Partnership Tax Notes

Code pages 126-160

Regulations pages 480-735

Chapter 1. Choice of Entity: What is a Partnership for Tax Purposes?
- Subchapter K of IRC: 701-761
+ Partnership acts as a conduit, through which its various items of income and loss flow to the individual
partners, who must annually report their shares of those items on their own income tax returns
+ Subchapter K provides rules governing:
/ The character
/ Timing
/ Amount of income or loss allocated to each partner
/ Tax consequences of moving property into and out of partnerships
/ Characterization of transactions between partners and their partnerships
- Definition of Partnerships. What business ventures are governed by Subchapter K?
+ 761: 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 corporation or trust or estate
/ + Check the box regulations
g All business entities with 2 or more members are taxed either as partnerships or
corporations
+ Has a business entity been formed? If no, Subchapter K does not apply
/ 1. Separate Entity
g Any entity recognized for federal tax purposes, i.e. entity separate from its owners
Much broader than partnership definition under UPA
g A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if
the participants carry on a trade, business, financial operation or venture and divide the profits therefrom
E.g. lessor/lessee, employer/employee, lender/borrower
But not necessarily
g When does a joint venture or other contractual arrangement create an independent
entity for tax purposes?
Undertakings solely to share expenses do not create a separate entity
g Two features which distinguish an entity from mere co-ownership are
Business activity
Sharing of profits
g Whether the activities of the members with respect to (e.g. cab) rose to the level of the
conduct of a business
/ 2. Not a corporation
g Once characterized as an entity, the enterprise will be taxed as a partnership unless it
elects to be taxed as a corporation
If co-owners are unaware that they have created a partnership, they may
inadvertently trigger adverse tax consequences
/ 761 election-out procedure
g If an unincorporated organization is used for investment purposes, and not for the
active conduct of a business, and the income of the individual members can be
determined without the need to compute the organizations taxable income, then at the
election of all members, the organization will not be taxed under Subchapter K
- Choice of Form of Doing Business
+ Traditionally the choice was simply between corporate form and the partnership form (general/limited)
+ Since 20 years ago, however, the limited liability company (LLC) has been gaining popularity
/ Share all the non-tax advantages of the corporate form, as well as taxed like partnerships
+ Non-tax considerations
/ Owners desire to limit their personal liability for the business debts
/ The ability to easily transfer ownership interests in the business
/ The ability of the managers of the business to contract on behalf of the company without
consulting each and every owner
/ *limited partnerships have some of these advantages, though not all
g There must be at least one general partner who is liable for the businesss debt
g Although limited partners are not liable for the partnerships debt, they will lose this
protection if they participate in management
+ Tax considerations
/ The existence of the double tax on corporate income is the primary tax consideration that
influences the choice of business entity
/ Historically, dividends received by individual shareholders were treated as ordinary income
g Since 2001, however, dividends received from domestic corporations are treated as net
capital gain and subject to a maximum tax rate of 15%
/ Some corporations can avoid the corporate level tax and pass through SOME of their losses to
their shareholders by electing to be taxed under Subchapter S (S Corporations)
g However, Subchapter S imposes substantial restrictions, making Subchapter K more
favorable
g Main advantage of an S Corporation over a partnership is the fact that a shareholder of
an S Corporation can be an employee, while a partner of a partnership cannot
+ Why historically the popularity of C Corporations over Partnerships
/ Blatant non-tax advantages
/ The rate of tax on corporate income was substantially lower than that of individuals
g Second level of tax does not apply until earnings are distributed, earnings could be
accumulated at the corporate level at a lower tax cost than if they were taxed directly to
the owners
g But this is no longer true, i.e. corporate bracket is 35%
/ Under the current brackets, very little reason to opt for C Corporation, unless the start-up has
intentions to go public
g Especially since most of the non-tax advantages are available in most states in the form
of LLCs
+ LLC offers all of its members limited liability without restrictions on their participation in the enterprise
/ Ownership in the LLC can be freely transferable
- Electing Partnership Treatment: The Check the Box Regulations
+ If publicly traded, the entity will be taxed as a C Corporation, even if it is a partnership or LLC for local
law purposes
+ If the entity is organized as a corporation under local law, the entity will be taxed as a C Corporation
unless it is eligible (and elects) to be an S Corporation
+ All other business entities with 2 or more members, including partnerships and LLCs, will be taxed as
partnership UNLESS the entity makes an affirmative election to be taxed as a C Corporation
+ Previously, the determination was made by comparing the number of corporate characteristics of the
entity to the number of non-corporate characteristics
- Aggregate versus Entity approaches
+ Pure Aggregate conception
/ Partners would be viewed as co-owners, each with an undivided interest in the partnerships
assets and each partner would account separately for her share of all partnership transactions
+ Pure Entity conception
/ The partnership would be treated as a separate and distinct taxpayer, adopting a method of
accounting and a taxable year and annually reporting its taxable income
/ The partners would each own an undivided interest in the partnership entity, and would be
viewed very much like shareholders in a corporation
+ When Subchapter K was enacted in 1954 Congress adopted a hybrid approach
/ For most purposes, a partnership is treated as an aggregate of its partners
g Not a taxpayer, and its partners report their shares of partnership operations each year
on their own tax returns
/ Entity considerations
g A partnership must adopt a method of accounting, a taxable year and report its taxable
income each year on an information return
g Partnership has a basis in each of its assets, and the character of its income is
determined at the partnership level
g In computing income, partnership must make various elections, such as how to
depreciate its assets, or whether to use the installment method
g *These are necessary to avoid the administrative nightmare which would ensue if each
partner was required to track, monitor and report each of the above
Chapter 2. Partnership Formation: The Basics
- Congresss purpose: provide flexible & simple rules for those choosing to do business in the partnership form
+ Ensure nonrecognition of gain or loss wherever feasible
/ Formation of a partnership rarely results in recognition of gain or loss
+ Matters concerning calculating each partners share of an item of income and deduction are largely left to
the agreement of the partners
+ The role of the partnership entity for tax purposes: to serve as an accounting entity to assist the partners
(and the IRS) in calculating their shares of the ventures income and deductions
- Basic statutory scheme for the formation
+ 721. Nonrecognition. Except in cases of certain investment partnerships, 721 protects both the
partnership and its partners from recognizing any gain or loss on the transfer of property to a partnership
in exchange for an interest in the partnership
+ 722. Partners Outside Basis. Each contributing partner takes as her basis in the partnership interest
received, an amount equal to the sum of the adjusted basis she had in any contributed property, plus any
cash contributed
/ In contrast to inside basis which is the partnerships basis in the contributed property
/ Since the partner has merely changed the form of her investment in the contributed property,
they are permitted to tack the holding period she had in that property to the holding period of
her partnership interest
g 1223(1) Some items contributed to a partnership, such as money, inventory and
services, do not have holding periods, i.e. when a partner receives her interest in the
partnership in exchange for such items, their holding period in the partnership interest
received begins upon formation of the partnership
+ 723. Partnerships Inside Basis. Partnership takes a transferred basis in contributed property equal to
that of the contributing partner
/ Partnership is entitled to tack the partners holding periods to its own
- Common issues on formation
+ Property v. Services for 721 purposes
/ Unclear what property is, but includes money, installment obligations, goodwill, and accounts
receivable of a cash method taxpayer
/ If a person contributes services in exchange for a capital interest in a partnership, such exchange
is not protected by 721 and is a taxable event
/ Litigation over the precise scope of property and services
/ Stafford v. United States (Fifth Circuit 1980)
g Taxpayer, a real estate developer, successfully negotiated a letter of intent with an
insurance company for the financing of a hotel
g Government argued that the exchange of that letter for a partnership interest merely
compensated the taxpayer for his services
g Taxpayer argued that the letter was property in its own right
g The Court stated that the letter was of value and constituted property for purposes of
721(a)
+ Contributions of Appreciated (or Depreciated) Property
/ 704, generally, gives partnerships enormous flexibility in allocating their income, loss and
deductions such flexibility does not extend to pre-contribution gain or loss
/ The built-in gain or loss must be taken into account by the contributing partner
g Take into account using any reasonable method
E.g. traditional method: for allocating built-in gain or loss from non-
depreciable property defers recognition of the gain or loss until the partnership
ultimately recognizes it, and then allocates the gain or loss to the contributing
partner
g Example
A contributes stock with $100 value and $60 basis to ABC partnership
ABC sells the stock for $130, resulting in $70 gain
ABC must first allocate $40 of the gain to A
ABC may then have the partners allocate the remaining $30 as they like
+ Contribution of Depreciable Property
/ For the contributing partner
g Whether the contribution will trigger recapture of depreciation under 1245 or 1250 in
spite of the general nonrecognition rule of 721
g 1245 and 1250 appear to trigger recognition of gain in what might otherwise be
expected to be a nonrecognition transaction, but contain exceptions including
transactions described in 721
g Contributing party is protected from the recognition of recapture
Remains subject to recapture upon a later disposition by the partnership
/ For the partnership
g How should it calculate its cost recovery deductions with respect to the contributed
property
g Partnership steps into the shoes of the contributing partner
Inherits adjusted basis in the property
Inherits partners method of cost recovery
+ Characterization of Gains and Losses from the Disposition of Contributed Property
/ 702 treats a partnership as a distinct entity, separate and apart from its partners
/ Out of concern with the possibility of converting ordinary income into capital gains, 724
establishes 3 special characterization rules for gain or loss
g Unrealized receivables (751c)
Any gain or loss that is recognized by the partnership on the disposition of that
property is characterized as ordinary, no matter how long it is held by the
partnership
g Inventory items (751d)
Any gain or loss that is recognized by the partnership within 5 years of the
contribution shall be characterized as ordinary
g Capital loss property
If built-in loss, then, to the extent of the amount of that build-in loss, any loss
recognized on that property by the partnership within 5 years of the
contribution shall be characterized as capital
- Liabilities (Chapter 8)
+ Generally, when an individual borrows money to invest, even without personal liability, she is given basis
for the borrowed funds but does not recognize income
g Currently given basis credit for future outlays
/ 752 provides rules for dividing partnership liabilities among the partners, and each partner is
treated as making a cash contribution to the partnership in an amount equal to her share
g I.e. each partner is given credit in her outside basis for her share of partnership liabilities
/ 752(a) Each partner is treated as contributing cash to the partnership in an amount equal to any
partnership liabilities that she assumes, and any increase in her share of partnership liabilities
g +722 = increases the partners outside basis by the amount of such increase
/ 752(b) A partner is treat as having received a distribution of cash from the partnership in an
amount equal to the amount of any of her individual liabilities that are assumed by the
partnership, and any decrease in her share of partnership liabilities
g +733 = reducing the partners outside basis (but not below zero) by the amount of the
distribution
/ Recourse liabilities are allocated to those partners who bear the economic risk of loss
associated with those liabilities
g Determining who bears the risk of loss: who would have the ultimate responsibility for
the liability if all assets of the partnership became worthless and the liability became due
/ Nonrecourse liabilities allocated among the partners in the same way the partners share profits
g Makes sense because payments on the liability will come from profits from the venture
+ Contribution of encumbered property
/ When a partner contributes encumbered property to a partnership, the partnership replaces the
partner as obligor on the loan
g Contributor is simultaneously relieved of her personal liability on the loan, and as a
partner becomes responsible for a share of the partnerships responsibilities
/ Only the net change is taken into account
g When there is a net increase in a partners share of partnership liabilities, she is treated as
having made a cash contribution in that amount
g When there is a net decrease in her share of partnership liabilities, she is treated as
having received a cash distribution
If the contributing partners net decrease in liabilities is greater than her total
basis in all the assets she contributes, the contribution will result in gain!
/ 2 important implications
g A partners outside basis reflects her share of partnership liabilities
g Under some circumstances, the deemed cash distribution which occurs on the
distribution of encumbered property may result in recognition of gain
I.e. outside basis will not go below $0
+ Contributions of accounts receivable and payable (by a cash method taxpayer)
/ Concern of the assignment of income: income inherent in the accounts receivable must be taxed
to the contributing partner
g Treating the accounts receivable as property for purposes of 721
g Assigning partnership a transferred (typically zero) basis in the receivables under 723
g Characterizing the income realized by the partnership upon collection of the receivables
as ordinary under S724
g Allocating the income to the contributing partner under 704(c)
- Organization and syndication expenses; under 709 neither are deductible
+ 709(b)(2) defines organizational expenses as expenditures which
/ Are incident to the creation of the partnership
/ Are chargeable to capital account; and
/ Are of a character which, if expended in the creation of the partnership having an ascertainable
life, would have been amortized over such life
+ E.g. legal and accounting fees incident to the creation of the partnership as well as various filing fees
+ Syndication expenses: those incurred in connection with selling the partnership interests
/ Issuing and marketing of the partnership interests (legal, accounting, brokerage fees)
+ Not deductible
/ Since both types of expenses are incurred in connection with creation of the partnership entity,
they are properly chargeable to capital
/ Some relief from Congress
g 195 for business start-up expenses
g 248 for corporation organization expenses
g 709(b) a partnership may elect to currently deduct the lesser of:
The amount of organization expenses (not syndication expenses); OR
$5,000 reduced by the amount by which its organization expenses exceed $50k
Those not deducted may be amortized over 180 months
Syndication expenses continue to be nondeductible, nonamortizable capital
expenditures
Chapter 3. Partnership Operations: The Basics
- Introduction
+ The rules are designed to ensure that the tax consequences track the economics of whatever deal the
partners strike
/ Partnership is not a taxpayer, but a partnership is treated as an entity whenever doing so
facilitates computation of the partners shares of income and deduction
/ Otherwise it would be unduly cumbersome to require each of the partners to keep their own set
of books for the enterprises activities
+ Partnership must adopt a taxable year, choose a method of accounting, and make certain elections just as
if it were a taxpayer
+ Also required to compute its taxable income (as defined in 703a) and to file an informational return
(Form 1065), that informs the IRS and the partners about the entitys operations
- Partnership taxable years
+ 706(a) a partner must include her distributive share of partnership income for any taxable year of the
partnership ending within or with the taxable year of the partner
/ Key date is the last day of the partnerships taxable year: on that date each partner is treated as
receiving and paying (cash method partners) or accruing (accrual method partners) their
distributive share of the partnerships income and deductions for the partnerships taxable year
which has just ended
+ Prior to 1986: The number of months of deferral for a particular partner with respect to partnership
income is always equal to the number of months from the beginning of the partnerships taxable year
until the end of the partners taxable year
/ Congress amended 706(b) in reaction to the widespread use of the deferral technique
/ Amendments limit a partnerships choice of taxable year
g Must show valid business purpose for choosing a particular taxable year
25% test: 25% or more of the partnerships gross receipts for the selected year
earned in the last 2 months
Facts & Circumstances test
_ Insufficient
[ Use of a particular year for regulation or accounting purposes
[ Seasonal hiring patterns of a business
[ Administrative convenience is not sufficient
[ Nor is the desire to maximize deferral
_ However, a taxable year that conforms to the partnerships natural
business year will qualify
g If no business purpose, a partnership MUST adopt its required taxable year in
accordance with 706(b)(1)(B) unless it make an election under 444
MECHANICAL RULES. See pages 23-25
_ First tier: if one or more partners with the same taxable year own in the
aggregate more than a 50% interest in profits and capital
_ Second tier: if all of the principal partners (5%+ ownership) have the
same taxable year, then the partnership must adopt that taxable year
_ Third tier: least aggregate deferral
[ If the partnership regularly changes its composition, then
partnership must test the validity of its taxable year on the
first day of each year, and if the test shows the taxable year to
be invalid then it must be changed
444 ELECTION. Even in the absence of a valid business purpose, for $, a
partnership may elect to adopt a taxable year other than its required taxable year
as long as the year chosen does not result in more than 3 months of deferral
- Method of Accounting
+ The choice is limited by the identity of its partners
+ Under 448, C Corporations are generally prohibited from using the cash method of accounting
partnerships with C corporations as partners are similarly prohibited
/ Prohibition does not apply to partnerships for any year unless average annual gross receipts of
the partnership for the prior 3 years exceeds $5 million
+ If a partnership comes within the definition of a tax shelter in 461(i)(3), it must use the accrual method
regardless of its size
- The Computation of a Partnerships Taxable Income
+ Dont forget limitations on Partnership losses 704(d) basis limitation
+ In general
/ 701: a partnership as such shall not be subject to the income tax imposed by this chapter.
Persons carrying on business as partners shall be liable for income tax only in their separate or
individual capacities
/ 702 requires each partner to account separately for their share of (i) various items, such as
capital gains and losses; and (ii) bottom line income or loss, computed without regard to the
separately listed items
/ 703(a) taxable income determined the same way as the taxable income of an individual with
certain modifications
g Items described in 702(a) are separately stated
g Two types of deductions which individuals are permitted are denied
Deductions considered inappropriate for partnerships, such as the deduction
for personal exemptions and the additional itemized deductions
Deductions the benefits of which are (or have been) directly passed through to
the partners in their individual capacities
_ E.g. foreign taxes and charitable contributions, because they must be
separately stated under 702(a)
_ Net operating losses, because such losses will have already been taken
into account by the partners in the year that the losses were incurred
_ Depletion of oil and gas wells
+ 706(a)(1)-(6). Separately stated items
/ There are some items that will affect all partners the same way, without regard to their tax
profiles, and which can safely be included in the bottom line income or loss
/ Short and long term capital gains and losses
/ Gains and losses from 1231 property (each partner must throw into their individual hotchpot)
/ Charitable contributions (each partner will combine with their other contributions before
applying the relevant limitations of 170)
/ Dividends eligible for the dividends received deduction (available only to corporate partners)
/ Dividends that constitute net capital gain under 1(h)(11) (available only to Noncorporate
partners)
/ Foreign taxes paid (each partner will separately elect to deduct or take a credit under the rules of
901)
/ ***the list is not exhaustive Treasury expanded on the list through 1.702-1(a)(8)(i)-(ii)
g Each partner must also take into account separately his distributive share of ANY
partnership item which if separately taken into account by any partner would result in an
income tax liability for that partner different from that which would result if that partner
did not take the item into account separately
+ Partnership elections
/ Sometimes necessary for administrative and accounting reasons to treat the partnership as an
entity, even though the income is ultimately taxed under the aggregate theory to each individual
partner, e.g. partnership elections
/ 703(b) favors elections at the entity level, with only three exceptions, 108(b)(5), 617, 901
- Adjustments to the Partners Outside Basis
+ Outside basis = Partners contributions to the partnership (722) distributions from the partnership
(733) additional adjustments to account for the operations of the partnership
/ 705(a)(1) increase a partners outside basis by the sum of the partners distributive share of
g (i) taxable income, and
Necessary to avoid a partner paying twice on income
g (ii) tax exempt income
Necessary in order to allow the partners the full benefit of the tax exemption
/ 705(a)(2) decrease a partners outside basis by distributive share of
g (i) partnership losses, and
Necessary to prevent partners from benefiting twice from the same loss
g (ii) 705(a)(2)(B) expenditures
Necessary to ensure that a non-deductible item is not eventually given the effect
of a deduction on a later sale
g ***Decrease also by distribution
Chapter 4. Financial Accounting and Maintenance of Capital Accounts
- Introduction
+ A partnerships financial accounts are commonly referred to as its books
+ Treasury promulgated its own rules for maintaining capital accounts under 1.704-1(b)(2)(iv)
/ Special allocations under 704(b)
/ Allocation of liabilities under 752
/ Allocations of pre-contribution gain or loss under 704(c)
+ The purpose of financial accounting is to reflect the economic well-being of a firm and the relationship
among its partners, and it is quite independent of determining tax liability of the partners
/ Tax law uses the financial accounts of a partnership as a surrogate for economic reality
+ Capital accounting rules are not governed by generally accepted accounting principles (GAAP), but by tax
accounting principles
- Essential elements of financial accounts
+ In assessing a firms economic well-being = firms income statement + its balance sheet
/ Firms income statement: summarizes the economic activity over various periods of time,
specifying the amount and nature of the firms revenue and its expenses
/ Balance sheet: snapshot of the firms financial situation at a particular point in time
g Assets = Liabilities + Equity
g Assets (book values)
Values used for assets are generally historical cost, adjusted for depreciation
Not necessarily the same as fair market value
g Equity (capital accounts)
Each partner has a separate capital account, the balance of which represents her
equity in the partnership
_ The amount they would receive on liquidation if the partnership sold all
of its assets for their book value, paid off its creditors, and distributed
the net proceeds to the partners
Capital accounts are adjusted periodically to reflect any contributions to, or
distribution from, the partnerships assets that may have occurred, as well as any
increase in partnership assets caused by income or any decrease in assets caused
by losses
- (Book Accounts) Basic Capital Accounting Rules (see page 504 in Regs.)
+ Basic capital accounting rules are found in 1.704-(1)(b)(2)(iv)(b)
+ Contributions. 1.704-(1)(b)(2)(iv)(d)
/ A partners capital account is increased by the amount of money plus the fair market value of any
property (net of liabilities) contributed by that partners
/ Contributing partners tax basis in the property is not relevant for this purpose
/ Since liabilities are separately stated on the balance sheet, the adjustment to the capital account is
net of any liabilities on the property
+ Operations
/ A partners capital account is increased by their share of the partnerships income for the year,
and is decreased by their share of the partnerships losses for the year
/ Tax character of the income or loss does not matter
g Tax exempt income is treated the same as ordinary
g Capital losses and passive activity losses are treated the same as ordinary business loss
/ If the book value of partnership assets increases or decreases for any reason other than increased
or decreased liabilities, a corresponding increase or decrease in capital MUST occur
+ Distributions. 1.704-(1)(b)(2)(iv)(e). Mirror-image of contributions!
/ A partners capital account is decreased by the amount of money plus the fair market value of
any property (net of liabilities) distributed to that partner
/ Based on VALUE, not tax basis, and the adjustment is made net of liabilities
/ Any inherent gain or loss in the property distributed, even though not recognized for tax
purposes, must be taken into account for book purposes
g See example bottom of 35
+ Liabilities. 1.704-(1)(b)(2)(iv)(c)
/ Separately stated and NOT reflected in capital accounts, i.e. no adjustments are made to capital
accounts when a partnership borrows or repays a loan, and the adjustments to capital accounts
for contributed and distributed property are made net of liabilities
g ***Outside basis does reflect each partners share of partnership liabilities
+ See examples page 36-38
- Introduction to Tax Capital Accounts
+ Tax capital = previously taxed capital
+ The above capital accounts do not provide any information regarding the partners shares of tax
attributes of the partnership, specifically inside basis
/ Generally, partners shares of inside basis will be consistent with their shares of book capital, but
g Property is contributed to a partnership and is reflected on the partnerships books at a
value that differs from its basis
g Partnership revalues its assets from historical cost to current fair market value
+ Contributions
/ In the absence of liabilities
g Total balance in the partners tax capital accounts equals the partnerships inside basis
g Each partners tax capital account equals her outside basis
/ Liabilities complicates this
g Reflected in the partnerships inside basis and partners outside bases
g Not reflected in the partners tax capital accounts
/ Necessary to reflect the different capital accounts of a partner (tax and book) because once the
contributed property is sold for fair market value by the partnership, the partner will need to be
credited for the increase in inside basis
/ We maintain tax capital accounts because tax/book disparities highlight and help keep track of 704(c)
allocation problems
+ Revaluations. 1.704-(1)(b)(2)(iv)(f)
/ Circumstances when a partnership may revalue its existing assets, i.e. book-up (or down) the
assets to their current fair market value
g Generally limited to those transactions in which the partners have significant non-tax
reasons for determining the values of their assets, and the partners have adverse interests
/ If a partnership revalues its assets, the partnership recognizes for book, but not tax, purposes any
inherent gain or loss in its assets
/ We maintain tax capital accounts because tax/book disparities highlight and help keep track of 704(c) and
reverse 704(c) allocation problems
Chapter 5. Partnership Allocations: Substantial Economic Effect
- Background
+ http://itech.fgcu.edu/faculty/sthompso/pship/outline/Lect4c.htm
+ How the partnerships income and loss will be divided among the various partners
/ 704(a): a partnerships distributive share of income, gain, loss, deduction or credit, shall, except as otherwise
provided in this chapter, be determined by the partnership agreement
/ But Subchapter K was not intended to permit taxpayers to circumvent general principles
prohibiting tax avoidance and assignment of income and losses 704(b) will override 704(a)
+ Substantial Economic Effect (SEE)
/ Originally (1954) 704(b) provided that the partners agreement as to allocation of these items was
to be respected for tax purposes, unless the principal purpose of an allocation was tax
avoidance or evasion
g Whether the allocation may actually affect the dollar amount of the partners shares of
the total partnership income or loss independently of tax consequences
/ Balance in each partners capital account is the amount that she would be entitled to if the
partnership were to sell all of its assets for their book value, pay off all its liabilities and liquidate
g Courts found it useful to analyze capital accounts of a partnership to determine if a
particular allocation was meaningful apart from its consequences
g If allocations were not reflected in the capital accounts, they lacked independent
significance and hence could not have substantial economic effect
+ Significance of Capital Accounts: The Orrisch Case (1970) Respect for Capital Accounts!!!
/ In this case, the partnership agreement was amended to allocate all of the depreciation on two
buildings to Orrisch.
g The agreement provided that gain on the sale of partnership property would be charged
to Orrischs capital account to the extent of the depreciation allocations, and the
remainder shared according to partnership interests.
/ Although the capital accounts were to reflect a chargeback in the event of a gain, the allocation
lacked substantial economic effect because the adjusted capital accounts were not to provide the
basis for liquidating distributions.
/ Additionally, Orrisch was not required to make up his capital account in the event that the
property was sold at a gain less than the allocated depreciation.
+ Codification of Substantial Economic Effect
/ In 1976, 704(b) amended by codifying the phrase substantial economic effect
g A special allocation cannot be respected unless it has substantial economic effect
g Despite the language of the original regulations treating SEE as one of several factors to
consider, there is now no other alternative
/ In 1985, Treasury promulgated new regulations under 704(b)
g Extremely detailed and require an analysis much more complicated than under earlier
law
g Except for the portion dealing with nonrecourse debt, the regulations have precisely the
same underlying rationale: a special allocation will be respected for tax purposes as long as it reflects
the economics of the partners deal
If merely a device to reduce the aggregate taxes of the partners, the allocation
will not be respected and the item will be reallocated in a manner that does
reflect the true economics of the partners deal
- 704(b) regulations
+ Structure
/ Not the only provision governing allocation, but governs the vast majority of allocations
g 704(c) governs the allocation of gain or loss inherent in contributed property
g Additionally, 704(e) and 706(c) may play a role
/ 704(b) comprised of 4 parts
g Part 1. 1.704-1(b)(2) defines SEE and establishes the safe harbor
If an allocation has SEE it will be respected
If it does not, the item will be reallocated in accordance with the partners
economic interests, i.e. in accordance with each partners interest in the partnership
g Part 2. 1.704-1(b)(3)(e) describes what is meant by partners interests in the
partnership
Establishes default rules for allocations which fail to meet the safe harbor
g Part 3. Contains special rules to deal with specific situations where the concept of SEE
is inapplicable
Nonrecourse liabilities [1.704-2]
Revaluations of partnership assets in connection with certain partnership
transactions [1.704-1(b)(4)]
g Part 4. Consists of very useful examples illustrating the application of the rules set forth
in the first three parts
Pages 512-528
/ 3 different ways in which a particular allocation can be sustained
g 1. If the allocation satisfies the definition of SEE
Partnership assured that its allocations will be respected
g 2. If it is in accordance with the partners interests in the partnership
g 3. Allocations governed by special rules (revaluations and nonrecourse deductions)
cannot have SEE, yet will be deemed to be in accordance with the partners interests in
the partnership
+ Substantial Economic Effect
/ In general
g Unlike before, a finding now that an allocation lacks SEE under the current regulations
means only that the partnership is outside the safe harbor
g Then the allocation must be tested to see if it is consistent with the partners interests in
the partnership
g If it is not, then it will be reallocated in accordance with those interests
/ 1.704-1(b)(2)(ii) Economic effect (pages 497-501)
g Allocation must be consistent with underlying economic arrangement of partners
g Generally, an allocation will have economic effect if the partnership keeps meaningful
capital accounts and maintains them in accordance with a strict set of rule
g 1.704-1(b)(2)(ii)(b) Basic test for economic effect
An allocation will have economic effect only if the partnership agreement meets
the following 3 requirements
_ 1. Capital Account Requirement. Partnership must maintain its capital
accounts in accordance with the rules found in 1.704-1(b)(2)(iv)
_ 2. Liquidation Requirement. Upon liquidation, liquidating distributions
must be made in accordance with the positive balances in the partners
capital accounts
[ This is where Orrisch failed they had no plan to liquidate in
accordance with the capital accounts
_ 3. Deficit Makeup Requirement. If after liquidation any partner has a deficit
in her capital account, she must be unconditionally obligated to
restore that deficit.
[ Can be satisfied by a clause in the partnership agreement or an
unconditional obligation imposed under state or local law
[ Cannot be a limited deficit reduction obligation!!!
Simply look to the partnership agreement for specific language, absence
of which will render the test not met
Examples on pages 53-54
_ Also see Additional Problem
g 1.704-1(b)(2)(ii)(d) Alternate test for economic effect
Principal reason that most limited partnerships are formed is to limit the
financial exposure of its limited partners
_ An unlimited deficit makeup obligation is antithetical to that goal
_ Allocations made to limited partners would never have economic effect
under the Basic Test
_ The Basic Test works for general partners in a partnership, but not for
limited partners. Limited partners, by the nature of having limited
liability, do not have to pay back deficits
An allocation is considered to have economic effect as long as
_ 1. Partnership agreement satisfies first two requirements of the Basic
Test (capital account and liquidation requirements of the Basic Test)
_ 2. The agreement contains a qualified income offset provision, and
[ Protects the integrity of the prior allocations and the
partnerships capital accounts by requiring the partnership to
eliminate such an unexpected deficit as quickly as possible
through income allocations
[ Partners who unexpectedly receive an adjustment, allocation,
or distribution that brings their capital account balance
negative, will be allocated all income and gain in an amount
sufficient to eliminate the deficit balance as quickly as possible
_ 3. The allocation does not create (or increase) a deficit in a partners
capital account in excess of the partners obligation to restore a deficit, as
adjusted
[ Have to look at every allocation on an annual basis
[ Adjustments serve the purpose of taking into account
events that are reasonably expected to reduce a partners
capital account
[ Required adjustments
w ***Any future distributions that are reasonably
expected to be made to that partner in excess of any
reasonably expected offsetting allocations (i.e. income)
w Depletion (beyond scope of class)
w Other mandatory allocations
[ Used in conjunction with limited deficit restoration obligations
w Can be deemed
w Revenue Ruling 97-38
[ Make sure that a partners capital account has enough to incur
expected downward adjustments
Examples pages 54-59
g 1.704-1(b)(2)(ii)(i) Economic Effect Equivalence Test
Designed for a general partnership that not technically comply with the
requirements of the Basic Test, but whose practices would produce the same
economic results to the partners that would have been generated if they had
complied with all of the requirements of the Basic Test
_ Careless oversight in partnership agreement drafting
A partnership that meets this test would be unlikely to need to rely on the safe
harbor, as almost by definition the allocations would be consistent with the
partners interests in the partnership
/ 1.704-1(b)(2)(iii) Substantiality (pages 501-504)
g Proper analysis
Q1. Is either Partners capital account significantly different under special
allocation?
Q2. Does allocation enhance after-tax consequences?
g Generally
Rationale to identify those allocations that have little significance except to
reduce the governments share of the partnership operations
_ The idea here is that the IRS is looking for partnerships whose sole goal
is to improve the tax situation of the partners. This is effectively the
definition of a tax shelter
Pre-tax element: there must be a reasonable possibility that the allocation will
affect substantially the dollar amounts received by partners independent of tax
considerations
Post-tax element: of the after-tax effect of an allocation is to enhance the
economic consequences of one or more partners without adversely affecting
any other partner, the allocation will not be substantial
If found not substantial, the income must be reallocated in accordance with the
partners interests in the partnership
g Highly subjective but guidance through provision of two common situations where the
special allocation will have a negligible effect on the net adjustments to the partners
capital accounts, while significantly reducing taxes
Shifting tax consequences (allocations that occur within a single taxable year)
_ Not substantial if, at the time the allocation(s) becomes part of the
partnership agreement, there is a strong likelihood* that
[ The net effect on the capital accounts of the partners will not
be significantly different from what it would be in the absence
of the allocations, AND
[ The total tax liability of all of the partners (taking into account
their individual circumstances) will be less than it would be in
the absence of the allocation
_ E.g. A+B form AB (50/50), A is in the 0% tax bracket B is in the
35% bracket.
[ Partnership agreement satisfies the Basic Test
[ B is allocated all of Partnership tax-exempt income up to 50%
share of overall income
[ Year 1: Partnership has $1000 of income, $600 tax-exempt,
and $400 taxable
w B is allocated $500 tax-exempt income
w A is allocated $100 tax-exempt and $400 taxable
w Both pay $0, despite the fact that the capital accounts
are the same
w *In the absence of special allocation, B would have
$300 tax-exempt and $200 taxable income on which
they would pay tax (A wouldnt pay tax in either case)
_ *Hindsight presumption rebuttable
[ Strong likelihood is presumed, can be rebutted
w E.g. new product that you honestly did not know the
accuracy of the income stream
Transitory allocations (allocations that occur over two or more taxable years)
_ Transitory allocation occurs when a partnership makes an original
allocation in one year, and then cancels out the economic effects of
that allocation in a later year when the partnership makes an offsetting
allocation
_ Not substantial if, at the time the allocations become part of the
partnership agreement, there is a strong likelihood that:
[ The net effect of the original and offsetting allocations on the
partners capital accounts will not differ substantially from
what it would have been in the absence of these allocations,
AND
[ The total tax liability of the partners will be reduced from what
it would otherwise be, THEN
[ The allocations will not be substantial and the items will have
to be reallocated in accordance with the partners interests in
the partnership
_ Two extremely important (rebuttable) presumptions
[ Five-year rule
[ Value-equals-basis rule
_ Hindsight presumption rebuttable
g After-tax exception
Generally this rule is an exception that results in a finding that the allocation
is not substantial, even if it met one of the pre-tax tests
Test Economic effect of an allocation is not substantial if, at the time the
allocation becomes part of the partnership agreement
_ The allocation may enhance the after-tax economic consequences of one partner, in
present value terms, AND
_ There is a strong likelihood that the after-tax economic consequences of no partner
will be diminished
*Exception focuses on the after-tax consequences to the partners, not the pre-
tax effects on capital accounts
**In contrast with the transitory allocation rule, the exception tells us to take
present values into account
g Presumptions
Presumption #1 Value-equals-basis (not trumped by the hindsight
presumption)
_ Partnerships assets are irrebutably presumed to have a value equal to
their (adjusted) basis
[ Dont care about what the property is actually worth
_ E.g. AB partnership have a 50/50 interest in a partnership with a single
asset a depreciable apartment building ($1M), which will likely
increase in value. A is in the 35% bracket and D is in the 0% bracket.
All items are shared equally, but A is allocated all depreciation. A is
then subject to a gain-chargeback provision
[ Assume they plan to sell this building in four years
[ As a result of the gain-chargeback provision there is no change
in the capital accounts or tax
[ But according to value-equals-basis after-tax
Presumption #2 Five-year rule
_ There is a presumption that the economic effect of an allocation is not
transitory IF at the time the original and offsetting
_ Presume that there is a sufficient economic risk that the transaction will
never be equalized
Applicability Value-equals-basis 5-year
_ Shifting tax Yes N/A
_ Transitory Yes Yes
_ After-tax Yes Unclear (page 69 footnote 41)
/ Taking a step back (page 70)
g Literal interpretation of substantiality test would invalidate many allocations that
appropriately are respected
SEE regulations are so complicated and detailed, that it is easy to focus
exclusively on the rules and lose sight of their purpose
g Regulations were not intended to prevent taxpayers from forming a partnership and
allocating income and deductions in any way they deem appropriate so long as the
allocations are not simply a tax play
g Treasury was concerned with allocations made by a partnership with a stable, predictable
income stream that presents little risk of not playing out as expected, solely to save taxes
(e.g., rental payments from a long-term lease)
Allocations that are commercially motivated (not tax motivated) should be
respected
+ 1.704-1(b)(3) Reallocation based upon the Partners Interests in the Partnership (PIP)
/ Reallocation needed when the allocation lacks substantial economic effect
g Generally, the item will be allocated to those partners who are actually bearing the
economic burden, or enjoying the economic benefit, of that item, taking into account
all relevant facts and circumstances
/ Factors to be considered 1.704-1(b)(3)(ii)
g Relative contributions;
g Interests in economic profits and losses (if different from taxable income and loss);
g Interests in cash flow and other non-liquidating distributions; and
g Right to distribution on liquidation
/ Certain Determinations. Applies for allocations that fail to meet economic effect because they
lack the 3
rd
requirement of the Basic Test the deficit make up requirement
g Compare the amount that each partner would receive if the partnership were liquidated
at the end of the current year with what each would have received if the partnership
were liquidated on the last day of the prior year
g However, this only applies if the allocations are substantial
g Works the same as SEE but happens to not meet safe harbor, i.e. even though you failed
SEE we are not going to make you reallocate everything
/ See Slide Example Baseline Comparison
g Will respected pre-tax impact (capital accounts) but will adjust
+ Drafting Allocation Provisions: A Real World Perspective
/ Frustration with the complexity of drafting partnership agreements that satisfy the requirements
of the regulations has led many practitioners over the last decade to look for alternative ways to
draft allocation provisions that focus more on the economics of the deal and less on tax items
/ Targeted allocations
g In contrast with traditional tax allocation provisions, targeted allocations focus on those
provisions in the partnership agreement dealing with cash flows (i.e. contributions and
distributions), and simply state that the taxable income and loss of the partnership will
be allocated among the partners as necessary to conform their capital accounts to the
amounts that they would be entitled to receive if the partnership liquidated at year end
g Although likely that such allocations do not come within the safe harbor, it is likely that
they would be respected as consistent with Partners Interests in the Partnership (PIP)
- Limitation Family Partnerships Avoiding Assignment of Income Consequences
+ Even though a partnership complies with all of the requirements of 704(b), its allocation still might not
be respected if it is a family partnership
/ Rationale in a progressive rate structure, taxpayers have come up with devices to split income
among family members
+ Assignment of Income Doctrine
/ Income must be taxed to the person who earns it, or to the person who owns the income-
producing capital
/ Commissioner v. Culbertson (1949) the appropriate question is whether, considering all the facts and
circumstances . . . the parties in good faith and acting with business purpose intended to join
together in the present conduct of the enterprise
/ 704(e)(1) provides that a person shall be recognized as a partner if they own a capital interest,
no matter how acquired
/ 704(e)(2) limits the extent to which income allocations can be made to such partners
g If one family member has acquired a capital interest from another, by gift or purchase,
the donee may report their distributive share as long as the donor has received
reasonable compensation for all services rendered to the partnership
g **Kiddie tax: taxing the income of minor children at the parents rate
- Conclusion
+ Those partnerships which choose to avail themselves of the safe harbor know precisely what they must
do to accomplish that
+ Those partnerships remaining outside the safe harbor have more guidance than ever before on what the
term partners interests in the partnership means
Chapter 6. The Allocation of Nonrecourse Deductions
- 704(b) Regulations has 4 distinct parts
+ Safe harbor
+ Partners interests in the partnership
+ Special rules where SEE is inapplicable e.g. nonrecourse
/ Cannot satisfy SEE will be deemed
- Background
+ When partnership property is pledged as security for a nonrecourse loan, it is the lender, not the
partnership, who bears the economic risk that the value of the property will not satisfy the loan
/ Accordingly, the allocation of the deduction generated by the property to the partners cannot
have substantial economic effect allocations of nonrecourse deductions must be allocated in
accordance with the partners interests in the partnership
/ The Code permits the owner of property to take depreciation and other deductions which may
be economically borne by a nonrecourse lender
g The most common type of nonrecourse deduction is depreciation on property which is
acquired or improved with the proceeds of nonrecourse financing
/ ***In a recourse loan, allocation would be tested under Safe Harbor/SEE
g Until the taken depreciation actually meets the nonrecourse loan, it is treated just
like recourse and tested similarly
+ Crane Tufts
/ Crane when property is purchased with proceeds of a nonrecourse mortgage, the purchaser is
the sole owner of the property, and the purchaser is therefore the only party entitled to deduct
depreciation with respect to the property
/ It is now law that when property is purchased with the proceeds of a nonrecourse mortgage, the
purchaser is the sole owner of the property, and the only party entitled to deduct depreciation
with respect to it
/ These deductions must be taken by the partnership as the sole owner of the property, even
though none of the partners are economically at risk
g In theory, the partnership might allocate the deductions among the partners in any way
they see fit no allocation scheme would be more rational than another, since none
would be anchored to the economic burden borne by any partner
/ Tufts
g When property subject to a nonrecourse mortgage is disposed of in a taxable
transaction, the full amount of the liability must be included in the amount realized,
regardless of the value of the property
g Since a nonrecourse mortgage was treated as true debt when it was incurred, the
mortgage must be treated as true debt when it is discharged
g Minimum gain the difference between the principal amount of the mortgage and the
partnerships adjusted basis
- Regulations Allocations attributable to nonrecourse liabilities 1.704-2 (pages 535-557)
+ Introduction
/ Permits partnerships to allocate nonrecourse deductions in virtually any way the partners agree,
so long as the minimum gain is allocated in the same fashion!
/ Like SEE there is safe harbor if the partnership agreement complies with all of the
requirements of the safe harbor, then the allocations of nonrecourse deductions will be
respected, i.e. the allocations will be deemed to be in accordance with the partners interests in
the partnership
g If partnership does not comply with the requirements of the safe harbor Service has
the authority to reallocate the deductions under the facts and circumstances rules of 1.704-
1(b)(3) until 2009 the reallocation would be made in accordance with partners share
Practical issue this test focuses on the economics of the partners agreement,
however it is not clear how rules would apply, as risk of nonrecourse deductions
are actually borne by the lender
/ Nonrecourse Safe Harbor Test 1.704-2(e) safe harbor requirements which must be met
g 1. The partnership agreement must satisfy either the basic or the alternate test for economic effect
***Safe harbor within safe harbor if the partnership chooses not to comply
with the safe harbor for SEE under 1.704-1, then the nonrecourse debt safe
harbor is unavailable
g 2. Nonrecourse deductions must be allocated by the partnership agreement in a manner that is
reasonably consistent with allocations of some other significant partnership item attributable
to the property securing the debt
Example
_ Partnership agreement provides that income/loss will initially be
divided 90/10
_ Agreement provides that when profits exceed losses (as expected),
income/loss will be divided 50/50
_ Each of these allocations have SEE
_ Permissible allocations of nonrecourse liabilities
[ Range: 90/10 50/50
[ I.e. 95/5 allocation would fail!
g 3. Partnership agreement must contain a minimum gain chargeback provision; AND
I.e. requires those partners who received allocations of nonrecourse deductions
to report an offsetting amount of gain when the partnership disposes of the
property
E.g. AB purchase property for $1000, nonrecourse liability of $800.
Depreciation $100/year, all allocated to A
_ Year 3 depreciation is a nonrecourse deduction
_ A must be allocated $100/income or gain in the future
g [4. All other material allocations and capital account adjustments must be respected under 1.704-1(b)]
Seems redundant given requirement #1
g If #1-4 are not met, the partnership nonrecourse deductions will be allocated in
accordance with the partners interests in the partnership
+ Definitions
/ Basis $400 Nonrecourse liability of $750 Sell for $1000
g $350 is Partnership Minimum Gain to be allocated for nonrecourse purposes
g $250 would be allocated differently
/ Partnership Minimum Gain (PMG) 1.704-2(d)
g A.k.a. Tufts gain, the minimum amount of gain that the partnership would realize were it
to make a taxable disposition of property secured by nonrecourse financing
Normally, at any given time that gain is the excess of the amount of the loan
over the propertys basis
Future Tufts Gain amount of gain the partnership will realize when it
disposes of the property securing the nonrecourse liabilities in full satisfaction
thereof and no other consideration
g Reasons why PMG is important
Regulations measure the amount of nonrecourse deductions for a given year
indirectly by reference to the increase in PMG during the year
A decrease in a partners share of PMG may trigger a minimum gain chargeback
g Two events which will cause PMG to increase
1. Cost recovery deductions (depreciation
_ If depreciation reduces the partnerships adjusted basis in the secured
property faster than the principal of the nonrecourse liability is repaid
2. Secondary financing
_ I.e. if a partnership borrows funds without incurring personal liability,
using its property as security for the loan
_ E.g. AB Partnership has land with FMV of $500 and a basis of $200
and borrows $350, secured by the land
[ To the extent that the loan exceeds the basis is PMG $150
_ If the proceeds of such a borrowing are distributed to the partners,
then to the extent that the borrowing caused an increase in PMG
($150), it will be considered nonrecourse distribution
g Amount of PMG at any time represents the total of deductions taken by the partnership
and distributions made by the partnership for which the lender has borne the burden
Although partnership can take these deductions, and permitted to make the
distributions, it must upon the disposition of the underlying property recognize
an offsetting minimum gain
/ Nonrecourse Deductions (NRDs) 1.704-2(c)
g Measured annually and equal to the net increase in the partnerships minimum gain
during the taxable year, less any nonrecourse distributions made during the year
g NRDs are comprised of the cost recovery deductions on the encumbered property
However, the cost recovery deductions of the partnership may be less than the
increase in PMG
Accordingly, regs. create an ordering rule to determine which of the
partnerships deductions are characterized as nonrecourse:
_ Depreciation or cost recovery with respect to the encumbered property,
and
_ If necessary, a pro rata portion of the partnerships other expenses
[including deductible items and non-deductible 705(a)(2)(B) expenses]
for the year, and
_ If there are insufficient deductions for the year, the excess nonrecourse
deductions are carried over to the following year
/ Partners Share of Partnership Minimum Gain 1.704-2(g)(1)
g The ultimate objective of the regulations is to ensure that each partner will eventually
report an amount of income or gain equal to their share of nonrecourse deductions and
distributions
g Regulations require partnerships to keep track of each partners share of PMG
g If there has been a net decrease in PMG during the year, it will allocated among the
partners and may trigger the minimum gain chargeback provision
g ****At any given time each partners share of the total PMG of the partnership
will be equal to the excess of:
The sum of the NRDs allocated to the partner and nonrecourse
distributions received OVER
That partners share of net decreases in PMG
/ Minimum Gain Chargeback Provision 1.704-2(f)
g Generally: if there is a net decrease in PMG for a taxable year, each partner must be
allocated an amount of income or gain equal to their share of the decrease
Most common cause of a decrease in PMG is disposition of the encumbered
property
_ Partners must be allocated the applicable share of the current Tufts
gain resulting from the disposition equal to their share of the PMG
decrease
Loan repayment in excess of any annual depreciation taken on the secured
property
_ Partners must be allocated a pro rata share of other items of
partnership income or gain
g Causes which decrease PMG but inappropriate to trigger the chargeback
Conversions and refinancing
_ Decrease in PMG can result from the conversion of a nonrecourse
obligation into one on which one or more of the partners are personally
liable no reason to trigger chargeback for those partners since they
are not actually bearing the economic burden associated with the
deductions they have already taken
Contributions of capital
_ Partners contribution of capital that is used either to repay the
principal of a nonrecourse liability or to make a capital improvement to
the encumbered property
_ The decrease is caused by an actual investment in the property
Revaluations
_ Revaluations have the effect of converting each partners share of PMG
into 704(c)-type gain for which the partners remain personally
responsible
Waiver
_ Under circumstances when it can be demonstrated that the chargeback
actually is distorting the economic arrangement, the partnership may
request a waiver
+ Illustrations (pages 83-89)
/ ***See Example #3 Alternative #3
g What happens if one of the partners personally guarantees the mortgage?
g Mortgage changes its character from a partnership nonrecourse liability to a partner
nonrecourse debt
g A partner nonrecourse debt is one that is nonrecourse with respect to the partnership,
but is recourse with respect to one or more of the partners
- Conclusion
+ Safe harbor gives partnerships enormous flexibility in allocating nonrecourse deductions among their
partners if partnership does not come within the safe harbor then allocated in accordance with the
partners interests in the partnership since the burden represented by these deductions is being borne
by the lender, and not the partnership, there is no certainty as to exactly how these deductions will be
allocated
+ Many partnerships are now using targeted allocations which may or may not have SEE
Chapter 7. Contributions of Property: 704(c) and Its Principles
- Introduction
+ However a partnership allocates its book items, it must allocate its corresponding tax items in the same
manner tax must follow book
/ When a partnership purchases an asset and reflects it on the books at cost for both tax and book
purposes easily met, i.e. the partnerships gain, loss or depreciation with respect to that asset
will be the same for book and tax purposes, so that the partnership can comply with the tax
follows book mandate
+ Two events which create a disparity between a partnerships book and tax accounts
/ 1. The contribution to a partnership of 704(c) property, i.e. property whose fair market value
differs from its basis (resulting in built-in gain or built-in loss
/ 2. Revaluation of a partnerships assets as permitted by 1.704-1(b)(2)(iv)(f)
g The book/tax disparity resulting from revaluing partnership assets is so much like that
caused by the contribution of 704(c) property, allocations with respect to revalued
assets are referred to as reverse 704(c) allocation
+ The disparity is created because at the time of contribution or revaluation, the property must be reflected
on the partnerships books at its FMV even though no gain or loss is recognized for tax purposes
/ When the partnership makes a taxable disposition of the property there will be tax gain (or loss)
for which there is no corresponding book gain (or loss)
/ In the case of depreciable property, the partnerships book depreciation will not match its tax
depreciation
g Tax cannot follow book and it is impossible for the tax allocations to have substantial
economic effect governed by the special rules of 704(c) and the corresponding
regulations
g When a partnership revalues its assets as permitted by capital accounting rules, 704(c)
principles require that the built-in gain or loss be allocated to the partners to whom the
gain or loss was allocated for book purposes at the time of the revaluation
- Contributions of Property
+ Introduction
/ 704(c) requires that tax items with respect to contributed property must be shared so as to take
into account the built-in gain or loss at the time of contribution
/ The regulations state that the partnership may use a reasonable method which is consistent with
the purpose of 704(c)
g Traditional method
g Traditional method with curative allocations
g Remedial allocation method
g ***if you dont use one of the three methods, the burden is on you to demonstrate that
the method is reasonable
+ Nondepreciable property
/ Traditional method 1.704-3(b) (page 561)
g The noncontributing partner is effectively treated as though she purchased an undivided
interest in the property for its FMV, and allocations of tax items are made consistent
with that treatment
When property is nondepreciable, only tax gains (or losses) corresponding to
book gains (or losses) will be allocated to her
g Ceiling Rule limitation prohibiting shifts in built-in gain
To the extent anyone is hurt by the ceiling rule someone else is benefited
Assets Capital Accounts
Basis Book Tax Book
Cash $100 $100 A $60 $100
Land $60 $100 B $100 $100
$160 $200 $160 $200
But the land goes down in value and AB sells it for $70 although AB has a book loss
of $30, it has a tax gain of $10
Assets Capital Accounts
Basis Book Tax Book
Cash $170 $170 A $70 $85
B $100 $85
704(c)(1)(C) Built-in Loss Special Rules SEE SLIDES
_ Rule 1. Contributing partner: if a partner contributes property to a
partnership with a built-in loss, then the partnership must allocate any
tax item related to that loss to the contributor, AND
_ Rule 2. Non-contributing partner: to determine the amount of any item
with respect to built-in loss property that is to be allocated to a
noncontributing partner, the partnership shall be treated as having an
initial tax basis in the property equal to its FMV on the date of
contribution
***Purpose cannot shift built-in losses
g Under the traditional method the book/tax disparity once formed will never be cured
until the partnership interest is liquidated!!!
/ Traditional method with curative allocations 1.704-3(c) (page 563)
g Partnerships using this method may elect to make reasonable curative allocations to
eliminate ceiling rule distortions
Curative allocation = an allocation of an item for tax purposes that differs from
the allocation of the corresponding book item
Meant to cure the disparities caused by the ceiling rule and available only if the
ceiling rule creates an initial book/tax disparity
g ***Must have an additional item to offset the disparity (as opposed to remedial
allocation)
g See variation #4 on page 97
/ Remedial Allocation Method 1.704-3(d) (page 568)
g Provides an alternative method of curing ceiling rule distortions
Permits partners to ignore the ceiling rule: tax allocations will always be
available to match book allocations to the non-contributors because the
partnership is permitted to manufacture them
g These allocations are fictitious or notional their only role is to precisely eliminate any
disparities between book and tax accounts created by the ceiling rule
Since notional they have no effect on the partnerships taxable income or
adjusted bases
But treated as actual tax items by the partners and may affect both their tax
liability and outside bases
+ Depreciable property
/ Unlike the case of nondepreciable property, simply waiting until sale to allocate the gain or loss
will not ordinarily accomplish the purpose of taxing the contributing partner on the built-in gain
g Because depreciable property does not generate gain on sale if held for its useful life
instead its value is realized by the owner during the propertys life in the form of the
ordinary income that it generates
g The only way to ensure that the contributor will be taxed on the built-in gain is to
increase her share of current income from the property
Accomplished under the traditional method by allocating depreciation away
from the contributing partner: i.e., the noncontributing partner receives tax
depreciation up to her share of book depreciation, and only if tax depreciation
remains thereafter is it allocated to the contributing partner
g Two additional rules (page 100)
Rule #1: When a partner contributes depreciable property to a partnership, the
partnership steps into the shoes of the partner for purposes of cost recovery
the partnership must recover its transferred basis in the property over the
remaining recovery period using the same method as the contributor
Rule #2: For book purposes under the capital accounting rules, a partnership
must recover the same percentage (proportion) of basis for book purposes as it
does for tax purposes
/ Traditional Method
g General intent to treat noncontributing partners as if each purchased an undivided
interest in contributed property for cash, the noncontributors are allocated (if possible)
the same amount of cost recovery for tax purposes as they are for book purposes
If the partnerships cost recovery deduction exceeds the noncontributors share,
the contributing share, the contributing part must be allocated the balance
/ Traditional Method with Curative Allocations
g Under the traditional method, the built-in gain in the property is amortized over the life
of the property, as it produces income
g When the ceiling rule applies, in the absence of curative allocations, the noncontributor
is reporting more than his economic share of the propertys income
g Allows reasonable allocation to offset the disparity
/ Remedial allocation method
g If method is adopted, the partnership must use a special rule (NOT ON EXAM) to
determine the amount of book depreciation with respect to that property
Partnership then uses the traditional method to allocate the related tax items, i.e.
tax allocations will follow book allocation
If the ceiling rule prevents the noncontributing partner from receiving a tax
allocation equal to the corresponding book allocation, the partnership makes
offsetting remedial allocations of the appropriate character and amount to both
the contributing and noncontributing partners
g Special rule the contributing partner sold the property on a deferred basis to the
partnership on the date of contribution for its FMV
+ Choice of methods
/ Partnerships are permitted to choose a reasonable method
g Choice of allocation may be made on a property-by-property basis, so that a partnership
is not bound to use one method with respect to all contributed or revalued property
g However, the overall method or combination of methods must be reasonable based on
the facts and circumstances and consistent with the purpose of 704(c)
/ Factors to consider in choosing method
g Tax profiles of the individual partners
/ Generalizations
g Each of the three methods yields precisely the same amount of annual net tax
depreciation differ only in how that net amount is allocated among the partners
If all partners are in the same tax bracket, both the government and the
partnership should not care which method is adopted individual partners
however may care greatly
If different brackets, partnership will choose the method that results in the
largest aggregate tax savings for its partners
_ If A is in a relatively high bracket as compared to B, the traditional
method will generate the most savings
_ If a is in a relatively low bracket, then the traditional method with
curative allocations is best
+ Anti-abuse rules 1.704-3(a)(10)
/ An allocation method is NOT reasonable if the contribution of property . . . and the corresponding
allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in
gain or loss among the partners in a manner that substantially reduces the present value of the partners aggregate
tax liability
/ An appropriate reading of the rule would limit it to situations like those in the two examples
illustrating the rule, where the noneconomic capital accounting rules have the effect of
accelerating a ceiling rule shift of income, or permitting the noncontributory to expense her
investment
- Revaluations [reverse 704(c) allocations]
+ The second common event that predictably creates a disparity between book value and tax basis is the
revaluation of partnership assets in connection with a contribution (or distribution) of money or other
property to (or from) a partnership in exchange for an interest in that partnership
+ When a revaluation occurs, all of the partnerships existing built-in gains and losses are recognized for
book purposes and allocated among the existing partners in accordance with their agreement the
corresponding tax items are not recognized
+ Reverse 704(c) allocations are to be made in accordance with 704(c) principles
/ The only difference from 704(c) is that the existing partners, not the contributor, are credited
with the unrealized appreciation from the revaluation
+ See three allocation methods at work pages 111-113
Chapter 8. Partnership Liabilities
- Introduction
+ For income tax purposes: when a person uses borrowed funds to purchase an asset or pay a deductible
expense, she is treat just as if the funds were hers outright: she is given full basis credit for purchases, and
is entitled to deduct the expense, even though the funds are excluded from the tax base at the time of
receipt, and will only be included if and when the taxpayer is relieved of the liability
+ Applies whether or not the borrowed funds are recourse or nonrecourse
+ 752 functions to apply that understanding within the partnership context
/ Treats changes in a partners share of partnership liabilities as contributions and distributions of
cash to and from the partnership
/ Liabilities are included in a partners outside basis under 722
g 704(d) a partner cannot deduct partnership losses in excess of her outside basis
g If a partner receives a distribution of cash from a partnership which exceeds her outside
basis, she will have gain under 731(a)(1)
+ Until the early 1980s
/ Recourse liabilities are shared by general partners in accordance with their shares of partnership
losses
/ Nonrecourse liabilities are shared by all partners in accordance with their profit shares
+ However, due to commercial lending practices becoming more sophisticated it became harder to
distinguish between recourse and nonrecourse debt
/ E.g. Raphan v. United States (1985)
g GL is a limited partnership to which GP and LP each contribute $50
g LP has no obligation to contribute more capital to the partnership or to restore any
deficit
g GP and LP agree to share profits and losses equally to the extent of each partners basis
If LPs basis is reduced to zero, GP will be allocated all future losses
g GL acquires a building for $1k by paying $100 in cash and giving $900 nonrecourse
mortgage for the balance the lender insists that GP personally guarantee the
mortgage recourse or nonrecourse?
g The Court held that despite the guarantee, the mortgage should be treated as
nonrecourse decision permitted limited partners to deduct losses borne economically
by the guaranteeing general partner
/ Congress enacted legislation to overrule Raphan current 752
- What is a liability?
+ Two types of liabilities
/ 1.752-1 liability, defined as only those obligations that when incurred
g 1. Create or increase basis directly (e.g. a purchase money mortgage) or indirectly (e.g. a
second mortgage or unsecured loan); or
g 2. Give rise to a deduction (e.g. accrued but unpaid expenses of [only] an accrual method
partnership); or
g 3. Give rise to expenditures described in 705(a)(2)(B) (i.e. expenses that cannot either
be deducted or capitalized, e.g. syndication fees)
/ 1.752-7 liability, defined as any partnership obligation that is not governed by the general rules
g Often contingent and includes:
Contingent liabilities
Environmental obligations
Tort obligations
Contract obligations
Pension obligations
Various obligations that may arise under derivative financial instruments
g Although not reflected in basis, these liabilities do reduce the value of the property to
which they relate
g *Similar to built-in losses
g Governed by 704(c)
Not reflected in either the partners or the partnerships basis
Reflected solely in the partners capital account, creating the same type of
disparity that would result from contributing property with a built-in loss
Contributing partner, upon subsequent sale of burdened asset, is allocated the
tax loss
g E.g. Land with FMV/Basis of $100k; burdened by $20k environmental liability
Partners tax capital account/basis $100k
Partners book capital account $80k
- Regulations governing 1.752-1 liabilities (pages 698-700)
+ Introduction
/ Two sets of rules
g Recourse liabilities recourse to the extent that ANY partner (or related person)
bears the economic risk of loss associated with that liability
Must be shared among partners in the same way that they share the economic
risk of loss represented by the liability
g Nonrecourse liabilities nonrecourse to the extent that NO partner (or related
person) bears the economic risk of loss, the partnership liability is a nonrecourse liability
Must be shared in a manner consistent with the allocation of nonrecourse
deductions, so that the partners to whom those deductions are allocated will
have enough basis to use them
+ Economic risk of loss
/ Serves two purposes
g 1. If the economic risk of loss associated with a liability is borne by one or more of the
partners liability is recourse
g 2. If recourse shared among the partners in the same manner that they share the
economic risk of loss associated with it
/ WHO will ultimately bear the economic risk of loss? Look to and assess:
g 1. Partnership agreement
g 2. Obligations created by other contractual arrangements (if any)
g 3. Obligations imposed by local law (if any)
E.g. joint liability for partnership obligations, which combine to create the
equivalent of an unlimited deficit makeup obligation for general partners
/ De minimis exception
g Permits commercial lenders to hold minor interests (10% or less) in partnerships to
which they lend money on a nonrecourse basis without the loan being recharacterized
recourse only applies if the loan would constitute qualified nonrecourse financing
+ Sharing recourse liabilities
/ Partners share partnership recourse liabilities in the same way that they share the economic risk
of loss associated with that liability
g The determination of who bears the economic risk of loss for any liability is based upon
whose pocket the money would come from to satisfy the liability if the partnership went
belly up constructive liquidation
/ Constructive liquidation (page 119), during which the following 5 events are deemed to occur
g 1. All partnership liabilities become due and payable in full
g 2. All partnership assets, including cash, become worthless
*Except certain property held by the partnership in name only for the purpose of securing
indebtedness
g 3. All partnerships assets are disposed of in taxable transactions for no consideration
*other than satisfaction of nonrecourse liabilities secured by the property
g 4. The partnership allocates all items of income, gain, loss or deduction for its last taxable year ending
on the date of the constructive liquidation
g 5. The partnership liquidates
g ***Following this, if and to the extent that a partner is ultimately responsible for paying
a partnership liability, either directly to the creditor or by way of a contribution to the
partnership or to her other partners, that partner bears the economic risk of loss for the
liability and shares in the liability to that extent
Key assumption all parties are assumed to live up to their obligation
_ Impact if general partner has a right to contribution from other
partners, we assume this happens even if we know the other partners
are not able to do so
+ Illustration recourse liabilities (pages 120-124) (CL-1 CL-3 walks through constructive liquidation
/ Gregs example. A+B form AB (excel problem CL-1)
g A contributes $60 / B contributes $40
g Profits/loss will be shared 60/40
g Basic test for economic effect satisfied
g Upon formation AB immediately purchases land for $1k, taking out $900 recourse
mortgage (no principle or interest payments for 5 years)
g Intuitive result recourse will be allocated 60/40 ($540/$360)
/ Scenario #1 (variation #3 in book). Any impact if mortgage is fully recourse and A personally
guarantees the partnership obligation?
g NO we assume all parties live up to obligations, thus partnership will pay and As
guarantee is never called
/ Scenario #2 (variation #5 in book). Mortgage is nonrecourse, but B personally guarantees the loan?
(excel CL-2)
g Partner nonrecourse liability (never applies when we have a full recourse liability)
Step #4 of constructive liquidation is different, the partner guaranteeing it will
be allocated the entire loss therefore all goes into that partners outside basis
/ Scenario #3 (variation #6 in book). Recourse mortgage, but B agrees to indemnify A for any losses
in excess of capital contribution ($60). (excel CL-3)
g Can only allocate $60 loss to A because otherwise it would fail Basic Test and Alternate
Test
+ Partners providing property as security for partnership debt
/ Sometimes a lender may require security for a loan in addition to the personal liability of the
partner or beyond the property which the partnership has pledged as collateral, and in lieu of a
personal guarantee one of the partners may pledge her individual property as collateral
+ Sharing of nonrecourse liabilities
/ No partner bears the economic risk of loss
g Constructive liquidation is of no use in determining how to allocate nonrecourse
liabilities
/ 1.752-3(a) partners share of a partnerships nonrecourse liabilities is equal to the sum of:
g 1. Partners share of partnership minimum gain
Generally equal to the sum of the nonrecourse deductions allocated to that
partner, plus any nonrecourse distributions made to her
Ensure that
_ A partner will have sufficient outside basis to prevent a nonrecourse
deduction from being suspended under 704(d) and
_ A nonrecourse distribution will not trigger gain under 731(a)(1)
g 2. Partners share of 704(c) minimum gain
The amount of gain that would be allocable to the partner under 704(c) if the
encumbered property were disposed of for no consideration other than
satisfaction of the liability
Excess of nonrecourse liabilities encumbering contributed property over basis
g 3. Partners share of the excess (residual) nonrecourse liabilities, i.e. those nonrecourse
liabilities not allocated under (1) and (2)
1.752-3(a)(3) Excess nonrecourse liabilities the balance of nonrecourse
liabilities remaining after each partner has been allocated her share of those
liabilities based on partnership minimum gain and 704(c) minimum gain
_ Permissible sharing arrangements extremely flexible approving
multiple possible sharing arrangements
_ 1. General rule sharing based on profit shares
_ 2. Also allowed for partners to agree to share nonrecourse liabilities in
the same ratios that they share nonrecourse deductions
[ Most common because allows the partnership to not have to
calculate on a year to year basis, because they will remain
constant
_ 3. If the liability encumbers contributed property, the regulations allow
the partners to allocate the excess nonrecourse liabilities first to the
contributor, in an amount of any 704(c) gain in excess of the 704(c)
minimum gain that is allocated under 1.752-3(a)(2)
g See slides, e.g. nonrecourse liability allocation example
Limitation on partnership losses (see slides Day #4 pages 8-11)
- Basis limitations 704(d) (Review)
+ A partners distributive share of partnership loss, including capital loss,
- At-risk limitations (when partners are accorded outside basis adjustments based solely on nonrecourse)
+ Simply mention if on exam
+ 465 operates to limit a taxpayers deductible losses from a broad range of business and investment
activities to the amount the taxpayer is at-risk with respect to those activities
+ Partnership setting the at-risk rules are applied on a partner by partner by basis (not partnership level)
/ Cash contributions to the activity
/ Adjusted basis of property contributed by the partner to the activity
/ Amounts borrowed for use in the activity for which the partner is personally liable or which are
secured by property of the partner (not otherwise used in the activity)
/ Sounds like outside basis
g Nonrecourse liabilities of the partnership will increase a partners outside basis, but a
taxpayer is not considered at risk with respect to nonrecourse loans and similar
arrangement where the taxpayer has no economic risk
Result loss allowable under 704(d) may be deferred by 465
/ Any loss disallowed by 465 may be carried over and deducted when
g The partner becomes at risk
g The partnership disposes of the activity
g The partner disposes of his PSP interest
g *Outside basis is reduced by the amount of the loss, even if it is deferred by 465
+ Rules generally applies to each activity in which a partnership is engaged
+ Types of debt
/ Recourse at-risk
/ Deficit capital account restoration obligation
/ Qualified nonrecourse financing exception
- Passive loss limitations (not tested)
+ Enacted to restrict taxpayers from using deductions and other losses generated from certain passive
investment activities to shelter income from other sources (i.e. regular business income, compensation,
dividends & interest)
+ General impact disallows the current deductibility of losses and the use of credits from passive
activities
+ Passive loss limitations are applied on a partner by partner basis, not at the partnership level
/ Applied only after application of the 704(d) and 465 limitations
+ Income and loss from each of a taxpayers passive activities are first computed and then all are combined;
in any taxable year, passive activity losses can be deducted only to the extent of the taxpayers income
from passive activities for that year
/ Excess losses if losses from passive activities exceed income, then excess may be carried
forward and deducted against future net income from passive activities
+ Test: Material Participation Standard
Chapter 10. The Sale of a Partnership Interest
- Overview
+ What issues arise?
/ What are the consequences of sale to the transferor
/ What are the consequences of sale to the transferee
/ Tension between aggregate and entity approaches
+ Basic rules
/ Rule #1. The seller must recognize gain/loss on the sale of her interest equal to the difference between her amount
realized and her outside basis
g The character of that gain or loss will be capital (741)
Except to the extent it is attributable to certain ordinary income assets, 751(a)
g The seller is entitled to use the installment method of reporting gain under 453, with
some modifications
/ Rule #2. The buyer of a partnership interest takes a cost basis in that interest.
g The buyer generally inherits the sellers capital accounts (both tax and book) and her
share of inside basis*
*Not true if the selling partner contributed property with a built-in loss to the
partnership under 704(c)(1)(C), no one other than the contributor can
benefit from this loss
g In almost all cases this will result in a disparity between the buyers outside basis and her
share of inside basis
Due to depreciation or fluctuation in value of the asset
/ Rule #3. If the partnership makes (or has previously made) an election under 754, or if the partnership has a
substantial built-in loss, the partnership will make a special basis adjustment under the rules of 743(b) and
755 that is intended to eliminate the disparity between the buyers outside basis and her share of inside basis
g Purpose eliminate the disparity between the buyers outside basis and share of inside
basis
g This adjustment impacts only the buying partners basis and has no effect on the
partnerships common basis in its assets!
g Substantial built-in loss if the aggregate ( ) exceeds the FMV by $250k
/ Rule #4. Unless the sale results in a termination of the partnership under 708, there are no other tax
consequences to the partnership
g Under 708(b)(1)(B), a termination occurs if there is sale of 50% or more of the total
interests in partnership profits and capital within a 12 month period
- Statutory Scheme
+ 741 characterizes gain/loss from the sale of a partnership interest as capital
+ 743(a) sale of a partnership interest has no effect on the inside basis of partnership assets
+ 751(a) partially overrides 741, by treating gain/loss as ordinary if attributable partnerships ordinary
income assets
+ 743(b)-(d) if there is a substantial built-in loss or partnership has made a 754 election, there is a
special adjustment to the basis of partnership assets to take into account amount actually paid for interest
- Impact on The Seller (a.k.a. transferor)
+ Statutory Scheme
/ 741 states that the sale or exchange of a partnership interest is treated as the sale or exchange of
a capital asset, except as otherwise provided in 751
/ 751(a) states that any portion of a selling partners amount realized attributable to:
g Unrealized receivables, or
g Inventory items
g Shall be treated as being an amount realized from the sale or exchange of a noncapital
asset (i.e. ordinary income)
+ 751(a) Property
/ History
g 751 originally enacted to prevent taxpayers from using partnerships to convert ordinary
income into capital gain or to shift ordinary income from one taxpayer to another
g Had limited reach of inventory items, applying only if
Gain rather than loss on inventory items, and
Gain was substantial
g Now
751(a) property: unrealized receivables and inventory items
751(b) property / hot assets: substantially appreciated inventory
/ 751(c) Unrealized Receivables defined very broadly
g Generally, those amounts earned by a cash method taxpayer, but not yet received or
reported as income
g Under 751(c) three types of unrealized receivables
If the partnership holds rights to payments for either
_ Type 1 Goods delivered or to be delivered or
_ Type 2 Services rendered or to be rendered
_ And if the partnership has not yet included those amounts in income
under its method of accounting, then the rights are categorized as
unrealized receivables
[ If already included weve already reported income on it
Type 3: essentially a list of Congressional exceptions carved out to the
preferential treatment afforded capital gains
_ 1245 (and 1250) recapture most significant
[ I.e. 751(c) includes as an unrealized receivable any amount
that would be recaptured as ordinary income if the partnership
had sold its property for its fair market value
_ 1245 recapture to the extent that gain upon the sale or disposition
of an asset represents depreciation taken on the asset, that gain will be
treated as ordinary income
[ 1245 property personal property (as opposed to real
property) used in a taxpayers trade or business
w Excludes: (i) real estate; (ii) buildings; (iii) doesnt
apply to dispositions by gift or death transfers
_ 1250 recapture any additional depreciation (depreciation
deductions which exceed the deduction allowed under S/L) is
recognized as 1250 recapture
[ Unrecaptured 1250 gain any gain that is above the adjusted
basis under the S/L method but below the original cost of the
real property, is taxed at 25%
w Not an unrealized receivable Look-through rule
[ 1250 property depreciable real property
/ 751(d) Inventory Items all inventory items of a partnership (both loss/gain)
g 1. Property of the partnership of the kind described in 1221(1)
I.e. classic inventory and other property held for sale to customers
g 2. Any other property of the partnership which, on sale or exchange by the partnership,
would be considered property other than a capital asset and other than property
described in 1231
I.e. Any property which if sold would not be considered a capital asset or
property described in 1231
+ 751(a) Computation
/ If a partner in a partnership which holds 751(a) property sells or exchanges her interest in the
partnership, a portion of the gain will be taxed as ordinary income under 751(a)
/ The mechanism
g Step 1. Determine the total gain or loss realized by the selling partner from the sale of
her partnership interest (i.e. the difference between her total amount realized and her
outside basis)
Total amount realized Outside basis = gain/loss
g Step 2. Calculate the gain or loss from 751(a) property which would be allocated to the
selling partner if the partnership sold all of its assets for their FMV immediately prior to
the sale of the selling partners interest (the hypothetical transaction/ liquidation)
That amount of the sellers total gain or loss is characterized as ordinary
by 751
g Step 3. Subtract the amount characterized as ordinary in Step 2 from the selling partners
total gain in Step 1
This is the amount of capital gain or loss determined under 741
Different rates for different types of capital gains
_ 1(h) collectibles taxed at a maximum rate of 28%
_ 1250 capital gain at a maximum rate of 25%
_ All other capital gains taxed at a maximum rate of 15%
g Look-through rule
Requires the seller of a partnership interest to determine if any part of her 741
capital gain is allocable to either:
_ Collectible gains (max 28%) or
_ 1250 capital gain (max 25%)
_ I.e. Lukewarm Assets
g See excel 751-1, 751-2, 751-3
+ Installment Sales of Partnership Interests
/ 453 provides for installment method reporting of gains when at least one payment for the sale
of property is received after the close of the year in which the sale takes place
g Generally, allows the taxpayer to report gain proportionately to receipt of payments
g 453(d) permits a seller to elect out of the installment method of reporting and report all
gain in the year of sale
/ Gain from certain sales, e.g. inventory, accounts receivable, recapture, and securities traded on an
established exchange, is not eligible for the installment method and must be report in the year of
sale essentially 751(a) property is not eligible
- The Buyer (See rules #2 and #3 above)
+ (Rule #2) Ideally, a partnerships aggregate inside basis should equal the sum of the partners outside
bases, and each partners share of that inside basis should equal her outside basis
/ However, the sale of a partnership interest will almost always result in a disparity between inside
basis and outside basis
/ Caused by the fact that, even though the buying partner has an outside basis equal to her cost,
the sale of an interest in the partnership generally has no effect on the partnerships inside basis
in its assets
g The buying partner succeeds to the sellers share of inside basis, which does not reflect
the gain or loss realized on the sale of the purchased interest this does not reflect the
gain/loss realized on the sale of the purchased interest
g As a result the buyer can be under/over taxed
Only temporary, as outside basis does reflect the actual amount paid, but only
corrected upon sale of interest
+ (Rule #3) If a partnership makes a 754 election or if it has a substantial built-in loss this disparity
between inside and outside basis will be resolved, so that the buying partner will be treated as if she had
purchased an undivided interest in each asset
/ Once a partnership makes a 754 election with respect to one transaction, the election remains in
effect with respect to all future transactions and it can be revoked only with the consent of IRS
+ EXCEPTION when a partner contributes property with a built-in loss to a partnership, only that
partner is entitled to take the build-in loss into account
/ Buyers share of inside basis is equal to the sellers less any amount of 704(c) loss inherent in the
property at the time of purchase
+ Substantial built-in loss defined as when the partnerships adjusted basis in its property exceeds the
propertys fair market value by more than $250k
/ Purpose dont want a new buyer to come in and recognize a huge loss despite the fact that
since joining the economics have not changed
/ If substantial built-in loss than partnership must make 743(b) adjustments
g The adjustment is made only if the partnership makes or has previously made an
election under 754, or the partnership has a substantial built-in loss
g The amount of the adjustment is determined under 743(b) and it is equal to the
difference between the buyers outside basis and her share of inside basis
The regulations under 743 provide a means of calculating the buyers share of
inside basis
g 755 provide rules for allocating the adjustment among the partnerships assets
The goal of these rules is to give the buying partner a cost basis in her share of
each asset. This prevents the buying the partner from being over/under taxed.
g The basis adjustments made by the partnership apply only with respect to the transferee
partner, so that they have no impact on future allocations of income, deduction, gain or
loss to the other partners
+ Calculating the overall 743(b) adjustment
/ The adjustment under 743(b) is equal to the difference between the buyers outside basis and
her share of inside basis, and has the effect of equating these two amounts
g If the buyers outside basis is higher than her share of inside basis the adjustment is +
g If the buyers outside basis is less than her share of inside basis the adjustment is
/ Buyers outside basis is simply the amount she paid for her interest, i.e. her cost (including her
share of liabilities, if any)
/ Buyers share of inside basis = sum of her
g 1. Share of previously taxed capital AND
Previously taxed capital page 157 hypothetical transaction a cash by the
partnership of all of its assets for FMV immediately after the transfer of the
partnership interest
_ Partners share of previously taxed capital is equal to the sum of
[ 1. The amount of cash the partner would receive on liquidation
following the hypothetical transaction, plus
[ 2. The amount of any taxable loss allocated to the partner from
the hypothetical transaction, less
[ 3. The amount of any taxable gain allocated to the partner as a
result of the hypothetical transaction
g 2. Her share of liabilities
g *In most cases a partners share of previously taxed capital is simply the balance in her
tax capital account
+ Allocating the 743(b) adjustment among the partnerships assets
/ The rules for allocating the 743(b) adjustment among the partnerships assets are found in 755
and the regulations thereunder
g Step One. Divide the adjustment between two classes of assets
Ordinary income property
Capital gain property
g Step Two. Allocate the 743(b) adjustment among the assets in each class
Use the same hypothetical transaction first for calculating the sellers
ordinary income under 751(a) and later for purposes of calculating the buyers
share of previously taxed capital
/ Goodwill
g How do we allocate basis adjustment if new partner paid an amount in excess of sellers
share of total FMV of the assets on the balance sheet
Likely reason goodwill/going concern value
g Application utilize the residual method if purchase price exceeds . . .
+ Effect of the Adjustment
/ Having calculated the adjustment and allocated it among the various partnership assets, question
remains of what to do with it
g The adjustment is not reflected in capital accounts, nor does it enter into the common
basis of the partnerships assets
g The partnership making the adjustment will compute its taxable income, gain, loss and
deduction without regard to the adjustment and then allocate those amounts among all
of the partners under the principles of 704(b)
/ ***Now the adjustment comes into play
g Partnership will adjust the transferee partners distributive share of income, gain, loss
and deduction to reflect the adjustment
g If the partnership has sold an asset with respect to which a partner has a special basis
adjustment, the amount of that adjustment will reduce (or increase, if the adjustment is
negative) the transferee partners distributive share of the gain or loss from the sale of
the asset
- Related Matters - 706(c) and (d)
+ Shifts in partnership interest can be created by a variety of transactions, including the withdrawal of an
old partner, the admission of a new one, or the sale of all or a portion of an interest in the partnership
/ Under 706(c) the shift in interest may close the partnerships taxable year with respect to one or
more partners
/ Under 706(d) the partnership must allocate its income, gain and loss for the year of change to
take into account the varying interests of the partners
+ Closing a Partnerships Taxable Year
/ 706(a) a partner must take into account items of partnership income, etc. for any partnership
taxable year ending within or with the taxable year of the partner
/ If the partnership year was to close early, that could shift the partners share of income for that
year into an earlier year of the partner
/ 706(c)(2) Two circumstances when the partnerships year will close prematurely (other than
liquidation)
g 1. In the event of a partnership termination as defined under 708(b)(1)
A termination will occur if the partnership ceases to do business, or if within a
12 month period there is a sale/exchange of 50%+ of the total interests in
partnership capital and profits
g 2. Sale/exchange/liquidation of a partners entire interest in the partnership, or the
death of a partner. In that event, the partnerships year will close SOLELY with respect
to the terminated partner, who will be required to include her share of income for the
year in their current taxable year. Transfer or liquidation of less than a partners entire
interest does NOT trigger a premature closing of the partnerships taxable year unless,
of course, the transfer would otherwise trigger a termination under 708
+ Allocation of Income for the Year of Change
/ 706(d)(1) enacted during the tax shelter heyday
g Partnerships would admit a limited partner at the end of the partnerships taxable year,
and allocate to the new partner a full years share of the ventures deductions and losses
g In order to avoid this, now if one or more partners interest in a partnership varies
during a year, either because of a sale or liquidation of a partners interest, the death of a
partner, or any other transaction having that effect, the partnership must take into
account these variations in determining its partners shares of partnership items for the
year
/ Proposed Regulations
g Two methods for accomplishing this result
Both methods divide the year into segments representing periods of time during
which the partners interests in the partnership remain constant when a
variation in interest occurs that segment ends
_ For any given taxable year, the partnership can only use one method,
and whichever chosen, must be used consistently by all partners and
the partnership
Interim closing method (default)
_ Two ways to determine the end of a segment
[ Calendar day convention
w A segment would end on the actual date that the
partners interest changes
[ Semi-monthly convention
w The date the segment ends is basically rounded back
to the last day of the prior month or the 15
th
day of
the current month
Proration method
_ Calendar day convention required
_ The partnership simply waits until the end of the taxable year and
prorates its annual income on a daily basis between or among the
segments
/ Exceptions excusing the partnership from the cumbersome bookkeeping
g Permissible changes among contemporary partners
Existing partners may reallocate items among themselves during the course of a
year as long as the allocations would otherwise be respected
g Service partnerships
Allowed to take into account varying interests using any reasonable method
provided that the partnerships allocations are respected under 704(b)
g Publicly traded partnerships
Chapter 11. Distributions: The Basics
- Overview
+ 731-737 provide the general rules for partnership distributions
/ Just like with contributions, the rules reflect the Congressional policy of deferring recognition of
gain/loss by partners and partnerships whenever possible maximum nonrecognition
+ General rule neither partner nor partnership recognize gain/loss on a distribution of cash or property
/ Only when deferral is impracticable or when it would result in a change of character that
gain/loss is recognized upon a distribution
+ Current distribution one made to a partner whose interest in the partnership continues after the
distribution, although perhaps at a reduced share
+ Liquidating distribution one or more distributions that terminate a partners interest
+ Although the rules are not different to apply, they can create disparities between inside and outside basis
/ To reduce or eliminate these disparities, 734(b) provides a basis adjustment for those
partnerships with a 754 election in effect
- Preliminary Issues
+ 706(c) and (d)
/ Just like a sale of a partnership interest may close a taxable year of the partnerships with respect
to the selling partner and require the partnership to take into account the varying interests of the
partners for the year of sale, the same rules generally apply to any distribution that has the effect
of changing the relative interests of the partners
+ Capital Accounting Rules
/ Whenever property is distributed by a partnership, the partnership MUST recognize any gain or
loss inherent in the distributed property for book, but not tax, purposes
/ Accomplished by
g Adjusting all partners capital accounts to reflect the way in which the partners have
agreed to share in the inherent book gain or loss in the distributed property
g The balance of the distributees capital account must be reduced by the net FMV of the
distributed property
/ A partial or complete liquidation of a partners interest is one of the circumstances in which the
capital accounting rules permit the partnership to revalue all of its assets and restate capital
accounts to reflect that revaluation
+ Character and Holding Period of Distributed Property
/ 735(a) provides special rules regarding the character of certain types of distributed property
g Functions similarly to 724 which guides the contribution of property
g Principal purpose prevent conversion of partnership ordinary income into partner
capital gain simply by distributing property to a partner
/ According to 735(a), a distributee partner will realize ordinary income if she sells or exchanges
certain property previously distributed to her by a partnership
g 1. Previously distributed inventory items which are sold or exchanged within 5 years of
the distribution
In effect, treat the transferee as succeeding, for 5 years, to the transferors
purpose in holding primarily for sale to customers in the ordinary course,
regardless of the transferees actual purpose in holding the property
g 2. Unrealized receivables, regardless of when they are sold
/ 735(b) provides that when property is distributed by a partnership, the distributees holding
period in the property includes the period during which the partnership held the property
g The tacking ensures that long term capital gain property distributed by a partnership
retains its character
g Doesnt apply for purposes of the 5-year rule of inventory items
+ Basis of Partnerships Undistributed Property
/ 734(a) provides that unless 754 election is in effect or there is a substantial basis reduction*
the partnerships basis in its property is unaffected by a distribution
g Substantial basis reduction is defined as one that would require the partnership to reduce
the basis it has in its property by more than $250k
/ If 754 election is in effect or there is a substantial basis reduction, the basis of partnership
property must be adjusted (in the manner prescribed in 755) by the amount determined under
754(b)
- Recognition of Gain or Loss
+ Unless the distribution is recharacterized, the partnership never recognizes gain or loss, and the
distributee partner will recognize gain only under very narrow circumstances
/ In the case of cash distributions, the distributee simply reduces their outside basis by the amount
of money received, preserving any inherent gain/loss in her partnership interest
/ In the case of property distribution, the distributees outside basis is allocated among both the
properties received and her continuing interest in the partnership (if any)
g Any predistribution inherent gain/loss in the distributees partnership interest is
preserved either in the property received or in her continuing interest in the partnership
+ Only when deferral is impracticable or would change the character of income/loss must gain/loss be
characterized
/ Generally treated as though it arose from the sale or exchange of the partnership interest, i.e.
capital gain/loss
+ Recognition of gain
/ Distributions trigger gain to the distributee only under one circumstance if a partner receives
a distribution of money in excess of her outside basis, 731(a)(1) requires that partner to
recognize that excess as a gain
g *Whether in a current or liquidating distribution
g A reduction in a partners share of partnership liabilities is treated as distribution of $
/ When a partnership distributes property to a partner, the inherent gain/loss in the partners
interest can be preserved by adjusting the basis of the distributed property
/ 731(c) contains a special rule applicable to distributions of marketable securities by partnerships,
other than investment partnerships
g The marketable securities are treated as cash to the extent of their fair market value,
reduced by the distributees share of net appreciation in those securities
g The basis of the securities in the hands of the distributee is the bases determined under
the normal rules 732 plus any gain recognized by the distribuee
g Both the distributees outside basis and the partnerships basis in its remaining assets are
determined as if no gain were recognized
+ Recognition of loss
/ A partner recognizes a loss ONLY in a liquidating distribution and then only under narrow
circumstances a loss is never recognized in a current (non-liquidating) distribution
/ When liquidating distribution consists of only cash, unrealized receivables, and inventory, if the
distributees outside basis exceeds the sum of money distributed plus the partnerships basis in
the distributed property, she must recognize a capital loss
g Necessary because the partner receives no capital asset in which to defer the loss
g The basis of the cash received cannot be adjusted to defer the loss, and adjusting the
basis of the ordinary income assets to postpone the loss until they are sold will result in
conversion of the capital loss inherent in the partnership interest into an ordinary loss
- Basis of Distributed Property
+ 732 and 733 work in tandem to determine both the basis of the distributed property in the hands of the
distributee as well as the appropriate adjustments to her outside basis
/ 732 provides different rules depending on whether the distribution is a current or a liquidating
distribution
+ Current Distributions (nonliquidating)
/ Procedure/Mechanism
g 1. Begin with the distributees outside basis and reduce that amount by any distributed,
including liability relief, to determine her reduced outside basis.
If the distributee receives cash in excess of her outside basis, she will recognize
gain in the amount of that excess
Otherwise, no gain/loss will be recognized by either the partnership or the
distributee
g 2. As long as the distributees ROB equals or exceeds the partnerships basis in the
distributed property, she simply takes a transferred basis in that property
The balance of the ROB, if any, becomes her continuing outside basis
g 3. If the distributees ROB is insufficient to give her a transferred basis in the distributed
property, then the distributee must divide her ROB among the distributed property
under the rules of 752(c). The distributees continuing outside basis will be zero
g See examples on pages 176-178
+ Liquidating Distributions
/ The rules have to be different than they for current contributions because the distributee is
closing out her investment in the partnership she will not have a continuing basis after the
distribution
/ The goal allocate the distributees reduced outside basis among the distributed properties
/ Procedure/Mechanism
g 1. Assign to each asset distributed a basis equal to that which the partnership had in the
asset
Since the sum of these bases will invariably be more or less than the
distributees reduced outside basis, the bases must be adjusted
Congress enacted special rules under 732(c) in order for the adjustments to in
the aggregate be equal to the distributees reduced outside basis
/ Allocation of outside basis among distributed properties
g The reduced outside basis is first allocated to any distributed 751(a) property (i.e.
unrealized receivables, inventory) in an amount equal to (but not more than) the
partnerships bases in these assets
The remaining balance, if any, is then allocated among all other contributed
properties
g Section 751(a) property
In most cases the distributee simply takes a transferred basis in the property (i.e.
the basis the partnership had in the distributed property)
_ Except when the distributees reduced outside basis is less than the sum
of bases of the distributed 751(a) property
[ In that case it is necessary to reduce the bases the distributee
would otherwise take so that the sum equals the distributees
reduced outside
_ ***The transferred basis in 751(a) property will NEVER be increased
if the distributees reduced outside basis is greater than the transferred
basis the excess will either be
[ Allocated to other property received, or
[ Treated as a capital loss under the rules of 731(a)(2)
g Other property
1. Distributee takes a transferred basis in the other property
_ However, the distributees remaining reduced outside basis (after
reduction for any 751(a) property distributed in the same transaction)
will be more or less than the sum of the partnerships bases in the
distributed properties
_ If the remaining balance is less than the sum decrease the basis of
the distributed property by that amount
_ If the remaining balance exceeds the sum increase the basis of the
distributed property by that amount
2(a) Decrease Problem 45
_ Can occur in the context of a current or a liquidating distribution and
can apply to 751(a) property or to other property
_ Decrease is first allocated (proportionately) to those properties that
have unrealized depreciation*
[ Used first to reduce or eliminate any inherent losses that may
be present
[ *Depreciation is solely referring to loss in value, not cost
recovery
_ If a further decrease is required, then, it is allocated among all
properties in proportion to their respective bases (after reduction for
any unrealized depreciation)
_ See example #6 on page 180
2(b) Increase
_ Can only occur in the context of a liquidating distribution and then
only in the case where
[ The distributee receives at least one item of other property
AND her reduced outside basis is greater than the sum of the
transferred bases of the distributed properties
[ Only the basis of other property can be increased
w The basis in 751(a) is never increased, because if the
distributee receives cash and/or 751(a) property and
still has unrecovered basis, she will recognize a loss
under 731(a)
_ Increase is first allocated (proportionately) to those properties that have
unrealized appreciation
[ Used first to reduce or eliminate any inherent gain that may be
present
[ If a further increase is required, then it is allocated among all
other property in proportion to their fair market values
/ Procedure/Mechanism for analyzing a liquidating distribution
g Step 1. As with current distribution, begin with the distributees outside basis, and reduce
that amount by any cash distributed, including liability relief, to determine her reduced
outside basis.
If the distributee receives cash in excess of her outside basis, she will recognize
gain in the amount of the excess
If not, then the distributee must allocate her ROB among the properties she
received in the distribution in accordance with 732(c)
g Step 2. Under 732(c), the ROB is first allocated to any 751(a) property distributed in an
amount equal to the partnerships basis in that property.
The balance must be allocated to other property.
If there is a balance and the partner received no other property, then she
recognizes a capital loss in the amount of her balance.
g Step 3. If the partner receives other property in the distribution, then the remaining ROB
must be divided among those assets.
As a starting point, these assets are assigned a transferred basis, which is then
adjusted under 732(c)(2) & (3) so that in the aggregate their bases will equal the
partners remaining ROB.
/ See examples on pages 183-184
+ Special Rule under 732(d)
/ A purchasing partners 743(b) special basis adjustments are taken into account in determining
the basis of property distributed to her
g If partnership does not make 754 election purchaser of a partnership interest is not
entitled to a special basis adjustment in the partnerships assets
May result in an unintended windfall or hardship to a partner who receives
property distribution after purchasing her partnership interest
/ 732(d) special rules
g Rule #1. If a partner acquired her interest by transfer (i.e. by purchase or by reason of
the death of a partner) during the two years prior to a distribution, that partner may elect
to be treated as if there had been a 754 election in place at the time of transfer
g Rule #2. No matter when the distribution occurs, and even if the purchasing partner
makes no 732(d) election, under certain circumstances the regulations make the
application of 732(d) mandatory
Intended to prevent the shifting of basis from nondepreciable to depreciable
assets
/ 732(d) enables the partner to step-up their basis in the distributed property, even though the
partnership, for whatever reasons, is unwilling to make a 754 election
- Partnership Termination
+ 708(b) provides that a partnership will terminate if it ceases to do business, or if there is a sale or
exchange of 50%+ of the total interests in partnership capital and profits within a 12 month period
+ In 1997 Treasury amended the regulations under 708 to minimize the tax consequences of a termination
+ Currently
/ If a partnership terminates by reason of a sale or exchange of a partnership 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
/ The terminated partnership then makes a liquidating distribution of partnership interests in the
new partnership to its partners in proportion to their respective interests
+ To eliminate as many of the tax consequences of terminations as possible, following rules
/ Rule #1. The capital accounts of the terminated partnership carryover to the new partnership;
the purchasing partner assumes the capital accounts of the selling partner
/ Rule #2. No 704(c) property will be created by the termination. The only 704(c) property of
the new partnership will be that held by the terminated partnership
/ Rule #3. If the terminated partnership had a 754 election in effect for the year of termination,
this election applies to the new partnership. Therefore, the purchaser would be entitled to a 743
adjustment
/ In the end the main tax consequences of a termination is the closing of the taxable year
Chapter 12. Optional Basis Adjustment - 734(b)