I. General Concepts
The adjusted basis of a partner's interest in the partnership is important for many purposes.
A. When Basis Is Important.
1. Gain or Loss on Sale.
The computation of gain or loss on sale or exchange of a partnership interest is measured by gross receipts less any applicable expenses and adjusted basis.
2. Taxability of Distributions.
Adjusted basis is a vital aspect in determining the taxation of a partner's receipt of a partnership distribution.
3. Limitation on Current Deductibility of Losses.
Section 704(d) limits a partner's distributive share of partnership loss for any year to the adjusted basis of his or her interest in the partnership at the end of that year.
B. Effect of Liabilities.
The allocation of partnership liabilities plays a significant role in determining a partner's adjusted basis in its partnership interest. Section 752 includes in a partner's adjusted basis the partner's share of partnership liabilities.
Illustration:
AB Partnership; A and B each contribute $10,000. AB Partnership purchases property for $100,000 with a ten-year depreciation period, paying $20,000 in cash and $80,000 borrowed under a note requiring no principal payments for 10 years. In each of the first 5 years, the partnership has a net loss of $5,000 after depreciation.
The net cash flow of $5,000 each per year is distributed equally to partners A and B.
- If liabilities are not included in basis, the original basis of $10,000 would decrease to zero at the end of the second year, because adjusted basis is reduced each year by the partner's share of the $5,000 loss and the $2,500 in cash distributed to each partner.
- Section 704(d) would bar each partner from deducting partnership losses, unless the partner makes additional capital contributions or engages in some other transaction increasing basis.
If the liability is allocated equally between the partners, each partner's original basis of $10,000 is increased by $40,000 as a result of the loan to the partnership. Thus, each partner has sufficient basis to absorb the share of partnership losses allocated to that partner.
C. Distinction between Cash Distributions and Taxable Income.
1. Taxable Income.
Each partner includes its distributive share of each item of partnership income, gain, deduction, loss and credit in its separate taxable income or loss. I.R.C. 702. The distributive share of a partner includes amounts allocable to a partner whether or not distributed. Regardless of any reason for nondistribution, each partner pays taxes on his or her distributive share. United States v. Basye, 410 U.S. 441, 454 (1973).
II. Basis
A partner's basis in its partnership interest is significant in the event the interest is transferred or liquidated. It is also important in ascertaining the consequences of partnership distributions under sections 731 and 732 and in determining the deductibility of partnership losses, as prescribed by section 704(d).
A. Computational Rules.
1. Initial Basis.
Section 722 states the basis of a partnership interest acquired by contribution of property, including money, is equal to the amount of money or the adjusted basis of other property contributed to the partnership.
2. Adjustments.
Section 705(a) contains the computational rules the adjusting a partner's basis in its partnership interest over the life of the partnership.
a. Aggregate Approach.
These rules reflect an aggregate approach that is consistent with the overriding notion of the partnership as a conduit for the taxation of partnership income and loss directly to the partners. This approach is in contrast to the entity approach of corporate tax provisions under which income and loss at the corporate level are neither taxed to the shareholders nor reflected in the basis of their shares.
b. Specific Adjustments.
Under section 705, the following specific adjustments are made:
The partner’s adjusted basis in its partnership interest is increased by the partner’s share of:
i. taxable income of the partnership
ii. income of the partnership exempt from tax; and
iii. the excess of the deductions for depletion over the basis of property subject to depletion; and
decreased (but not below zero) by the partner's share of:
i. losses of the partnership;
ii. partnership expenditures not deductible in computing taxable income and not properly chargeable to capital account; and
iii. the amount of the partner's deduction for depletion for any partnership oil and gas property, as limited by the adjusted basis of such property allocated to the partner.
3. Comparison of Inside and Outside Basis.
Despite the clear distinction between the basis of a partner's interest in a partnership and the partnership's basis in its assets, the aggregate of the partners' adjusted basis in the partnership interest generally equals the aggregate of the adjusted basis of partnership assets. This fundamental equity between the aggregate basis of partnership assets and the aggregate basis of partners is reflected in the "alternative rule" of section 705(b), which provides for the determination of a partner's basis in its interest by reference to its proportion share of the basis of partnership assets. A partner has a single unified basis in its partnership interest for tax purposes even if a partner holds different classes of interest (e.g., general and limited) or interests that were acquired at different times. Rev. Rul. 84-53, 1984-1 C.B. 160.
4. No Negative Basis Rule.
Sections 705(a)(2) and 705(a)(3) prohibit reduction of a partner's basis below zero. This floor under a partner's basis reflects the limitation of section 704(d) for deducting losses to an amount not greater than a partner's basis in the partnership at the end of the year in which the loss is incurred.
B. Timing of Basis Calculations and Adjustments.
1. When Basis Computation Required.
A partner is only required to compute its basis in its partnership interest if the computation is necessary to determine tax liability. Typically, basis computations are necessary at the following times:
- the end of a partnership year during which the partnership suffered a loss, to determine the deductibility of the partner's share of the loss under section 704(d);
- upon the liquidation or disposition of a partner's interest, in order to determine gain or loss under section 731(a) or section 741 and the basis of property received from the partnership under section 732(b) as part of a liquidating distribution;
- upon the distribution of cash or property to a partner in order to ascertain the basis of the distributed property under section 732(a)(2) or the taxability of cash distributed under section 731(a).
2. Ordering Rules.
The order in which the various section 705 basis adjustments are made can be important in applying the loss limitation rule and the current distribution rules. The section 704(d) limitation is based on the partner's basis at the end of the partnership year. In contrast, section 731 through 733 operate with respect to the partner's basis "immediately before" the partnership distribution.
a. Cash before loss.
Revenue Ruling 66-94, 1966-1 C.B. 166, illustrates the general ordering rules with respect to section 704(d). A has a basis of $50 in her partnership interest at the beginning of the year. She receives cash distributions of $30 and is allocated a $60 distributive share of partnership loss. In determining what portion of the loss will be deductible, basis is first adjusted for the $30 cash distribution, so that her deductible loss is limited to the remaining $20.
b. Advances.
In Revenue Ruling 94-4, 1994-1 C.B. 196, the Service treated a deemed distribution of money under section 752(b) (resulting from a decrease in a partner's share of liabilities) as an advance or drawing of money under Reg. 1.731-1(a)(1)(ii) to the extent of the partner's distributive share of partnership income for the taxable year. Advances or drawings are taken into account at the end of the taxable year.
C. Effect of Basis on Property Distributions in Nonliquidating Distribution.
The timing rules also affect the basis determination for property distributed in a nonliquidating distribution. If money and property are distributed as part of the same distributions, the distributee's basis in its partnership interest is first reduced by any money distributed and then by the basis of the distributed property to the partnership.
Illustration:
A receives a distribution of $30 in cash and property with a basis of $40 to the partnership. Prior to the distribution, A has a basis of $50 in her partnership interest. Under sections 705(a)(2) and 733, the partner's basis is first reduced by the $30 cash distribution. Next, A's remaining $20 basis ($50-30) in her partnership interest is reduced (but not below zero) by the partnership's $40 basis in the distributed property. After the distribution, A's basis in her interest is zero and so she would be limited by section 704(d) as to any loss that is allocable to her for the year. Under section 732(a)(2), the basis of the distributed property in the hands of A is limited to her pre-distribution adjusted basis (after taking into account the cash distribution), or $20.
These timing rules provide taxpayers with some flexibility in planning, subject to the Service invoking the step transaction doctrine when all of the events are preplanned and dependent upon one another. For example, if the partners are considering distributions of both cash and property, they should ordinarily distribute the cash either prior to or at the same time as the property if the sum of the cash and the adjusted basis of the property to be distributed exceed the basis for their interest. A cash distribution made subsequent to a distribution of property would trigger unnecessary recognition of gain.
D. 1997 Act Changes to Basis Determinations on Property Distributions in Nonliquidating Liquidations.
Prior to the 1997 Act, section 732(a) provided that a distributee partner took a basis in property received in a nonliquidating distribution equal to the property’s basis in the hands of the partnership, capped at the partner’s adjusted basis in its partnership interest and reduced by any money distributed. In the event multiple properties were distributed by the partnership and the total carryover basis of the properties exceeded the partner’s basis in its partnership interest, the partner’s basis in its partnership interest was allocated among the assets with the partner’s basis first allocated to unrealized receivables and inventory items, and the remainder of the partner’s basis allocated among the remaining properties in proportion to their adjusted bases to the partnership.
To prevent taxpayers from engaging in basis shifting transactions that increased basis artificially and thereby creating inflated depreciation deductions, Congress amended section 732(c) to require an allocation of basis among distributed properties using fair market values. Under the 1997 Act, when multiple properties are distributed by a partnership, the partner’s basis in its partnership interest is allocated:
- first, to unrealized receivables and inventory items in an amount equal to their bases in the hands of the partnership, subject to the limitation that basis in the distributed properties cannot exceed the distributee’s basis in its partnership interest; and
- as to any remaining amount, among the other properties by first assigning each property a carryover basis and then increasing or decreasing the basis under the rules described below.
Any required reduction in the basis of the distributed properties is first made for those properties with unrealized depreciation in proportion to such unrealized depreciation, and any additional required basis reduction is made in proportion to the respective bases of the properties, as adjusted.
Any increase in the basis of distributed properties is first made for those properties with unrealized appreciation in proportion to such unrealized appreciation, and any additional basis increase remaining is allocated among the distributed properties, in proportion to their fair market values.
Illustration
A partnership distributes two of its assets, C and D, in a nonliquidating distribution to a partner with a basis in its partnership interest of $20. C and D are not unrealized receivables or inventory items. C has a basis and fair market value to the partnership of $15; D has a basis to the partnership of $15 and a fair market value of $5. The combined basis of C and D to the partnership exceed the partner’s basis in its partnership interest by $10 ($30 combined basis of assets - $20 basis of partnership interest). Each of the properties is first assigned a carryover basis of $15. Since a $10 decrease is required, the decrease is allocated solely to D’s basis. Thus, C has a basis of $15 and D has a basis of $5 to the distributee partner.
E. Inclusion of Liabilities.
The other major component of the basis adjustment rule relates to the inclusion of partnership liabilities in basis. Increases in a partner's share of partnership liabilities are treated as cash contributions (section 752(a)) and decreases in shares of partnership liabilities are treated as a cash distribution to the partner (section 752(b)). If, as a result of a single transaction, a partner incurs both an increase in his or her share of partnership liabilities and a decrease in his or her share of partnership liabilities, only the net increase or the net decrease will be treated as a cash contribution or a cash distribution. Reg. ‘ 1.752-1(f). In determining what constitutes a ‘single transaction’, the Service has shown some indication that the term may be construed broadly. For example, the Service has ruled that the following events constitute a single transaction for purposes of Reg. ‘ 1.752-1(f): (1) a partnership contributes property to an UPREIT in exchange for interests in the UPREIT, (2) the partnership distributes the UPREIT interests to its partners, and (3) the debt secured by the contributed property is refinanced. TAMs 199943005; 199943006; 199943007.
Assumptions of a partnership liability by a partner is also treated as a cash contribution by the partner and the assumption of a partner's liability by the partnership is likewise treated as a cash distribution to the partner.
Illustration:
Partnership buys property for $100,000, paying the price with $20,000 contributed by the partners and $80,000 from borrowed funds. The partnership has a $100,000 basis for the property; and section 752 causes the original bases for all partners to total $100,000. Thus, the partnership's basis for the assets, and the aggregate of the bases for the individual partners, are the same.
III. Liabilities
Currently, the term "liability" is not defined in Internal Revenue Code, nor in the Regulations.
Illustration:
ABC Partnership purchases property for $1,000, paying $200 in cash, and the balance by a purchase money mortgage of $800. The note is a "liability" because the liability accounts for $800 of the property's cost basis of $1,000.
Prior regulations under section 752 defined an obligation to be a liability only to the extent that the obligation gave rise to (i) the creation of, or an increase in the, basis of property owned by the obligor, (ii) a deduction taken in computing the obligor's taxable income, or (iii) an expenditure that is not deductible in computing the obligor's taxable income. Temporary Reg. 1.752-1T(g)(1991).
Examples given in Temporary Reg. 1.752-1T(k) concluded that accrued but unpaid expenses for a partnership that uses the cash method of accounting are not liabilities under section 752 (example 2). That result was consistent with the holding in Revenue Ruling 88-77, 1988-2 C.B. 129. An underlying premise of the classification of an obligation as a liability is that it is a "legally enforceable" obligation of the partnership and has economic substance.
Compare La Rue v. Commissioner, 90 T.C. 465, 478 (1988) which holds that for an accrual method partnership, the test of whether an incurred expense is a "liability" under section 752 depends on whether the expense is deductible. Therefore, an account payable for a deductible expense is a liability if a partnership uses the accrual method of accounting, but not if the partnership account is on a cash basis.
IV. Distinction between Recourse and Nonrecourse Liabilities and Deductions
A nonrecourse liability is a partnership liability for which no partner or related person bears the economic risk of loss. Reg. 1.752-1(a)(2). A liability which is treated as a nonrecourse liability for other tax and business purposes may constitute a recourse liability for purposes of section 752. For example, a partner is treated as bearing the economic risk of loss for a liability (and therefore the liability is treated as recourse) to the extent that the partner (or related person) holds or guarantees the liability, even if the liability would be treated as nonrecourse for purposes of Reg. 1.1001-2. The distinction between recourse and nonrecourse liabilities can generally be made based upon:
i. whether the creditor's right to repayment of a partnership liability is limited solely to one or more assets of the partnership; and
ii. whether the liability is extinguished by a transfer (whether voluntarily or involuntarily) of the security for the debt to the lender.
If the answer to both questions is yes, the debt would be classified as nonrecourse.
However, in several recent private letter rulings the Service has classified a general partnership liability as nonrecourse debt even where the debt was not secured by any particular partnership assets. PLRs 199906025; 199903017; 9815022; 9815001. The partnership issued or undertook debt that was a general obligation of the partnership, with no recourse to any of the partners, any related person, or any assets of a related person. The debt was not secured by any particular partnership assets. The Service ruled that the debt was a nonrecourse liability to which more than one item of partnership property was subject. For purposes of determining section 704(c) minimum gain, the partnership may allocate the debt among its properties that are subject to the debt in any amount that does not exceed the lesser of (i) the fair market value of the property or (ii) the amount of debt previously allocated to the property and repaid with the proceeds of the debt.
Reg. 1.752-2(a) establishes the concept that a partner's share of a partnership liability includes the portion of the liability for which the partner or person related to the partner bears the economic risk of loss. If any partner or person related to a partner bears the economic risk of loss with respect to a liability, that liability is recourse. If economic risk of loss exists only with respect to a portion of the liability, then the liability is bifurcated into a recourse liability to the extent of the economic risk of loss and a nonrecourse liability for the remainder. To determine who, if anyone, bears the economic risk of loss, the regulations first employ a mechanical test based upon a constructive liquidation of the partnership, which involves the following hypothetical events, all of which are deemed to occur simultaneously:
1. All of the partnership liabilities become payable in full.
2. With the exception of property contributed to secure a partnership liability, all of the partnership's assets, including cash, have a zero value.
3. The partnership disposes of all of its properties for no consideration (except relief from nonrecourse liabilities).
4. All items of partnership income, gain, loss or deduction are allocated among the partners.
5. The partnership liquidates.
When a partnership holds depreciable property subject to nonrecourse debt and allocations of depreciation deductions have created deficit capital accounts for one or more partners, allocation of the deemed gain on the hypothetical disposition effectively eliminates negative capital account of the partners. Since the debt obligation is extinguished by the disposition, there is, therefore, no remaining payment obligation to be satisfied as the result of any deficit restoration obligation imposed upon a partner. In other words, a deficit capital account restoration obligation with respect to nonrecourse deductions is illusory.
Illustration:
A and B form a general partnership, each contributing $100 in cash. The partnership purchases an office building on leased land for $1,000 from an unrelated seller, paying $200 in cash and executing a note to the seller for the balance of $800. The note is nonrecourse to the partnership, but the seller requires B to guarantee repayment of the obligation. The partnership agreement provides that all items are allocated equally except that tax losses are specially allocated 90% to A and 10% to B and that capital accounts will be maintained in accordance with the regulations under section 704(b). A has a DRO. In a constructive liquidation, the following should be deemed to occur:
(i) The partnership's liability of $800 becomes payable in full;
(ii) All of the partnership's assets have a zero value;
(iii) The partnership disposes of all of its property in a fully taxable transaction.
Applying Reg. 1.752-2(b)(2), the creditor's right to repayment of the $800 partnership liability is not limited solely to one or more assets of the partnership, since B has guaranteed the debt. Therefore, a loss equal to the remaining tax basis of the partnership's assets, $1,000, is recognized. The $1,000 loss is allocated to the partners' capital accounts as follows:
|
|
A |
B |
|
Initial Capital |
$ 100 |
$100 |
|
Allocation of Loss |
(900 ) |
(100 ) |
|
|
($800) |
$-0- |
Thereafter, B would be required to pay on her guarantee. Since B has paid on her guarantee, she would have an economic incentive to enforce the deficit restoration obligation of A. A would have an obligation to restore his deficit capital account in the amount of $800, which would then be distributed to B. Adjustments to the capital accounts for these events would be:
|
|
A |
B |
|
Capital Account at Liquidation |
$(800) |
$-0- |
|
Deemed Contribution for Assumption |
1 -- |
800 |
|
Contribution for DRO |
$800 |
-- |
|
|
$-0- |
$800 |
|
Distribution |
-- |
(800 ) |
|
|
$-0- |
$-0- |
1
B's guarantee should be treated as an "assumption" under Reg. 1.704-1(b)(2)(iv)(c).Thus, a critical aspect in applying the regulations is determining whether all obligations related to the partnership liability will be extinguished by the deemed conveyance of property. Even if a partner's payment obligation "with respect to a partnership liability" would not be legally extinguished by the deemed conveyance, however, the obligation will be recognized, in applying the economic risk of loss analysis, only if the obligation satisfies the criteria of Reg. 1.752-2(b)(3).
This article is intended to provide the reader with general information and should not be considered a substitute for legal advice or opinion. Readers are advised not to act upon this information without seeking professional counsel.
For more information, please call M. Celeste Pickron, Sutherland Asbill & Brennan LLP, 999 Peachtree Street, NE, Atlanta, GA 30309, Phone: 404.853.8222, mcpickron@sablaw.com