 with a zero basis. If a  § 754 election applies, Oppar adjusts the inside basis of its other assets for Propp's gain and for the lost basis on Capital Asset #3. If the partners agree, and the agreement is respected, that the cash is the  § 736(b) payment and Capital Asset #3 is the  § 736(a)(2) guaranteed payment, Propp recognizes $40,000 gain on the cash liquidating distribution, and $5,000 ordinary income on the  § 736(a)(2) guaranteed payment even though it is in kind. Oppar recognizes a capital loss of $20,000 on the use of Capital Asset #3 to pay a fixed obligation taxed as a guaranteed payment. Since Propp is not a 50+% partner, there is no impediment to deduction of the loss. If a  § 754 election applies, Oppar adjusts its inside basis for Propp's gain, but has turned the otherwise lost basis on Capital Asset #3 into a current loss, one that should be allowed even with no  § 754 election. This may lead the IRS and the courts to reject the agreement, and supports the suggestion that in-kind distributions should be allocated first to  § 736(b) payments.

If the distribution is both Capital Asset #2 and Capital Asset #3, some portion of the in-kind distribution must be allocated to the  § 736(a)(2) guaranteed payment. In the absence of statutory or regulatory guidance or an agreement of the partners, a ratable allocation seems appropriate. This results in allocating $75,290 of the value of Capital Asset #2 and $4,710 of Capital Asset #3 to the § 736(b) distribution on which no gain or loss is recognized with an equivalent transferred basis for Propp limited by the outside basis of her Oppar interest, and the remaining portion of each Capital Asset to the  § 736(a)(2) payment ($4,710 of Capital Asset #2 and $290 of Capital Asset #3), with an equivalent portion of the gain or loss recognized and a fair market value basis for Propp. This mess also gives Propp a split holding period. There is no basis for requiring an allocation solely to the gain property, but it is not clear that an agreement to allocate the loss property should be respected.

If the extra $5,000 value is not a fixed amount, but the result of allocating to Propp an extra share of Oppar income in the year of withdrawal, or later, these complications should not exist. Since the $5,000 is allocated to Propp's capital account, it is the allocation—not the distribution—that is the taxable event. The distribution in money, or in kind, is simply an additional nonrecognition distribution under § 731.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Detailed Analysis 
  V. Withdrawal Payments—§ 736

D. Successor to a Deceased Partner 

The transfer of a partner's interest on death is a disposition that does not result in gain or loss recognition, even if the liability share exceeds outside basis.1532 Since death is a disposition that terminates the decedent's entire interest in the partnership, the partnership's tax year closes at the date of death for the deceased partner, so that the income for the period prior to death is included on the decedent's final return.1533 Prior to 1998, death was not itself a terminating event, so that partnership income for the entire year of death was reported by the deceased partner's estate or other successor.1534
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1532 See Manning & Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities (Part Four),”11 Tax Mgmt. Real Est. J. 263, 272 (1995); del Cotto and Joyce, “Inherited Excess Mortgage Property: Death and the Inherited Tax Shelter,” 34 Tax L. Rev. 569 (1979).

1533 § 706(c)(2)(A). Note that REG-144689-04, 74 Fed. Reg. 17119 (4/14/09), would amend Regs. § 1.706-1(c) to reflect § 706(c)(2)(A), which requires that the taxable year of the partnership close with respect to a partner who dies. The proposed amendment would apply for partnership taxable years that begin after the date the final regulations are published, but not before taxable years beginning after Dec. 31, 2009. See IV, E, above, for a discussion of allocation of income when the partnership's tax year closes for a partner.

1534 Pre-1997 § 706(c)(2)(A). See also Regs. § 1.706-1(c)(3)  (now obsolete, but not yet deleted). Even prior to 1998, the partnership tax year terminated for a deceased partner when a buy-sell or similar arrangement terminated the deceased partner's interest as of the date of death. Cf. Prop. Regs. § 1.706-1, REG-144689-04, 74 Fed. Reg. 17119 (4/14/09).

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While there is an estate tax, a partnership interest transferred at death has a stepped-up basis, to estate tax value, plus the estate's share of partnership liabilities (since estate tax value is net of liabilities),1535 but if estate tax repeal becomes permanent, the basis will be the lesser of the decedent's basis or fair market value, with a limited step-up in basis to preserve existing exemptions from the estate tax and for spousal transfers.1536 Unfortunately, under the entity approach, unless an election under  § 754 applies, the estate or other successor may risk being taxed on the results of subsequent partnership operations that increase basis, possibly above value to the extent attributable to built-in gain or income at the estate tax valuation date.1537
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1535 § 1014(a), (b) Regs. § 1.1014-1(a), (b); § 742; Regs. § 1.742-1.

1536 § 1022, as added by 2001 Tax Relief Act, P.L. 107-16, § 542.

1537 See Dupree Est. v. U.S., 391 F.2d 753 (5th Cir. 1968) (in absence of  § 754 election, decedent's successor taxed on share of gain when partnership property sold giving basis far in excess of value; no loss on subsequent distribution of notes received as proceeds even though face amount of notes less than basis of interest as increased for share of gain); see also Maule and Starczewski, “IRS Hot Asset Regs. Re-Tuning Falls Flat, Causing Sharp Pain for Partner Estates,” 94 Tax Notes 751 (Feb. 11, 2002) (regrets that amendment to  § 751 regulations to take into account  § 704(c) adjustments eliminated a limited application of  § 732(d) that ameliorated the issue in some circumstances, and suggests further amendment to resolve issue; assumes step-up in outside basis for inventory items; does not discuss IRD items).

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1. Section 754 Election or Substantial Built-In Loss 

A  § 754 election allows the successor the benefit of a step-up in the inside basis of its share of partnership assets to reflect the step-up in basis of its partnership interest.1538 Under a 2004 amendment to § 743(b), there is, however, a mandatory downward adjustment when the partnership has a substantial (more than $250,000) built-in loss, for the excess of the successor's proportionate share of the inside basis of partnership assets over the outside basis of the partnership interest.1539 The aggregate principle, however — and, consequently, the  § 754 election does not apply to property that would be treated as IRD under § 6911540 — if held directly by the deceased partner, including  § 736(a) payments,1541 and other unrealized receivables,1542 so that there is no step-up in basis for these at death.1543 The  § 754 election does not apply to inventory in the traditional sense.1544 Accordingly, a transferee of a partnership interest on death does not adjust basis for any portion of the value attributable to items of IRD, so that no portion of the  § 743(b) basis adjustment is allocated to those items.1545 In applying the residual method for determining the value of  § 197 intangibles,1546 including goodwill, items of IRD are included in determining partnership gross value, even though they are not entitled to a basis step-up.1547 This, presumably, reflects that IRD items are included in determining the value of the gross estate, and should affect the hypothetical liquidating distribution that is the basis for determining partnership gross value. Even if there is no  § 754 election in effect, the successor may obtain a similar result for a liquidating property distribution from the partnership within two years of the date of death, if the successor makes an election under § 732(d).1548
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1538 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of how the adjustment works;since making the  § 754 election may result in increases or decreases in the inside basis of partnership property for continuing and transferee partners, the decision to make the election may involve conflicts among the partners, and other ethical issues. When the partnership attorney, in effect, represents all partners, there should be informed written consent to the conflict and other ethical issues. A form of Representation Letter dealing with similar issues at the withdrawal stage is included in the Working Papers.

1539 § 743, as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(b), effective Oct. 22, 2004.

1540 § § 1014(c), 691(a)(1); Regs. § 1.691(a)-1(b). See 862 T.M., Income in Respect of a Decedent; for a comprehensive treatment of IRD.

1541 See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the consequences to a withdrawing or deceased partner and the partnership of  § 736(a) payments.

1542 See V, D, 4, below, for a discussion of the judicial and administrative expansion of the concept of income of respect of a decedent on the death of a partner.

1543 § 1014(c). See Woodhall v. Comr., T.C. Memo 1969-279, 28 T.C.M. (CCH) 1438, aff'd, 454 F.2d 226 (9th Cir. 1972). There is a similar principle for S corporations. § 1367(b)(4).

1544 See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 71 (1954); S. Rep. No. 1622, 83d Cong, 2d Sess. 99, 406 (1954).

1545 Regs. § 1.755-1(b)(4)(i).

1546 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of how the value is determined in applying the  § 743(b) inside basis adjustment.

1547 Regs. § 1.755-1(a)(4)(i)(C).

1548 Regs. § 1.732-1(d)(1)(iii);see III, C, 2, b, above, for a discussion of the mechanics and effect of the  § 732(d) election.

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If the  § 754 election applies at the date of death, the successor is entitled to an inside basis adjustment, since the basis step-up at death (as long as there is an estate tax) is equivalent to a purchase.1549 As indicated above, under a 2004 amendment to § 743(b), there is a mandatory downward adjustment when the partnership has a substantial(more than $250,000) built-in loss, for the excess of the transferee partner's proportionate share of the inside basis of partnership assets over the outside basis of the partnership interest, but with special rules for investment and securitization partnerships.1550 To the extent that adjustment has not been used when the successor's interest is liquidated, the remaining partners succeed to it.1551 If no  § 754 election was in effect for the date of death, but the deceased partner's interest is liquidated shortly thereafter, the absence of the election at the time of death makes little difference, because, at least as long as there is an estate tax, the step-up in basis at death limits gain. If an election applies at the time of liquidation of the successor's interest, there is little or no adjustment to the inside basis of the partnership's assets, because the adjustment is based on gain recognized.1552 There is a trap for the unwary when a § 754 election is not in effect for the year of death, but is for the year in which the deceased partner's interest is liquidated, if the liquidation is in kind. If property with a low inside basis is transferred to the successor as part of a liquidating distribution there is a reduction in the inside basis of partnership assets for the excess of the outside basis of the successor's partnership interest over the inside basis of the distributed property. This does not occur if the election applies at date of death, because the inside basis is adjusted for the basis step-up at death, or, even when no  § 754 election applies, for any basis adjustment under § 732(d).1553 Moreover, even when the inside basis adjustment does not apply to distributed properties, any unused inside basis adjustment for the decedent's successor shifts over to other partnership properties, thus, offsetting any downward adjustment.
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1549 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the inside basis adjustment on sale of a partnership interest.

1550 § 743, as amended by the American Jobs Creation Act of 2004, P.L. 108-357, § 833(b), effective Oct. 22, 2004. See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the 2004 amendment to § 743(b).

1551 Regs. § 1.734-2(b)(1).

1552 § 734(b); Regs. § 1.734-1(b)(1).

1553 Regs. § 1.734-1(b)(1)(ii). See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of inside basis adjustment on sale of a partnership interest, which also applies to the basis step-up at death; and V, D, 2, below, for a discussion of the election for a successor to a deceased partner(or other transferee partner) to elect similar basis adjustments for distributions within two years of acquisition.

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Example: Effect of § 754 Election at Death or at Distribution. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Oppar's assets are:
Asset	Basis	Value	
Cash	$80,000	$80,000	
Capital Asset #1	  30,000	120,000	
Capital Asset #2 	  10,000	  40,000	
Total	$120,000	$240,000	

Each partner's interest is worth $80,000 and each has an outside basis of $40,000, so that after Munn's death, his successor's outside basis becomes $80,000, if there is an estate tax. If no election under  § 754 applies for the year of Munn's death, the successor is not entitled to an inside basis adjustment to reflect the basis step-up. If a  § 754 election applies, the inside basis in Capital Asset #1 is increased by one-third of inherent gain, that is, $30,000 for Capital Asset #1 and $10,000 for Capital Asset #2, solely for the benefit of Munn's successor. Thus, if either or both capital assets are depreciable, Munn's successor is entitled to depreciate the adjustment over the useful life of the asset, as if purchased on the date of death, while continuing to share in Oppar's depreciation of the remaining Oppar inside basis. If the successor receives a current distribution of either asset, the transferred inside basis includes the  § 734(b) inside basis adjustment, so that the successor's basis in Capital Asset #2 is $20,000 ($10,000 as the general inside basis + $10,000 for the § 734(b) adjustment).

If a  § 754 election applies for the year of Munn's death, and the successor's interest is liquidated by payment of cash, the successor's unused $40,000 inside basis adjustment is transferred to Oppar, so that the inside basis of Capital Asset #1 increases from $30,000 to $60,000 and of Capital Asset #2 from $10,000 to $20,000. If the liquidating distribution is $40,000 in cash and Capital Asset #2, the unused $30,000 adjustment for the Capital Asset #1 transfers to Oppar, but Oppar has an offsetting negative adjustment for the increase in the successor's basis for Capital Asset #2, from the $20,000 adjusted inside basis to the remaining$40,000 of the outside basis of the successor's Oppar interest (after reduction for the cash distribution), so that the net increase in inside basis for Oppar for Capital Asset #1 is only from $30,000 to$40,000. The result is, apparently, the same if Oppar did not have or make the  § 754 election, but Munn's successor made the  § 732(d) election. Of, course there is no such adjustment made if there was no election. The successor succeeds to Munn's capital account (the special allocation regulations apply).

Moreover, if no  § 754 election applies at Propp's death, it is too late to make the election for the year of liquidation of the successor's interest, since the Oppar inside basis adjustment is based on the successor's gain, and there is no gain because of the basis step-up. The situation is even worse if the distribution is $40,000 cash and Capital Asset #2, as the successor's basis step-up is $30,000, resulting in a $30,000 negative adjustment to the basis of Capital Asset #1, without any offsetting unused adjustment for that asset, reducing its basis to zero. If the reduction was more than the inside basis, the excess is held in suspense until Oppar acquires another capital or  § 1231 asset.

2. Successor's Basis Adjustment Without § 754 Election—§ 732(d) 

Even if a  § 754 election that is needed to give the successor to a deceased partner (or purchaser of a partnership interest) the benefit of a basis adjustment reflecting the date of death value (or the purchase price) does not apply, the successor (or purchaser) may make a  § 732(d) election,1554 without partnership approval, that provides the successor (or purchaser partner) the benefit of the same special basis adjustment as a  § 754 election,1555 but only if the partnership distributes the assets for which there would have been a basis adjustment or like-kind property to the purchasing partner within two years of purchase.1556 There does not seem to be any reason for a successor to make a  § 732(d) election when there is a substantial built-in loss.
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1554 The  § 732(d) election is made by the distributee partner's attaching a schedule to the income tax return setting out (i) the election to adjust the basis of distributed property under  § 732(d) and(ii) the computation of the basis adjustment and its allocation of the adjustment to the distributed properties. Regs. § 1.732-1(d)(3). The election must be made in the year of the distribution if includes depreciable, depletable or amortizable property, but if not then the election can wait until the first year in which basis has tax significance. Regs. § 1.732-1(d)(2).

1555 Regs. § 1.732-1(d)(1)(i), (iii).

1556 § 732(d); Regs.  § 1.732-1(d)(1)(i) to (iii).  See III, C, 2, b, above, for a discussion of the effect of the election in current distributions, and IV, C, 3, b, above, for a discussion of the mandatory application of the  § 732(d) adjustment in certain circumstances.

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The adjustment is computed under  § 743(b) relating to sales or transfers of partnership interests, and not under  § 734(b) relating to distributions.1557 The amount of the adjustment is based on the excess of the successor's outside basis in the partnership interest over the successor's ratable share of the partnership's inside basis.1558 The adjustment is notionally made to the inside basis of the partnership's property owned on the date of purchase, for purposes of determining the transferred inside basis to the distributee under § 732, and is allocated to all partnership properties whether distributed or not.1559 If any property for which the transferee has a notional inside basis adjustment is distributed to another partner, the adjustment for the distributed property is reallocated to remaining partnership property.1560 The inside basis is, however, not adjusted for interim depreciation or depletion between the date of purchase and the date of distribution.1561 A partner who receives a distribution of property with respect to which another partner has a  § 743(b) adjustment is not entitled to take into account the other partner's  § 743(b) adjustment, but the partner with the  § 743(b) adjustment reallocates the special basis adjustment to other like-kind property remaining in the partnership.1562 This provides complete relief for liquidating distributions. Since the distributed basis of capital and  § 1231 assets equals the outside basis of the purchaser, the principal effect of the election is to prevent distortions caused by the basis allocation rules that allocate only gains or losses,1563 while the allocations under  § 743(b) can include both positive and negative amounts.1564
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1557 Regs. § 1.732-1(d)(1)(iii). See III, C, and IV, C, above, for discussions of the adjustment of the inside basis of partnership property in connection with current and liquidating distributions, respectively.  See 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of adjustments under  § 743(b) for sales and other dispositions of partnership interests.

1558 § 743(b)(1); Regs. § 1.743-1(b), (c), and (d).

1559 Regs.  § § 1.732-1(d)1(vi) Ex., 1.743-1(g)(1) and (5) Ex. (ii).

1560 Regs. § 1.743-1(g)(2), (5) Ex. (iv).

1561 Regs. § 1.732-1(d)(1)(iv).

1562 Regs. § § 1.743-1(g)(2), 1.755-1(c).

1563 § 732(c); Regs. § § 1.732-1(c).  See IV, B, 1, above, for a discussion of the allocation of basis to distributed property in a liquidating distribution.

1564 § 743(b), Regs. § § 1.743-1(e), 1.755-1(c). See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a comprehensive treatment of the allocation of the inside basis adjustment for the benefit of the purchaser or other transferee.

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To the extent that the distribution includes § 751 property, or other property in lieu of the distributee's interest in  § 751 property,  § 751(b) applies first,1565 as do the mixing bowl rules.1566 The role of  § 732(d) is limited to determining the basis of the other property in the deemed exchange.1567 The partnership is required to supply the successor who notifies it of the election with the information needed to compute the adjustment.1568 Capital accounts are adjusted to reflect basis adjustments under  § 732(d) to the extent they properly correspond to changes in book value.1569
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1565 § 751(b); Regs. § § 1.751-1(b), 1.732-1(d)(5). See III, D, above, for a discussion of when nonpro rata current distributions involving changes in shares of ordinary income property are treated as taxable exchanges.

1566 § § 704(c)(1)(B), 737; Regs. § § 1.704-4, 1.737-1 to -5. See III, E, above, for a discussion of how unrealized  § 704(c) income may be taxed on distributions of contributed property to others, or of other property to the contributor.

1567 Regs. § 1.732-1(d)(5).

1568 Regs. § 1.732-1(d)(5).

1569 Regs. § 1.704-1(b)(2)(iv)(m)(3), (5).

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Example: Liquidating Distribution to Successor with § 732(d) Election. Munn, Propp and Sess are equal(one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Sess acquired the Oppar interest one year ago on the death of Surv, an original partner. The estate tax value of Surv's interest was $200,000. No § 754 election was in effect at Surv's death. Oppar owns four capital or  § 1231 assets, three with a basis of $200,000 each, but with different values: Property#1 worth$500,000 ($300,000 inherent gain), Property#2 with a value of $650,000($450,000 inherent gain), Property#3 with a value of $50,000 ($150,000 inherent loss), and Property#4 with a basis of $1,200,000 and a value of $2,400,000 ($1,200,000 inherent gain). Accordingly, the total basis of Oppar's assets is $1,800,000, their total net value is $3,600,000, and the net inherent gain is $1,800,000 ($300,000 Property#1 + $450,000 Property#2 - $150,000 Property#3 + $1,200,000 Property#4). The outside basis of Munn and Propp in their Oppar interests is $600,000 each, while the outside basis of Sess's interest is, of course $1,200,000, or $600,000 more than her one-third ($600,000) share of the inside basis of Oppar's assets. Pursuant to a buy-sell agreement, Oppar distributes Property#1, Property#2 and Property#3 to Sess in complete liquidation of her interest in Oppar. Sess's basis in the distributed properties is not limited by the $600,000 inside basis of the assets to Oppar, but is the $1,200,000 outside basis of her Oppar interest, which also equals the total value of the properties distributed. Under the basis allocation rules of § 732, however, the basis of the individual assets is not the same as their value because there is no negative allocation to Property#3. The $600,000 appreciation is allocated to Property#1 and Property#2 in proportion to their 80% shares of the total gain ($750,000 ($300,000 Property#1 and $450,000 Property#2)) so that Sess's basis in Property#1 is $440,000($200,000 inside basis + $240,000 (80% of $300,000 inherent gain))v. its $500,000 value; in Property#2 is $560,000 ($200,000 inside basis + $360,00 (80% of $450,000 inherent gain)) v. its $650,000 value;and in Property#3 is its $200,000 inside basis v. its $50,000 value. The $150,000 inherent loss in Property#3, has, in effect, been allocated$60,000 to Property#1 ($500,000 value - $440,000 basis) and$90,000 to Property#2 ($650,000 value - $560,000 basis). If Sess makes the  § 732(d) election, each distributed property has a basis equal to its value.

3. Valuing Deceased Partner's Interest 

Since a partnership interest owned at death is included in the gross estate, valuing the partnership interest for estate tax purposes has been a major concern, particularly in family limited partnerships and LLCs.1570 The outside basis of the deceased partner's interest is determined by the value for estate tax purposes, which is the value a willing purchaser would pay a willing seller both knowledgeable and free of compulsion,1571 as long as there is an estate tax,1572 and, thereafter to the extent of the limited step-up that remains, up to $1,300,000 in value of assets, or up to $3,000,000 for certain transfers to surviving spouses.1573
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1570 See 722 T.M., Family Limited Partnerships and Limited Liability Companies, for a comprehensive treatment of valuation and other issues related to such family entities, many of which valuation issues also relate to non-family partnerships.

1571 Regs. § § 20.2031-3. See 809 T.M.,  Estate Planning for Owners of Closely Held Business Interests; and 831 T.M., Valuation of Corporate Stock, for comprehensive treatments of valuation issues valuation of partnership interests and other closely held businesses for estate tax purposes.

1572 § 1014.

1573 § 1022(b), (c).

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a. Buy-Sell Agreements 

An arm's-length buy-sell or redemption agreement may fix the value of the interest, even when the option price is less than the fair market value of the decedent's partnership interest as of the date of death of the partner.1574 The agreement must:(i) be a bona fide business arrangement, and not a device to transfer the interest to the natural objects of the decedent's bounty,1575 which requires that the option price approximate the fair market value of the shares at the time of agreement;1576 (ii) apply for dispositions of the decedent's shares during life, limiting the lifetime price to that at death,1577 so that a mere right of first refusal to meet an outside offer is not enough, but an option to purchase at the stated price at the time of a proposed sale apparently is;1578 and (iii) obligate the decedent's estate to sell, but does not have to obligate the partnership or other partners to buy, and may have to be specifically enforceable.1579
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1574 Regs. § 20.2031-2(h). See 700 T.M., Choice of Entity; 809 T.M., Estate Planning for Owners of Closely Held Business Interests;and 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703 and 2704, for a comprehensive treatment of buy-sell agreements.

1575 Compare Hoffman v. Comr., 2 T.C. 1160, aff'd on other grounds sub nom Giannini v. Comr., 148 F.2d 285 (9th Cir. 1945) (option unilaterally granted by decedent, who had no wife or issue, to brother to acquire partnership interest did not fix value since brother was natural object of bounty); with Gloeckner Est. v. Comr., 152 F.3d 208 (2d Cir. 1998) (respects agreement price when transferred control to unrelated employee whom decedent wanted to have and to run business; held not to be natural object of bounty of bachelor who left residuary estate to nephews and nieces;reverses Tax Court); Reynolds Est. v. Comr., 55 T.C. 172 (1955), acq. (agreement not testamentary because of purpose to ensure continuity of management); Bensel v. Comr., 100 F.2d 639 (3d Cir. 1938) (agreement between father and son valid where they were estranged, the son was a valued employee, and the option was given to retain him with the business).

1576 See, e.g., True Est. v. Comr., 390 F.3d 1210 (10th Cir. 2004), aff'g T.C. Memo 2001-167, 82 T.C.M.(CCH) 27 (buy-sell agreement using book values was a substitute for a testamentary disposition, even if there was also a valid business purpose when book value price not reasonably equivalent to fair market value, or arm's-length bargaining;opinion includes detailed review of law in the area).

1577 See, e.g., Matthews Est. v. Comr., 3 T.C. 525 (1944), acq. (stock included in gross estate at fair market value not option price because agreement did not restrict transfers during life);Chaplain Est. v. Comr., T.C. Memo 1974-39 (transfer to sons pursuant to buy-sell agreement within three years of death for less than adequate consideration did not keep value of stock out of gross estate); Gannon Est. v. Comr., 21 T.C. 1073 (1954) (agreement did not fix estate tax value, because it did not cover lifetime transfers); PLR 8634004 (agreement to sell to employees not binding during life did not fix estate tax value, but decedent's successors did not make a gift on sale under the agreement).

1578 See e.g., Weil Est. v. Comr., 22 T.C. 1267 (1954), acq. (estate tax value set by agreement that prohibited transfers during life); Broderick v. Gore, 224 F.2d 892 (10th Cir. 1955) (agreement to sell at book value to sons, the surviving partners, fixed estate tax value); Salt Est. v. Comr., 17 T.C. 92 (1951), acq.(executed purchase option fixed estate tax value); Wilson v. Bowers, 57 F.2d 682 (2d Cir. 1932) (preferential right to purchase stock at decedent's death fixed estate tax value).

1579 See Reynolds Est. v. Comr., 55 T.C. 172 (1955), acq. (first refusal price a relevant valuation factor); Lomb v. Sugden, 11 F. Supp. 472 (W.D.N.Y. 1935) (agreement that could not be specifically enforced did not fix estate tax value), rev'd, 82 F.2d 166 (2d Cir. 1936) (appellate court held that agreement could be specifically enforced under New York law).

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The estate freeze rules1580 may apply to a partnership buy-sell agreement that provides an option price that is less than the fair market value of the partnership's assets, when the partners are related.1581 Specifically, under § 2703, for purposes of the estate, gift and generation-skipping taxes, buy-sell agreements and other restrictions on property are disregarded for valuation purposes, unless they are: (i) bona fide business arrangements: (ii) not intended to transfer property to a family member for less than full consideration;and (iii) comparable to similar arrangements entered into in an arm's-length transaction.1582 Although § 2703 is directed at family buy-sell agreements, it applies to all agreements, regardless of the identity of the parties, but the regulations provide that it is deemed satisfied when more than 50% of the value of the property subject to the agreement is owned by nonfamily members.1583 There is no express requirement that the price be binding during life, but that is probably implicitly required by the arm's-length agreement requirement.1584
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1580 § § 2701 to 2704.

1581 § § 2701 to 2704 were added to the Code by § 11602(a) of the Revenue Reconciliation Act of 1990 (1990 RRA), P.L. 101-508. See 835 T.M., Chapter 14, for a comprehensive treatment of the estate freeze rules.

1582 Regs.  § 25.2703-1(a) and (b). See Blount Est. v. Comr., T.C. Memo 2004-116 (buy-sell agreement disregarded where no valid evidence that was comparable to arm's-length agreements, even though beneficiaries were employee-beneficiaries of ESOP who were not natural objects of decedent's bounty; also not binding during decedent's life).

1583 Regs. § 25.2703-1(b)(3); see Lauder Est. v. Comr., T.C. Memo 1994-527, 68 T.C.M. (CCH) 985 (subsequent determination of value; rejects application of agreement in willing-buyer/willing seller analysis; takes family control purpose agreement into account in valuation); PLR 8634004 (agreement to sell to employees did not fix estate tax value, because not binding during life; sale pursuant to agreement not gift, because arm's length;apparent result is loss on sale).

1584 See S. Rep. No. 3209, 101st Cong., 2d Sess. 68 (1990).

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Although these standards are similar to those for buy-sell agreements generally, they may be interpreted more strictly under § 2703.1585 The third requirement involves showing: (i) comparables with a similar time span, (ii) the value at the time of the agreement, (iii) the expected value at time of exercise, and (iv) the consideration for the agreement. Failure to enforce the terms of a buy-sell or other agreement may result in a disguised gift.1586
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1585 See S. Rep. No. 3209, 101st Cong, 2d Sess. 67-68 (1990) (“clarifies” that these are independent tests, and that maintenance of family control assures absence of a device). They probably require not only showing a business purpose for the agreement, but also some indication that the price is fair.

1586 See Snyder v. Comr., 93. T.C. 529 (1989)(failure to convert noncumulative preferred shares to cumulative preferred shares was a continuing gift of foregone dividends); TAM 9420001 (failure to call convertible preferred shares before they become convertible into common shares with a higher value when corporation could afford to redeem shares was gift to holders of preferred shares; follows Snyder); PLR 9315005 (family corporation's failure to exercise option to purchase shares at fixed price, permitting son of majority shareholder to do so, was gift from father to son); PLR 9117035 (son's failure to exercise right of first refusal, permitting sale by father to ESOP at higher price is a gift).

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Example: Effect of Buy-Sell Agreement on Valuation. Propp, Junior, her son, and Dora, her daughter, are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. The three partners are parties to a cross-purchase agreement requiring purchase by the remaining partners at a formula price based on 10 times earnings for the year preceding the death (or other withdrawal)of a partner. The agreement restricts transfers during life by requiring sale at the same formula price. At the time the agreement was executed the formula price was a reasonable estimate of fair market value and the formula is a reasonable one. If Propp dies and Junior and Dora purchase her shares the formula price, which is only $700,000, because Ceeco suffered an extraordinary loss in the year preceding death, the sale price should, nevertheless, determine the estate tax value, since the agreement probably satisfies Regs. § 20.2031-2(h). If, on the other hand, the formula price is based on book value at the time of execution of the agreement, and has not been modified for interim accumulated earnings, the agreement is probably not a bona fide business arrangement, because Propp's life expectancy is shorter than those of the other two partners. There is considerable doubt, moreover, that it also satisfies the buy-sell agreement requirements of § 2703(b). To do so it is necessary to prove that a formula that uses a single year's earnings, without adjustment for extraordinary losses, is of the type used in arm's-length arrangements.

b. Valuation Discounts and Premiums 

The basic approach of valuation under the estate freeze rules is a subtraction method.1587 The value of the partnership, or of the partner's pre-transfer interest, is initially determined under standard valuation methods,1588 but treating all family interests as held by a single individual, thus excluding minority discounts, unless the family is a minority, but apparently permitting discounts for nonmarketablility and blockage.1589 The IRS now recognizes minority discounts in intrafamily transfers.1590 There is major current controversy about the use of family limited partnerships to obtain minority discounts, with some recent cases, in effect disregarding the transfer to the partnership on the ground that the decedent implicitly retained the use of the property.1591 Discounts have the effect of reducing the potential adjustment under a  § 754 election.
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1587 Regs. § 25.2701-3.

1588 Regs. § 25.2701-2(a).

1589 Regs. § 25.2701-3(b)(1), (4)(ii). See TAM 9719001 (gift of shares to three trusts with same trustee, each trust to be divided into three trusts, but with each trust having the same three beneficiaries treated as nine gifts for blockage purposes).

1590 See Rev. Rul. 93-12, 1993-1 C.B. 202 (gifts of all shares of corporation equally to five children valued as separate gifts of minority interests without taking into account overall family control; follows Bright Est. v. U.S., 658 F.2d 999 (5th Cir. 1981)); see TAM 9432001 (minority block valued with discount, even though beneficiary will have majority).

1591 See, e.g., Strangi Est. v. Comr., 417 F.3d 468 (5th Cir. 2005) (property transferred to family limited partnership included in gross estate under  § 2036 because decedent had retained enjoyment of the assets and had not made a bona fide sale). See 722 T.M., Family Limited Partnerships and Limited Liability Companies, for a comprehensive treatment of family limited partnerships, including valuation issues, and other transfer tax issues.

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This is not an unmixed blessing, since the converse of a minority discount is a control premium,1592 but again the courts have been reluctant to go along with the IRS.1593 When there is a premium, the value of the partnership interest is likely to exceed a ratable share of the value of partnership assets, with the excess, presumably, allocated to goodwill, for purposes of any adjustment under a  § 754 election.
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1592 See TAM 9403005 (decedent's controlling block valued as such for inclusion in gross estate, but minority portion transferred to spouse valued with minority discount;relies on Chenowith v. Comr., 88 T.C. 1577 (1987), giving majority block to surviving spouse a greater than pro rata portion of total value of interest); Ahmanson Foundation v. U.S., 764 F.2d 761 (9th Cir. 1981) (reaching similar result for minority block given to charity); TAM 9436005 (“swing”vote characteristic of each of three transfers of 30% interest in corporation enhances value of block).

1593 See, e.g., Simplot Est. v. Comr., 249 F.3d 1191 (9th Cir. 2001), rev'g 112 T.C. 130 (1999) (no premium for voting shares of decedent who owned 23+% of voting shares while siblings owned similar amounts, with one having enough that with decedent's shares would acquire control, and only 2+% of nonvoting shares; 35%marketability discount applied; vigorous dissent); Bosca v. Comr., T.C. Memo 1998-251, 76 T.C.M. (CCH) 62 (gift involved in exchange of controlling voting common for nonvoting common that effectively gave each of two sons 50% of voting power valued as gift of two 25% interests, not one 50% interest; not governed by § 2701); Adams v. U.S., 218 F.3d 393 (5th Cir. 2000) (minority or other discounts allowed for general partnership interest when not clear whether death of partner gives estate right under state law to demand pro rata share of liquidation value); Mellinger Est. v. Comr., 112 T.C. 26 (1999) (did not aggregate individual and QTIP holdings in determining value of surviving spouse's interest in closely held corporation (Frederick's of Hollywood)); Strangi Est. v. Comr., 115 T.C. 478 (2000), aff'd, rev'd and rem'd, 293 F.3d 279 (5th Cir. 2002) (allowed IRS's 31% discount for 99% limited partnership interest, rather than estate's claimed 44%, with comment that IRS may have been overly generous;vigorous dissents would have found lack of economic substance and no discount; some would also tax an amount equal to the discount as a gift; reversal and remand on refusal of Tax Court to allow IRS to add a claim under  § 2036) on remand T.C. Memo 2003-145; 85 T.C.M. (CCH) 1331 (property transferred to limited partnership included in gross estate under § 2036); Godley Est. v. Comr., 286 F.3d 210 (4th Cir. 2002) (Tax Court not clearly erroneous in applying lack of marketability discount, but no minority discount for 50% interest; minority discount is factual valuation issue).

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The value so determined is then reduced by:(i) any senior family interests not subject to the estate freeze rules and (ii) any applicable retained interests using the valuation principles of § 2701, which generally gives such interests a zero value, unless they are qualified payments—the equivalent of cumulative preferred stock.1594 The remaining value of the pre-transfer interest is then allocated among the transferor, and appropriate family members in a manner that allocates the effect of the special valuation rules in accordance with standard valuation principles.1595 The portion of the family value so determined that is allocated to the interest transferred may be reduced by minority discounts, but in a manner that preserves the full shift in value resulting from applying the special valuation rules.1596 Qualified payments not made when due are, in effect, added to the value of the retained interest with an addition on a compound interest basis using the rate used in discounting the value of the retained interest, after a four-year grace period.1597 The value of the transferred junior interest cannot be less than 10% of the value of the enterprise.1598 Thus, the emphasis is on preventing over-valuation of the retained interest and on assuring that the transferor's estate will ultimately include property related to that value. There are also special rules to prevent double taxation when an interest subject to the special valuation rules is subsequently disposed of by gift or at death.1599
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1594 § 2701(a)(3)(A);Regs. § 25.2701-3(b)(2), (d) Ex. 1;Regs. § § 25.2701-2,-3(d) Ex. 4: See TAM 9447004 (values noncumulative dividend right, conversion right and redemption right determined not to have a fixed time at zero).

1595 Regs. § 25.2701-3(b)(3); see TAM 9447004 (uses an if-converted basis in making this valuation).

1596 Regs. § 25.2701-3(b)(4), (d) Ex. 3; see TAM 9447004 (permits such a discount when retained senior interest valued at zero).

1597 § 2701(d); Regs. § 25.2701-4(c). The four-year grace period apparently does not apply if death, or another triggering event, occurs before payment. Regs. § 25.2701-4(b).

1598 § 2701(a)(4), Regs. § 25.2701-3(c). Value is determined by including indebtedness to family members. § 2701(a)(4)(A)(ii);Regs. § 25.2701-3(c).

1599 § 2701(e)(6); Regs. § 25.2701-5.

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Example: Valuation Discounts. Propp contributes her holdings of real estate and securities, properly appraised at $10,000,000, to a limited partnership, Limpar, with Junior, her son, and Dora, her daughter. Under the Limpar partnership agreement Propp has a capital account of $10,000,000, and a guaranteed payment of the lowest reasonable rate. Dora and Junior have capital accounts of $1,000, each, and receive all profits after Dora's guaranteed payment, but Propp is allocated all losses to the extent of her capital account, with a priority allocation of subsequent income to offset any losses allocated to her, before Junior and Dora receive allocations of future profits. The Limpar partnership agreement satisfies the special allocation regulations. If the general partnership interests of Junior and Dora are considered transferred by Propp, their value cannot be less than$1,000,000 for gift tax purposes, despite Propp's capital account and guaranteed payment, even if, under standard valuation techniques, its value equals its $10,000,000 capital account. On the other hand, when Propp dies owning her limited partnership interest, her estate or other successor can probably claim minority, and nonmarketablility or blockage discounts, unless the court decides she has implicitly received the benefit of the assets of Limpar during her life. If it does so successfully, it of course reduces any § § 743(b)/754 adjustment to basis of the Limpar securities. The discount, presumably, does not affect the successor's right to return of the full $10,000,000 capital account.

4. Income in Respect of a Decedent 

A deceased partner's estate or other successor in interest steps into the shoes of the decedent as a member of the partnership.1600 The decedent's estate or other successor must report income in respect of a decedent(“IRD”), that is, income to which a decedent had a right at the time of death but which, under the partnership's method of accounting, was not properly includible in income on the decedent's final return, for example, accounts receivable of a cash-method taxpayer, or the remaining gain on an installment sale.1601 Items of IRD are not entitled to a basis step-up at death.1602 Nevertheless, in applying the residual method for determining the value of  § 197 intangibles,1603 including goodwill, items of IRD are included in determining partnership gross value.1604
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1600 See Dupree Est. v. U.S., 391 F.2d 753 (5th Cir. 1968) (in absence of  § 754 election, decedent's successor taxed on share of gain when partnership property sold giving basis far in excess of value; no loss on subsequent distribution of notes received as proceeds, even though the face amount of notes was less than the outside basis of the partnership interest as increased for the share of gain).

1601 § 691(a)(1); Regs. § § 1.691(a)-1(b),-2.

1602 § 1014(c).

1603 See 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of how the value is determined in applying the  § 743(b) inside basis adjustment.

1604 Regs. § 1.755-1(a)(4)(i)(C).

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A partnership agreement may provide for withdrawal distributions that include a price based on the value of the decedent's partnership interest at the date of death —  § 736(b) payments1605 — that should be received without tax consequences in view of the step-up in basis at death, as long as there is an estate tax. It may also provide for additional payments based on partnership profits, or a fixed amount —  § 736(a) payments.1606  Section 736(a) payments received by a successor to a deceased partner are IRD.1607 These include: (i)  § 736(a) payments to the successor in liquidation of the decedent's partnership interest, (ii)  § 736(a) payments that the decedent was receiving from an earlier withdrawal that are continued to the successor, and (iii) amounts paid for a third party's acquisition from the successor of a right to receive  § 736(a) payments.1608 In addition, since payments for partnership goodwill in service partnerships that not labeled as for goodwill in the partnership agreement are  § 736(a) payments,1609 they would also become IRD, even though they would be  § 736(b) payments with a basis step-up if labeled goodwill in the agreement. Another thing for the agreement drafter to keep in mind.
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1605 See V, D, 3, a, above, for a discussion of the role of partnership buy-sell agreements in fixing the estate tax value of the decedent's partnership interest.

1606 See Bull v. U.S., 295 U.S. 247 (1935) (treating such amounts as subject to income tax, but not estate tax; prior to enactment of § § 753 and 691). See V, B, above, for a discussion of the treatment of  § 736(a) payments as income.

1607 § 753; Regs. § 1.753-1. The regulations logically expand this to include the distributive share of income for the period ending with death, but in view of the closing of the tax year at death, this seems to be obsolete. Regs. § 1.753-1(b). See 710 T.M., Partnerships — Conceptual Overview, for a discussion of the allocation of income and loss when the partnership tax year closes.

1608 Regs. § 1.753-1(a).

1609 See V, B, 1, b, above, for a discussion of the treatment of unspecified goodwill in service partnerships as  § 736 payments.

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The IRS and courts have applied an aggregate approach, despite the fact that  § 753 only refers to  § 736(a) payments, to extend IRD treatment to the decedent's share of partner's share of partnership rights that would be IRD if held individually.1610Potential depreciation recapture is not an unrealized receivable, and, thus, not IRD for this purpose,1611 presumably, because depreciation recapture is not excluded from the basis step-up for property held directly.1612 Accordingly, the deceased partner's share of partnership assets includes depreciable property at their full value in determining the basis step-up under § 1014(a), without any reduction for any amount that would be subject to recapture if sold, since recapture is not an unrealized receivable for this purpose.1613 Thus, death eliminates the deceased partner's share of potential recapture if a  § 754 election applies. If there is no  § 754 election, the successor is taxed on the recapture as ordinary income when realized by the partnership, with only a capital loss on disposition of the partnership interest as an offset. Similarly, substantially appreciated inventory is not IRD and should not reduce the basis step-up at death.1614 A successor to the shares of a deceased S corporation shareholder treats as IRD a pro rata share of any item of income of the corporation that would have been IRD if that item had been acquired directly from the decedent, and reduces the stepped-up basis in the shares by the portion of the value attributable to IRD items.1615
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1610 Quick Trust v. Comr., 54 T.C. 1336 (1970), acq., aff'd per curiam, 444 F.2d 90 (8th Cir. 1971) (receivables of a cash-method partnership that had ceased operating); Woodhall v. Comr., T.C. Memo 1969-279, 28 T.C.M. (CCH) 1438, aff'd, 454 F.2d 226 (9th Cir. 1972) (same); cf. Rev. Rul. 72-172, 1972-1 C.B. 265 (treats sale of partnership interests to a related corporation as a sale of assets for purposes of applying  § 1239 to tax the sale as ordinary income).

1611 See § 751(c).

1612 See PLR 9715008 (in connection with sale of partnership interest, states that purchase price will be income in respect of a decedent “only to the extent it is allocable to partnership items that would have been income in respect of a decedent had the items been owned directly by the deceased partner(for example, accounts receivable)”).

1613 § 751(c) (flush language).

1614 See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 71 (1954); S. Rep. 1622, 83d Cong, 2d Sess. 99, 406 (1954).

1615 § 1367(b)(4).

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The successor must report IRD when received by the partnership (or the successor), but is entitled to a deduction for any estate tax attributable to inclusion of the right to income in the gross estate,1616 even though the estate tax value of the partnership interest does not include amounts that the deceased partner may have drawn against the income for the year.1617 The same should be true for a guaranteed payment received by the decedent before death, but includible by the successor when the partnership's tax year ends.1618 Similarly the amount reportable on the deceased partner's final return is not reduced for those life-time drawings.1619
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1616 § 691(c); Regs. § § 1.691(c)-1, -2.

1617 Rev. Rul. 67-305, 1967-1 C.B. 229 (successor's distributive share of partnership income not reduced by amounts drawn before death and not includible in gross estate).

1618 Regs. § 1.753-1(b); see Regs. § 1.707-1(c) (guaranteed payment is treated as a partner's distributive share of partnership ordinary income for all purposes with exceptions not relevant here).

1619 See Regs. § 1.706-1(c)(3)(vi) Ex. 4 (under prior law when death did not terminate the deceased partner's tax year, but the same principle should still apply for drawings under current law). See also 710 T.M., Partnerships —Conceptual Overview, for a discussion of the effect of a partner's drawings against the share of current year income.

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Example: Income in Respect of a Decedent. Munn, Propp and Surv are equal (one-third) partners in a law firm operating as a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Surv has no sources of taxable income other than his distributive share of Oppar income. Surv dies on June 30, 20X1. Nevertheless, under the Oppar agreement, she and her successor are entitled to her full share of the income for all of 20X1. Surv's final return reports her distributive share until June 30, 20X1, and the successor reports the share for the rest of the year. Although her share of income up to June 30 was only $90,000 to be reported on her final return, she had drawn $100,000 before her death. Her estate's share of the income for the balance of the year is also $90,000, but it will only receive cash distributions of $80,000. Nevertheless, Surv and her estate each report $90,000 as their respective distributive shares. In determining the estate tax deduction for IRD, the estate is entitled to a deduction for the estate tax attributable to $90,000. The estate (or other successor)is not entitled to a step-up in basis for Surv's share of Oppar's receivables, or any rights to receive  § 736(a) payments, whether attributable to withdrawal before or after death, even if those receivables or  § 736(a) payments are taken into account in determining the value of the Oppar interest for estate tax purposes. On the other hand, if Surv's share of Oppar's assets includes depreciable property worth $100,000 that would be subject to $20,000 depreciation recapture if sold, the full $100,000(not $80,000) is taken into account as the estate tax value that measures the basis step-up under § 1014(a), since recapture is not an unrealized receivable for this purpose.

5. Income in Year of Death 

The partnership tax year closes at death for the decedent, so that the decedent's final return (and not that of any successor) reports partnership income (or loss) for the portion of the tax year prior to death.1620 The result is similar for an S corporation shareholder and successor under the rule that allocates income ratably on the per-share/per-day basis.1621 Death also terminates the deceased partner's own tax year,1622 but if the partner was married, the income may appear on a joint return with the surviving spouse.1623
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1620 § 706(c)(1), (a). See 710 T.M., Partnerships —Conceptual Overview, for a discussion of the allocation of income and loss when the partnership tax year closes.

1621 § 1377(a); Regs. § 1.1377-1; see 730 T.M., S Corporations: Formation and Termination, for a comprehensive treatment of the effects of termination of an S corporation shareholder's interest at death, or otherwise.

1622 § 443(a)(2); Regs. § 1.443-1(a)(2).

1623 § 6013(a)(3); Regs. § 1.6013-1(d).

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Prior to 1997 the tax year did not close on the death of a partner, but the income for the year of death was taxed to the successor in interest, not on the decedent's final return. This could create planning possibilities, or problems from possibly insufficient income to absorb deductions for individuals whose principal source of income was partnership income, and bunching for the partner or successor, when the partnership and the deceased partner had different tax years.1624
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1624 Unfortunately the regulations have not been amended in the more than 10 years since the rule was changed by Taxpayer Relief Act of 1997, P.L. 105-34, § 1246(a), effective for tax years beginning in 1998. See IV, E, above, for a discussion of allocating the income for the year of death.

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Unfortunately, the change did not eliminate all of the problems and planning opportunities, since the short tax year may still leave insufficient income. If the partnership interest does not terminate at death, there still may be ways to deal with insufficient income. If the spouse is the deceased partner's successor in interest, the income for the balance of the partnership year will be included on the spouse's portion of the return.1625 The same result when the partnership interest does not terminate at death can be achieved if the partnership interest is part of the estate but distributed to the surviving spouse before the end of the year.1626
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1625 Regs.  § 1.706-1(c)(3)(iii) (under prior rule when tax year did not close, but principle applies to portion of year taxed to successor).

1626 Regs.  § 1.706-1(c)(3)(vi) Ex. (3) (under prior law when death did not terminate the deceased partner's tax year, but the same principle should apply to income for the balance of the partnership's tax year).

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A partner's draws during the year against the partner's distributive share of partnership income are treated as current distributions that are made on the last day of the partnership's taxable year, taxable only to the extent that they exceed the partner's basis in the partner's interest in the partnership 1627 If the partner receives guaranteed payments rather than an advance against income, the partner does not include the guaranteed payments until the year in which the partnership deducts the payments,1628 which usually means the year after death.
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1627 Regs. § 1.731-1(a)(1)(ii); cf. Regs.  § 1.706-1(c)(3)(vi) Ex. (4) (similar principle for drawings under prior law that should still apply).

1628 Regs. § 1.707-1(c); cf. Rev. Rul. 68-215, 1968-1 C.B. 312 (similar result under prior rule that did not close the partnership's taxable year at death).

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Example: Income for Year of Death. Munn, Propp and Surv are equal (one-third) partners in a law firm operating as a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Propp and Oppar are both on a calendar taxable year. Propp has no sources of taxable income other than Propp's distributive share of Oppar income. Propp dies on June 30, 20X1, so that Oppar's tax year closes for him on that date. She is entitled to a guaranteed payment of $15,000 a month, so that she had collected $90,000 by June 30. Her allocable share of Oppar's residual income for 20X1 up to June 30 is $50,000;Propp's final return reflects only $50,000 Oppar income to offset any deductions or exemptions to which Propp may have been entitled. Under the Oppar partnership agreement, Propp's estate or other successor is entitled to continue collecting her guaranteed payment for the balance of 20X1 and to receive her share of Oppar income for the balance of 20X1. Propp's estate or other successor in interest includes the full $180,000 guaranteed payment (even though Propp had collected$90,000), and the $50,000 balance of her distributive share of Oppar income for 20X1. Even if Propp is married and files a joint return with her husband Harry, the $230,000 is not available on the joint return, which may include deductions incurred in anticipation of the full year's income. If Harry is Propp's successor under the partnership agreement, the $230,000 is available on the final joint return as Harry's income as her successor. If Propp's estate is her successor, but Harry is a residual beneficiary, the same result can be achieved if the executor or personal representative of her estate distributes the Oppar interest to Harry on account of his residuary share before the end of 20X1. The $90,000 share of the guaranteed payment attributable to (and paid to) Propp for the period ending with her death, but included in the successor's income, is income in respect of a decedent.

6. Suspended Losses 

A deceased partner may have losses that could not be deducted because of the basis limitation of § 704(d),1629 because of the at-risk limitations of § 465,1630 or because of the passive loss limitation of § 469.1631 On the death of a partner with losses suspended under the basis limitation of § 704(d), the losses do not pass to the estate, so they are apparently lost.1632 The result is apparently the same for suspended at-risk losses at death.1633 If there is no estate tax and a transferred basis at death, however, the result should be the same as for a gift.1634 If there is a positive at-risk amount and no suspended losses, the successor adds the decedent's at-risk amount to the basis step-up in determining the successor's at-risk amount.1635 On the death of a partner with suspended passive-activity losses, the suspended passive losses generally are allowed on the decedent's final income tax return. The amount of the suspended loss is reduced, however, to the extent that the basis of the decedent's partnership interest for the decedent's successor exceeds the adjusted basis of the partnership interest in the hands of the decedent immediately before death.1636 If the suspended losses of the decedent are not allowable on the final return due to the stepped-up basis limitation, the suspended losses of the decedent are not allowable to the initial transferee or to anyone else.1637
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1629 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the limitation of loss deductions to outside basis.

1630 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the at-risk limitations, and when liquidation of a partnership interest allows deduction of suspended at-risk deductions; see 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the parallel issues of when disposition of a partnership interest allows deduction of suspended at-risk deductions.

1631 See 710 T.M., Partnerships —Conceptual Overview, and 714 T.M., Partnerships —Allocation of Liabilities; Basis Rules, for discussions of the passive activity loss limitations, and when liquidation of a partnership interest allows deduction of suspended passive activity losses; see 718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination, for a discussion of the parallel issues of when disposition of a partnership interest allows deduction of suspended passive activity losses. See IV, D, above, for a discussion of suspended losses when a partner receives a liquidating distribution.

1632 See Rev. Rul. 74-175, 1975-1 C.B. 52 (decedent's net operating loss and capital loss carryovers do not pass to estate); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 10.05[2] (3rd ed. 1997); Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 8.07[1](6th ed. 1997).

1633 Prop. Regs. § 1.465-69(a); see Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 7.07[2](6th ed. 1997).

1634 See 560 T.M., Income Tax Basis: Overview and Conceptual Aspects, for a discussion of allowance of suspended losses.

1635 Prop. Regs. § 1.465-68.

1636 § 469(g)(2); see Willis, Pennell &  Postlewaite, Partnership Taxation, ¶ 8.08[1](6th ed. 1997). See 560 T.M., Income Tax Basis: Overview and Conceptual Aspects, for further discussion of the effect of  § 1022 if there is no estate tax.

1637 § 469(g)(2)(B).

——————————————————————————————

Example: Suspended Losses at Death. Munn, Propp and Surv are equal (one-third) partners in a partnership, Oppar. The Oppar partnership agreement satisfies the special allocation regulations. Munn's outside basis in his Oppar interest is zero, his at-risk amount is also zero, and he has $70,000 of suspended at-risk losses. Munn dies and bequeaths the Oppar interest to Stuart, when the estate tax value of the interest is $50,000, Stuart's outside basis is $50,000, as long as there is an estate tax. The $50,000 increase in the outside basis of the Oppar interest increases Stuart's at-risk amount by the same $50,000, so that Stuart's basis and at-risk amount becomes $50,000, which is available for future losses.

If, at Munn's death, there are suspended passive losses of $150,000, and the estate tax value is $100,000, since the Oppar interest is stepped up in basis under  § 1014(a) to its estate tax value, the amount of the passive activity losses that may be claimed on Munn's final income tax return is only $50,000 ($150,000 suspended losses minus the $100,000 step-up from Munn's zero basis), and losses equal to the $100,000 basis step-up are gone for good.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

B-101
	
ELECTION STATEMENTS

B-101
	
Worksheet 1
	
Disguised Sale Disclosure Statement (Regs. § 1.707-8(b)(1)).

B-201
	
Worksheet 2
	
Election to Adjust Basis of Partnership Property under § 754 (Regs. § 1.754-1(b)).

B-301
	
Worksheet 3
	
Request for Revocation of § 754 Election to Adjust Basis of Partnership Property (Regs. § 1.754-1(c)).

B-401
	
IRS PRONOUNCEMENTS AND REGULATORY MATERIALS

B-401
	
Worksheet 4
	
Preamble, T.D. 9207, Assumption of Partner Liabilities, 70 Fed. Reg. 30334, 30340 (5/26/2005).

B-501
	
Worksheet 5
	
Preamble, REG-107872-99, Assumption of Partner Liabilities, 68 Fed. Reg.  37434(6/24/2003).

B-601
	
Worksheet 6
	
Preamble, REG-106736-00, Assumption of Partner Liabilities, 68 Fed. Reg. 37434(6/24/2003).

B-701
	
Worksheet 7
	
Preamble, T.D. 8925, Partnership Mergers and Divisions, 66 Fed. Reg. 715 (1/4/2001).

B-801
	
Worksheet 8
	
Preamble, REG-111119-99, Partnership Mergers and Division, 65 Fed. Reg. 1572(1/11/2000).

B-901
	
Worksheet 9
	
Preamble, REG-143397-05, Partner's Distributive Share, 72 Fed. Reg. 46932 (8/22/2007).

B-1001
	
PRACTICE SUPPLEMENTS

B-1001
	
Worksheet 10
	
Draft Form Representation Letter.

B-1101
	
Worksheet 11
	
Checklist of Principal Tax Consequences of Current and Liquidating Distributions.

B-1201
	
Worksheet 12
	
Chart:Partner Withdrawal by Death or Retirement.

B-1301
	
Worksheet 13
	
Sample Redemption Agreement for the Interest of a Partner in a Service Partnership.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 1 Disguised Sale Disclosure Statement (Regs. § 1.707-8(b)(1)) 

DISCLOSURE UNDER § 707 FOR 2001 TAXABLE YEAR 

The taxpayer, Mr. A. Smith, discloses the following information pursuant to Income Tax Regulations § 1.707-3(c)(2)regarding certain transfers made within two years of each other:

(1) The taxpayer, a calendar year taxpayer using the cash method of accounting, is a partner in XYZ, a partnership that calculates income based on the calendar year using the cash method of accounting.

(2) In 2008, the taxpayer contributed undeveloped, unencumbered land with a basis of $500,000 and a fair market value of $1,000,000 to XYZ in exchange for his partnership interest.

(3) In 2001, XYZ transferred $900,000 to the taxpayer.

(4) The taxpayer rebuts the presumption that the transfer was a disguised sale of the land to the partnership, as this presumption is described in Income Tax Regulations § 1.707-3(c)(1), based on the following facts and circumstances:

(a) At the time the land was transferred, XYZ intended to construct a building on the land.

(b) The partnership agreement provided that upon completing construction of the building, the partnership would distribute $900,000 to the taxpayer.

(c) At the time the land was transferred to XYZ, XYZ's ability to make such distribution depended on certain entrepreneurial risks. Specifically, XYZ would be able to fund the transfer to the taxpayer only to the extent that XYZ's permanent loan proceeds, which consisted exclusively of nonrecourse financing, exceeded the cost of constructing the building. This excess would be available only if the cost to complete the building were significantly less than the amount projected by the budget.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 2 Election to Adjust Basis of Partnership Property under § 754(Regs. § 1.754-1(b)) 

KSS Partners

 643 Horace Harding Expressway 

Flushing, NY 

EIN 12-0121962 

KSS Partners hereby elects under Internal Revenue Code Section 754 to apply the provisions of § § 734(b)and 743(b) beginning with the calendar year 20XX (to the return for which year this statement is attached).

/s/___________________________

[partner]

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 3 Request for Revocation of § 754 Election to Adjust Basis of Partnership Property (Regs. § 1.754-1(c)) 

KSS Partners 

643 Horace Harding Expressway 

Flushing, NY 

EIN 12-0121962 

January 4, 20X9

 District Director 

 Holtsville Service Center  

Holtsville, NY  

To the District Director: 

KSS Partners requests IRS approval for a revocation of its Internal Revenue Code Section 754 basis adjustment election, effective for the partnership taxable year ending December 31, 20X8.

Before the tax year 20X8, KSS Partners' assets included inventory, consisting of 10,000 pairs of shoes, and bank accounts totalling $500,000. During the tax year, KSS Partners received partner contributions totalling $1,500,000 and acquired 500 acres of farmland. KSS Partners takes the position that the partner contributions and the acquisition of the farmland qualifies under Regs. § 1.754-1(c)as a change in the nature of the partnership business, a substantial increase in partnership assets, and a change in the character of partnership assets. Accordingly, KSS Partners respectfully requests that the IRS consents to revoke the election.

Very truly yours,

/s/_________________________

[partner]

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 4 Preamble, T.D. 9207, Assumption of Partner Liabilities, 70 Fed. Reg. 30334, 30340 (5/26/2005) 

Editor's Note: T.D. 9397, 73 Fed. Reg. 26321 (5/9/08), finalized the temporary regulations issued by T.D. 9207, making the § 358(h)(2)(B) exception unavailable.

DEPARTMENT OF THE TREASURY 

Internal Revenue Service 
  26 CFR Parts 1 and 602

[TD 9207]

RIN 1545-AX93

Assumption of Partner Liabilities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations; and removal of temporary regulations.

SUMMARY: This document contains final regulations relating to the definition of liabilities under section 752 of the Internal Revenue Code (Code). These regulations provide rules regarding a partnership's assumption of certain fixed and contingent obligations in connection with the issuance of a partnership interest and provide conforming changes to certain regulations. These regulations also provide rules under section 358(h) for assumptions of liabilities by corporations from partners and partnerships. Finally, this document also contains temporary regulations relating to the assumption of certain liabilities under section 358(h). The text of the temporary regulations also serves as the text of the proposed regulations set forth in the notice of proposed rulemaking on this subject in the proposed rules section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective May 26, 2005.

Applicability Dates: The final Section 1.752-6 regulations apply to assumptions of liabilities by a partnership occurring after October 18, 1999, and before June 24, 2003. All of the other final regulations in this Treasury Decision, as well as the temporary regulations under section 358, apply to liabilities assumed on or after June 24, 2003, except as otherwise noted.

FOR FURTHER INFORMATION CONTACT:  Laura Fields at (202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act 

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1843. Responses to these collections of information are mandatory and are required to obtain a benefit. The collections of information in this final regulation is in Section 1.752-7(e), (f), (g), and (h). This information is required for a former or current partner of a partnership to take deductions, losses, or capital expenses attributable to the satisfaction of the Section 1.752-7 liability. This information will be used by the partner in order to take a deduction, loss, or capital expense. An additional collection of information in this final regulation is in Section 1.752-7(k)(2). This information is required to inform the IRS of partnerships making the designated election and to report income appropriately. The collection of information is required to obtain a benefit, i.e., to elect to apply the provisions of Section 1.752-7 of the regulations in lieu of Section 1.752-6. The likely respondents are business or other for-profit institutions and small businesses or organizations.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Estimated total annual reporting burden: 125 hours.

The estimated annual burden per respondent varies from 20 to 40 minutes, depending on individual circumstances, with an estimated average of 30 minutes.

Estimated number of respondents: 250.

Estimated annual frequency of responses: On occasion.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this 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.

Background 

This document contains amendments to 26 CFR part 1 under sections 358, 704, 705, 737 and 752 of the Internal Revenue Code (Code).

As part of the Community Renewal Tax Relief Act of 2000 (the Act)(114 Stat.  2763), Congress enacted, on December 15, 2000, section 358(h), effective October  18, 1999, to address certain situations in which property is transferred to a corporation in exchange for both stock and the corporation's assumption of certain obligations of the transferor. In these situations, transferors took the position that the obligations were not liabilities within the meaning of section 357(c) or that they were described in section 357(c)(3), and, therefore, the obligations did not reduce the basis of the transferor's stock. These assumed obligations, however, did reduce the value of the stock. The transferors then sold the stock and claimed a loss. In this way, taxpayers attempted to duplicate a loss in corporate stock and to accelerate deductions that typically are allowed only on the economic performance of these types of obligations.

Section 358(h) addresses these transactions by requiring that, after the application of section 358(d), the basis in stock received in an exchange to which section 351, 354, 355, 356, or 361 applies be reduced (but not below the fair market value of the stock) by the amount of any liability assumed in the exchange. Exceptions to section 358(h) are provided where: (1) the trade or business with which the liability is associated is transferred to the person assuming the liability as part of the exchange; or (2)substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange. The Secretary, however, has the authority to limit these exceptions. The term liability for purposes of section 358(h) includes any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Code.

Congress recognized that taxpayers were attempting to use partnerships and S corporations to carry out the same types of abuses that section 358(h) was designed to deter. Therefore, in sections 309(c) and (d)(2)of the Act, Congress directed the Secretary to prescribe rules to provide “appropriate adjustments under subchapter K of chapter 1 of the Code to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to) liabilities described in section 358(h)(3) ... in transactions involving partnerships.” Under the statute, these rules are to “apply to assumptions of liability after October 18, 1999, or such later date as may be prescribed in such rules.”

In response to this directive, a notice of proposed rulemaking (REG-106736-00;2003-28 I.R.B. 46) under sections 358, 704, 705, and 752 was published in the Federal Register (68 FR 37434) on June 24, 2003. In addition, temporary regulations (TD 9062)were published on that same day (68 FR 37414). The proposed and temporary regulations provide rules to prevent the duplication and acceleration of loss through the assumption by a partnership of certain liabilities from a partner. Section 1.752-6T of the temporary regulations (the temporary regulations) applies to liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003. Section 1.752-7 of the proposed regulations (the proposed regulations) applies to liabilities assumed by a partnership on or after June 24, 2003. However, taxpayers may elect to apply the proposed regulations, instead of the temporary regulations, to liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003.

The temporary regulations adopt the approach of section 358(h), with some modifications. For example, the exception for contributions of “substantially all of the assets with which the liability is associated” does not apply to certain abusive transactions described in Notice 2000-44, released to the public on August ii, 2000, and published on September 5, 2000 (2000-2 C.B. 255).

The proposed regulations deviate somewhat from the rules of section 358(h). In particular, the proposed regulations do not reduce the partner's basis in the partnership at the time of the assumption of a Section 1.752-7 liability by the partnership, but delay that reduction until an event occurs that separates the partner from the liability(triggering event). The triggering events are: (1) a disposition (or partial disposition) of the partnership interest by the partner; (2)a liquidation of the partner's interest in the partnership; and (3)the assumption of the liability by another partner. After a triggering event, the partnership's (or the assuming partner's) deduction on the economic performance of the Section 1.752-7 liability is limited. However, if the partnership (or the assuming partner) notifies the partner of the economic performance of the Section 1.752-7 liability, then the partner may take a loss or deduction in the amount of the prior basis reduction.

The proposed regulations include an exception, similar to the exception in section 358(h)(2)(A), for transactions in which the partner contributes to the partnership the trade or business with which the liability is associated as part of the exchange (the trade or business exception), but do not include an exception, similar to the exception in section 358(h)(2)(B), for transactions in which the partner contributes to the partnership substantially all of the assets associated with the liability as part of the exchange. The proposed regulations also include an additional exception for situations in which, immediately before the triggering event, the amount of the remaining built-in loss with respect to all Section 1.752-7 liabilities assumed by the partnership (other than Section 1.752-7 liabilities assumed by the partnership with an associated trade or business) in one or more Section 1.752-7 liability transfers is less than the lesser of 10% of the gross value of partnership assets or $1,000,000 (the de minimis exception).

In addition, the proposed regulations provide detailed rules to address the treatment of the liability between the date of the assumption of that liability by the partnership and the date of a triggering event and to address tiered entity situations.

The proposed regulations distinguish between a Section 1.752-1 liability, for which a basis reduction is required when the liability is assumed by the partnership from a partner, and a Section 1.752-7 liability, for which a basis reduction is not required until the occurrence of a triggering event. Under the proposed regulations, an obligation is a Section 1.752-1 liability to the extent 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. All remaining obligations are Section 1.752-7 liabilities. Under the proposed regulations, Section 1.752-7 liabilities are subject to the rules of section 704(c) and the regulations thereunder.

The American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418) (the Act), was enacted on October 22, 2004. Section 833(a) of the Act amended section 704(c) of the Code by adding section 704(c)(1)(C), effective for contributions of property to a partnership after October 22, 2004. Under new section 704(c)(1)(C), if “built-in loss” property is contributed to a partnership, the built-in loss shall be taken into account only in determining the items allocated to the contributing partner, and, except as provided in regulations, in determining the amount of items allocated to the other partners, the basis of the contributed property shall be treated as being equal to its fair market value at the time of contribution. For this purpose, a “built-in loss” is defined to mean the excess of the adjusted basis of the property in the hands of the contributing partner over its fair market value at the time of its contribution to the partnership.

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 the Act, section 743(a) and (b) of the Code requires a partnership to reduce the basis of partnership property upon the transfer 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 such property. Exceptions are provided for electing investment partnerships and for securitization partnerships, as defined in the Act. See also sections 734(b) and (d), as amended by section 833(c) of the Act (requiring a basis adjustment to be made following a distribution from a partnership for which no section 754 election is in effect in the case of a “substantial basis reduction”).

The IRS and the Treasury Department are aware of certain similarities between the treatment of Section 1.752-7 liabilities in these regulations and the treatment of built-in losses under sections 704(c)(1)(C), 734, and 743 of the Code, as added by the Act. For example, it is possible to view the contribution of property with an adjusted tax basis equal to the fair market value of the property, determined without regard to any Section 1.752-7 liabilities, as “built-in loss” property after the Section 1.752-7 liability is taken into account in those cases where the Section 1.752-7 liability is related to the contributed property. Although a partnership's assumption of a Section 1.752-7 liability as part of the contribution of property to the partnership can be analogized to a property with an adjusted tax basis greater than fair market value, the purposes of section 704(c)(1)(C) and Section 1.752-7 are different in certain respects. Section 704(c)(1)(C) and the other changes in section 833 of the Act are directed toward loss duplication whereas Section 1.752-7 is directed at both loss duplication and loss acceleration. Therefore, to the extent of any built-in loss attributable to a Section 1.752-7 liability, Section 1.752-7 shall be applied without regard to the amendments made by the Act, unless future guidance provides to the contrary. Any such guidance would be prospective in application.

Written comments were received in response to the notice of proposed rulemaking, and a public hearing was held on October 14, 2003. Two commentators requested to speak at that hearing. After consideration of the comments, the proposed and temporary regulations are adopted as modified by this Treasury decision.

Explanation of Provisions 

These final regulations generally follow the proposed and temporary regulations with the changes described below.

1. Comments on Section 1.752-6T 

Several commentators suggested that the issuance of Section 1.752-6T exceeded the authority granted to the Secretary in Section 309 of the Act. More specifically, some commentators suggested that Section 1.752-6T results in the inappropriate denial of a bona fide loss, that Section 1.752-6T was issued to bootstrap the IRS's litigating position regarding transactions described in Notice 2000-44 (2000-2 C.B. 255), and that section 309 of the Act only granted the Secretary the authority to prescribe rules to address situations in which a partnership liability is assumed by a corporation. In addition, several commentators argued that the Treasury Department and the IRS exceeded their authority in providing that Section 1.752-6T applies retroactively to assumptions of liabilities occurring after October 18, 1999, and before June 24, 2003, the date the regulations were issued.

The Treasury Department and the IRS believe that Section 1.752-6T does not result in the inappropriate denial of a bona fide loss. The exceptions in Section 1.752-6T generally limit the application of the regulations to transactions that are abusive in nature and that lack a business purpose. In addition, the regulations allow taxpayers to elect into Section 1.752-7 so as to avoid the immediate basis reduction under Section 1.752-6T. Recognizing, however, that some taxpayers may not have expected the approach taken in Section 1.752-7 when engaging in transactions in prior years, Section 1.752-6T employs rules similar to section 358(h) for partnership transactions.

Those commentators who suggested that the IRS issued Section 1.752-6T to “bootstrap”its litigating position in Notice 2000-44 pointed to the fact that Notice 2000-44 did not mention that regulations would be issued in the future to challenge the transactions described in that notice. As discussed earlier, the Act was enacted with a retroactive effective date and granted the Treasury Department and the IRS the authority to issue retroactive regulations. The Treasury Department and the IRS believe that they have appropriately exercised this grant of authority. Also, Notice 2000-44 was released on August 11, 2000.  The Act was not enacted into law until December 15, 2000, after the release of Notice 2000-44. Therefore, the Treasury Department and the IRS could not reference regulations promulgated under the Act in Notice 2000-44.

The Treasury Department and the IRS have concluded that the Secretary's authority under section 309(c) is not limited to addressing assumptions of liabilities by corporations from partnerships. The plain language of the legislative directive is not so limited and the legislative history does not support such a limitation.

To the contrary, the Treasury Department and the IRS believe that the rules of Section 1.752-6T carry out the explicit directive of section 309(c) of the Act by applying to partnership transactions rules that are analogous to the rules that apply to corporate transactions under section 358(h). For example, if the transactions described in Notice 2000-44 were effected through a contribution to a corporation, rather than a contribution to a partnership, section 358(h) would generally apply to such a transaction, causing a basis reduction identical to that provided by Section 1.752-6T.

Section 7805(b) addresses when a regulation(temporary, proposed, or final) may be effective retroactively. Section 7805(b)(1) generally provides that no temporary, proposed, or final regulations relating to the internal revenue laws shall apply to any taxable period ending before the earliest of the following dates: (A) the date on which such regulation is filed with the Federal Register; (B) in the case of any final regulation, the date on which any proposed or temporary regulation to which such final regulation relates was filed with the Federal Register; or (C)the date on which any notice substantially describing the expected contents of any temporary, proposed, or final regulation is issued to the public. However, section 7805(b) provides a list of exceptions to the general rule stated above. Included in that list, and relevant in this context, is section 7805(b)(6). Section 7805(b)(6) provides that the limitation may be superseded “by a legislative grant from Congress authorizing the Secretary to prescribe the effective date with respect to any regulation.” Also included among the exceptions to the general rule in section 7805(b)(1) is section 7805(b)(3). Section 7805(b)(3) states that the “Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse.”

The retroactive effective date of Section 1.752-6T is in accordance with the directive in section 309(c) and(d)(2) of the Act and section 7805(b)(6). Furthermore, pursuant to section 7805(b)(3), the Secretary has determined that a retroactive effective date is appropriate to prevent abuse.

For these reasons, the Treasury Department and the IRS have concluded that  Section 1.752-6T is a valid exercise of the Secretary's regulatory authority under the Code and section 309 of the Act.

2. Extension of Time to Adopt the Provisions of Section 1.752-7 in lieu of Section 1.752-6T 

Section 1.752-6T(d)(2) provides that partnerships may elect to apply the provisions of Section 1.752-7 of the proposed regulations to all assumptions of liabilities by the partnership occurring after October 18, 1999, and before June 24, 2003, in lieu of applying Section 1.752-6T of the temporary regulations. The election must be filed with the first Federal income tax return filed by the partnership on or after September 24, 2003.

Several commentators expressed a need for additional time to make this election. In response to these comments, the election period described in Section l.752-6T(d)(2) has been extended. Under the extension, an election to apply the regulations under Section 1.752-7, rather than the regulations under Section 1.752-6, to all liabilities assumed by a partnership after October 18, 1999, and before June 24, 2003, must be filed with a Federal income tax return filed by the partnership on or after September 24, 2003, and on or before December 31, 2005.

3. Section 1.358-5T, Special Rules For Assumption of
  Liabilities 

The preamble to the proposed regulations advised taxpayers that, with respect to an exchange to which Section 358(a)(1) applies, the Treasury Department and the IRS were considering exercising their authority under Section 358(h)(2) to issue regulations that would limit the exceptions to Section 358(h)(1) to follow the exceptions set forth in the proposed regulations under Section 1.752-7 (other than the de minimis exception). The preamble indicated that such regulations would be retroactive to the extent necessary to prevent abuse. No comments were received regarding the appropriate scope or substance of such regulations. The Treasury Department and the IRS have determined that removing the exception of Section 358(h)(2)(B) (which applies where substantially all of the assets with which the liability is associated are transferred to the person assuming the liability as part of the exchange) is necessary to prevent the abuse that Section 358(h) was designed to prevent. Therefore, with respect to an exchange to which Section 358(a)(1) applies, this document contains temporary regulations providing that the exception contained in Section 358(h)(2)(B) does not apply to exchanges under Section 358(a)(1) in which liabilities are assumed on or after June 24, 2003.

4. Section 1.752-7 Liability 

Commentators have asked for clarification on whether an obligation could be a Section 1.752-1 liability in part and a Section 1.752-7 liability in part. Certain obligations that create liabilities under Section 1.752-1 may also create Section 1.752-7 liabilities. For example, a fixed obligation that gives rise to basis can have a component portion that changes in value between the time the obligation is first incurred by the partner and the time that the partnership assumes the obligation due to changes in interest rates, stock price, or other similar factors. In these and other cases, the value of the obligation to the holder has increased and, as a result, the cost to the obligor has increased by a like amount. The final regulations clarify that an obligation can be treated in part as a Section 1.752-7 liability and in part as a Section 1.752-1 liability.

5. Satisfaction Other than by Economic Performance 

The proposed regulations allow the Section 1.752-7 liability partner to claim a loss or deduction upon “economic performance” of the obligation. Certain Section 1.752-7 liabilities may be settled in cash or in kind, extinguished, satisfied or otherwise resolved under circumstances where there may not be an “economic performance”of the obligation within the meaning of that term. See section 461(h)and Section 1.461-4. In addition, economic performance only applies to “liabilities”as defined in Section 1.446-1(c)(1)(ii)(B), and it is possible that some Section 1.752-7 liabilities may not come within the meaning of that term. As a result, the final regulations allow the Section 1.752-7 liability partner to claim a loss or deduction under Section 1.752-7 upon the “satisfaction of the Section 1.752-7 liability”. A Section 1.752-7 liability is treated as satisfied on the date upon which, but for Section 1.752-7, the partnership, or the assuming partner, would have been allowed to take the Section 1.752-7 liability into account for federal tax purposes. The final regulations provide a nonexclusive list of examples of when the Section 1.752-7 liability would be taken into account for these purposes.

6. Application of Section 704(c) 

Under Section 1.752-7(c), any Section 1.752-7 liability assumed by a partnership in a Section 1.752-7 liability transfer is treated under section 704(c) principles as having a built-in loss equal to the amount of the Section 1.752-7 liability as of the date of the partnership's assumption of the Section 1.752-7 liability. The proposed regulations provide that, if a Section 1.752-7 liability is assumed from the partnership by a partner other than the Section 1.752-7 liability partner, and the trade or business or de minimis exceptions does not apply, then section 704(c)(1)(B) does not apply to the assumption and instead the rules of Section 1.752-7(g) apply. Commentators asked whether section 704(c)(1)(B) applies to the assumption of a Section 1.752-7 liability by another partner if the trade or business or de minimis exceptions apply to that assumption. In addition, commentators questioned whether the successor partner rule of Section 1.704-3(a)(7) applies to the built-in loss amount of the Section 1.752-7 liability. The successor partner rule provides that, if a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner.

The intent of the Treasury Department and the IRS was that all of the rules of section 704(c), Section 1.704-3, and Section 1.704-4, including section 704(c)(1)(B), apply to Section 1.752-7 liabilities unless otherwise specifically stated. The Section 1.752-7 regulations have been modified to make this clear. In addition, Section 1.704-3 has been amended to provide that Section 1.752-7 liabilities are section 704(c) property and to provide that in general, the successor partner rule does not apply to Section 1.752-7 liabilities.

Comments were also received regarding the application of section 704(c) principles to the extent that a Section 1.752-7 liability has decreased after the partnership's assumption of the liability. Consistent with the principles of  Section 1.704-3, the final regulations provide that, if there is a post-assumption change in the value of the Section 1.752-7 liability, resulting in an obligation amount that is either greater or less than the initial amount of the obligation, the change in the amount will be treated as a section 704(b) and not a section 704(c) item, thereby creating book income or loss to be allocated to the partners. The final regulations also provide that, if the value of the Section 1.752-7 liability decreases after the assumption of the obligation by the partnership, the “ceiling rule” applies, and the partnership and the partners are entitled to adopt one of the reasonable methods specified in Section 1.704-3 to correct any ceiling rule disparities.

7. Section 1.752-7 Liabilities that are Capitalized and Not Deducted 

The proposed regulations make reference in several places to a “deduction or capital expense”, but no rules are provided as to how the capital expense is taken into account. For example, no rules are provided in the proposed regulations for situations where the contributing partner is still a partner in the partnership at the time that the obligation is recognized for federal tax purposes and capitalized into the tax basis of one or more assets of the partnership.

The final regulations add a rule to Section 1.704-3 providing that, to the extent a partnership properly capitalizes all or a portion of an item as described in paragraph Section 1.704-3(a)(12), then the item or items to which such cost is properly capitalized is treated as section 704(c) property with the same amount of built-in loss as corresponds to the amount capitalized. Similar rules are provided under Sections 1.704-4 and 1.737-2.

In addition, the proposed regulations do not provide any guidance as to the appropriate tax treatment if a triggering event occurs after a Section 1.752-7 liability has been capitalized into the basis of one or more assets of the partnership. Under the final regulations, no reduction in the partner's basis in the partnership interest is required with respect to such a capitalized amount as a result of the triggering event, but, after the triggering event, neither the partnership nor the remaining partners may use the capitalized basis.

8. Exception for Trading and Investment Partnerships. 

The proposed regulations contain an exception to Section 1.752-7(e), (f), and (g) for assumptions of liabilities in connection with the contribution of an associated trade or business, provided that the partnership continues to carry on that trade or business after the contribution. The proposed regulations provide that, for this purpose, a trade or business generally does not include the activity of acquiring, holding, or disposing of financial instruments, unless such activity is carried on by an entity registered with the Securities and Exchange Commission as a management company under the Investment Company Act of 1940, as amended (15 U.S.C. 80a).

The exception for entities registered as management companies was intended to apply narrowly to master-feeder partnerships; however, it appears that the exception could apply to a broader range of entities, some of which could be carrying on the types of transactions that section 309 of the Act and these regulations were intended to address. Consequently, the Treasury Department and the IRS have removed the exception for entities registered as management companies.

The Treasury Department and the IRS do not believe that eliminating the exception will create a substantial burden for master-feeder partnerships, because interests in these partnerships are not regularly sold, and because distributions by these partnerships typically take the form of nonliquidating distributions of cash. Accordingly, master-feeder partnerships are unlikely to engage in triggering events that would implicate this regulation.

Therefore, under the final regulations, the activity of acquiring, holding, dealing in, or disposing of financial instruments is not treated as a trade or business even if engaged in by an entity registered as a management company. For assumptions of liabilities on or after June 24, 2003, and before May 26, 2005, however, entities registered as management companies may rely on the exception to the trade or business definition in the proposed regulations.

9. Technical Terminations, Mergers, and Divisions 

Section 1.708-1(b) 4) provides that if a partnership is terminated under section 708(b)(1)(B) by a sale or exchange of an interest, the partnership is deemed to contribute all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and, immediately thereafter, the terminated partnership is deemed to distribute interests in the new partnership to the purchasing partner and the other remaining partners.

A commentator asked whether the rules provided in Section 1.752-7 apply to the contribution and distribution of partnership interests deemed to occur under  Section 1.708-i(b)(4). Rules have been added to the final regulations to clarify how the regulations apply to technical terminations and partnership mergers and divisions. These rules are designed to ensure that, after a technical termination, merger, or division, the partners that were Section 1.752-7 liability partners of the prior partnership continue to be Section 1.752-7 liability partners of the new partnership, and that built-in loss associated with the Section 1.752-7 liability does not shift from one partner to another partner. In addition, these rules are designed to ensure that a deemed assumption of a liability as a result of a technical termination of a partnership does not create any new Section 1.752-7 liabilities that did not exist prior to the technical termination.

Accordingly, Section 1.752-7(b)(6)(ii) of the final regulations provides that, in determining if a deemed contribution of assets and assumption of liability as a result of a technical termination is treated as a Section 1.752-7 liability transfer, only liabilities that were Section 1.752-7 liabilities of the terminating partnership are taken into account and, then, only to the extent of the amount of the liability that was subject to Section 1.752-7 prior to the technical termination.

In addition, the definition of a Section 1.752-7 liability partner has been amended to clarify that, if, in a transaction described in Section 1.752-7(e)(3), a partnership(lower-tier partnership) assumes a Section 1.752-7 liability from another partnership (upper-tier partnership), then any partners that were Section 1.752-7 liability partners of the upper-tier partnership continue to be Section 1.752-7 liability partners of the lower-tier partnership with respect to the remaining built-in loss associated with the Section 1.752-7 liability at the time of the assumption of the Section 1.752-7 liability by the lower-tier partnership from the upper-tier partnership. Any new built-in loss associated with the Section 1.752-7 liability that is created on the assumption of the Section 1.752-7 liability from the upper-tier partnership by the lower-tier partnership is shared by all the partners of the upper-tier partnership in accordance with their interests in the upper-tier partnership, and each partner of the upper-tier partnership is treated as a Section 1.752-7 liability partner with respect to that new built-in loss.

The definition of Section 1.752-7 liability partner has also been amended to provide that, if, in a transaction described in Section 1.752-7(e)(3), an interest in a partnership (lower-tier partnership) that has assumed a Section 1.752-7 liability is distributed by a partnership (upper-tier partnership) that is the Section 1.752-7 liability partner with respect to that liability, then the persons receiving interests in the lower-tier partnership are Section 1.752-7 liability partners with respect to the lower-tier partnership to the same extent that they were prior to the distribution. In addition, Section 1.752-7(e)(3) has been amended to provide that a distribution of an interest in a lower-tier partnership is exempt from the application of Section 1.752-7(e) only if the partners that were Section 1.752-7 liability partners with respect to the lower-tier partnership prior to the distribution continue to be Section 1.752-7 liability partners with respect to the lower-tier partnership after the distribution.

10. Disguised Sale Rules 

Section 707(a)(2)(B) provides that where there is a direct or indirect transfer of money or other property by a partner to a partnership and a related direct or indirect transfer of money or property by the partnership to such partner and the transfers, when viewed together, are properly characterized as a sale or exchange, such transfers shall be treated either as a transaction between the partnership and one who is not a partner, or as a transaction between two or more partners acting other than in their capacity as members of the partnership.

Section 1.752-7(a)(2) of the proposed regulations provides that the assumption of a Section 1.752-7 liability is not treated as an assumption of a liability or as a transfer of cash for purposes of section 707(a)(2)(B). One commentator noted that the language contained in the proposed regulations was not consistent with Section 1.707-5(a), which takes into account all liabilities, regardless of whether those liabilities are taken into account under section 752.

The intent of the proposed regulations under section 752 was not to override the disguised sale rules under section 707, which may include Section 1.752-7 liabilities as consideration. Therefore, Section 1.752-7(a)(2) has been removed.

11. Revisions to Section 1.704-1(b)(2)(iv) 

Under section 704(b), a partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) is determined in accordance with the partnership agreement provided that those allocations have substantial economic effect. If the allocations under the partnership agreement do not have substantial economic effect or the partnership agreement does not provide as to a partner's distributive share of partnership items, then the partner's distributive share of such items is determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances).

Section 1.704-1(b) describes various requirements that must be met for partnership allocations to have substantial economic effect. Among these requirements is that (except as otherwise provided in Section 1.704-1(b))the partnership agreement must provide for the determination and maintenance of capital accounts in accordance with the rules of Section 1.704-1(b)(2)(iv).

Section 1.704-1(b)(2)(iv)(b) generally requires that a partner's capital account be increased by the value of property contributed by the partner to the partnership net of liabilities secured by such contributed property that the partnership is considered to assume or take subject to under section 752, and be decreased by the value of property distributed by the partnership to the partner net of liabilities secured by such distributed property that the partner is considered to assume or take subject to under section 752. Section 1.704-1(b)(2)(iv)(c) requires that a partner's capital account be increased by liabilities of the partnership that are assumed by such partner (other than liabilities described in Section 1.704-1(b)(2)(iv)(b)(5)), and be decreased by liabilities of the partner that are assumed by the partnership (other than liabilities described in Section 1.704-1(b)(2)(iv)(b)(2)). The proposed regulations revised Section 1.704-1(b)(2)(iv)(b) to take into account all liabilities to which the contributed or distributed property is subject, not just liabilities described in section 752. The proposed regulations did not revise Section 1.704-i(b)(2)(iv)(c), because that section is not limited to assumptions of liabilities described in section 752.

A commentator suggested that, if all liabilities are covered by  Section 1.704-1(b)(2)(iv)(b), then Section 1.704-1(b)(2)(iv)(c) did not have any effect and should be removed. The final regulations do not adopt this comment, because the Treasury Department and the IRS believe that Section 1.704-1(b)(2)(iv)(c) has significance even though Section 1.704-1(b)(2)(iv)(b) is no longer limited to liabilities described in section 752. Section 1.704-1(b)(2)(iv)(b) applies only to situations in which liabilities are assumed by the partnership or the partner in connection with the contribution or distribution of property, or contributed or distributed property is taken subject to liabilities. Section 1.704-1(b)(2)(iv)(b) does not apply if liabilities are assumed by the partnership or a partner other than in connection with a contribution or distribution;these assumptions are covered by Section 1.704-1(b)(2)(iv)(c).

12. Notification upon Satisfaction of the Section 1.752-7 Liability 

One commentator suggested that, to prevent the loss of a deduction to the  Section 1.752-7 partner, the regulations should require the assuming partnership or partner to notify the Section 1.752-7 liability partner of the satisfaction of the Section 1.752-7 liability. The proposed regulations impose no penalty on the partnership for failure to notify the Section 1.752-7 liability partner. The commentator also suggested that the Section 1.752-7 liability partner be required to keep contact information current with the assuming partnership or partner.

The Treasury Department and the IRS do not believe that imposing additional requirements is necessary in these circumstances. It is anticipated that the  Section 1.752-7 liability partner, upon entering the partnership, will negotiate with the partnership for the necessary notification. Therefore, this comment was not adopted.

13. Treatment of Section 1.752-7 Liabilities 

Commentators have requested that the final regulations include guidance on the recourse or nonrecourse treatment of Section 1.752-7 liabilities for all purposes of subchapter K. Under the proposed regulations, a Section 1.752-7 liability is treated as a nonrecourse liability solely for purposes of Section 1.704-2, dealing with the allocation of nonrecourse deductions among the partners. The only other provision that the Treasury Department and the IRS are aware of for which the characterization of a Section 1.752-7 liability as recourse or nonrecourse is Section 1.707-5 (addressing the treatment of liabilities for purposes of the disguised sale rules of section 707(a)(2)(B)), and Section 1.707-5 already provides adequate rules for determining if a Section 1.752-7 liability is recourse or nonrecourse. Because a Section 1.752-7 liability is not, by definition, a Section 1.752-1 liability, the recourse or  nonrecourse nature of a Section 1.752-7 liability is not relevant for purposes of Sections 1.752-1 through 1.752-5. For this reason, this comment was not adopted.

14. Valuation of Section 1.752-7 Liabilities 

Comments were received requesting that the final regulations include guidance on acceptable methods for identifying and valuing Section 1.752-7 liabilities, as well as identifying the appropriate discount rate for determining the liability's present value.

The Treasury Department and the IRS believe that such matters are best left to the negotiation of the financial arrangement among the parties and are beyond the scope of this regulation. In an arm's length transaction, the parties will take the potential occurrence of these obligations into account in arriving at the agreement among the parties that will govern their affairs, including the appropriate valuation methodology to apply to these obligations. Accordingly, the final regulations do not adopt this comment.

However, the final regulations clarify that, if the obligation arose under a contract in exchange for rights granted to the obligor under that contract, and those contractual rights are contributed to the partnership in connection with the partnership's assumption of the contractual obligation, then the amount of the Section 1.752-7 liability is the amount of cash, if any, that a willing assignor would pay to a willing assignee to assume the entire contract.

Effective Date 

The final Section 1.752-6 regulations apply to assumptions of liabilities by a partnership occurring after October 18, 1999, and before June 24, 2003. All of the other final regulations in this Treasury decision apply to liabilities assumed on or after June 24, 2003, except as otherwise noted.

Special Analyses 

These final and temporary regulations are necessary to prevent abusive transactions involving transfers to partnerships and corporations of the type Section 358(h) was enacted to Prevent. Accordingly, good cause is found for dispensing with notice and public procedure pursuant to 5 U.S.C. 553(b)(B) with respect to the temporary regulations, and for dispensing with a delayed effective date pursuant to 5 U.S.C. 553(d)(1) and (3) with respect to the final and temporary regulations.

It has been' determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that the final regulations in this document will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that few partnerships engage in the type of transactions that are subject to these regulations (assumptions of liabilities not described in section 752(a) and (b) from a partner). In addition, available data indicates that most partnerships that engage in the type of transactions that are subject to these regulations are large partnerships. Certain broad exceptions to the application of these regulations (including a de minimis exception) further limit the economic impact of these regulations on small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. For the applicability of the Regulatory Flexibility Act to the temporary regulations in this document (Section 1.358-5T), refer to the cross-reference notice of proposed rulemaking published in the proposed rules section in this issue of the Federal Register. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking that preceded these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information 

The principal author of these regulations is Laura Nash, Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 5 Preamble, REG-107872-99, Assumption of Partner Liabilities, 68 Fed. Reg. 37434 (6/24/2003) 

Background 

As part of the Tax Reform Act of 1986, Congress enacted section 1060, which generally requires the use of the residual method in order to allocate the purchase price of “applicable asset acquisitions”among individual assets purchased. An applicable asset acquisition is defined as any transfer of assets that constitute a trade or business where the transferee's basis is determined wholly by reference to the consideration paid for the assets. Both direct and indirect transfers of a business were intended to be covered by the provision, including “the sale of a partnership interest in which the basis of the purchasing partner's proportionate share of the partnership's assets is adjusted to reflect the purchase price.” See section 1060(c) and S. Rep. No. 99-313, 1986-3 C.B. Vol. 3 at 254-255.

In July of 1988, the IRS and the Treasury Department issued temporary and proposed regulations, which, among other things, provided guidance concerning the application of section 1060 and coordinated the application of sections 755 and 1060. TD 8215 (1988-2 C.B. 305).

In 1988, shortly after the IRS and the Treasury Department issued its temporary and proposed regulations, Congress enacted section 1060(d), which expressly addresses the extent to which section 1060 should apply to transactions involving partnerships. As amended in 1993, section 1060(d)(1) applies the section 1060 residual method in the case of a distribution of partnership property or a transfer of an interest in a partnership, but only in determining the value of section 197 intangibles for purposes of applying section 755. Section 1060(d)(2)provides that if section 755 applies, such distribution or transfer(as the case may be) shall be treated as an applicable asset acquisition for purposes of section 1060(b) (which imposes certain reporting requirements for applicable asset acquisitions).

Section 755 governs the allocation of certain adjustments to the basis of partnership property among partnership assets. Section 1.755-2T applies the residual method to transfers and distributions which trigger basis adjustments under section 743(b) (involving certain transfers of partnership interests) or section 732(d) (involving certain distributions within two years of a partnership interest transfer) if the assets of the partnership constitute a trade or business for purposes of section 1060(c). Section 1.755-2T(c) contains a cross reference to the reporting requirements applicable to such transfers and distributions.

Explanation of Provisions 

1. Application of Proposed Regulations 

The temporary regulations under section 755 apply only if the assets of the partnership comprise a trade or business within the meaning of section 1060(c), and the basis adjustments are made under section 743(b) or section 732(d). They do not apply the residual method in valuing partnership property for the purpose of allocating basis adjustments under section 734(b). However, the temporary regulations were issued prior to the enactment of section 1060(d)(1), which expressly refers to basis adjustments triggered by partnership distributions, and does not reference a trade or business requirement.

The IRS and the Treasury Department anticipate that the regulations under Sec. 1.755-2, when finalized, will apply to all transfers of partnership interests and partnership distributions to which section 755 applies, and not just to transfers and distributions relating to partnerships conducting a trade or business. This approach is consistent with the language of section 1060(d) and is supported by language contained in the legislative history. See H.R. Rep. No. 100-795, at 70 n.34(1988) (the IRS is not precluded from applying the residual method under other provisions of the Code).

Proposed Sec. 1.755-2(d) contains a cross reference to the reporting requirements applicable to such transfers and distributions.

2. Basis Adjustments Under Section 743(b) or 732(d) 

In the case of a basis adjustment under section 743(b) or section 732(d), the proposed regulations determine the fair market value of partnership assets in two steps. In most situations, it first is necessary to determine partnership gross value. Second, partnership gross value must be allocated among partnership property.

(a)Partnership gross value. In general, partnership gross value equals the amount that, if assigned to all partnership property, would result in a liquidating distribution to the partner equal to the transferee's basis in the transferred partnership interest immediately following the relevant transfer (reduced by the amount, if any, of such basis that is attributable to partnership liabilities). Here, the amount paid for the partnership interest provides the frame of reference for valuing the entire partnership.

In the case of basis adjustments which are triggered by an exchange of a partnership interest 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 (transferred basis exchange), the transferee's basis does not necessarily have any connection to the value of partnership assets. Accordingly, a transferred basis exchange provides no frame of reference for valuing partnership assets. Furthermore, if the valuation rules which apply to other transfers were applied to transferred basis exchanges, then partners could use these exchanges to shift basis from capital gain assets to ordinary income assets, or vice versa. The proposed regulations do not provide a rule addressing transferred basis exchanges. Comments are requested as to how the residual method should apply if basis adjustments under section 743(b) are triggered by transferred basis exchanges, or if basis adjustments under section 732(d) relate to prior transferred basis exchanges.

(b)Allocating partnership gross value among partnership property. Once determined, partnership gross value is allocated among five classes of property, as follows: first among cash and general deposit accounts(including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions (referred to hereafter as cash); then among partnership assets other than cash, capital assets, section 1231(b)property, and section 197 intangibles (referred to hereafter as ordinary income property); then among capital assets and section 1231(b) property other than section 197 intangibles; then among section 197 intangibles other than goodwill and going concern value; and finally to goodwill and going concern value (referred to hereafter as goodwill).

In determining the values to be assigned to assets in the third, fourth, and fifth classes, properties or potential gain within these classes that are treated as unrealized receivables under the flush language in section 751(c) are not counted as assets in the second class. To provide otherwise would be inconsistent with the residual method, because the residual method is justified, at least in part, by the fact that goodwill is not readily subject to valuation. Where goodwill is subject to amortization under section 197, the portion of the intangible that is subject to recapture under section 1245 will be treated as an unrealized receivable under the flush language of section 751(c). To assign value to this portion of the asset in the second class would require a determination that the goodwill has a value equal to at least the amount of the recapture. If these assets are not readily subject to valuation, this determination presumably could not be made. Accordingly, in allocating value among the five classes under the residual method, it is appropriate to include properties or potential gain treated as unrealized receivables under the flush language of section 751(c) within the overall class to which the underlying property belongs rather than treating the section 751(c) portion of such property as a separate asset included in the second class.

Although properties or potential gain treated as unrealized receivables under the flush language of section 751(c) are not included in the second class of assets under these proposed regulations for purposes of allocating value, they are treated as separate assets that are ordinary income property for purposes of allocating basis adjustments among such assets under Sec. 1.755-1.

With respect to allocating value within the asset classes, in general, if the value assigned to a class is less than the sum of the fair market values of the assets in that class (determined without regard to the residual method), then the assigned value must be allocated among the individual assets in proportion to their fair market values. Although, as discussed above, it is not appropriate to treat properties or potential gain treated as unrealized receivables under the flush language of section 751(c) as separate ordinary income assets, it is appropriate to allocate value within each class by giving priority to the portions of the assets that will be taxed at higher rates as ordinary income. Such treatment better equates the basis adjustments of the transferee with the higher taxed income recognized by the transferor, thereby avoiding duplicative recognition of ordinary income on subsequent transfers with respect to the same asset. Accordingly, once values have been assigned generally to the third, fourth, and fifth classes of assets, such values will be assigned within each of these classes first to properties or potential gain treated as unrealized receivables under the flush language in section 751(c), if any, in proportion to the income that would be recognized if the underlying assets were sold for their fair market values (determined without regard to the residual method), but only to the extent of the income attributable to the unrealized receivables. Any remaining value in each class will be allocated among the remaining portions of the assets in that class in proportion to the fair market values of such portions (determined without regard to the residual method).

In general, the value assigned to an asset (other than goodwill) cannot exceed the fair market value (determined without regard to the residual method) of that asset on the date of the relevant transfer. Therefore, if partnership gross value exceeds the aggregate value of the partnership's individual assets, the excess must be allocated entirely to the value of goodwill. However, an exception is provided if partnership gross value exceeds the aggregate value of the partnership's individual assets, and goodwill could not under any circumstances attach to the assets. Under this exception, the excess partnership gross value must be allocated among all partnership assets other than cash in proportion to their fair market values (determined without regard to the residual method).

(c)Special situations. In general, partnership gross value may be determined without reference to the value of individual partnership assets. In calculating partnership gross value, it is only necessary to determine the relevant partner's share of book value in partnership assets and how much book gain or loss must be recognized by the partnership on the disposition of all such assets to cause the partner to receive the appropriate liquidating distribution. The manner in which the book gain or loss is allocated among the partnership's assets generally will not affect the amount of the liquidating distribution to the partner.

In certain circumstances, however, such as where book income or loss with respect to particular partnership properties is allocated differently among partners, partnership gross value may vary depending on the value of particular partnership assets. In these situations, it is not possible to first determine the total value of the partnership(i.e., partnership gross value) and then apply the residual method to allocate that value to the partnership's individual assets. Instead, it is necessary first to determine the fair market value of the partnership's individual assets (determined taking into account all relevant facts and circumstances), and then to assign such value among the asset tiers described in the residual method such that the combined value of all partnership assets would cause the appropriate distribution to the relevant partner. The proposed regulations include a rule to address these special situations. In addition, under this rule, if the value determined for assets in the first four asset classes is not sufficient to cause the appropriate liquidating distribution, then, so long as goodwill could attach to the assets of the partnership, the value of goodwill is presumed to be an amount that, if assigned to such property, would cause the appropriate liquidating distribution.

3. Basis Adjustments Under Section 734(b) 

The proposed regulations do not provide a rule for valuing partnership assets in the case of distributions that result in a basis adjustment under section 734(b). The IRS and the Treasury Department have considered several alternative approaches, described below. Two of these approaches utilize a method similar to the one provided for basis adjustments under sections 743(b) and 732(d); that is, first determine partnership gross value and then allocate such amount among the partnership property applying the residual method. The third approach does not rely on the concept of partnership gross value. The IRS and the Treasury Department request comments as to which, if any, of these approaches should be utilized in applying the residual method in the context of basis adjustments under section 734(b). In addition, comments are requested concerning whether the second or third approach should be adopted in the context of basis adjustments under sections 743(b) and 732(d) involving transferred basis transactions.

Under the first approach, in the case of a distribution which results in a basis adjustment under section 734(b) and which causes the distributee partner's interest in the partnership to decrease, partnership gross value would be deemed to equal the amount that, if assigned to all partnership property, would result in a liquidating distribution to the partner (attributable to the reduction in interest) equal to the value of the consideration received by the distributee partner in the distribution. Under this approach, the amount distributed in exchange for the relinquished interest would provide the frame of reference for valuing the entire partnership. The reduction in a partner's interest could be measured as the difference between the partner's interest in the partnership immediately before the distribution and the partner's interest in the partnership immediately after the distribution. However, the IRS and the Treasury Department recognize that measuring the reduction in a partner's interest in the partnership in connection with a distribution can be difficult in some situations (for example, situations in which partners do not share profits or other items in proportion to their relative capital account balances). Moreover, in the case of a distribution that results in a basis adjustment under section 734(b) and does not reduce the distributee partner's interest in the partnership (such as in a pro rata distribution of cash), the transaction provides no frame of reference to value the partnership.

A second approach would be to determine partnership gross value as the value of the entire partnership as a going concern, and to apply the residual method by reference to that overall value. This method has the disadvantage of divorcing the valuation of partnership property from the transaction that gives rise to the adjustment. However, there would be no need to measure the reduction in the distributee partner's interest or even to have a reduction in the distributee partner's interest to apply this method. The method would work equally well for distributions where the partner's interest in the partnership is reduced and for distributions where it is not.

Under a third possible approach, the concept of partnership gross value would be disregarded, and, instead, value would be allocated to goodwill for section 755 purposes only if the amount of a positive basis adjustment under section 734(b) exceeds the appreciation in all assets of the character required to be adjusted which are not goodwill. This approach avoids the problems relating to the measurement or presence of a reduction in the distributee partner's interest and has the added benefit of avoiding a valuation of the partnership's overall operations. In contrast with the second approach, however, the value that is assigned to goodwill under this approach would not necessarily bear any relation to the actual value of goodwill in the hands of the partnership. In addition, this rule arguably would be inconsistent with the rule in Sec. 1.755-1(c), which requires that positive basis adjustments must be allocated to undistributed property of like character to the distributed property (or capital gain property in the case of adjustments attributable to gain recognized by the distributee partner) first in proportion to unrealized appreciation with respect to such property and then in proportion to fair market value. Under the third approach, a basis adjustment under section 734(b) to the class of assets composed of capital assets and property described in section 1231(b) could not exceed the unrealized appreciation with respect to any such partnership property other than goodwill. Accordingly, a section 734(b) basis adjustment never would be made in proportion to the fair market value of the property in the class of capital assets and property described in section 1231(b).

4. Effect on Sec. 1.755-1 

Section 1.755-1(b)(3)(ii)(B) of the Income Tax Regulations published on December 15, 1999 (64 FR 69903) contains a rule allocating discounts among capital assets following the transfer of a partnership interest that results in a basis adjustment under section 743(b). Because proposed Sec. 1.755-2 takes discounts and premiums into account when assigning values to partnership property for purposes of section 755 in such cases, the rule in Sec. 1.755-1(b)(3)(ii)(B) would become unnecessary.

5. Possible Expansion of Regulations 

With respect to transfers of partnership interests, the IRS and the Treasury Department are considering applying the rules contained in these proposed regulations not just for valuing partnership assets for purposes of applying section 755, but also to determine the value of assets for purposes of applying section 1(h)(6)(B) (collectibles gain or loss)with respect to partnerships, section 1(h)(7) (section 1250 capital gain), and section 751(a) (ordinary income treatment upon sale or exchange of an interest in a partnership). Applying the rules in these proposed regulations in connection with these provisions is consistent with the legislative history to section 1060(d) and would provide greater uniformity with respect to the amount and character of income recognized upon the transfer of a partnership interest and the basis adjustments to partnership assets to which the different income character is attributable. However, this application of the rules could cause an increase in complexity, particularly if a section 754 election is not in effect for a year in which the transfer of a partnership interest occurs(so that application of the residual method otherwise would not be required). The IRS and the Treasury Department request comments on whether partnerships should value partnership assets using the residual method for purposes of sections 1(h)(6)(B), 1(h)(7), and 751(a).

Proposed Effective Date 

The regulations are proposed to be effective for any basis adjustment resulting from any distribution of partnership property or transfer of a partnership interest that occurs on or after the date final regulations are published in the Federal Register.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 6 Preamble, REG-106736-00, Assumption of Partner Liabilities, 68 Fed. Reg. 37434 (6/24/2003) 

REG-106736-00 

DEPARTMENT OF THE TREASURY 
 Internal Revenue Service
 26 CFR Part 1 
 [REG-106736-00] 
 RIN 1545-AX93
 Assumption of Partner Liabilities 

AGENCY: Internal Revenue Service (IRS),  Treasury.

ACTION: Notice of proposed rulemaking;  notice of proposed rulemaking by cross-reference to temporary regulations; and notice of public hearing.

SUMMARY: This document contains proposed  regulations relating to the definition of liabilities under section 752  of the Internal Revenue Code.  These regulations provide rules  regarding a partnership's assumption of certain fixed and  contingent obligations in exchange for a partnership interest and  provide conforming changes to certain regulations.  These regulations also provide rules under section 358(h) for assumptions of liabilities by corporations from partners and partnerships.  In addition, this document provides notice that the IRS and Treasury intend to issue supplemental guidance that may apply certain of the rules outlined in  these proposed regulations to transactions involving corporations.  This document also provides notice of public hearing on the proposed regulations.

DATES: Written or electronic comments and  requests to speak at the public hearing scheduled for Tuesday, October  14, 2003, must be received by September 22,  2003.

ADDRESSES: Send submissions to: CC:PA:RU  (REG-106736-00), room 5226, Internal Revenue Service, POB 7604, Ben  Franklin Station, Washington, DC 20044.  Submissions may be  hand-delivered between the hours of 8 a.m. and 4 p.m. to CC:PA:RU (REG-106736-00), Courier's Desk, Internal Revenue Service, 1111  Constitution Avenue, NW., Washington, DC or sent electronically, via  the IRS Internet site at: www.irs.gov/regs.  The public hearing will be  held in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:Horace  Howells at (202) 622-3050; concerning submissions, the hearing, and/or  placement on the building access list to attend the hearing, Sonya  Cruse, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act 

The collection of information contained in this notice of proposed  rulemaking has been submitted to the Office of Management and Budget  for review in accordance with the Paperwork Reduction Act of 1995 (44  U.S.C. 3507(d)).  Comments on the collection of information should be  sent to the Office of Management and  Budget, Attn: Desk Officer for the Department of the Treasury,  Office of Information and Regulatory Affairs, Washington, DC 20503,  with copies to the Internal Revenue Service, Attn: IRS Reports Clearance  Officer, W:CAR:MP:T:T:SP Washington, DC 20224.  Comments on the  collection of information should be received by August 25, 2003.   Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the  proper performance of the functions of the Internal Revenue Service,  including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed  collection of information (see below);

How the quality, utility, and clarity of the information to be  collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation,  maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in  Section 1.752-7(e), (f), (g), and (h).  This information is required for a former or current partner of a partnership to take deductions  attributable to the economic performance of certain fixed or contingent  obligations assumed from the partner by a partnership.  This  information will be used by the partner to permit the partner to take a  deduction. An additional collection of information in this proposed  regulation is in Section 1.752-7(j)(2).  This information is required to  inform the IRS of partnerships making the designated election and to  report income appropriately.  The collection of information is required to obtain a benefit, i.e., to elect to apply the provisions of  Section 1.752-7 of the proposed regulations in lieu of Section 1.752-6T of the temporary regulations.  The likely respondents are individuals, business or other for-profit institutions, and small businesses or organizations.

Estimated total annual reporting burden: 125 hours.

The estimated annual burden per respondent varies from 20 to 40  minutes, depending on individual circumstances, with an estimated  average of 30 minutes.

Estimated number of respondents: 250

Estimated annual frequency of responses: On occasion

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

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.

Background 

With certain exceptions, no gain or loss is recognized if property is transferred to a corporation solely in exchange for stock of the corporation, and, immediately after the exchange, the transferors control the corporation.  If, however, the transferee corporation assumes a liability of the transferor, then, under section 358(d), the  transferor's basis in the stock received in the exchange is  reduced by the amount of that liability.  If the amount of the liability exceeds the transferor's basis in the property  transferred to the corporation, then the transferor recognizes gain  under section 357(c)(1).  Under section 357(c)(3), a liability the  payment of which would give rise to a deduction or that would be  described in section 736(a) (regarding payments to a retiring partner)  is not taken into account in applying section 357(c)(1), unless the  incurrence of the liability resulted in the creation of, or an increase  in, the basis of any property.

Under section 752(a) and (b), similar rules apply where a partnership  assumes a liability from a partner or a partner contributes property to  a partnership subject to a liability.  The difference between the  amount of the liability and the partner's share of that liability after the partnership's assumption is treated as a distribution of money, which reduces the partner's basis in the partnership interest and may cause the partner to recognize gain.  There is no statutory or regulatory definition of liabilities for purposes of section 752.  Case law and revenue rulings, however, have established that, as under section 357(c)(3), the term  liabilities for this purpose does not  include liabilities the payment of which would give rise to a  deduction, unless the incurrence of the liability resulted in the  creation of, or an increase in, the basis of property.  Rev. Rul. 88-77  (1988-2 C.B. 128); Salina Partnership LP, FPL  Group, Inc. v. Commissioner, T.C. Memo 2000-352.

On December 21, 2000, as part of the Community Renewal Tax Relief Act of 2000 (Appendix G of H.R. 4577, Consolidated Appropriations Act, 2001) Public Law 106-554, 114 Stat. 2763, 2763A-638 (2001) (the Act), Congress enacted section 358(h) to address certain situations where property was transferred to a corporation in exchange for both stock and the corporation's assumption of certain obligations of the  transferor.  In these situations, transferors took the position that  the obligations were not liabilities within the meaning of section 357(c) or that they were described in section 357(c)(3), and,  therefore, the obligations did not reduce the basis of the  transferor's stock.  These assumed obligations, however, did  reduce the value of the stock.  The transferors then sold the stock and  claimed a loss. In this way, taxpayers attempted to duplicate a loss in  corporate stock and to accelerate deductions that typically are allowed  only on the economic performance of these types of obligations.

Section 358(h) addresses these transactions by requiring that, after  application of section 358(d), the basis in stock received in an  exchange to which section 351, 354, 355, 356, or 361 applies be reduced  (but not below the fair market value of the stock) by the amount of any liability assumed in the exchange.  Exceptions to section 358(h)are  provided where: (1) the trade or business with which the liability is  associated is transferred to the person assuming the liability as part  of the exchange; or (2) substantially all of the assets with which the  liability is associated are transferred to the person assuming the  liability as part of the exchange.  The term  liability for purposes of section 358(h)  includes any fixed or contingent obligation to make payment without  regard to whether the obligation is otherwise taken into account for  purposes of the Internal Revenue Code (Code).

Congress recognized that taxpayers were attempting to use partnerships  and S corporations to carry out the same types of abuses that section 358(h) was designed to deter.  Therefore, in section 309(c) and (d)(2) of the Act, Congress directed the Secretary to prescribe rules to provide “appropriate adjustments under subchapter K of chapter 1  of the Code to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to)  liabilities described in section 358(h)(3) ... in transactions  involving partnerships” and to prescribe similar rules for S  corporations. Under the statute, these rules are to “apply to  assumptions of liability after October 18, 1999, or such later date as  may be prescribed in such rules.”

In response to this directive, these proposed regulations provide rules to prevent the duplication and acceleration of loss through the assumption by a partnership of a Section 1.752-7 liability from a partner.  For this purpose, a partnership that takes property subject to a liability is generally treated as assuming the liability.  A Section 1.752-7 liability is any fixed or contingent obligation to make  payment that is not described in Section 1.752-1(a)(1), without regard to  whether the obligation is otherwise taken into account for purposes of  the Code.

The proposed regulations also provide that section 704(c) principles shall apply to a Section 1.752-7 liability assumed by a partnership from  a partner.  Accordingly, the Section 1.752-7 liability is treated under  section 704(c) principles as having a built-in loss equal to the amount  of such liability at the time of its assumption by the partnership.   The amount of the Section 1.752-7 liability is the amount that a willing  assignor would pay to a willing assignee to assume the Section 1.752-7  liability in an arm's-length transaction.

In addition, the proposed regulations make conforming amendments to Sections 1.704-1(b)(2)(iv)(b) (by providing  that a partner's capital account be reduced by the Section 1.752-7  liabilities that the partnership assumes from the partner),  1.704-2(b)(3) (by treating a Section 1.752-7 liability as a nonrecourse  liability for purposes of the partnership allocation rules), and  1.705-1 (by directing taxpayers to Section 1.358-7(b) and Section 1.752-7  for basis adjustments necessary to coordinate section 705 with section  358(h) and Section 1.752-7).

Moreover, the proposed regulations provide rules under section 358(h)  for assumptions of liabilities by corporations from partners and  partnerships.  In addition, in the Explanation of Provisions section of  this preamble, the IRS and Treasury are alerting taxpayers that they  are considering adopting the definition of liability proposed in these  regulations as an appropriate interpretation of the term  liability for purposes of subchapter C of  chapter 1 of the Code.  The IRS and Treasury are also considering  issuing regulations to conform the exceptions to section 358(h) to the  exceptions described in these regulations. These regulations will be  retroactive to the extent necessary to prevent abuse.

Section 358(h) applies to S corporations.  The Act states that the  Secretary may prescribe comparable rules which provide appropriate  adjustments under subchapter S.  These proposed regulations do not  address the assumption of liabilities by S corporations; however, any  rules applicable to assumptions of liabilities by corporations would,  in the absence of provisions to the contrary, apply equally to S  corporations. Comments regarding the assumption of liabilities by S  corporations are requested.

Explanation of Provisions 

1. Addition of Section 1.752-1(a)(1)—Definition of Liability 

The question of what constitutes a liability for purposes of section 752 was addressed in Rev. Rul. 88-77 (1988-2 C.B. 128).  Rev. Rul. 88-77 holds that partnership liabilities include an obligation only if,  and to the extent that, incurring the obligation creates or increases the basis to the partnership of any of the partnership's assets (including cash attributable to borrowings), gives rise to an immediate deduction to the partnership, or, under section 705(a)(2)(B) (relating to noncapital, nondeductible expenditures of a partnership) currently decreases a partner's basis in the partner's partnership interest.  Section 1.752-1T(g) (1989-1 C.B. 180), included a definition of a liability for purposes of section 752 that reaffirmed the position of the IRS in Rev. Rul. 88-77.  This definition was removed from the  final version of those regulations in response to comments that the  definition was redundant and therefore unnecessary.  The Service continues to follow the definition of liability set forth in Rev. Rul.  88-77.  See Rev. Rul. 95-26 (1995-1 C.B. 131).

Because these proposed regulations define a Section 1.752-7 liability as a fixed or contingent obligation to make payment to which section 752  does not apply, Treasury and the IRS believe that it is appropriate to  describe in these regulations the liabilities to which section 752 does  apply.  Therefore, following the principles set forth in Section 1.752-1T(g) and Rev. Rul. 88-77, the proposed regulations provide  that an obligation is a liability if and to the extent that incurring  the obligation: (A) creates or increases the basis of any of the  obligor's assets (including cash); (B) gives rise to an immediate  deduction to the obligor; or (C) gives rise to an expense that is not  deductible in computing the obligor's taxable income and is not  properly chargeable to capital.  An obligation for this purpose is any  fixed or contingent obligation to make payment without regard to  whether the obligation is otherwise taken into account for purposes of  the Code.  Obligations include, but are not limited to, debt  obligations, environmental obligations, tort obligations, contract  obligations, pension obligations, obligations under a short sale, and  obligations under derivative financial instruments such as options,  forward contracts, and futures contracts.  The definition of a  liability contained in these proposed regulations does not follow Helmer v. Commissioner, T.C. Memo  1975-160.  (The Tax Court, in Helmer, held  that a partnership's issuance of an option to acquire property  did not create a partnership liability for purposes of section  752.)

Treasury and the IRS are considering adopting the definition of  liability proposed in these regulations as an appropriate  interpretation of the term liability for  purposes of subchapter C of chapter 1 of the Code.  Treasury and the  IRS request comments on the scope and substance of such regulations,  which will be retroactive to the extent necessary to prevent  abuse.

2. Section 1.752-7—Partnership Assumption of Partner's Section 1.752-7 Liability 

In the corporate context, section 358(h) prevents the duplication and acceleration of loss with respect to obligations not encompassed by  section 358(d) by reducing the transferor shareholder's basis in  corporate stock received in the exchange.  Treasury and the IRS do not  believe that this is the best approach for partnerships given their  passthrough nature.  Ultimately, the partners’shares of a  partnership's deductions are limited by the partners’bases  in their partnership interests (their outside bases).  If, at the time  of an assumption of a Section 1.752-7 liability by a partnership from a  partner (the Section 1.752-7 liability partner), the partner's  outside basis were reduced by the amount of the Section 1.752-7  liability, then the partner would not have sufficient outside basis to  absorb any deduction with respect to the Section 1.752-7 liability that  passed through the partnership.

For this reason, these proposed regulations do not reduce the outside basis of the Section 1.752-7 liability partner upon the  partnership's assumption of the Section 1.752-7 liability.  If the  partnership satisfies the Section 1.752-7 liability while the  Section 1.752-7 liability partner is a partner in the partnership, then  the deduction with respect to the portion of the Section 1.752-7  liability assumed by the partnership from the Section 1.752-7 liability  partner (the built-in loss associated with the Section 1.752-7 liability)  is allocated to the Section 1.752-7 liability partner, reducing that  partner's outside basis.  If, instead, one of three events occur  that separate the Section 1.752-7 liability partner from the  Section 1.752-7 liability, then the Section 1.752-7 liability  partner's outside basis is reduced at that time.  These events  are: (1) a disposition (or partial disposition) of the partnership  interest by the Section 1.752-7 liability partner, (2) a liquidation of  the Section 1.752-7 liability partner's partnership interest, and  (3) the assumption (or partial assumption) of the Section 1.752-7  liability by a partner other than the Section 1.752-7 liability partner.   Immediately before the occurrence of one of these events, the  Section 1.752-7 liability partner's basis in the partnership  interest generally is reduced by the lesser of: (1) the excess of the  Section 1.752-7 liability partner's basis in the partnership  interest over the adjusted value of that interest, or (2) the remaining  built-in loss associated with the Section 1.752-7 liability (the  Section 1.752-7 liability reduction).  For this purpose, the adjusted  value of a partner's interest in a partnership is the fair market  value of that interest increased by the partner's share of  partnership liabilities under Sections 1.752-1 through 1.752-5.  In  the case of a partial disposition of the Section 1.752-7 liability  partner's partnership interest or a partial assumption of the  Section 1.752-7 liability by another partner, the Section 1.752-7 liability  reduction is pro rated based on the portion of the interest sold or the  portion of the Section 1.752-7 liability assumed.

After the occurrence of such an event, the partnership (or the assuming partner) is not entitled to any deduction or capital expense on the economic performance of the Section 1.752-7 liability to the extent of  the remaining built-in loss associated with the Section 1.752-7 liability.  If, however, the partnership (or the assuming partner) notifies the Section 1.752-7 liability partner of the partial or complete  economic performance of the Section 1.752-7 liability, then the  Section 1.752-7 liability partner is entitled to a deduction or loss.   The amount of that deduction or loss is, in the case of a partial  satisfaction of the Section 1.752-7 liability, the amount paid by the  partnership in satisfaction of the Section 1.752-7 liability(but not  more than the Section 1.752-7 liability reduction) or, in the case of a  complete satisfaction of the Section 1.752-7 liability, the remaining  Section 1.752-7 liability reduction.  To the extent of the amount paid in  satisfaction of the Section 1.752-7 liability, the character of that  deduction or loss is determined as if the Section 1.752-7 liability  partner had satisfied the Section 1.752-7 liability. To the extent that  the Section 1.752-7 liability reduction exceeds the amount paid in  satisfaction of the Section 1.752-7 liability, the character of the  Section 1.752-7 liability partner's loss is capital.

The proposed regulations further provide that, solely for purposes of section 705 (adjustments to the basis of a partnership interest)and  Section 1.704-1(b)(2)(iv)(b)  (partnership capital accounting rules), the remaining built-in loss  associated with the Section 1.752-7 liability is not treated as a  nondeductible, noncapital expense to the partnership.  Therefore, the  remaining partners’ bases in their partnership interests and  capital accounts are not reduced by the remaining built-in loss  associated with the Section 1.752-7 liability.

If the Section 1.752-7 liability is assumed by a partner other than the Section 1.752-7 liability partner, then, on economic performance of the  Section 1.752-7 liability, the assuming partner is treated as  contributing cash to the partnership in the amount of the lesser of:  (1) the amount paid to satisfy the Section 1.752-7 liability;or (2) the  remaining built-in loss associated with the Section 1.752-7 liability as  of the time of the assumption.  Adjustments as a result of this deemed  cash contribution may include adjusting the basis of the partnership  interest, any assets (other than cash, accounts receivable, or  inventory) distributed by the partnership to the partner, or gain or  loss on the disposition of the partnership interest or of property  distributed by the partnership, as the case may be. However, the  assuming partner cannot take into account any adjustments to  depreciable basis, reduction in gain, or increase in loss until economic performance of the Section 1.752-7 liability.  Any adjustment to  the basis of an asset under this provision is taken into account over  the recovery period of that asset.

3. Exceptions 

Certain exceptions apply to these rules.  In the corporate context,  section 358(h) does not apply in the following two situations:(1) where  the trade or business with which the liability is associated is  transferred to the corporation assuming the liability; and (2) where  substantially all of the assets with which the liability is associated  are transferred to the corporation assuming the liability.  Section  358(h)(2) authorizes the Secretary to limit the application of these  exceptions.

The statutory provision relating to partnerships does not specify  whether the exceptions in section 358(h)(2) should apply.  The only  cross-reference to section 358(h) in this statutory provision is to  section 358(h)(3), which defines the term  liability.  Treasury and IRS believe it is appropriate to provide for a variation on one of the two exceptions to  section 358(h), as well as an additional exception that is not included  in section 358(h), in these proposed regulations.  Treasury and the IRS  request comments on these exceptions and on whether additional exceptions should be included in the final regulations.

The first exception applies where the partnership assumes the  Section 1.752-7 liability as part of the contribution of the trade or  business with which the liability is associated and the partnership  continues to conduct that trade or business after the contribution.   For this purpose, a trade or business is a specific group of activities  carried on by a person for the purpose of earning income or profit if  the activities included in that group include every operation that  forms a part of, or a step in, the process of earning income or  profit.

The proposed regulations provide that the activity of acquiring,  holding, or disposing of financial instruments constitutes a trade or  business for this purpose if and only if the activity is conducted by  an entity registered with the Securities and Exchange Commission as a  management company under the Investment Company Act of 1940, as  amended.  Treasury and the IRS are concerned that certain activities  involving acquiring, holding, or disposing of financial instruments  could be structured to accomplish the types of transactions that  section 309(c) of the Act was designed to prevent.  Nonetheless,  Treasury and the IRS recognize that many persons contribute such  activities to partnerships for substantial business purposes.  For  example, mutual funds often contribute substantially all of their  assets to a master partnership to save administrative costs.  Under some circumstances, such a mutual fund may  transfer portfolio positions (including hedge positions that could be  considered Section 1.752-7 liabilities under the proposed regulations) to  the master partnership.  Because a contribution by a mutual fund  to a master partnership is not the type of abusive loss duplication  transaction that section 309(c) of the Act was designed to address, the  proposed regulations treat this type of contribution as a contribution  of a trade or business.  Treasury and the IRS request comments on  additional types of activities that should be treated as trades or  businesses for purposes of these regulations.

The proposed regulations do not include the section 358(h) exception for situations in which substantially all of the assets with which the  liability is associated are transferred to the partnership assuming the  liability.  Treasury and the IRS are concerned that taxpayers would  rely on that exception to facilitate transactions of the type that  section 309(c) of the Act was designed to prevent.

An additional de minimis exception, not present in section 358(h), is included in the proposed regulations.  Under this exception, the proposed regulations do not apply where, immediately before the disposition of the partnership interest by the Section 1.752-7 liability partner, the liquidation of the Section 1.752-7 liability partner's partnership interest, or the assumption of the Section 1.752-7 liability by another partner, the amount of the remaining built-in loss with respect to all Section 1.752-7 liabilities assumed by the partnership (other than Section 1.752-7 liabilities that are assumed by the partnership with an associated trade or business) is less than the lesser of 10% of the gross value of the partnership's assets or  $1,000,000.  This exception was added in recognition of the fact that  loss acceleration and duplication strategies typically are engaged in  only if the accelerated or duplicated loss is substantial.

4. Advanced Notice of Proposed Rulemaking Under
  Section 358(h)(2) 

Treasury and the IRS are considering exercising their regulatory  authority under section 358(h)(2) to limit the exceptions to section  358(h)(1)to follow the exceptions set forth in these proposed  regulations(other than the de minimis exception).  Treasury and the  IRS request comments on the scope and substance of such regulations,  which will be retroactive to the extent necessary to prevent  abuse.

5. Rules Applicable to Tiered Structures 

Proposed Section 1.752-7(e) and (i) provide rules to address a  contribution of a partnership interest to another partnership.  First,  under Section 1.752-7(e)(3), a transfer by a partner of an interest in a  partnership(lower-tier partnership) to another partnership (upper-tier  partnership)is not treated as a transfer of a partnership interest for  purposes of applying these rules.  Therefore, the partner does not have  to reduce the basis of the partnership interest before such a transfer.  However, look-through rules in Section 1.752-7(i) apply to treat the  transfer of the partnership interest as a transfer of the  partner's share of the assets and Section 1.752-7 liabilities of  the partnership. Therefore, a transfer of a partnership interest to  another partnership may be treated as an assumption of a Section 1.752-7  liability by a partnership under these proposed regulations.  Under  proposed Section 1.358-7(a), similar rules apply to a contribution of a  partnership interest to a corporation.

Also, Section 1.752-7(i)(2) provides a limitation on the trade or  business exception where a partnership (upper-tier partnership) assumes  a Section 1.752-7 liability from a partner, and then another partnership (lower-tier partnership) assumes the Section 1.752-7 liability from the  upper-tier partnership.  In such a case, the trade or business exception does not apply on the assumption of the Section 1.752-7 liability by the lower-tier partnership from the upper-tier partnership unless it applied on the assumption of the Section 1.752-7 liability by the upper-tier partnership from the Section 1.752-7 liability partner.  Section 1.358-7(c) of these proposed regulations provide for similar rules where a corporation assumes an obligation described in section 358(h)(3) from a partnership that the partnership had previously assumed from a partner.  In addition, Section 1.358-7(b) of these proposed regulations provide special rules for adjusting the  partners’bases in a partnership when a corporation assumes a  Section 1.752-7 liability from the partnership.

Additional rules are provided for look-through treatment where a  partnership is a Section 1.752-7 liability partner in another  partnership.  The proposed regulations also provide special rules for  situations in which the Section 1.752-7 liability partner disposes of the  partner's interest in the partnership and then another  partnership (or a corporation)assumes the Section 1.752-7 liability from  the partnership.

Effective Date 

The regulations described above are proposed to apply to assumptions of Section 1.752-7 liabilities occurring on or after June 24, 2003. In the  Rules and Regulations section of this issue of the  Federal Register, the IRS is issuing  temporary regulations (Section 1.752-6T)that apply to liabilities  assumed by a partnership after October 18, 1999, and before June 24,  2003 .  The text of those temporary regulations published in the Rules  and Regulation section of this issue of the  Federal Register serves as the text of  Section 1.752-6 of these regulations.  In lieu of applying Section 1.752-6T  of the temporary Income Tax Regulations, partnerships may elect to be  subject to the proposed rules of Sections 1.358-7 and 1.752-7 and  the proposed revisions of  Sections 1.704-1(b)(2)(iv)(b),  1.704-2(b)(3), 1.705-1(a)(7), and 1.752-1, published as part of this  Notice of Proposed Rulemaking, with respect to all liabilities  (including Section 1.752-7 liabilities)assumed by the partnership after  October 18, 1999 and before June 24, 2003.  The election must be filed  with the first Federal income tax return filed by the partnership on or  after September 22, 2003. The election will be valid only if the  partnership and its partners promptly amend any returns for open  taxable years that would be affected by the election.

Special Analyses 

It has been determined that this notice of proposed rulemaking is not a  significant regulatory action as defined in Executive Order 12866.  Therefore, a regulatory assessment is not required.  It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities.  This certification is based upon the fact that few partnerships engage in the type of transactions that are subject to these regulations (assumptions of liabilities not described in section 752(a) and (b) from a partner).  In addition, available data indicates that most partnerships that engage in the type of transactions that are subject to these  regulations are large partnerships.  Certain broad exceptions to the  application of these regulations (including a de minimis exception)  further limit the economic impact of these regulations on small  entities.  Therefore, a Regulatory Flexibility Analysis under the  Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.   Pursuant to section 7805(f)of the Code, this notice of proposed  rulemaking will be submitted to the Chief Counsel for Advocacy of the  Small Business Administration for comment on its impact on small  business.  Comments are sought as to the number of legitimate business  transactions that will be affected by the proposed regulations.

Drafting Information 

The principal author of these regulations is Horace Howells, Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS.  However, other personnel from the IRS and Treasury Department  participated in their development.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 7 Preamble, T.D. 8925, Partnership Mergers and Divisions, 66 Fed. Reg. 715 (1/4/2001) 

DEPARTMENT OF THE TREASURY 

Internal Revenue Service
  26 CFR Part 1

[TD 8925]

RIN 1545-AX32

Partnership Mergers and Divisions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations on the tax consequences of partnership mergers and divisions. The final regulations affect partnerships and their partners.

DATES: Effective Date: These regulations are effective January 4, 2001.

Applicability Date: For dates of applicability of these regulations, see Sections 1.708-1(c)(7), 1.708-1(d)(7), and 1.752-5(a).

FOR FURTHER INFORMATION CONTACT:  Mary Beth Collins or Dan Carmody, (202) 622-3080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background 

This document amends sections 708 and 752 of the Income Tax Regulations(26 CFR part 1) regarding partnership mergers and divisions.

On January 11, 2000, a notice of proposed rulemaking and a notice of public hearing (REG-111119-99, 2000-5 I.R.B. 455) were published in the Federal Register (65 FR 1572) regarding sections 708, 743, and 752 of the Internal Revenue Code. No one requested to speak at the public hearing. Accordingly, the public hearing scheduled for May 4, 2000, was canceled in the Federal Register (65 FR 24897) on April 28, 2000. Comments responding to the proposed regulations were received. After consideration of the comments, the proposed regulations are adopted as revised by this Treasury decision.

I. Partnership Mergers 

Section 708(b)(2)(A) provides that in the case of a merger or consolidation of two or more partnerships, the resulting partnership is, for purposes of section 708, considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership. Section 1.708-1(b)(2)(i) of the Income Tax Regulations provides that if the resulting partnership can be considered a continuation of more than one of the merging partnerships, the resulting partnership is the continuation of the partnership that is credited with the contribution of the greatest dollar value of assets to the resulting partnership. If the members of none of the merging partnerships own more than a 50 percent interest in the capital and profits of the resulting partnership, all of the merged partnerships are considered terminated, and a new partnership results. The taxable years of the merging partnerships that are considered terminated are closed under section 706(c).

II. Partnership Divisions 

Section 708(b)(2)(B) provides that, in the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) are considered a continuation of the prior partnership. Section1.708-1(b)(2)(ii)  provides that any other resulting partnership is not considered a continuation of the prior partnership but is considered a new partnership. If the members of none of the resulting partnerships owned an interest of more than 50 percent in the capital and profits of the prior partnership, the prior partnership is terminated. Where members of a partnership that has been divided do not become members of a resulting partnership that is considered a continuation of the prior partnership, such members' interests are considered liquidated as of the date of the division.

Explanation of Revisions and Summary of Comments 

I. Assets-Up Form for Partnership Mergers and Divisions 

The proposed regulations provide that the form of a partnership merger or division accomplished under laws of the applicable jurisdiction will be respected if the partnership undertakes the steps of one of two prescribed forms. Generally, for partnership mergers, a terminating partnership contributes its assets and liabilities to the resulting partnership in exchange for interests in the resulting partnership, and immediately thereafter, the terminated partnership distributes interests in the resulting partnership to its partners in liquidation of the terminating partnership (Assets-Over Form). Alternatively, for partnership mergers, the terminating partnership liquidates by distributing its assets and liabilities to its partners who then contribute the assets and liabilities to the resulting partnership (Assets-Up Form). The default rule for partnership mergers is the Assets-Over Form, so that if a transaction is not characterized under the Assets-Up Form, it will be characterized under the Assets-Over Form regardless of whether that form is followed.

In general, for partnership divisions, a prior partnership transfers certain assets and liabilities to a resulting partnership in exchange for interests in the resulting partnership, and immediately thereafter, the prior partnership distributes the resulting partnership interests to partners who are designated to receive interests in the resulting partnership (Assets-Over Form). Alternatively, for partnership divisions, the prior partnership distributes certain assets and liabilities to some or all of its partners who then contribute the assets and liabilities to a resulting partnership in exchange for interests in the resulting partnership (Assets-Up Form). As with partnership mergers, the default rule for partnership divisions is the Assets-Over Form, so that if a transaction is not characterized under the Assets-Up Form, it will be characterized under the Assets-Over Form regardless of whether that form is followed.

One commentator expressed concern that where the assets of an operating business are distributed to the partners as joint owners, and the partners continue to operate the business, the owners of the assets may be considered to remain partners for federal income tax purposes. Under the proposed regulations, it was intended that the Assets-Up Form would be respected where the assets are conveyed to the partners under the laws of the applicable jurisdiction and then reconveyed to the resulting partnership. An example has been added to the final regulations to confirm this result. The example also confirms that a partnership can use the Assets-Up Form for partnership mergers and divisions regardless of whether the partners could otherwise generally hold certain assets, such as undivided interests in goodwill, outside of a partnership.

The same commentator suggested that the Assets-Up Form should be respected if, rather than actually conveying ownership of the assets under applicable jurisdictional law, the partners assign their rights to receive title to the assets in liquidation of the partnership, or direct the partnership to transfer title to the assets to the resulting partnership. In providing that the Assets-Up Form would be respected in accomplishing partnership mergers and divisions, the IRS and Treasury did not intend to establish a regime whereby partners essentially could elect between the Assets-Up Form and the Assets-Over Form by creating different documents that have the same legal effect. The IRS and Treasury believe that if the Assets-Up Form is to be respected, a partnership must actually undertake the steps that are necessary, under the laws of the applicable jurisdiction, to convey ownership of the assets that are distributed to the partners. For most types of assets, this will not require the actual transfer and recording of a deed or certificate of title.

While the IRS and Treasury believe that it should be necessary for a partnership to actually convey ownership of the partnership's assets to its partners in order to follow the Assets-Up Form, it should not be necessary for the partners to actually assume the liabilities of the partnership in order to follow such form. Pursuant to section 752 and the regulations thereunder, a partner essentially is deemed to have directly incurred a share of the partnership's liabilities. Requiring the partners to actually assume debt that they already are deemed to have incurred is unnecessary. Such a requirement also could create a trap for the unwary. If a partner momentarily assumes an amount of the partnership's debt that is less than the partner's share of such debt under section 752 (and other partners momentarily assume an amount of debt in excess of their shares), the partner could inappropriately recognize gain as a result of the deemed distribution.

II. Bifurcation of Assets-Over Form and Assets-Up Form 

The proposed regulations provide that the form of a partnership merger or division accomplished under laws of the applicable jurisdiction will be respected if the partnership undertakes the steps of either the Assets-Over Form or the Assets-Up Form. One commentator recommended that a single partnership merger or division be respected if the partnership undertakes the steps of the Assets-Over Form with respect to some assets and the Assets-Up Form with respect to others. For example, in a partnership merger, the terminating partnership could distribute some assets to certain partners who then contribute the assets to the resulting partnership in exchange for interests in the resulting partnership (Assets-Up Form), and simultaneously, the terminating partnership could transfer the remaining assets to the resulting partnership in exchange for interests in the resulting partnership and then distribute the interests to the remaining partners in liquidation of their interests in the terminating partnership (Assets-Over Form).

In the preamble to the proposed regulations, the IRS and Treasury recognized that there are numerous transactions that may be undertaken pursuant to local jurisdictional law to accomplish the result of a partnership merger or division. The rules set forth in the proposed regulations were not intended to provide unlimited flexibility among the various structural alternatives for accomplishing these transactions. Instead, the proposed regulations were intended to provide a set of administrable rules that taxpayers and the IRS could apply in characterizing these transactions.

In view of this purpose, the IRS and Treasury do not believe it is appropriate for a partnership merger to be accomplished using both the Assets-Over Form and the Assets-Up Form when all the assets and liabilities of the terminated partnership are transferred to a single resulting partnership. While a partnership merger may be accomplished by using any number of transactional structures, the result is a single transaction that combines two partnerships. In the two alternatives set forth in the proposed regulations, and adopted in these final regulations, each partner must participate (or will be deemed to participate) in the partnership merger in the same manner (with the exception of those partners who are subject to the buy-out rule). Therefore, if the partners wish for a partnership merger to be characterized under the Assets-Up Form, the terminated partnership must undertake the steps of the Assets-Up Form for all of its assets when it distributes the assets to its partners. Otherwise, the transaction will be characterized under the Assets-Over Form. However, where more than two partnerships are combined, each combination will be viewed as a separate merger so that the characterization of a merger of one partnership into the resulting partnership under the Assets-Over Form will not prevent a simultaneous merger of another partnership into the same resulting partnership from being characterized under the Assets-Up Form.

For the same reasons, with respect to partnership divisions, the IRS and Treasury believe that it is appropriate to require consistency in applying either the Assets-Over Form or the Assets-Up Form to characterize a transfer of assets to a resulting partnership. However, where a single partnership is divided in a transaction that involves a transfer of assets (either actual or deemed) to multiple partnerships, the transfer to each resulting partnership should be viewed separately. As with mergers involving more than two partnerships, it is consistent with the purposes of these regulations, in the context of divisions, to allow the transfer to one resulting partnership to be characterized under the Assets-Over Form while characterizing the transfer to another resulting partnership under the Assets-Up Form. The proposed regulations provided an example that illustrates when such a division accomplished under both the Assets-Over Form and the Assets-Up Form will be respected. The final regulations do not change the example. See Section 1.708-1(d)(5) Example 7 of the final regulations. The final regulations also add an example to illustrate when a division accomplished under both the Assets-Over Form and the Assets-Up Form will not be respected.

III. Clarification of Partnership Merger Buy-out Rule 

The proposed regulations contain a special buy-out rule that allows a resulting partnership in a merger to fund the purchase of one or more partners' interests in a terminating partnership without triggering the disguised sale rules, which otherwise would cause all of the partners in the terminating partnership to recognize gain or loss as a result of the purchase. Specifically, the proposed regulations provide that if the merger agreement (or similar document) specifies that the resulting partnership is purchasing the exiting partner's interest in the terminating partnership and the amount paid for the interest, the transaction will be treated as a sale of the exiting partner's interest to the resulting partnership.

Because the transaction described in the proposed regulations is treated as a sale of a partnership interest, the resulting partnership inherits the exiting partner's capital account in the terminating partnership and any section 704(c) liability of the exiting partner. Additionally, if the terminating partnership has an election in effect under section 754 (or makes an election under section 754), the resulting partnership will have a special basis adjustment regarding the terminating partnership's property under section 743. The proposed regulations provide that the resulting partnership's basis adjustments under section 743 must be allocated solely to the partners who were partners in the resulting partnership immediately before the merger.

Commentators questioned whether the exiting partner must be a party to the merger agreement in order to obtain the benefit of the special buy-out rule contained in the proposed regulations. Another commentator asked whether the exiting partner must consent to the sale treatment. The commentator explained that it may be difficult to receive consent from small investors in a large partnership whose interests are being sold to the resulting partnership.

The IRS and Treasury believe that the exiting partner does not have to be a party to the merger agreement in order to obtain the benefit of the special buy-out rule. However, to ensure that all partners to the transaction treat the transaction consistently when filing their returns, the final regulations require that, prior to or contemporaneous with the transfer, the exiting partner must consent to the sale treatment provided in the special rule.

Commentators noted that the resulting partnership's basis adjustments under section 743 should not be allocated solely to the partners who were partners in the resulting partnership immediately before the merger. As indicated in Section 1.708-1(c)(4) Example 4 of the proposed regulations, where the resulting partnership has acquired an interest in the terminating partnership in accordance with the special buy-out rule, the terminating partnership, as part of the merger, distributes assets to the resulting partnership in liquidation of the resulting partnership's interest in the terminating partnership. Accordingly, the resulting partnership should take an exchanged basis in the distributed assets under section 732(b), rather than a transferred basis that includes the basis adjustment under section743(b) . In response to these comments, the IRS and Treasury have removed the proposed regulations under section 743 and have clarified the example to indicate that the basis rules under section 732(b) apply.

Commentators also asked whether a partnership termination under section708(b)(1)(B)  occurs immediately before a merger if exiting partners sell 50 percent or more of the total interests in the terminating partnership under the buy-out provision. Although not discussed in the final regulations, it follows from treating the buyout as occurring immediately prior to the merger that, if exiting partners sell 50 percent or more of the total interest in the terminating partnership's capital and profits as part of a merger, then a partnership termination under section 708(b)(1)(B) will occur immediately before the merger.

IV. Partnership Division Tax Consequences 

The proposed regulations provide that the resulting partnership that is regarded as continuing shall file a return for the taxable year of the partnership that has been divided. Commentators requested that the final regulations clarify the tax consequences of a partnership that is regarded as continuing. For instance, commentators asked how a partnership files a return and which partnership retains the prior partnership's employer identification number (EIN) when more than one resulting partnership is considered a continuation of the prior partnership. Additionally, commentators asked whether subsequent elections by one resulting partnership that is regarded as continuing binds all resulting partnerships that are regarded as continuing.

In response to these comments, the final regulations clarify certain tax consequences that follow from a partnership division when more than one resulting partnership is regarded as continuing. Specifically, the final regulations provide that when more than one resulting partnership is regarded as continuing, the resulting partnership that is treated as the divided partnership will file a return for the taxable year of the partnership that has been divided and retain the EIN of the prior partnership. All other resulting partnerships that are regarded as continuing and all new partnerships (i.e., resulting partnerships that are not considered continuing) will file separate returns for the taxable year beginning on the day after the date of the division with new EINs for each partnership.

The final regulations also provide that all resulting partnerships that are continuing partnerships are subject to preexisting elections that were made by the prior partnership. However, a post-division election that is made by a resulting partnership will not bind any of the other resulting partnerships.

V. Definition of Partnership Mergers and Divisions 

The proposed regulations do not define what constitutes a partnership merger or division. Some commentators have requested that these terms be defined in the final regulations. Other practitioners have stated that the selectivity that would be created by attempting to draw lines in such definitions could lead to planning opportunities that would be adverse to the government's interest. The IRS and Treasury have decided not to provide comprehensive definitions of what is a partnership merger or division in these final regulations.

In addition to requesting guidance as to the general definitions of a partnership merger and division, some commentators have asked more narrowly whether a partnership division can occur when only one partner from the prior partnership is a partner in a resulting partnership. Consider the following example: ABC partnership owns X business and Y business. A and B each own a 20-percent interest, and C owns a 60-percent interest in the ABC partnership. C does not want to continue in the partnership with A and B and would like to operate X business with D. Accordingly, ABC partnership distributes X business to C in liquidation of C's interest in partnership ABC. Subsequently, C forms a partnership with D and contributes X business to the CD partnership. After the distribution and contribution of X business, AB partnership owns Y business and CD partnership owns X business.

The IRS and Treasury believe that the above transaction does not constitute a division. To have a division, at least two members of the prior partnership must be members of each resulting partnership that exists after the transaction. In the above example, C is the only member of the ABC partnership in the CD partnership. Accordingly, this transaction would not be treated as a division for Federal income tax purposes. The final regulations modify the proposed regulations to clarify this result.

VI. Application of Sections 704(c) and 737 in Partnership Divisions 

In the preamble to the proposed regulations, the IRS and Treasury requested comments as to whether expanded exceptions under sections 704(c)(1)(B) and737  would be appropriate in the context of partnership divisions. Most commentators agreed that it would not be wise to expand the current exceptions. In a related point, some commentators stated that the contribution of assets in a division should not create new section 704(c) property or section 737 net precontribution gain.

To the extent that a partnership division merely affects a restructuring of the form in which the partners hold property (that is, each partner's overall interest in each partnership property does not change), the IRS and Treasury agree that a partnership division should not create new section704(c)  property or section 737 net precontribution gain. However, it is not clear that this result is necessarily appropriate where a division is non-pro rata as to the partners, where some property is extracted from or added to the partnerships in connection with the division, or where new partners are added to the ownership group in connection with the division. The IRS and Treasury intend to study this issue and request comments in this regard.

VII. Effective Date 

The proposed regulations apply to mergers and divisions occurring on or after the date final regulations are published in the Federal Register. Commentators requested that the final regulations allow partnerships to apply the regulations to mergers and divisions occurring on or after January 11, 2000, (the date the proposed regulations were published in the Federal Register). The commentators explained that the regulations provide needed clarity in an area that has lacked guidance.

The IRS and Treasury believe it is appropriate to allow partnerships to apply the final regulations retroactively to the publication date of the proposed regulations. Therefore, the final regulations apply to mergers and divisions occurring on or after January 4, 2001. However, a partnership may apply the rules in the final regulations for mergers and divisions occurring on or after January 11, 2000.

Special Analyses 

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section7805(f) of the Internal Revenue Code, the notice of proposed rulemaking that preceded these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information 

The principal author of these regulations is Mary Beth Collins, Office of Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury participated in their development.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 8 Preamble, REG-111119-99, Partnership Mergers and Division, 65 Fed. Reg. 1572 (1/11/2000) 

Partnership Mergers 

Background 

Section 708(b)(2)(A) provides that in the case of a merger or consolidation of two or more partnerships, the resulting partnership is, for purposes of section 708, considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership. Section 1.708-1(b)(2)(i)of the Income Tax Regulations provides that if the resulting partnership can be considered a continuation of more than one of the merging partnerships, the resulting partnership is the continuation of the partnership that is credited with the contribution of the greatest dollar value of assets to the resulting partnership. If none of the members of the merging partnerships own more than a 50 percent interest in the capital and profits of the resulting partnership, all of the merged partnerships are considered terminated, and a new partnership results. The taxable years of the merging partnerships that are considered terminated are closed under section 706(c).

Although section 708 and the applicable regulations provide which partnership continues when two or more partnerships merge, the statute and regulations do not prescribe a form for the partnership merger. (Often, state merger statutes do not provide a particular form for a partnership merger.) In revenue rulings, however, the IRS has prescribed the form of a partnership merger for Federal income tax purposes.

In Rev. Rul. 68-289 (1968-1 C.B. 314), three existing partnerships (P1, P2, and P3) merged into one partnership with P3 continuing under section 708(b)(2)(A). The revenue ruling holds that P1 and P2, the two terminating partnerships, are treated as having contributed all of their respective assets and liabilities to P3, the resulting partnership, in exchange for a partnership interest in P3. P1 and P2 are considered terminated and the partners of P1 and P2 receive interests in P3 with a basis under section 732(b) in liquidation of P1 and P2 (Assets-Over Form). Rev. Rul. 77-458 (1977-2 C.B. 220), and Rev. Rul. 90-17 (1990-1 C.B. 119), also follow the Assets-Over Form for a partnership merger.

Explanation of Provisions 

A. Form of a Partnership Merger 

The IRS and Treasury are aware that taxpayers may accomplish a partnership merger by undertaking transactions in accordance with jurisdictional laws that follow a form other than the Assets-Over Form. For example, the terminating partnership could liquidate by distributing its assets and liabilities to its partners who then contribute the assets and liabilities to the resulting partnership (Assets-Up Form). In addition, the partners in the terminating partnership could transfer their terminating partnership interests to the resulting partnership in exchange for resulting partnership interests, and the terminating partnership could liquidate into the resulting partnership (Interest-Over Form).

In the partnership incorporation area, a taxpayer's form generally is respected if the taxpayer actually undertakes, under the relevant jurisdictional law, all the steps of a form that is set forth in one of three situations provided in Rev. Rul. 84-111 (1984-2 C.B. 88). The three situations that Rev. Rul. 84-111 sets forth are the Assets-Over Form, Assets-Up Form, and Interest-Over Form. Rev. Rul. 84-111 explains that, depending on the form chosen to incorporate the partnership, the adjusted basis and holding periods of the various assets received by the corporation and the adjusted basis and holding periods of the stock received by the former partners can vary. Like partnership incorporations, each form of a partnership merger has potentially different tax consequences.

Under the Assets-Up Form, partners could recognize gain under sections 704(c)(1)(B)and 737 (and incur state or local transfer taxes) when the terminating partnership distributes the assets to the partners. However, under the Assets-Over Form, gain under sections 704(c)(1)(B) and 737 is not triggered. See Secs. 1.704-4(c)(4) and 1.737-2(b). Additionally, under the Assets-Up Form, because the adjusted basis of the assets contributed to the resulting partnership is determined first by reference to section 732 (as a result of the liquidation) and then section 723(by virtue of the contribution), in certain circumstances, the adjusted basis of the assets contributed may not be the same as the adjusted basis of the assets in the terminating partnership. These circumstances occur if the partners’ aggregate adjusted basis of their interests in the terminating partnership does not equal the terminating partnership's adjusted basis in its assets. Under the Assets-Over Form, because the resulting partnership's adjusted basis in the assets it receives is determined solely under section 723, the adjusted basis of the assets in the resulting partnership is the same as the adjusted basis of the assets in the terminating partnership.

The regulations propose to respect the form of a partnership merger for Federal income tax purposes if the partnerships undertake, pursuant to the laws of the applicable jurisdiction, the steps of either the Assets-Over Form or the Assets-Up Form. (This rule applies even if none of the merged partnerships are treated as continuing for Federal income tax purposes.) Generally, when partnerships merge, the assets move from one partnership to another at the entity level, or in other words, like the Assets-Over Form. However, if as part of the merger, the partnership titles the assets in the partners’ names, the proposed regulations treat the transaction under the Assets-Up Form. If partnerships use the Interest-Over Form to accomplish the result of a merger, the partnerships will be treated as following the Assets-Over Form for Federal income tax purposes.

In the context of partnership incorporations, Rev. Rul. 84-111 distinguishes among all three forms of incorporation. However, with respect to the Interest-Over Form, the revenue ruling respects only the transferors’conveyances of partnership interests, while treating the receipt of the partnership interests by the transferee corporation as the receipt of the partnership's assets (i.e., the Assets-Up Form). The theory for this result, based largely on McCauslen v. Commissioner, 45 T.C. 588 (1966), is that the transferee corporation can only receive assets since it is not possible, as a sole member, for it to receive and hold interests in a partnership (i.e., a partnership cannot have only one member; so, the entity is never a partnership in the hands of the transferee corporation).

Adherence to the approach followed in Rev. Rul. 84-111 creates problems in the context of partnership mergers that are not present with respect to partnership incorporations. Unlike the corporate rules, the partnership rules impose certain tax results on partners based upon a concept that matches a contributed asset to the partner that contributed the asset. Sections 704(c) and 737 are examples of such rules. The operation of these rules breaks down if the partner is treated as contributing an asset that is different from the asset that the partnership is treated as receiving.

Given that the hybrid treatment of the Interest-Over Form transactions utilized in Rev. Rul. 84-111 is difficult to apply in the context of partnership mergers, another characterization will be applied to such transactions. The Assets-Over Form generally will be preferable for both the IRS and taxpayers. For example, when partnerships merge under the Assets-Over Form, gain under sections 704(c)(1)(B) and 737 is not triggered. Moreover, the basis of the assets in the resulting partnership is the same as the basis of the assets in the terminating partnership, even if the partners’ aggregate adjusted basis of their interests in the terminating partnership does not equal the terminating partnership's adjusted basis in its assets.

If partnerships merge under applicable law without implementing a form, the proposed regulations treat the partnerships as following the Assets-Over Form. This approach is consistent with the treatment of partnership to corporation elective conversions under the check-the-box regulations and technical terminations under section 708(b)(1)(B), other formless movements of a partnership's assets.

B. Adverse Tax Consequences of the Assets-Over Form 

The IRS and Treasury are aware that certain adverse tax consequences may occur for partnerships that merge in a transaction that will be taxed in accordance with the Assets-Over Form. These proposed regulations address some of the adverse tax consequences regarding section 752 liability shifts and buyouts of exiting partners.

1. Section 752 Revisions 

If a highly leveraged partnership (the terminating partnership) merges with another partnership (the resulting partnership), all of the partners in the terminating partnership could recognize gain because of section 752 liability shifts. Under the Assets-Over Form, the terminating partnership becomes a momentary partner in the resulting partnership when the terminating partnership contributes its assets and liabilities to the resulting partnership in exchange for interests in the resulting partnership. If the terminating partnership (as a momentary partner in the resulting partnership) is considered to receive a deemed distribution under section 752 (after netting increases and decreases in liabilities under Sec. 1.752-1(f)) that exceeds the terminating partnership's adjusted basis of its interests in the resulting partnership, the terminating partnership would recognize gain under section 731. The terminating partnership's gain then would be allocated to each partner in the terminating partnership under section 704(b). In this situation, a partner in the terminating partnership could recognize gain even though the partner's adjusted basis in its resulting partnership interest or its share of partnership liabilities in the resulting partnership is large enough to avoid the recognition of gain, provided that the decreases in liabilities in the terminating partnership are netted against the increases in liabilities in the resulting partnership.

The proposed regulations clarify that when two or more partnerships merge under the Assets-Over Form, increases or decreases in partnership liabilities associated with the merger are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of the merger under section 752. The IRS and Treasury consider it appropriate to treat the merger as a single transaction for determining the net liability shifts under section 752. Therefore, a partner in the terminating partnership will recognize gain on the contribution under section 731 only if the net section 752 deemed distribution exceeds that partner's adjusted basis of its interest in the resulting partnership.

2. Buyout of a Partner 

Another adverse tax consequence may occur when a partner in the terminating partnership does not want to become a partner in the resulting partnership and would like to receive money or property instead of an interest in the resulting partnership. Under the Assets-Over Form, the terminating partnership will not recognize gain or loss under section 721 when it contributes its property to the resulting partnership in exchange for interests in the resulting partnership. However, if, in order to facilitate the buyout of the exiting partner, the resulting partnership transfers money or other consideration to the terminating partnership in addition to the resulting partnership interests, the terminating partnership may be treated as selling part of its property to the resulting partnership under section 707(a)(2)(B). Any gain or loss recognized by the terminating partnership generally would be allocated to all the partners in the terminating partnership even though only the exiting partner would receive the consideration.

The IRS and Treasury believe that, under certain circumstances, when partnerships merge and one partner does not become a partner in the resulting partnership, the receipt of cash or property by that partner should be treated as a sale of that partner's interest in the terminating partnership to the resulting partnership, not a disguised sale of the terminating partnership's assets. Accordingly, the proposed regulations provide that if the merger agreement (or similar document) specifies that the resulting partnership is purchasing the exiting partner's interest in the terminating partnership and the amount paid for the interest, the transaction will be treated as a sale of the exiting partner's interest to the resulting partnership. This treatment will apply even if the resulting partnership sends the consideration to the terminating partnership on behalf of the exiting partner, so long as the designated language is used in the relevant document.

In this situation, the exiting partner is treated as selling a partnership interest in the terminating partnership to the resulting partnership(and the resulting partnership is treated as purchasing the partner's interest in the terminating partnership) immediately prior to the merger. Immediately after the sale, the resulting partnership becomes a momentary partner in the terminating partnership. Consequently, the resulting partnership and ultimately its partners (determined prior to the merger) inherit the exiting partner's capital account in the terminating partnership and any section 704(c) liability of the exiting partner. If the terminating partnership has an election in effect under section 754 (or makes an election under section 754), the resulting partnership will have a special basis adjustment regarding the terminating partnership's property under section 743. The proposed regulations provide that the resulting partnership's basis adjustments under section 743 must be ultimately allocated solely to the partners who were partners in the resulting partnership immediately before the merger; the adjustments do not affect the common basis of the resulting partnership's assets.

C. Merger as Part of a Larger Transaction 

The proposed regulations provide that if the merger is part of a larger series of transactions, and the substance of the larger series of transactions is inconsistent with following the form prescribed for the merger, the form may not be respected, and the larger series of transactions may be recast in accordance with their substance. An example illustrating the application of this rule is included in the proposed regulations.

D. Measurement of Dollar Value of Assets 

As discussed above, the regulations currently provide that in a merger of partnerships, if the resulting partnership can be considered a continuation of more than one of the merging partnerships, the resulting partnership is the continuation of the partnership that is credited with the contribution of the greatest dollar value of assets to the resulting partnership. Commentators have questioned whether this rule refers to the gross or net value of the assets of a partnership. The proposed regulations provide that the value of assets of a partnership is determined net of the partnership's liabilities.

E. Effective Date 

The regulations are proposed to apply to mergers occurring on or after the date final regulations are published in the Federal Register.

Partnership Divisions 

Background 

Section 708(b)(2)(B) provides that, in the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership)are considered a continuation of the prior partnership. Section 1.708-1(b)(2)(ii)provides that any other resulting partnership is not considered a continuation of the prior partnership but is considered a new partnership. If the members of none of the resulting partnerships owned an interest of more than 50 percent in the capital and profits of the prior partnership, the prior partnership is terminated. Where members of a partnership that has been divided do not become members of a resulting partnership that is considered a continuation of the prior partnership, such partner's interest is considered liquidated as of the date of the division.

Section 708(b)(2)(B) and the applicable regulations do not prescribe a particular form for the division involving continuing partnerships. The IRS has not addressed in published guidance how the assets and liabilities of the prior partnership move into the resulting partnerships. Taxpayers generally have followed either the Assets-Over Form or the Assets-Up Form for partnership divisions.

Under the Assets-Over Form, the prior partnership transfers certain assets to a resulting partnership in exchange for interests in the resulting partnership. The prior partnership then immediately distributes the resulting partnership interests to partners who are designated to receive interests in the resulting partnership.

Under the Assets-Up Form, the prior partnership distributes certain assets to some or all of its partners who then contribute the assets to a resulting partnership in exchange for interests in the resulting partnership.

Explanation of Provisions 

A. Form of a Partnership Division 

As with partnership mergers, the IRS and Treasury recognize that different tax consequences can arise depending on the form of the partnership division. Because of the potential different tax results that could occur depending on the form followed by the partnership, the regulations propose to respect for Federal income tax purposes the form of a partnership division accomplished under laws of the applicable jurisdiction if the partnership undertakes the steps of either the Assets-Over Form or the Assets-Up Form. Thus, the same forms allowed for partnership mergers will be allowed for partnership divisions.

Generally, an entity cannot be classified as a partnership if it has only one member. This universally has been held to be the case in classifying transactions where interests in a partnership are transferred to a single person, so that the partnership goes out of existence. McCauslen v. Commissioner, 45 T.C. 588 (1966); Rev. Rul. 99-6, 1999-6 I.R.B. 6; Rev. Rul.67-65, 1967-1 C.B. 168; Rev. Rul. 55-68, 1955-1 C.B. 372.

However, in at least one instance involving the contribution of assets by an existing partnership to a newly-formed partnership, regulations have provided that the momentary existence of the new partnership will be respected for Federal income tax purposes. See Sec. 1.708-1(b)(1)(iv). Pursuant to the proposed regulations, under the Assets-Over Form of a partnership division, the prior partnership's momentary ownership of all the interests in a resulting partnership will not prevent the resulting partnership from being classified as a partnership on formation.

The example in current Sec. 1.708-1(b)(2)(ii) indicates that when a partnership is not considered a continuation of the prior partnership under section 708(b)(2)(B) (partnership considered a new partnership under current Sec. 1.708-1(b)(2)(ii)), the new partnership is created under the Assets-Up Form. The regulations propose to modify this result and provide examples illustrating that partnerships can divide and create a new partnership under either the Assets-Over Form or the Assets-Up Form.

Consistent with partnership mergers, if a partnership divides using a form other than the two prescribed, it will be treated as undertaking the Assets-Over Form.

These proposed regulations use four terms to describe the form of a partnership division. Two of these terms, prior partnership and resulting partnership, describe partnerships that exist under the applicable jurisdictional law. The prior partnership is the partnership that exists under the applicable jurisdictional law before the division, and the resulting partnerships are the partnerships that exist under the applicable jurisdictional law after the division. The other two terms, divided partnership and recipient partnership, are Federal tax concepts. A divided partnership is a partnership that is treated, for Federal income tax purposes, as transferring assets in connection with a division, and a recipient partnership is a partnership that is treated, for Federal income tax purposes, as receiving assets in connection with a division. The divided partnership must be a continuation of the prior partnership. Although the divided partnership is considered one continuing partnership for Federal income tax purposes, it may actually be two different partnerships under the applicable jurisdictional law (i.e., the prior partnership and a different resulting partnership that is considered a continuation of the prior partnership for Federal income tax purposes).

Finally, because in a formless division it generally will be unclear which partnership should be treated, for Federal income tax purposes, as transferring assets (i.e., the divided partnership) to another partnership(i.e., the recipient partnership) where more than one partnership is a continuation of the prior partnership, the proposed regulations provide that the continuing resulting partnership with the assets having the greatest fair market value (net of liabilities) will be treated as the divided partnership. This issue also is present where the partnership that, in form, transfers assets is not a continuation of the prior partnership, but more than one of the other resulting partnerships are continuations of the prior partnership. The same rule applies to these situations.

B. Consequences under Sections 704(c)(1)(B) and 737 

Gain under sections 704(c)(1)(B) and 737 may be triggered when section 704(c) property or substituted section 704(c) property is distributed to certain partners. These rules often will be implicated in the context of partnership divisions.

Where a division is accomplished in a transaction that is taxed in accordance with the Assets-Over Form, the partnership interest in the recipient partnership will be treated as a section 704(c) asset to the extent that the interest is received by the divided partnership in exchange for section 704(c) property. Section 1.704-4(d)(1). Accordingly, the distribution of the partnership interests in the recipient partnership by the divided partnership generally will trigger section 704(c)(1)(B)where the interests in the recipient partnership are received by a partner of the divided partnership other than the partner who contributed the section 704(c) property to the divided partnership. In addition, section 737 may be triggered if a partner who contributed section 704(c) property to the divided partnership receives an interest in the recipient partnership that is not attributable to the section 704(c) property.

Where a division is accomplished under the Assets-Up Form, assets are distributed directly to the partners who will hold interests in the recipient partnership. The distribution could trigger section 704(c)(1)(B) or 737 depending on the identity of the distributed asset and the distributee partner.

The regulations under section 737 provide an exception for certain partnership divisions. Section 737 does not apply when a transferor partnership transfers all the section 704(c) property contributed by a partner to a second partnership in a section 721 exchange, followed by a distribution of an interest in the transferee partnership in complete liquidation of the interest of the partner that originally contributed the section 704(c) property to the transferor partnership. Section 1.737-2(b)(2). This rule, however, may not apply to many partnership divisions because the original contributing partner often remains a partner in the divided partnership. No similar rule is provided under section 704(c)(1)(B).

In many instances, the application of sections 704(c)(1)(B) and 737 will be appropriate when a partnership divides under either the Assets-Over Form or the Assets-Up Form. Consider the following example: A, B, C, and D form a partnership. A contributes appreciated property X($0 basis and $200 value), B contributes property Y ($200 basis and$200 value), and C and D each contribute $200 cash. The partnership subsequently divides into two partnerships using the Assets-Over Form, distributing interests in the recipient partnership in accordance with each partner's pro rata interest in the prior partnership. Property X remains in the prior partnership, and property Y is contributed to the recipient partnership. Under these facts, section 737 could be avoided if an exception were created for the distribution of the recipient partnership interests. If, subsequent to the division, half of property Y is distributed to A, section 737 would not be triggered because property X (the section 704(c) property) is no longer in the same partnership as property Y.

While the IRS and Treasury generally believe that it is appropriate to apply sections 704(c)(1)(B) and 737 in the context of partnership divisions, comments are invited on whether it would be appropriate to expand the exceptions to these sections in certain circumstances relating to divisive transactions.

C. Division as Part of a Larger Transaction 

The proposed regulations provide the same rule for partnership divisions that applies to partnership mergers.

D. Effective Date 

The regulations are proposed to apply to divisions occurring on or after the date final regulations are published in the Federal Register.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 9 Preamble, REG-143397-05, Partner's Distributive Share, 72 Fed. Reg. 46932 (8/22/2007) 

REG-143397-05 

DEPARTMENT OF THE TREASURY 
 26 CFR Parts 1
 [REG-143397-05]
 RIN 1545-BE99
 Rules for Contribution and Subsequent Distribution of Section 704(c) Property in Connection with Partnership Mergers 

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed regulations and notice of public hearing.

SUMMARY: This document contains regulations that provide rules concerning the application of sections 704(c)(1)(B) and 737 to distributions of  property after two partnerships engage in an assets-over merger.  The  proposed regulations affect partnerships and their partners.  This  document also provides a notice of public hearing on these proposed  regulations.

DATES: Written or electronic comments must be received by November 20, 2007.  Outlines of the topic to be discussed at the public hearing scheduled for  December 5, 2007 at 10 a.m. must be received by November 21, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-143397-05), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington DC  20044. Submissions may be hand delivered Monday through Friday, between  the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-143397-05),  Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue,  NW., Washington, DC or sent electronically via the Federal eRulemaking  Portal at http://www.regulations.gov(IRS  REG-143397-05).  The public hearing will be held in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT:Concerning the proposed regulations, Jason Smyczek or Laura Fields(202) 622-3050, concerning submissions of  comments, the hearing, and/or to be placed on the building access list  to attend the hearing, Richard Hurst, Richard.A.Hurst@irscounsel.treas.gov,  (202) 622-7180(not toll-free numbers).

SUPPLEMENTAL INFORMATION:

Background 

Section 704(c)(1)(B) provides that a partner  that contributes section 704(c)property to a partnership must  recognize gain or loss on the distribution of such property to another  partner within seven years of its contribution to the partnership in an  amount equal to the gain or loss that would have been allocated to such  partner under section 704(c) if the distributed property had been sold  by the partnership to the distributee partner for its fair market value  at the time of the distribution.

Section 737(a) provides that a partner that  contributes section 704(c) property to the partnership and then  receives a distribution of property (other than money) within seven  years of its contribution must recognize gain in an amount equal to the  lesser of (1) the excess (if any)of (A) the fair market value of  property (other than money) received in the distribution over (B) the  adjusted basis of the partner's interest in the partnership immediately  before the distribution reduced(but not below zero) by the amount of  money received in the distribution, or (2) the net precontribution gain  of the partner.

Section 737(b) provides that for purposes of  section 737, the term “net precontribution gain” means the  net gain (if any) which would have been recognized by the distributee  partner under section 704(c)(1)(B)if all property which (1) had been  contributed to the partnership by the distributee partner within seven  years of the distribution, and (2) is held by the partnership  immediately before the distribution, had been distributed by the  partnership to another partner.

Rev. Rul. 2004-43, 2004-1 C.B. 842, (see section 601.601(d)(2) of  this chapter) issued on April 12, 2004, addressed the application of  sections 704(c)(1)(B) and 737 in an assets-over partnership merger  described in section 1.708-1(c)(3)(i). Rev. Rul. 2004-43 held that section 704(c)(1)(B)applies to newly created section 704(c) gain or loss in property contributed by the transferor partnership to the transferee partnership in an assets-over partnership merger.  The revenue ruling also held that for purposes of section 737(b), net precontribution gain includes newly created section  704(c) gain or loss in property contributed by the transferor  partnership to the transferee partnership in an assets-over partnership  merger.  In addition, the revenue ruling held that section 704(c)(1)(B)  will not apply to, and, for purposes of section 737, net  precontribution gain will not include, reverse section 704(c) gain or  loss resulting from a revaluation of property of the transferee  partnership.

Some commentators argued that Rev. Rul. 2004-43 was not consistent with the existing regulations under sections 704(c)(1)(B) and 737, and that the  conclusions contained in the ruling should not be applied retroactively.  In response to these comments, the Treasury Department and the IRS issued Notice 2005-15, 2005-7 I.R.B. 527, (see  section 601.601(d)(2) of this chapter) indicating their intent to issue  regulations under sections 704(c)(1)(B) and 737 implementing the  principles of the ruling, and issued Rev.  Rul. 2005-10, 2005-7 I.R.B. 492, (see section 601.601(d)(2) of  this chapter) officially revoking Rev. Rul. 2004-43.  The Notice provided that any such regulations  would be effective for distributions made after January 19, 2005.

Explanation of Provisions 

A.  Assets-Over Partnership Mergers 

These proposed regulations implement the  principles articulated in Rev. Rul. 2004-43.  The proposed regulations under  section 1.704-4(c)(4)and section 1.737-2(b) provide that in an assets-over  merger, sections 704(c)(1)(B) and 737 do not apply to the transfer by a  partnership(the transferor partnership) of all of its assets and  liabilities to another partnership (the transferee partnership),  followed by a distribution of the interests in the transferee  partnership in liquidation of the transferor partnership as part of the  same plan or arrangement.

The proposed regulations, however, provide  that section 704(c)(1)(B)applies to a subsequent distribution by the  transferee partnership of section 704(c) property contributed in the  assets-over merger by the transferor partnership to the transferee  partnership.  The proposed regulations also provide that section 737  applies when a partner of the transferor partnership receives a  subsequent distribution of property (other than money) from the  transferee partnership.

The proposed regulations provide that for  property contributed to the transferor partnership (original  contribution), the amount of original section 704(c) gain or loss is  the difference between the property's fair market value and the  contributing partner's adjusted basis at the time of contribution to  the extent such difference has not been eliminated by section 704(c)  allocations, prior revaluations, or in connection with the merger.  In  the case of property contributed with original section 704(c) loss,  section 704(c)(1)(C) which was added by the American Jobs Creation Act  of 2004 provides special rules for determining the basis of the  property contributed.  The Treasury Department and IRS are currently  developing guidance that will implement the provisions of section  704(c)(1)(C).  Thus, the proposed regulations do not address the impact  of section 704(c)(1)(C)in applying these rules.  However, when  finalized, these regulations will clarify the application of section  704(c)(1)(C) to these rules.

The proposed regulations provide that the  seven year period will not restart with respect to the original section  704(c) gain or loss as a result of the merger.  Accordingly, a  subsequent distribution by the transferee partnership of property with  original section 704(c)gain or loss is subject to sections  704(c)(1)(B) and 737 if the distribution occurs within seven years of  the contribution of the property to the transferor partnership  (original contribution).  However, with respect to new section 704(c)  gain or loss, the regulations provide that the seven-year period in  sections 704(c)(1)(B) and 737 begins on the date of merger.  Thus, a  subsequent distribution by the transferee partnership of property with  new section 704(c) gain or loss is subject to sections 704(c)(1)(B) and  737 if the distribution occurs within seven years of the merger.

The regulations further provide that no  original section 704(c) gain or loss will be recognized under section  704(c)(1)(B) or section 737 if property that was originally contributed  to the transferor partnership is distributed to the original  contributor.  If property has new section 704(c) gain or loss, then a  subsequent distribution of such property within seven years of the  merger to one of the former partners of the transferor partnership  (former partner) is subject to section 704(c)(1)(B) only to the extent  of the other former partners'shares of such gain or loss.

New section 704(c) gain or loss shall be  allocated among the partners of the transferor partnership in a manner  consistent with the principles of sections 1.704-3(a)(7) and newly  designated 1.704-3(a)(10) (previously section 1.704-3(a)(9)).  In  addition, the partners of the transferor partnership are deemed to have  contributed an undivided interest in the assets of the partnership.   The proposed regulations provide that the determination of the  partners' undivided interest for this purpose shall be made by the  transferor partnership using any reasonable method.  The Treasury  Department and the IRS request comments on methods that should be  considered reasonable for this purpose.

The proposed regulations also provide that  if less than all of a section 704(c) property is distributed, then a  proportionate amount of original and new section 704(c) gain or loss  must be recognized under section 704(c)(1)(B).  Similarly, if gain is  required to be recognized under section 737, a proportionate amount of  original and new section 704(c)gain must be recognized under section  737.  Each partner must recognize its respective proportionate share of  gain or loss required to be recognized.

The proposed regulations further provide a  subsequent merger rule.  This rule provides that if the transferee  partnership is subsequently merged (a subsequent merger) the new  section 704(c) gain or loss that resulted from the original merger  shall be subject to section 704(c)(1)(B) for seven years from the time  of the original merger and the new section 704(c) gain or loss that  resulted from the subsequent merger will be subject to section  704(c)(1)(B) for seven years from the time of the subsequent merger.

In addition, the proposed regulations  provide an identical ownership and a de minimis change in ownership  exception to sections 704(c)(1)(B)and 737 with regard to assets-over  partnership mergers.  Under the identical ownership exception, section  704(c)(1)(B) will not apply to, and section 737 net precontribution  gain will not include, new section 704(c) gain or loss in any property  contributed in an assets-over partnership merger where the ownership of  both partnerships is identical. In order for merging partnerships to  qualify for the identical ownership exception, each partner must own  identical interests in book capital and in each item of income, gain,  loss, deductions and credit, and identical shares of distributions and  liabilities in each of the transferor and transferee partnerships.   Where ownership of both partnerships is identical, the merger more  accurately represents a change in form, and should have no substantive  tax consequences. The same principles apply where the change in  ownership is de minimis. For purposes of the de minimis exception, a  difference in ownership is de minimis if ninety seven percent of the  interests in book capital, items of income, gain, loss, deduction and  credit and share of distributions and liabilities of the transferor  partnership and transferee partnership are owned by the same owners in  the same proportions.

Proposed regulations under  section 1.704-3(a)(9) provide that taxpayers may distinguish between  the original and new portions of section 704(c)gain or loss.  The  proposed regulations provide that the transferee partnership may  continue to use the section 704(c) allocation method adopted by the  transferor partnership with respect to original section 704(c)  property, or it may adopt another reasonable section 704(c)method.  In  addition, the transferee partnership may adopt any reasonable section  704(c) method with respect to new section 704(c) gain or loss.  With  respect to both the original and the new section 704(c)gain or loss,  the transferee partnership must use a reasonable method that is  consistent with the purpose of sections 704(b) and 704(c).

B.  Miscellaneous Provisions 

As part of this proposed regulation, the  Treasury Department and the IRS are also making certain regulatory  changes to reflect statutory changes that occurred as part of the  Taxpayer Relief Act of 1997(Public Law 105-34).  Effective June 8, 1997, Congress lengthened the period of time from five years to seven for accounting for section 704(c) gain or loss with respect to distributions.  Consistent with the statutory changes, various provisions in section 1.704-4 and section 1.737-1 have been amended.

Effective Dates 

Except as otherwise provided, these proposed  regulations will be effective for any distributions of property after  January 19, 2005, if such property was contributed in an assets-over  merger after May 3, 2004. Provisions relating to the change in the  regulations in section 1.704-4 and section 1.737-1 from the previous  five-year rule to the seven-year rule will be effective August 22,  2007.

Special Analyses 

It has been determined that this notice of  proposed rulemaking is not a significant regulatory action as defined  in Executive Order 12866. Therefore, a regulatory assessment is not  required.  It has also been determined that section 553(b)  of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply  to these regulations, and because the regulation does not impose a  collection of information on small entities, the Regulatory Flexibility  Act (5 U.S.C. chapter 6) does not apply.  Pursuant to section 7805(f)  of the Code, this notice of proposed rulemaking will be submitted to  the Chief Counsel for Advocacy of the Small Business Administration for  comment on its impact on small business.

Comments and Public Hearing 

Before these proposed regulations are  adopted as final regulations, consideration will be given to any  written comments (a signed original and eight(8) copies) or electronic  comments that are submitted timely to the IRS.  The Treasury Department  and IRS request comments on the clarity of the proposed rules and how  they may be made easier to understand. All comments will be available  for public inspection and copying.

A public hearing has been scheduled  for December 5, 2007, 10 a.m. in the  Auditorium, Internal Revenue Building, 1111 Constitution Avenue, N.W.,  Washington, DC.  Due to building security procedures, visitors must  enter at the Constitution Avenue entrance.  In addition, all visitors  must present photo identification to enter the building. Because of  access restrictions, visitors will not be admitted beyond the immediate  entrance area more than 15 minutes before the hearing starts.  For  information about having your name placed on the building access list  to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.  Persons who wish to  present oral comments at the hearing must submit written or electronic comments by November 20, 2007, and an outline of the topics to be discussed and time to be devoted to each topic (a signed original and  eight (8) copies) by November 21, 2007.  A period of 10 minutes will be  allotted to each person for making comments.  An agenda showing the  scheduling of the speakers will be prepared after the deadline for  receiving outlines has passed.  Copies of the agenda will be available  free of charge at the hearing.

Drafting Information 

The principal authors of these proposed  regulations are Jason Smyczek and Laura Fields, Office of the Associate  Chief Counsel (Passthroughs and Special Industries), IRS.  However,  other personnel from the IRS and the Treasury Department participated  in their development.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 10 Draft Form Representation Letter 

ATTORN, COUNS, AND LAW, LLP 

[Address]

[Date]

PERSONAL AND CONFIDENTIAL 

Account, Aud, and Num, CPAs LLP

[Address]

Ms. Arlene Aud

[Address]

Salutation:

This law firm has been representing Account, Aud and Num, (the “Partnership”) as general counsel, since we assisted the named partners in forming the firm, including drafting the partnership agreement.  Although we advised that the agreement should contain provisions relating to the withdrawal, death or retirement of a partner, the Partnership decided  at that time, and periodically thereafter, not to make such provisions.  We have been advised that Arlene Aud has announced her retirement and that the Partnership and she desire that we represent her as well as the firm in negotiating the terms of her retirement.  Under the Rules of Professional Conduct, the firm able to undertake the multiple representation only if the mutual interests of the Partnership and Ms. Aud in working out amicable terms for the retirement predominates over the inevitable conflict that such a transaction involves, and if we receive informed written consent to the multiple representation.

Because of the multiple representation involved in the services to be provided to the Partnership and Ms. Aud, individually, as owners or otherwise, we are required to disclose the implications of  possible conflicts of interest, and limitations on our representation. This letter is intended to provide the information our firm believes you need to give such informed consent and our request for  your written consent to the representation described herein. In this regard, to restate our law firm has served as general counsel to the Partnership since its inception and hopes to have the privilege of continuing to do so after Ms. Aud's retirement.

In connection with our legal services, the firm will be unable to hold, as confidential, any information it receives from the Partnership or Ms. Aud relating to Ms. Aud's retirement, and, upon request, will inform each of you equally of such information. This may include some information we possess relating to the affairs of the Partnership obtained in connection with our role as general counsel to the Partnership, to the extent that we determine it is relevant the terms of Ms. Aud's retirement. The Partnership therefore, may wish not to disclose any information relating to amounts or terms for Ms. Aud's retirement that differ from any offer the firm has made to her, since we might be obligated to disclose such information to her.  Similarly, Ms. Aud should not disclose any amounts or terms of her retirement that differ from any offer she has made to the Partnership, through us, or otherwise. This may limit our ability to represent you fully, since we cannot act as advocate of either of you, but can only provide our professional judgment of the effect of any offer made by either of you to the other and suggest possible means of effectuating the expressed mutual desire to promote amicable terms for her retirement, which, we understand the Partnership intends to consider as a possible model for a retirement provision to included as an amendment to the Partnership's partnership agreement. Our law firm will, of course, keep confidential from third parties, communications received for any of you relating to the Partnership, Ms. Aud's retirement,  and any other matters falling within the attorney-client privilege.

We have advised both of you that under the partnership statute, in the absence of an agreement as to price and terms, Ms. Aud is entitled to receive a payment equal to her share of the greater of the liquidation value of the Partnership or the price at which the Partnership could be sold as a going concern, and that the amount is to be paid to her within 120 days of her retirement.  Both the Partnership and Ms. Aud agree that the determination of these amount would be difficult, and that payment at the time specified is not necessarily practical or desirable.  To the extent relevant in negotiating the terms of Ms. Aud's retirement, our law firm will not be able to act as the advocate of either the Partnership or Ms. Aud in suggesting what those amounts may be.  Because the firm is a professional services business, under the Federal income tax law, the classification of payments to Ms. Aud may create conflicts.  For example, any amounts designated in the withdrawal agreement as for her share of the goodwill or going concern value of the firm will be taxable to her as capital gain and will be amortizable by the firm over 15 years, while amounts in excess of her capital account that may be represent the value of the firm as a going concern, but that are not designated as being for goodwill or going concern value are generally tax deductible by the firm as made and ordinary income to Ms. Aud as received.  The extent, if any, that the value of an immediate deduction instead amortization exceeds the detriment  to Ms. Aud of ordinary income instead of capital gain, is likely to be a matter of negotiation between the Partnership and Ms. Aud, but out law firm will not be able to be the advocate of either of you in determining how any such excess should be allocated. To the extent that the Partnership intends to use any agreement with Ms. Aud as a model for provision to be inserted in the Partnership's partnership agreement, the matter is complicated by considering that amounts payable for goodwill to the successor for a deceased partner that are attributable to goodwill and going concern value are generally not taxable because of the step-up in basis at death as long as there is an estate tax. With respect to any such matters, the firm will advise each party as to the nature of the issue, and firm's judgment of the considerations believed to be involved, and will work cooperatively to encourage a fair and amicable resolution. If, after exploring any issues with you, we determine that there are material differences that you cannot resolve on an amicable basis, or that we conclude cannot be resolved on terms compatible with the best interests of each party involved, we may withdraw from the representation. The Partnership and Ms. Aud, however, are advised that you have, and will continue to have, the right to engage separate counsel, with respect to any matters affecting you in connection with Ms. Aud's, or with respect to any other matters, including the review and approval of this letter.

In the event litigation were to ensue from a dispute between the Partnership and Ms. Aud in connection with her retirement including the enforcement of any retirement agreement, the our law firm would not be permitted to represent any interests in the litigation, unless all parties consent. Moreover, each of you is advised of the possibility that, even prior to litigation, it may be necessary, because of ethical considerations, for the our law firm to withdraw entirely from the representation of any or all of you in connection with the dispute. Any such withdrawal may result in increased legal costs. Any such withdrawal, of course, will not prevent the firm's continued representation of the Firm or Ms. Aud  with respect to matters not directly related to the dispute.

Acknowledging that each of you has similar overall goals with respect to Ms. Aud's retirement rather than conflicting ones, each of you have expressed your desire, and you have confirmed your agreement, to waive any actual or potential conflicts of interest, with respect to the multiple representation described above and expressly consent to our law firm's representation of the Firm and Ms. Aud with respect to the legal services relating to her retirement, as well as any other services in the future for it. You also expressly consent to the firm's representation of each of you individually, with respect to matters not directly related to the apartment venture, including, without limitation, individual tax and estate planning that may involve your respective interests in the new entity.

Our law firm reserves the right to withdraw as your legal counsel at any time, subject only to our obligations under the Rules of Professional Conduct. In the event that the firm does terminate its representation, the firm will complete such matters as it deems appropriate, and will cooperate in the selection of new legal counsel as may be necessary or appropriate under the circumstances. The circumstances of such withdrawal may result in additional legal costs to you.

If each of you agrees to the multiple representation as provided in this letter, please execute the additional, enclosed signed original of this letter, in order to confirm your individual consent to the terms of such representation.

 	Sincerely, 	
 	ATTORN, COUNS, AND LAW, LLP 	
 	By:  _______________________________	
 	  Partner 	
Acknowledged and Agreed:	 	
 Date:  __________ 	Account, Aud, and Num, CPAs LLP 	
 	By: _______________________________	
 	  Partner	
Acknowledged and Agreed:	 	
Date: __________	___________________________________	
 	  Arlene Aud	

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 11 Checklist of Principal Tax Consequences of Current and Liquidating Distributions 

All Distributions	Distributee	Partnership and Other Partners	
 Gain or Loss	General Nonrecognition	General Nonrecognition 	
Basis	 Outside basis generally reduced by
 amount of money or by inside
  basis of property distributed. 	Inside basis may be adjusted if
 § 754 election applies  	
Holding Period	 No effect on holding period 
 of partnership interest	 No effect on holding period
 of other partnership assets	
Distributed Property 	Generally transferred
 partnership inside basis 	Inside basis reduced by amount of
 distribution before any § 754 adjustment	
Holding Period 	Transferred inside holding
  period for distributed property	Not applicable	
 Liabilities	Any reduction in share of
  partnership liabilities is a
  distribution of money 	Any reduction in other partners' share
 of partnership liabilities is a
  distribution to other partners	
 § 1.752-7 Liabilities	Outside basis adjusted  for
  liquidating distribution or for
 assumption by another partner	 Assumption and 
 satisfaction do not
  affect partnership 	
 Capital Accounts	Adjusted for any revaluation; reduced by amount
 of money and by FMV of property distributed 	Generally  revalued	

Current Distributions	 	 	
 Money	 	 	
 Gain 	Only to extent amount
 exceeds outside basis	None for partnership or
 other partners	
Basis	Outside basis reduced by amount
  distributed, but not below zero	 Inside basis adjustment for distributee's 
 gain if § 754 election applies	
Capital 
  Accounts 	Reduced by amount
 distributed 	No effect for other
  partners.	
§ 704(c)/Reverse
 § 704(c) Allocations 	No effect	No effect for other
 partners	
 Capital
 Accounts	Reduced by amount
 distributed 	Generally not
 revalued	

Marketable Securities	 	 	
Gain 	Money to extent of FMV, reduced by
 share of same class of securities 	None	
Basis 	Outside basis reduced by inside
 basis of distributed
  marketable securities	None for distributee's gain from
 marketable securities even when
  § 754 election applies	
 Distributed
 Marketable
 Securities	Transferred inside basis
  increased by 
 gain recognized	None except elimination
 of inside basis of
 distributed securities 	
Capital 
  Accounts 	Reduced by inside basis of
  distributed marketable securities	Generally not
  revalued	

 § 751 Property	 	 	
Gain	Only if disproportionate
  distribution	If disproportionate
  distribution	
 Basis	Outside basis reduced by inside
  basis of distributed § 751 property, 
 but not below zero	 Other partners' outside basis reduced by 
 inside basis of exchanged property 	
Disproportionate
  Distribution	Deemed exchange of § 751
  property for excess other
  property or of other property
 for excess § 751 property	 Deemed exchange of other
 property for retained excess § 751
 property or of § 751   property
  for retained excess other property	
Exchanged 
  Property	Cost basis 
 without § 754 election 	Cost basis
 without § 754 election 	
 Capital 
 Accounts	Adjusted for revaluation; 
  reduced by FMV of property
  distributed, including that
 that in deemed exchange	 Not adjusted for gain or loss on deemed
 exchange, but revalued to reflect FMV of
  property distributed, including that
 in deemed exchange	

Other Property 	 	 	
Gain	 None, except if disproportionate
 distribution of § 751 property	None, except if disproportionate
 distribution of § 751 property	
 Basis	Outside basis reduced by inside
 basis of distributed property,
 but not below zero	 Inside basis adjustment if § 754 election 
  applies for distributee's “lost” basis if
 outside basis limitation applies 	
 Distributed
 Property	Transferred inside basis limited
 by outside basis	Inside basis of distributed property
 eliminated before any § 754 adjustment	
Character 	Ordinary for unrealized receivables, and
 for five years inventory,
 without regard to character to distributee	Not applicable	
 Holding
 Period  	Transferred partnership
  holding period	 Not applicable	
Capital
 Accounts 	Adjusted for revaluation; reduced
 by FMV of property distributed	Revalued to reflect 
  FMV of property distributed	

Mixing Bowl	 	 	
§ 704(c)(1)(B)	Property contributed by another 
 partner within seven years	Contributing
 partner	
Gain or loss	Same as for distribution of 
 property of the character
 received 	 Inherent gain or loss on distributed 
  contributed property recognized by
  contributor	
 Basis	 Outside basis reduced by inside
 basis adjusted for contributor's gain or loss	 Contributor's outside basis adjusted
  for recognized gain or loss	
 Distributed
 Property  	 Inside basis adjusted for gain or
   loss recognized by contributor 
 even if no § 754 election applies	No effect for partnership	
  Capital
 Account  	Adjusted for revaluation; reduced
 by FMV of property distributed 	Revalued to reflect FMV of property
 distributed;no effect to extent inherent gain  
 already reflected in contributor's capital account	
§ 737	 Contributed other property
 within seven years	Partnership retains
 contributed property	
  Gain	 Unrealized net gain on contributed property 
  limited to excess of FMV of distributed 
 property over unadjusted outside basis 	None	
Basis 	 Outside basis increased by
  recognized  gain or loss	Inside basis of contributed property 
  adjusted for recognized gain or loss
 even if  no § 754 election applies 	
 Distributed 
  Property	Transferred inside basis limited
  by increased outside basis 	Inside basis adjustment reduces
 contributor's § 704(c)gain 	
Capital 
  Accounts	 No effect because inherent gain already
  reflected in capital account 	None for other partners	

Disguised Sales	  	 	
By Partnership
  to Partner	Has contributed money or
   other property, deemed related   
 to distribution	 Has received contribution of
  money or other property, deemed 	
Gain or Loss	 None on money; should be
 exchange for other property	 Recognized by partnership	
Basis	 Outside basis not increased
 for contribution deemed 
 consideration for
  property deemed purchased  	Distribution treated as
 consideration for sale of property
  distributed	
Distributed 
 Property 	Generally cost basis	Considered sold or
 exchanged	
 Capital Account	 None, because  treated
  as sale, not distribution	 None, because treated
  as sale, not distribution	
 Of Partnership
  Interests 	 Distributee receives money or
 other property contributed 
  by existing or new partner	Contributing partner, not partnership,
 deemed to make transfer	
 Gain or loss
  recognizes	Determined by outside basis
 allocated to portion of partnership
 interest deemed sold	Deemed purchaser, not partnership, 
  gain or loss on contributed property
 transferred to distributee	
Basis 	Outside basis reduced by portion
  deemed sold, not entire distribution 	None for partnership; contributor
  generally has cost outside basis	
  Distributed
 Property	Generally cost basis for
  any property received	 Gain or loss on any property distributed
   allocated to deemed purchaser of 
  partnership interest. 	
  Capital 
   Account  	Ratable reduction for
 partnership interest deemed sold 	 Succeeds to ratable share of
  capital account of disguised seller	

 § 1.752-7 Liabilities	Assumed by distributee	§ 1.752-7 liability partner	
Gain or Loss 	 None; § 1.752-7 liability
 does not affect amount of  related distribution 	None	
 Basis 	Assumption of § 1.752-7
 liability does not affect outside 
 basis or distributed property basis	Outside basis reduced by amount of 
  § 1752-7 liability assumed
 by distributee; partnership 
  inside basis reduced by same amount 	
 Satisfaction of  
  § 1.752-7 Liability 	No deduction to extent of 
  remaining built-in loss;payment
  increases outside basis, basis of 
 distributed property, or gain
  or loss on partnership interest 	 Deduction for amount paid,
  limited to remaining
  built-in loss, if notified	

Liquidating Distributions	 	 	
 Money	 	 	
   Gain or 
  Loss	Gain same as for current distributions; loss only
  if solely money or § 751 property	  None for partnership or 
  other partners 	
Basis	Outside basis reduced
  (eliminated) by amount distributed 	  Inside basis adjustment if 
   § 754 election applies or if 
  substantial basis reduction	
 Capital 
  Accounts 	Reduced (eliminated) by amount
 distributed 	Generally not 
 revalued 	
 Marketable 
  Securities	 Same as for
   current distributions	Same as for 
  current distributions	
 Other Property 	 	  	
 Gain or
  Loss	No gain; except if disproportionate
 distribution of § 751 property; loss only if
 solely money or § 751 property 	 None, except if disproportionate
 distribution of § 751 property	
 Basis 	 Outside basis reduced by money and
 inside basis of § 751 property with balance
 applied to distributed capital and
 § 1231 assets. 	  Inside basis adjusted for distributee
 gain or loss, and increase in
 basis of distributed property if § 754
 election applies, or, if  substantial
  basis reduction, even without § 754 election 	
 Distributed 
  Property 	  Transferred inside basis limited by outside 
  basis, but any excess over money and 
 inside basis of § 751 property distributed
 applied to distributed capital and
   § 1231 assets regardless of FMV 
  or basis adjusted under § 732(d)
 for distributee transferee partner	  Inside basis reduced by inside
 basis of distributed property 
 and increased if § 754 
 election applies	
Capital 
 Accounts 	Increased for inherent gain or loss
  reduced (eliminated)by amount
   Distributed 	  Should be revalued for
  all partners 	
§ 751 Property 	Generally same as for current
 distributions	Generally same as for current
 distributions	
Mixing Bowl	Generally same as for current
 distributions 	Generally same as for current
 distributions 	
Disguised Sales	Generally same as for current
 distributions	Generally same as for current
 distributions 	
§ 1.752-7 Liabilities	§ 1.752-7 liability partner
 is distributee	Remain with partnership	
 Gain or Loss	 None; § 1.752-7 liability
 does not affect amount of
  liquidating distribution	 None	
 Basis 	Outside basis reduced by amount of 
 § 1.752-7 liability retained 	Partnership inside basis reduced
 amount of § 1.752-7 liability
  retained by partnership	
 Satisfaction of
  § 1.752-7  Liability 	Deduction for amount paid by,
  partnership, limited to remaining 
 built-in loss, if notified; capital
  loss if satisfied for less than
  amount of basis reduction 	No deduction to the extent of
 remaining built-in loss; any excess 
 deductible; remaining partners' outside
  basis not reduced by payment to extent 
 of remaining built-in loss.	

Capital 
 Accounts	None; built-in loss should have
  reduced capital account on
  assumption	 Remaining partners' capital accounts not
  reduced by payments in satisfaction 
  to the extent of the remaining built-in loss	
 Structural Changes	 	 	
Partnership 
  Termination	Only if liquidating distributions
  to all but one partner	 Also if  sale or exchange of  50% or more
  of partnership interests within 12 months	
  Gain or Loss	None, except if disproportionate
 distribution of § 751 property	 None, except if disproportionate
    distribution of § 751 property	
 Basis	Same outside basis as 
  for terminated partnership	Transferred inside basis from
   terminated partnership	
 Holding
  Period	Transferred inside holding period
  from terminated partnership;  
 	Transferred inside holding period
 from terminated partnership	
 § 704(c)/Reverse
   § 704(c)  Allocations 	  No change 	No change 	
Capital
 Accounts	Same as for terminated
  partnership 	 Same as for terminated 
 partnership 	
 Partnership
  Divisions	 Divided continuing partnership	 Resulting recipient partnership	
  Assets Over	 	 	
Gain or Loss	None	 None 	
   Inside Basis 	No change 	Transferred inside basis of divided partnership	
 Inside Holding
  Period	 No change 	 Transferred inside
 holding period 	
 Outside 
  Basis	No change, except if 
  receive interest in
  resulting recipient partnership	 Transferred inside of 
 divided partnership; built-in loss  
 allocated only to contributor	
 Outside Holding 
  Period	No change, except if 
 receive interest in 
  resulting recipient partnership	Transferred inside holding
  period of divided partnership	
 § 704(c)/Reverse
 § 704(c) Allocations 	  No new § 704(c)
    allocations; reflect 
 revaluations in
  reverse § 704(c) allocations	 No new § 704(c) 
 allocations; reflect
  revaluations in
  reverse § 704(c) allocations	
  § 1.752-7 
   Liabilities	Distributions may 
  shift § 1.752-7 liabilities 	 Reflect any shift in 
  § 1.752-7 liabilities	
 Capital 
 Accounts	Reflect revaluation and 
  distributions of interests in 
  resulting recipient partnerships	 New revalued capital 
 accounts	

 Assets Up	 	  	
Gain or Loss	None, except if disproportionate
 distribution of § 751 property	 None, except if disproportionate
 distribution of § 751 property	
 Inside
  Basis	No change	 Contributed basis same as
  basis of distributed property
 to contributing partners	
 Inside Holding
  Period	  No change 	Transferred inside holding
  period for contributing partners	
Outside 
  Basis	 No change, except if
  receive assets to be transferred
 to resulting recipient partnership	 Transferred inside
 basis; built-in loss
  allocated only to contributor	
 Outside Holding
  Period	  No change, except if 
 receive assets to be transferred
  to resulting recipient partnership	Transferred inside
   holding period	
  § 704(c)/Reverse
 § 704(c)  Allocations	 No new § 704(c)
 allocations; reflect
  revaluations in reverse 
  § 704(c) allocations	 New § 704(c) 
  allocations	
 § 1.752-7 Liabilities	 Distributions may 
   shift § 1.752-7 liabilities	 May be new § 1.752-7
 liabilities	
 Capital 
  Accounts 	Reflect revaluation and
 distribution of assets to
 partners of resulting
  recipient partnership	 New capital accounts for
  FMV of contributed property	

 Partnership 
 	 Merged transferor
  partnership 	 Resulting transferee  partnership	
 Mergers 	 	 	
Assets Over	 	 	
Gain or Loss 	 None	None	
 Basis	Same outside basis as for
  merged transferor partnership	Transferred inside basis
  of merged transferor partnership	
  Holding  Period 	Transferred inside holding period
  of merged transferor partnership	Transferred inside holding period
 of merged transferor partnership	
§ 704(c)/Reverse
  § 704(c) Allocations 	May be new § 704(c)
 allocations; reflect revaluations
  in reverse § 704(c) allocations	No new § 704(c) allocations; reflect
 revaluations in reverse
 § 704(c) allocations	
§ 1.752-7 
 Liabilities	May be new § 1.752-7 liabilities
  for increase in amount of § 1.752-7
  liabilities prior to merger	Should be no new
   § 1.752-7 liabilities	
 Capital
  Accounts 	Reflect revaluation
 	 Reflect revaluation
 	
Assets Up	 	 	
Gain or Loss	If disproportionate distribution
 of § 751 property or under mixing bowl rules if § 704(c) property distributed to partner other than contributor	 None	
 Basis	Outside basis is transferred
  inside basis; built-in loss
  allocated only to contributor 	 Inside basis is same as
 basis of distributed property to
  contributing partner	
 Holding
    Period	 Outside holding period is transferred 
   inside holding period of 
 transferor merged partnership	Transferred inside holding
 period of  transferor merged  partnership	
 § 704(c)/Reverse 
  § 704(c) Allocations 	New § 704(c)
 allocations; reflect
 revaluations in reverse
  § 704(c) allocations	 No new § 704(c) 
  allocations; reflect
 revaluations in reverse
  § 704(c) allocations	
 § 1.752-7
   Liabilities 	May be new § 1.752-7
 liabilities	No new § 1.752-7
 liabilities 	
 Capital 
 Accounts	New capital accounts for
  FMV of contributed property 	 Reflect revaluation	

  Incorporating the
 Going Partnership	Transferor  Partnership 	Transferee Corporation	
 Assets Over	 	 	
 Gain or Loss	  None, unless boot, including
   liabilities is excess of basis	None 	
 Basis 	 Stock basis is transferred 
 partnership inside basis net
  of liabilities transferred, adjusted for
 any difference between outside basis 
 and share of inside basis	Transferred inside basis
 of incorporating partnership	
Holding
  Period	Transferred inside holding period
 of incorporating partnership	Transferred inside holding period
   of incorporating partnership 	
 § 704(c)/Reverse
   § 704(c)  Allocations	 Not applicable 	Not applicable 	
§ 1.752-7
  Liabilities 	 Stock basis immediately
   reduced even below FMV	 Inherent deduction transferred
 	
 § 751 	Not applicable 	Not applicable 	
Capital
 Accounts	   Eliminated 	Not applicable	
 Assets Up	 	 	
Gain or Loss	If disproportionate distribution
 of § 751 property or under mixing bowl rules if § 704(c) property distributed to partner other than contributor	 None	
 Basis	 Stock basis is transferred
  partnership inside basis net 
  of liabilities transferred adjusted
  for any difference between outside
  basis and share of inside basis	Transferred inside basis is same as
 basis of distributed property to 
 contributing partner	
  Holding
  Period 	 Stock holding period is transferred 
 split inside holding period of 
  transferor incorporating partnership 	Transferred inside holding 
  period of transferor incorporating
  partnership	
 § 704(c)/Reverse
 § 704(c)  Allocations	  Not applicable 	Not applicable 	
  § 1.752-7
  Liabilities	  Stock basis immediately
  reduced even below FMV	Inherent deduction transferred 
 	
 Capital 
  Accounts	Eliminated	 Not applicable	
 Interests Up	 	 	
Gain or Loss	 None, unless boot, including
  liabilities in excess of basis 	 None	
Basis	 Stock basis is transferred outside
   basis of partnership interest	Inside basis is aggregate outside
 basis of partnership interests	
 Holding 
 Period 	Split to extent attributable to
  § 751 property	Transferred inside holding period
  of transferor incorporating partnership 	
 § 704(c)/Reverse
    § 704(c)  Allocations	 Not applicable 	 Not applicable	
  § 1.752-7 
  Liabilities	 Stock basis immediately
  reduced even below FMV	 Inherent deduction transferred
 	
 Capital 
 Accounts	 Eliminated	 Not applicable 	
Recapitalizations	 	 	
 Gain or Loss	Any reduction in liability share treated
 as current distribution of money	 None	
 Other
  Consequences	Same as for current distributions
   of money 	Same as for current distributions
 of money	
  Changing State 
  Law Entity	 	 	
  Changing Form of
  Tax Partnership 	Same as for
   recapitalization 	Same as for
   recapitalization	
 Partnership to
 Disregarded Entity	 Discontinued   Partners   	Continuing Owner 	
 Liquidating
  Distributions	Same as for other
  liquidating distributions 	 Receives assets as 
  liquidating distribution	
Sale of Partnership
 Interests	Gain or loss under 
   § 741 and § 751(a) 	 Receives assets as 
   liquidating distribution	
 Tax Partnership
  to Corporation 	 Same as for assets-over 
  incorporation  	Same as for assets-over
 incorporation	

Withdrawal Payments 

Effect determined under § 736

See Checklist of Principal Tax Consequences of Current and Liquidating Distributions

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 12 Chart: Partner Withdrawal by Death or Retirement 

ALLOCATION OF WITHDRAWAL PAYMENTS 

 	Capital Material
 Capital Partnership(s) & 
  Other Tax Partner(s)	Capital Not Material
 Service Partnership(s)
  General Partner 	
 	in Service Partnership(s)	 	
 Liquidating distributions/
  § 736(b) payments=
  portion of payments/
 distributions <=	Value of share of
 partnership property
 including goodwill—
 stated or not	 Value share of
  partnership property excluding
  unstated goodwill > basis & 
  share of unrealized receivables 	
 Excess =
  § 736(a) payments	 Since not goodwill 
 primarily “mutual insurance,”
 e.g., deferred compensation
  for service providers &  
 increase reflecting deferral
  in series of payments/
  distributions  	 Includes unstated
  goodwill > basis & 
  share of unrealized
   receivables
 + items for capital
 partnerships	

CHARACTERIZATION OF § 736(A) PAYMENTS 

 	Determined by
 partnership income =
 distributive share
  § 736(a)(1)	Not determined by
 partnership income =
 guaranteed payment(s)
  § 736(a)(2)	
Effect on Withdrawing
  Partner	 Characterized by
  share of partnership income	Ordinary income	
Effect on Partnership/ 
 Remaining Partners	Excluded from
 allocable shares	Generally deductible	

§ 736(B) PAYMENTS—LIQUIDATING DISTRIBUTIONS 

Effect determined under § § 731, 732, 734, 751.

See Checklist of Principal Tax Consequences of Current and Liquidating Distributions;  Death or Retirement
  of a Partner

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Working Papers

Worksheet 13 Sample Redemption Agreement for the Interest of a Partner in 
 a Service Partnership 

ARTICLE IX — DISTRIBUTIONS ON WITHDRAWAL OF PARTNER 

This Article IX provides for amounts which may be distributable  as a result of (i) the retirement of Partners from the Firm; (ii) the withdrawal of Partners from the Firm, and (iii)the death of Partners, retired partners, Withdrawn Partners, or other persons.  Certain definitions and general and other provisions applicable to this Article IX are set forth in paragraphs 6 through 13, inclusive, below.

1.  If a Partner withdraws from the Firm for any reason (“Withdrawn Partner”), the Withdrawn Partner shall be entitled to receive, within one year after the date of withdrawal, the amount of capital credited to the Withdrawn Partner on the Firm books, including any undrawn share of income of the Firm for years prior to the  year of withdrawal, minus any overdrawn share of income for such prior years, plus or minus the allocable share of net income or net loss for the portion of the year of withdraw that has elapsed prior to withdraw, after taking into account any amounts properly chargeable against such shares. The Withdrawn Partner's share of the net income or net loss for the portion of the year elapsed prior to withdrawal shall be the fraction of the distributive share such Partner would have received for such year in the absence of  such withdrawal of which the numeration is the number of  full calendar months of such year that elapsed prior to the withdrawal and the denominator shall be 12.  Except as provided in this Article IX, a Withdrawn Partner shall not share in the income or loss of the Firm received after such Partner's withdrawal, no matter when earned or billed.

2.  A Partner may elect to retire on the January 1 “Retirement Date”) that is nearest to any birthday beginning with the January 1 nearest to the Partner's [65th] birthday but shall retire, if no prior election has been made, not later than the January 1 which is five years after such date.  Upon retirement, a Partner becomes a Withdrawn Partner. A Partner who withdraws from the Firm on or after the January 1 nearest the Partner's [65th] birthday, other than by reason of death, shall be entitled to receive the Guaranteed Amount.

2.  A Partner who withdraws from the Firm prior to the January 1 nearest to the Partner's  [65th] birthday, other than on account of Disability, and states in writing that it is the Partner's/her intention to retire from the private practice of law[or other profession or service business] for a period of at least two years, shall be entitled to receive one-half of the Guaranteed Amount.

3.  A Partner who withdraws from the Firm prior to the January 1 nearest to the Partner's [65th] birthday on account of Disability shall be entitled to receive the Guaranteed Amount.

4.  If a Partner dies prior to the Retirement Date, the Partner's Beneficiary shall be entitled to receive the deceased Partners' Guaranteed Amount.  If a Withdrawn Partner dies before the total amount paid under this Article IX to such Withdrawn Partner equals the Guaranteed Amount, the  Partner's Beneficiary shall be entitled to receive the Remaining Amount.

5. If a Withdrawn Partner receiving, or entitled to receive, benefits under this Article IX elects to waive the right to receive any or all of such benefits, such  Partner's Beneficiary, shall then be entitled to receive the Remaining Amount.

6. Amounts payable under this Article IX will be paid in sixty equal monthly installments on the last day of each month beginning on the January 31 of the year following the event causing them to become payable (i.e., retirement, withdrawal, or death, , as the case may be), unless such event occurs within the first 30 days of any calendar year, in which event the installments will begin on the January 31 of the year of such event; provided that

(i)  in the case of amounts payable pursuant to paragraph 3 or 4, the person or legal entity initially entitled to receive such amount may elect, prior to the due date of the first installment, to receive the Guaranteed Amount in more than 60 and up to 120 equal monthly installments; and

(iii) upon the death of a Withdrawn Partner, or of a  Partner's Beneficiary, as the case may be, remaining installments will be paid to the Partner's Beneficiary at the same time and in the same amounts as they would have been paid to such deceased Withdrawn Partner, or deceased Partner's Beneficiary, as the case may be.

Whenever a benefit under this Article IX is paid in monthly installments, the final installment will be adjusted as necessary to permit the proper total benefit to be paid.

7.  For purposes of this Article IX, the Partner's Beneficiary shall be the person or persons or legal entity designated by the Partner in the Partner's will to receive payments due under this Article IX, or if no such designation is made, the Partner's estate. However, if the Partner's Beneficiary shell be a person or persons and shall die and any amounts shall be payable under this Article IX after the death of such Partner's Beneficiary, the Partner's Beneficiary shall become the person or persons or legal entity designated by the original Partner's Beneficiary in the Partner's will to receive such amounts (or, failing such designation, the estate of the original Partner's Beneficiary), unless the Partner shall have provided in the Partner's will for payment of such amounts following the death of the original Partner's Beneficiary, in which event the Partner's Beneficiary shall become the person or persons or legal entity so designated by the Partner in the Partner's will.

8.  For purposes of this Article IX, a Withdrawn Partner's “Guaranteed Amount” shall be the Partner's Partnership Factor multiplied by 150% of the Partner's Highest Average Annual Remuneration.  A withdraw Partner's “Partnership Factor”shall be determined under the following table:

 	If the Partner has, at the date of the Partner's
  withdrawal or death been with the Firm 
  as either a Partner or an Associate 	
 
 Partnership Factor	
 	 Less than one full calendar year 	0%	
 	At least one full calendar year but
   less than two full calendar years 	20%	
 	At least two full calendar years but   
 less than three full calendar years  	40%	
 	  At least three full calendar years but  
 less than four full calendar years	 60%	
 	At least four full calendar years but  
 less than five full calendar years	 80%	
 	Five full calendar years or more 	100%	

A Withdrawn Partner's “Highest Average Annual Remuneration” shall be the average annual remuneration of the Withdrawn Partner from the Firm (as a Partner and/or Associate)for the three consecutive calendar years during which such average annual remuneration was the greatest (or for such lesser number of full calendar years during which such Withdrawn Partner shall have been a Partner and/or Associate). In determining such average annual remuneration, there shall be included any amounts paid to an Associate as bonus, and there shall be excluded any amounts paid to an Associate as fee participation, or to a Partner as distributions on capital, or as deferred income.

The term “Remaining Amount” shall mean the Guaranteed Amount with respect to a Partner reduced by amounts previously paid to the Withdrawn Partner as installments on account of the Guaranteed Amount.

9.  If, on or after the January 1 nearest the Partner's[65th] birthday, the Firm determines that a Partner has suffered a permanent disability of a kind which seriously impairs the Partner's ability to engage in the practice of law, the Partner shall thereupon retire and thereby become a Withdrawn Partner for purposes of this Article IX.

10. In the event that the aggregate amount of all distributions to be made by the Firm under this Article IX to and in respect of Withdrawn Partners and Partners' Beneficiaries from the income of any year (including amounts carried forward to such year as herein provided) would exceed 15% of the Available Net Income of the Firm for such year, the amounts to be so distributed for such year under this Article IX shall be reduced in such manner as the Firm may, in its absolute discretion, determine so that the aggregate amount of all such distributions respect to such year under Article IX, shall not exceed the 15% limitation; provided, however, amounts to be distributed under this Article IX shall be reduced proportionately. In the event that as a result of such 15% limitation any distribution under this Article IX shall be reduced for any year, the amount of such reduction shall be carried forward and paid, in the next succeeding year or years in which, and to the extent that, such payment can be made within the 15% limitation herein provided, to the person then entitled to receive such distribution. “Available Net Income of the Firm” mean, for any year, the net income of the Firm determined on a cash basis for such year in accordance with generally accepted accounting principles but in any event (i) after deduction of the amount distributable for such year on Firm capital pursuant at the rate determined by the Firm for the relevant period, and (ii)before deduction of any amounts paid or payable for such year as amounts distributed or paid pursuant to this Article IX.

11. If a Partner who has Withdrawn (including a partner who has retired) resumes the private practice of law, neither the Partner nor any person claiming through the Partner shall be entitled to further distributions under this Article IX at any time after the date of such resumption.  Performance of services as a trustee or executor, director or officer or employee of a company (other than a professional corporation), or teaching or public service or pro bono work, even though compensated, shall not constitute the private practice of law within the meaning of this Article IX.

12. The provisions of this Article IX assume that distributions made pursuant to this Article IX constitute, and will be treated as, a division of the income of the continuing Firm and that such distributions will, therefore, not be treated as, taxable income of the remaining Partners of the Firm under federal or other applicable income tax law. If for any reason the facts underlying this assumption shall change in a manner adverse to the remaining Partners, the Firm may, in its sole discretion, adjust future distributions under this Article IX to reflect such change in the manner that it determines to be equitable. The Firm and the Withdrawn Partner mutually agree that neither shall take a position on any tax return that is inconsistent with such position.

13. The shall Firm shall make all necessary determinations for purposes of this Article IX. All determinations of Firm fur purposes of this Article IX, including, without limitation, a determination as to the amount to which a Withdrawn Partner or Partner's Beneficiary is entitled under this Article IX, as to the rights of any person claiming through such Partner, and as to the time or times when payment of any such amount shall be made and the time and manner of discharging such rights, and as to the validity of elections permitted under this Article IX, shall be conclusive. All elections and communications permitted under this Article IX shall not be effective unless made in writing and delivered to the Firm in the manner provided in the Agreement for notices to the Firm.

14. Each Partner agrees to include in the Partner's will a provision reading substantially as follows:

“With respect to any amounts which may be due to my estate or any successor in interest designated by me from the Firm, I direct my executor and any such successor in interest designated by me to accept without question certificates properly signed on behalf of the Firm, as provided in this Agreement. Such certificates shall be binding and conclusive on my executor and any such successor in interest and on all other interested persons, whether or not one or more of the Partners of the Firm (including any Partner signing such certificates) is also an executor of my will. I also direct my executor and any successor in interest to allow such Firm such extensions of time as the Firm) may request in writing for paying to my executor or to any such successor in interest any amounts due from the Firm, such extensions not to exceed, however, more than a total of one year from the date at which any such amount would otherwise have been payable. If at the date of my death my surname shall be part of the name of the Firm, I direct my executor to permit the Firm or any successor thereto to continue to use my surname as part of the firm name without compensation for so long a period after my death as such use may be desired by the firm.

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Bibliography

OFFICIAL 

Treasury Rulings: 

Rev. Proc. 95-10, 1995-1 C.B. 501.

Rev. Rul. 54-96, 1954-1 C.B. 111.

Rev. Rul. 57-200, 1957-1 C.B. 205.

Rev. Rul. 59-259, 1959-2 C.B. 115.

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

Rev. Rul. 66-264, 1966-2 C.B. 248.

Rev. Rul. 67-305, 1967-1 C.B. 229.

Rev. Rul. 67-65, 1967-1 C.B. 168.

Rev. Rul. 68-55, 1968-1 C.B. 140.

Rev. Rul. 68-289, 1968-1 C.B. 314.

Rev. Rul. 68-349, 1968-2 C.B. 143.

Rev. Rul. 68-357, 1968-2 C.B. 144.

Rev. Rul. 68-79, 1968-1 C.B. 310.

Rev. Rul. 69-516, 1969-2 C.B. 56.

Rev. Rul. 70-140, 1970-1 C.B. 73.

Rev. Rul. 70-225, 1970-1 C.B. 80.

Rev. Rul. 70-565, 1970-2 C.B. 110.

Rev. Rul. 72-135, 1972-1 C.B. 200.

Rev. Rul. 72-172, 1972-1 C.B. 265.

Rev. Rul. 72-350, 1972-2 C.B. 394.

Rev. Rul. 73-301, 1973-1 C.B. 215.

Rev. Rul. 74-40, 1974-1 C.B. 159.

Rev. Rul. 74-89, 1974-1 C.B. 125.

Rev. Rul. 74-175, 1975-1 C.B. 52.

Rev. Rul. 75-154, 1975-1 C.B. 186.

Rev. Rul. 75-423, 1975-2 C.B. 260.

Rev. Rul. 76-123, 1976-1 C.B. 94.

Rev. Rul. 76-249, 1976-2 C.B. 21.

Rev. Rul. 77-309, 1977-2 C.B. 216.

Rev. Rul. 77-332, 1977-2 C.B. 484.

Rev. Rul. 77-360, 1977-2 C.B. 86.

Rev. Rul. 77-458, 1977-2 C.B. 220.

Rev. Rul. 79-127, 1979-1 C.B. 189.

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

Rev. Rul. 79-34, 1979-1 C.B. 285.

Rev. Rul. 80-198, 1980-2 C.B. 113.

Rev. Rul. 80-285, 1980-2 C.B. 119.

Rev. Rul. 80-323, 1980-2 C.B. 124.

Rev. Rul. 81-241, 1981-2 C.B. 146.

Rev. Rul. 81-283, 1981-2 C.B. 115.

Rev. Rul. 81-300, 1981-2 C.B. 143.

Rev. Rul. 81-301, 1981-2 C.B. 144.

Rev. Rul. 81-38, 1981-1 C.B. 386.

Rev. Rul. 82-96, 1982-1 C.B. 113.

Rev. Rul. 83-155, 1983-2 C.B. 38.

Rev. Rul. 84-102, 1984-2 C.B. 110.

Rev. Rul. 84-111, 1984-2 C.B. 88.

Rev. Rul. 84-15, 1984-1 C.B. 158.

Rev. Rul. 84-44, 1984-1 C.B. 115.

Rev. Rul. 84-52, 1984-2 C.B. 157.

Rev. Rul. 84-53, 194-1 C.B. 159.

Rev. Rul. 84-71, 1984-1 C.B. 106.

Rev. Rul. 85-164, 1985-2 C.B. 117.

Rev. Rul. 86-73, 1986-1 C.B. 282.

Rev. Rul. 87-110, 1987-2 C.B. 189.

Rev. Rul. 87-115, 1987-2 C.B. 163.

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

Rev. Rul. 88-38, 1988-1 C.B. 246.

Rev. Rul. 88-77, 1988-2 C.B. 128.

Rev. Rul. 89-102, 1989-2 C.B. 100.

Rev. Rul. 90-17, 1990-1 C.B. 119.

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. 8.

Rev. Rul. 93-12, 1993-1 C.B. 202.

Rev. Rul. 93-13, 1993-1 C.B. 126.

Rev. Rul. 93-80, 1993-2 C.B. 239.

Rev. Rul. 94-4, 1994-1 C.B. 195.

Rev. Rul. 95-24, 1995-1 C.B. 14.

Rev. Rul. 95-26, 1995-1 C.B. 131.

Rev. Rul. 95-37, 1995-1 C.B. 130.

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

Rev. Rul. 95-45, 1995-1 C.B. 53.

Rev. Rul. 95-55, 1995-2 C.B. 313.

Rev. Rul. 95-74, 1995-2 C.B. 36.

Rev. Rul. 96-29, 1996-1 C.B. 50.

Rev. Rul. 99-5, 1999-1 C.B. 434.

Rev. Rul. 99-6, 1999-1 C.B. 432.

Rev. Rul. 2000-18, 2000-1 C.B. 847.

Rev. Rul. 2003-56, 2003-1 C.B. 985.

Rev. Rul. 2004-43, 2004-2 C.B. 842.

Rev. Rul. 2004-59, 2004-1 C.B., 1050.

Rev. Rul. 2005-10, 2005-1 C.B. 492.

Rev. Rul. 2007-40, 2007-25 I.R.B. 1426.

Cases: 

7050 Ltd. v. Comr., T.C. Memo 2008-112.

A. W. Chesterton Co. Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997).

ABKCO Industries, Inc. v. Comr., 482 F.2d 150 (3d Cir. 1973).

Abramson v. Comr., 86 T.C. 360 (1986).

Ach v. Commissioner, 358 F.2d 342 (6th Cir. 1966).

Adams v. United States, 218 F.3d 393 (5th Cir. 2000).

Ahmanson Foundation v. United States, 764 F.2d 761 (9th Cir. 1981).

Aliber v. Comr., T.C. Memo 1987-10, 52 T.C.M. (CCH) 1316.

Austin v. U.S., 461 F.2d 733 (10th Cir. 1972).

Bensel v. Comr., 100 F.2d 639 (3rd Cir. 1938).

Blount Est. v. Commissioner, T.C. Memo 2004-116.

Bosca v. Comr., T.C. Memo 1998-251, 76 T.C.M. (CCH) 62.

Bright Est. v. United States, 658 F.2d 999 (5th Cir. 1981).

Broderick v. Gore, 224 F.2d 892 (10th Cir. 1955).

Brountas v. Comr., 692 F.2d 152 (1st Cir. 1982).

Bull v. U.S., 295 U.S. 247 (1935).

Burnet v. Logan, 283 U.S. 404 (1931).

Cagle v. Comr., 539 F.2d 409 (5th Cir. 1976).

Champlin v. Comr., T.C. Memo 1977-196.

Chaplain Est. v. Comr., T.C. Memo 1974-39.

Chef's Choice Produce Ltd. v. Comr., 95 T.C. 388 (1990).

Chenowith v. Comr., 88 T.C. 1577 (1987).

Commercial Security Bank, Inc. v. Comr., 77 T.C. 145 (1981).

Communications Satellite Corp. v. U.S., 625 F.2d 997 (Ct. Cl. 1980).

Cooney v. Comr., 65 T.C. 101 (1975).

Corlett, Killian, Hardemon, McIntosh and Levi, P.A. v. Merritt, 478 So. 2d 828 (Fla. 2d DCA 1985).

Crane v. Comr., 331 U.S. 1 (1947).

Crenshaw v. U.S., 450 F.2d 472 (5th Cir. 1971).

Dana Distributors, Inc. v. Comr., 874 F.2d 102 (2nd Cir. 1989).

Danielson, Comr. v., 378 F.2d 771 (3rd Cir.) cert. denied, 389 U.S. 757 (1967).

Davis v. U.S., 370 U.S. 65 (1962).

Dixie Pine Products v. Comr., 320 U.S. 516 (1944).

Doe v. Comr., 97-1 USTC ¶ 50,460 (10th Cir. 1997).

Dupree Est. v. U.S., 391 F.2d 753 (5th Cir. 1968).

Esler v. Comr., T.C. Memo 1988-417.

Evans v. Comr., 54 T.C. 40 (1970), acq., aff'd, 447 F.2d 547 (7th Cir. 1971).

Falconer v. Comr., 40 T.C. 1011 (1963).

Fensel v. U.S., 617 F. Supp. 22 (W.D. Pa. 1985).

Fixel v. Comr., T.C. Memo 1974-197.

Flood v. U.S., 133 F.2d 173 (1st Cir. 1943).

Foglesong v. Commissioner, 691 F.2d 848 (7th Cir. 1982).

Foxman v. Comr., 41 T.C. 535 (1964), acq., aff'd 352 F.2d 466 (3rd Cir. 1965).

Franklin Est. v. Comr., 544 F.2d 1045 (9th Cir. 1976).

Freeland v. Comr., 393 F.2d 573 (9th Cir. 1968), cert. denied, 393 US 845 (4,.

Frontier Chevrolet Co. v. Comr., 116 T.C. 289 (2001), aff'd 329 F.3d 1131 (9th Cir. 2002).

Fuchs v. Comr., 80 T.C. 506 (1983).

Gannon Est. v. Comr., 21 T.C. 1073 (1954).

Gardner v. Comr., T.C. Memo 1987-420.

General Dynamics Corp., U.S. v., 481 U.S. 239 (1987).

Glazer v. Comr., 44 T.C. 541 (1965).

Gloeckner Est.  v. Comr., 152 F.3d 208 (2nd Cir. 1998).

Godley Est. v. Comr., 286 F.3d 210 (4th Cir. 2002).

Gregg v. U.S., 2001-1 USTC ¶ 50,169 (D. Ore. 2001).

Haines v. U.S., 76-1 USTC ¶ 9222 (N.D. N.J. 1976).

Hamilton v. U.S., 687 F.2d 408 (Ct. Cl. 1982).

Harris v. Comr., 61 T.C. 770 (1974).

Hempt Brothers Inc. v. U.S., 490 F.2d 1172 (3rd Cir. 1974), cert. denied, 419 U.S. 826 (1974).

Hillman v. Comr., 263 F.3d 338 (4th Cir. 2001), rev'g and rem'g 114 T.C. 103 (2000).

Hoffman v. Comr., 2 T.C. 1160, aff'd on other grounds sub nom Giannini v. Comr., 148 F.2d 285 (9th Cir. 1945).

Hogan v. Comr., T.C. Memo 1990-295.

Holdeman v. Epperson, 857 N.E.2d 583 (Ohio 2006).

Holman v. Comr., 66 T.C. 809 (1976), aff'd, 564 F.2d 283 (9th Cir. 1977).

Hughes Properties, Inc., U.S. v., 476 U.S. 593 (1986).

International Freighting Corp. v. Comr., 135 F.2d 310 (2nd Cir. 1943).

Jackson Investment Co. v Comr., 346 F.2d 187 (9th Cir. 1965), rev'g and rem'g 41 T.C. 675 (1964).

Jackson v. Comr., 708 F.2d 1402 (9th Cir. 1983).

Jacobs v. Comr., T.C. Memo 1974-196.

Joseph E. Seagram &  Sons, Inc., Comr. v., 394 F.2d 738 (1968), rev'g 46 T.C. 698 (1966).

Jupiter Corp. v. U.S., 2 Cls. Ct. 58, 83-1 USTC ¶ 9168 (1983);.

Kinney v. U.S., 228 F. Supp. 656 (W.D. La. 1964), aff'd per curium, 358 F.2d 738 (5th Cir. 1966).

Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp.2d 608 (E.D. Tex. 2006).

Krause v. Comr., 92 T.C. 1003 (1989).

Latham Park Manor, Inc. v. Commissioner, 69 T.C. 199 (1977).

LauderEst.  v. Comr., T.C. Memo 1992-736.

Ledoux v. Comr., 695 F.2d 1320 (5th Cir. 1983).

Lehman, Comr. v., 165 F.2d 383 (2d Cir. 1948), aff'g 7 T.C. 1088 (1946), acq., cert. denied, 334 U.S. 819 (1948).

Lomb v. Sugden, 11 F. Supp. 472 (W.D.N.Y. 1935), rev'd, 82 F.2d 166 (2nd Cir. 1936).

Long v. Comr., 77 T.C. 1045 (1981).

Maher v. Comr., 469 F.2d 225 (8th Cir. 1972).

Matthews Est.  v. Comr., 3 T.C. 525 (1944), acq.

McCauslen v. Comr., 45 T.C. 588 (1966).

McKay v. Comr., T.C. Memo 1968-276.

McMichael v. Comr., 99-2 USTC ¶ 50,979 (11th Cir. 1999).

Melvin v. Comr., 88 T.C. 63 (1987).

Miller v. U.S., 67-2 USTC ¶ 9685 (Ct. Cl. 1967).

Milliken v. Comr., 72 T.C. 256 (1979).

Neubecker v. Comr., 65 T.C. 577 (1975).

Nichols v. Comr., 32 T.C. 1322 1959.

O'Brien v. Comr., 77 T.C. 113 (1981).

Park Cities Corp. v. Byrd, 534 S.W.2d 668 (Tex. 1976).

Park Realty Co. v. Comr., 77 T.C. 412 (1981), acq. in result only.

Philadelphia and Reading Corp. v. U.S., 602 F.2d 338 (Ct. Cl. 1979).

Pietz v. Comr., 59 T.C. 207 (1972).

Powers v. Commissioner, 724 F.2d 64 (7th Cir. 1983).

Pratt v. Comr., 64 T.C. 203 (1975), aff'd, 550 F.2d 1023 (5th Cir. 1977).

Pritchett v. Comr., T.C. Memo 1989-21.

Professional Equities, Inc. v. Comr., 89 T.C. 99 (1977), acq.

Quick Trust v. Comr., 54 T.C. 1336 (1970), acq., aff'd per curiam, 444 F.2d 90 (8th Cir. 1971).

Quirk Est. v. Comr., 928 F.2d 751 (6th Cir. 1991).

Quirk Est. v. Comr., T.C. Memo 1988-286, aff'd, 928 F.2d 751 (6th Cir. 1991).

Raphan v. U.S., 759 F.2d 879 (Fed. Cir. 1985).

Reynolds Est.  v. Comr., 55 T.C. 172 (1955), acq.

Richardson v. Comr., 76 T.C. 512 (1981), aff'd, 693 F.2d 1189 (5th Cir. 1982).

Rooney v. U.S., 305 F.2d 681 (9th Cir. 1962).

Rubin v. Comr., 56 T.C. 1155 (1971).

Rudd v. Comr., 79 T.C. 225 (1982), acq.

Salina Partnership LP v. Comr., T.C. Memo 2000-352.

Scott v. Comr., T.C. Memo 1997-507.

Sloan v. Comr., T.C. Memo 1981-641.

Salt Est. v. Comr., 17 T.C. 92 (1951), acq.

Simplot Est. v. Comr., 249 F.3d 1191 (9th Cir. 2001), rev'g 112 T.C. 130 (1999).

Skaggs Est. v. Comr., 75 T.C. 191 (1980), aff'd per curiam, 672 F.2d 756 (9th Cir. 1982).

Smith v. Comr., 331 F.2d 298 (7th Cir. 1964).

Smith v. Comr., 37 T.C. 1033 (1962), aff'd, 313 F.2d 16 (10th Cir. 1962).

Snyder v. Comr., 93 T.C. 529 (1989).

Spector v. Comr., 641 F.2d 376 (5th Cir. 1981).

St. Charles Investment Co. v. Comr., 232 F.3d 773 (10th Cir. 2000), rev'g 110 T.C. 46 (1998).

Stilwell v. Comr, 46 T.C. 247 (1966).

Stonecrest Corp. v. Comr., 24 T.C. 659 (1955).

Strangi Est. v. Comr., 417 F.3d 468.

Strangi Est. v. Comr., 115 T.C. 478 (2000), aff'd, rev'd and rem'd, 293 F.3d 279 (5th Cir. 2002), on remand T.C. Memo. 2003-145.

Thor Power Tool v. Commissioner, 439 U.S. 522 (1979).

Tolmach v. Comr., T.C. Memo 1991-538.

True Est. v. Comr., 390 F.3d 1210 (10th Cir. 2004), aff'g T.C. Memo. 2001-167.

Tufts v. Comr., 461 U.S. 300 (1983).

Van Wyck v. Comr., 113 T.C. 440 (1999).

Ware v. Comr., 906 F.2d 62 (2d Cir. 1990), aff'g T.C. Memo. 1989-165.

Weikel v. Comr., T.C. Memo 1986-58.

Weil Est. v. Comr., 22 T.C. 1267 (1954), acq.

Weiss v. Comr., 956 F.2d 242 (11th Cir. 1992).

West Coast Marketing Corp. v. Comr., 46 T.C. 32 (1966).

Whitman &  Ransom v. Comr., T.C. Memo 2005-172.

Wilson v. Bowers, 57 F.2d 682 (2nd Cir. 1932).

Wolcott v. Comr., 39 T.C. 538 (1962).

Woodhall v. Comr., T.C. Memo 1969-279, 28 T.C.M. (CCH) 1438, aff'd, 454 F.2d 226 (9th Cir. 1972).

Zager v. Comr., T.C. Memo 1987-107, 53 T.C.M. (CCH) 230, aff'd in unpub. opin. 842 F.2d 336 (Table)(9th Cir. 1988).

Federal Register: 

T.D. 6175, Section 701—Partners, Not Partnership, Subject to Tax, 1956-1 C.B. 111.

T.D. 8385, Allocations Attributable to Partnership Nonrecourse Liabilities, 56 Fed. Reg. 66,978 (12/27/1991).

T.D. 8588, Subchapter K Anti-Abuse Rule, 60 Fed. Reg. 23 (1/3/95).

T.D. 8642, Recognition of Gain or Loss by Contributing Partner on Distribution of Contributed Property or Other Property, 60 Fed. Reg. 66727 (12/26/1995).

T.D. 8717, Termination of a Partnership Under Section 708(b)(1)(B), 62 Fed. Reg. 25498 (5/9/97).

T.D. 8844, 64 Fed. Reg. 66580 (11/29/1999).

T.D. 8902, Capital Gains, Partnership, Subchapter S, and Trust Provisions, 65 Fed. Reg. 57092 (9/21/00).

T.D. 8906, Allocation of Partnership Debt, 65 Fed. Reg. 64888.

T.D. 8925, Partnership Mergers and Divisions, 66 Fed. Reg. 715 (1/4/2001).

T.D. 9013, Limitations on Passive Activity Losses and Credits—Treatment of Self-Charged Items of Income and Expense, 67 Fed. Reg. 54087 (8/21/2002).

T.D. 9193, Section 704(c), Installment Obligations and Contributed Contracts, 70 Fed. Reg. 14394 (3/22/2005).

T.D. 9207, Assumption of Partner Liabilities, 70 Fed. Reg. 30334 (5/26/05).

T.D. 9431, Application of Section 409A to Nonqualified Deferred Compensation Plans, 72 Fed. Reg. 19234, 19244 (4/17/2005).

Prop. Regs. §  1.736-1(a)(2), 20 Fed. Reg. 5854, 5871 (Aug. 12, 1955).

PS-163-84, Treatment of Transactions Between Partners and Partnerships, 56 Fed Reg. 19055 (4/25/1991).

PS-2-95, Distribution of Marketable Securities by a Partnership, 61 Fed. Reg. 28 (1/2/96).

REG-111119-99, Partnership Mergers and Divisions, 65 Fed. Reg. 1572 (1/11/2000).

REG-106736-00, Assumption of Partner Liabilities, 68 Fed. Reg. 37434 (6/24/2003).

REG-14519-03, Section 707 Regarding Disguised Sales, Generally, 69 Fed. Reg. 68838 (11/26/04).

REG-158080-04, Application of Section 409A to Nonqualified Deferred Compensation Plans, 70 Fed. Reg. 57930, 57937 (10/4/2005).

REG-143397-05, Partner's Distributive Share, 72 Fed. Reg. 46932 (8/22/2007).

Congressional Reports: 

H.R. 1337, 83d Cong., 2d Sess. 71 (1954).

H.R. Conf. Rep. 108-755, 108th Cong. 2d Sess.

H.R. Conf. Rep. 213, 103d Cong., 1st Sess (1993).

H.R. No. 213, 103d Cong., 1st Sess. (Conference Report).

H.R. Rep. No. 108-548, (2004).

H.R. Rep. No. 111, 103d Cong., 1st Sess. (1993).

H.R. Rep. No. 247, 101st Cong. 1st Sess. (1989).

H.R. Rep. No. 631, 102d Cong., 2d Sess. (1992).

H.R. Rep. No. 826, 103d Cong., 2d Sess. 189.

H.R. Rep. No. 861, 98th Cong., 2d Sess. 856 (1984).

H.R. Rep. No. 432, (Part 2.

S. Rep. 1622, 83d Cong, 2d Sess. 99, 406 (1954).

S. Rep. No. 169, 98th Cong., 2d Sess. (1984).

S. Rep. No. 313, 99th Cong. 2d Sess.

Staff of the Joint Committee on Taxation

Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (“1997 Bluebook”)64.

Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 106th Congress (“106 Bluebook”)48.

Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (“1984 Bluebook”)33.

Staff of the Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification Pursuant to Section 8022((3)(B)of the Internal Revenue Code of 1986 (2001.

Text and Treatises: 

Bears, Brovosky, &  Shoulder, Advanced Accounting 601 (7th ed. 2000).

McKee, Nelson and Whitmire, Federal Taxation of Partners and Partnerships  (3rd ed. 1997).

Pollack, Amdur and Bellows, Partnership Buy-Sell Agreements (1995).

Willis, Pennell &  Postlewaite, Partnership Taxation (6th ed. 1997).

U.S. Income Portfolios: Partnerships 
  Portfolio 716-2nd: Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner 
  Bibliography

UNOFFICIAL: 

Periodicals: 

1971 

New York State Bar Association Tax Section Committee on Reorganization Problems, “Recommendations as to Federal Tax Distinction Between Corporate Stock and Indebtedness,”25 Tax Law. 57.

Plumb, “The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal,”26 Tax L. Rev. 369.

1979 

Del Cotto and Joyce, “Inherited Excess Mortgage Property: Death and the Inherited Tax Shelter,”34 Tax L. Rev. 569.

1983 

Manning, “The Service Corporation—Who is Taxable on Its Income? Reconciling Assignment of Income Principles, § 482 and § 351,” 37 U. Miami L. Rev. 657.

1985 

Emmons and Fine, “Coping with IRS Ruling Which Applies Sec. 751 on the Admission of New Partners,”62 J. Tax'n 160.

1994 

Cash, Note, “The Application of the At-Risk Rules to Limited Liability Companies,” 14 Va. Tax. Rev. 483.

1995 

Banoff, “Anatomy of an Antiabuse Rule: What's Really Wrong with Reg. §  1.701-2,” 66 Tax Notes 1859.

Cuff, “The §  704(c)(1)(B)Proposed Regulations,” 73 TAXES 283.

Frost, “Square Peg, Meet Round Hole:’ Classifying LLC Members as General Partners' or Limited Partners' for Federal Tax Purposes, 73 TAXES 676, 695.

Gann and Stroud, “The Recent Evolution of Anti-abuse Rules,” 66 Tax Notes 1189.

Kalinka, “Proposed Regulations Concerning Partnership Mergers and Divisions Provide Guidance and Some, But Not Enough, Flexibility,” 78 TAXES 15(Aug.).

Liveson, “Anti-Abuse Reg. Confuses and Clarifies,” 24 Tax'n for Law. 4 (July/Aug.).

Manning &  Hesch, “Sale or Exchange of Business Assets: Economic Performance, Contingent Liabilities and Nonrecourse Liabilities,” Part One, 11 Tax Mgmt. Real Est. J. 19; Part Two, 11 Tax Mgmt. Real Est. J. 35;Part Three, 11 Tax Mgmt. Real Est. J. 51; Part Four 11 Tax Mgmt. Real Est. J. 263.

Marion, “The Final Partnership Anti-Abuse Regulation: The Treasury Redefines the ‘Intent of Subchapter K,’  ” 73 TAXES  161.

1996 

Dienst and Frydland, “Revenue Ruling 95-41 Analyzes the Effect of Section 704(c) on the Allocation of Nonrecourse Liabilities,” 12 J. Part. Tax'n 385.

Schwidetzky, “Is It Time to Give the S Corporation A Proper Burial?” 15 Va. Tax. Rev. 591.

1997 

Hibschelweiler and Kopin, “LLCs Are Generally—But Not Always—The Right Choice,”58 Tax'n Acct. 159.

Johnson, “Point: Singing Reason: The Case for Excluding of Entity-Level Debt from the Basis of Limited Liability Owners,” 17 Newsletter ABA Sec. of Taxation 13.

1998 

Youngwood and Cerrito, “Tracing Property After Its Owner’ Changes: § §  337, 704(c)(1), 737, 751, 382, 384, 1031 and 1374,” 51 Tax Law. 511.

1999 

Abrams, “Doing the McCauslen Two-Step,” 1 Bus. Ent. 18 (Nov./Dec.).

Darrow, “Beyond Check-the-Box:New Rulings Address Entity Conversions Resulting From Changes in Ownership,”27 J. Real. Est. Tax'n 3.

2000 

ABA Section of Taxation, “Comments on Proposed Regulations under Section 1(h) and 1223 Issued August 9, 1999,” 19 Tax Mgmt. Weekly Rep. 986 (June 12).

Abrams, “Dealing with Contributions of Property, Part 1,” 2 Bus. Ent. 16 (Nov./Dec.).

Burke, “Reassessing the Administration's Proposals for Reform of Subchapter K,” 86 Tax Notes 1423 (Mar. 6).

Jackel and Fessler, “The Mysterious Case of Partnership Inside Basis Adjustment,” 89 Tax Notes 529 (Oct. 23).

Kalinka, “Proposed Regulations Concerning Partnership Mergers and Divisions Provide Guidance and Some, But Not Enough, Flexibility,” 78 TAXES 15(Aug.).

Raby and Raby, “Partners, LLC Members, and SE Tax,” 87 Tax Notes 665 (May 1).

Walsh, “New Regs. Offer Guidance on Partnership Adjustment Allocations,” 65 Prac. Tax Strat. 23.

Wregglesworth, “Slicing, Dicing and Combining Partnerships: A Look at the Proposed Regulations on Partnership Mergers and Divisions,” 41 Tax Mgmt. Mem. 35.

2001 

Banoff, “Partnership Interest Transfers Under the Holding Period Final Regs: Opportunities and Traps Remain,” 94 J. Tax'n 211.

Evans, “Terminating Partnership Terminations,” 90 Tax Notes 1397, 1401-07 (Mar. 5).

Humphreys, “Partnership Combinations of U.S. and Non-U.S. Corporations, 92 Tax Notes 241(Jul. 9).

Sowell, “Partnership Workouts:Is It That Time Again?,” 42 Tax Mgmt. Memo. 414.

2002 

Banoff &  Jackel, “Sales, Exchanges and Other Dispositions of Partnership Interests,”531 PLI/Tax 311, 385-91.

Goodman, “Corporate and Partnership M& A Tax Laws: Is It Time Merge Subchapters C and K?”95 Tax Notes 1497.

Maule and Starczewski, “IRS Hot Asset Regs. Re-Tuning Falls Flat, Causing Sharp Pain for Partner Estates,” 94 Tax Notes 751 (Feb. 11).

Sheppard, “Dissecting Partnership Gambits for Rich People,” 96 Tax Notes 22 (Jul. 1).

Sloan, Lipton, and Frediani, “Final Regulations under Section 708 Provide Expanded Guidance on Partnership Mergers and Divisions—Part 1,” 531 PLI/Tax 895.

2003 

New York State Society of Certified Public Accountants, Comments on Internal Revenue Service and Treasury Proposed and Temporary Regulations under Section 752, 2003 TNT ‘95-16 (Sept. 15).

2004 

Manning, “Proposed Regulations Deal with Partnership Assumption of Partner Liabilities,' Part 1,”6 Bus. Ent. 22 (Nov./Dec.).

2005 

Ely, Grissom and Houser, “State Tax Treatment of Limited Liability Companies and Limited Liability Partnerships,” 106 Tax Notes 1557 (Feb. 2).

2007 

Field, “Form, Fiction and Substance in Subchapter K: Taxing Partnership Mergers, Divisions and Incorporations,” 44 San Diego L. Rev. 259.

Friedman, “Some Thoughts on Partners' Interests in Partnerships” 115 Tax Notes, 995 (June 4).

Gall and Franklin, “Partnership Distributions of Marketable Securities,” 117 Tax Notes 687(Nov. 12).

Jackel and Walsh, “Disguised Sales Revisited,” 114 Tax Notes 179 (Jan. 15).

Jones “Young Guns and the Administrative Burden of Mergers and Mixing Bowls,” 117 Tax Notes 489 (Oct. 29).

Schwartz, “Section 83(b), Section 409A and Subchapter K,” 772 PLI/Tax 657.

2008 

Carman, “To Merge or Acquire, That is the Question: Deemed Terminations vs. the Partnership Merger Prop. Regs.,” 108 J. Tax'n 325.

Lipton, “Countryside: The Tax Court Rejects an IRS Challenge to the Economic Substance of a ‘Real Deal’,”108 J. Tax'n 137.

Rubin, Whiteway, and Rubinstein, “Passthrough Planning Corner: Tax Court Respects Partnership's Property Distribution:Countryside Limited Partnership,” 11 J. Passthrough Entities 9.

Sowell, “Partnership Mergers: The Saga Continues,” 119 Tax Notes 727.