United States: Adding a New Cash Partner to an Operating Partnership

The contribution of cash to an operating partnership should be a simple event raising only minor tax issues. Alas, that is not to be: the tax issues are many and their resolution often difficult. To be sure, the contribution of cash likely will not be a taxable event to the incoming partner, but in a number of circumstances it can be taxable to one or more of the continuing (or exiting) partners. Tax allocations for the year of the cash infusion can be complex and, in fact, even the tax year itself can be affected by the contribution. And last but not least, the incoming partner must examine the control structure of the partnership to ensure that future partnership events can be anticipated and exit strategies can be implemented.

The contribution of cash to an operating partnership is unlikely to be a taxable event to the contributing partner not because section 721 provides for nonrecognition (which it does) but simply because cash always has an adjusted basis equal to face value and so there is no unrealized gain or loss available for recognition. However, it is worth mentioning that this blanket rule applies only to a taxpayer's functional currency. See §988(c)(1)(C)(i)(I). For most US taxpayers "functional currency" means US dollars. As a result, a transfer of foreign currency can be treated as the disposition of property and so can result in the recognition.

For example, suppose US corporation contributes 10,000,000 euros to a partnership operated in the UK. If the value of the euros at the time of the contribution is more or less than their value (in US dollars) when acquired by the corporation, the contribution will result in the recognition of gain or loss despite the general nonrecognition rule of section 721 because of the general currency transaction override provision of section 988(a)(1)(a). Similarly, a foreign partner could contribute US dollars to a domestic partnership in exchange for a partnership interest and be taxed on the exchange because for most foreign taxpayers US dollars are treated as a nonfunctional currency.

In the domestic context, an infusion of cash into an operating partnership should not be taxable to the contributing partner but could be taxable to the existing partner. In particular, the cash contribution could work a shifting of partnership liabilities among the partners possibly triggering gain recognition under sections 752(b) and 731(a)(1). This would arise because when cash is contributed to a partnership, existing partnership liabilities may be reallocated away from an existing partner and to the incoming partner. Because a reduction in a partner's share of partnership's liabilities is treated as a distribution of cash, see §752(b), the contribution of cash can be taxable to a continuing partner whose outside basis is insufficient to absorb the constructive distribution, see §731(a)(1).

Nonrecourse liabilities of a partnership (see Reg. §1.752-1( a)(2) for the definition of a "nonrecourse" liability") are allocated among the partners in three tiers. Reg. §1.752-3(a). Under the first tier, nonrecourse liabilities are allocated to each partner in an amount equal to each partner's share of partnership minimum gain (that is, in the same proportions as prior nonrecourse deductions were allocated). Reg. §1.752-3( a)(1). Under the second tier, the remaining nonrecourse liabilities are allocated to each partner in an amount equal to the partner's §704(c) gain (including reverse §704(c) gain arising from the revaluation of partnership property) which would be recognized if the property were sold for the outstanding liability and no other consideration. Reg. §1.752-3( a)(2). Finally, all remaining nonrecourse liabilities are allocated among the partners in proportion to their profits interests. Reg. §1.752-3(a)(3). Tier three allocations may be made in accordance with the partners' general profits interests, in a manner reasonably consistent with the allocation of some tax item having economic effect, in a manner that takes account of any section 704(c) gain not taken into account under tier 2, or in the manner in which the partners will share the nonrecourse deductions from the property. Reg. §1.752-3(a)(3).

When an incoming partner contributes cash to the partnership, no change is made to the tier 1 allocation because the contribution has no affect on the allocation of prior nonrecourse deductions. Further, no change should arise under tier 2 unless the property declines in value below the amount of the nonrecourse encumbrance. However, the debt allocation under tier 3 is almost certain to change because the incoming partner will pick up of a share of partnership profit at the expense of the existing partners.

For example, suppose individual X contributed Blackacre to the XY partnership in exchange for a 50% interests in profits and losses when Blackacre has an adjusted basis of $100, a fair market value of $500, and is subject to a nonrecourse debt of $350. Y contributes property having an adjusted basis and fair market value of $150 for the remaining 50% interest.

Of the $350 debt, $250 will be allocated to X under tier 2 because that is the amount of gain that would be allocable to X if the contributed property were sold for the amount of the debt and for nothing else. The remainder of the debt – $100 – will be allocated under tier 3, and assume that this portion of the debt will be allocated in accordance with general profits interests; that is, it will be allocated equally between the partners. As a result of this debt allocation, X's initial outside basis will equal $50, computed as follows: $100 carryover basis less $350 debt transferred to the partnership plus $300 debt share from the partnership.

Suppose the partnership claims $80 of depreciation from the property contributed by Y, so that each partner's capital account and outside basis is reduced by $40. The property contributed by X remains worth $500 and subject to a nonrecourse debt of $350, and the partnership has net assets of $220. At this point Z joins the partnership by contributing $220 for a 50% interest in future profits and losses , and X and Y reduce their interests to 25% each.

There is no tier 1 allocation and X's tier 2 allocation remains at $250, but the tier 3 allocation is now $25 to X, $25 to Y, and $50 to Z. As a result, X's debt share is reduced by from $300 to $275, and that means X is treated as receiving a deemed distribution of $25 in cash. Since X's outside basis was only $10 prior to the admission of Z, this means X recognizes income of $15 by reason of Z's cash contribution.

This recognition could have been avoided if the partnership had adopted an alternate way of making its tier 3 allocation. Recent amendments to the regulations promulgated under section 704(c) now permit the tier 3 allocation to take into account any section 704(c) gain not taken into account under tier 2, see Reg. §1.752-3(a)(3); in the example above, the section 704(c) gain taken into account under tier 2 was $250, leaving $150 available for allocation to X under the new tier 3 regulations. If the partnership had allocated the remainder of the debt to X in this way under tier 3, the income recognition to X could have been avoided. Note that a partnership is permitted to change the way in which it allocates tier 3 liabilities on a year-by-year basis. Reg. §1.752-3(a)(3).

However, a slight change of the facts shows that the partnership may be helpless to prevent X's recognition of income. Suppose that the property contributed by X has declined in value to $350 when Z joins the partnership (indeed, the decline in value of the asset could be the reason that the partnership seeks an infusion of cash). Now, the excess section 704(c) gain has evaporated, leaving the partnership with little choice other than force X to recognize gain on the admission of Z.

As this example demonstrates, it will often be to the advantage of a partner contributing low-basis encumbered property to a partnership to use the flexibility of the tier 3 allocation to maximize the amount of the debt allocated to that contributing partner. However, whatever debt is allocated to one partner cannot be allocated to any other, and other low-basis partners may desire additional debt allocation under tier 3 to permit the pass-thru of partnership losses or to avoid recognition of gain on actual or constructive distributions. Indeed, in the example above if the basis of the property contributed by Y had been low, then the admission of Z would cause both prior partners to scramble for basis, basis that the debt can provide to one or to the other but not to both.

Partnership recourse liabilities are allocated among the partners in accordance with economic risk of loss. Under the regulations, a partner bears the economic risk of loss of a partnership liability to the extent the partner would be forced to make a payment to any person (including a contribution to the partnership) as the result of a constructive zero-value liquidation of the partnership. See Reg. §1.752-2(b)(1). In this context a zero-value liquidation means a liquidation of the partnership after all of its assets (including cash) have become worthless and are transferred for zero consideration in a fully taxable transaction. Id. The use of a zero-value constructive liquidation is to determine how the capital account balances will stand if the partnership should lose all of its investments when the partnership's debts become due.

For example, suppose P and Q form the PQ general partnership by contributing cash of $100 each. The partnership then purchases depreciable real estate for $1,000, paying $200 down and signing a recourse note for $800. If each partner has a 50% interest in profits and losses, each partner will have a capital account of $100 and an outside basis of $500.

After the partnership has claimed depreciation of $820, R joins the partnership as a one-quarter partner in exchange for a cash contribution of $400 (because the property is now worth $2,000 and the debt remains at $800). The effect of the admission of Z is to shift $200 of the debt away from the continuing partners and to Z. As a result, each partner will recognize income of $10 because the prior depreciation reduced each partner's outside basis from $500 to $90, and that amount is insufficient to cover the debt shift to Z. Note that, in general, the greater share of losses allocated to the incoming partner, the greater the debt shift away from the continuing partners.

Under section 721(a), the contribution of property is generally tax-free to the contributing partner, to the partnership, and to the other partners. However, that provision does not apply to transfers to investment partnerships as described in section 721(b). Even without the application of section 721(a), though, the contribution of cash should be tax-free to the contributing partner. But what of the partnership and, through it, the other partners?

There is no clear answer whether the contribution of cash to an investment partnership is taxable to the partnership, but the better reasoned answer is that it should not be.

The argument in favor of taxing the partnership seems to go like this: in the corporate context, section 351 protects the contributing partner and section 1032 protects the corporation. In the partnership context, section 721(a) plays both roles, protecting both the contributing partnership and the receiving partnership. Because the application of section 721(b) makes section 721(a) inapplicable in full, it is just as if, in the corporate context, neither section 351 nor section 1032 had been enacted. And since a corporation would be taxable on the issuance of its stock absent section 1032, so should a partnership be taxable on the issuance of a partnership interest absent section 721(a).

Which is just so much nonsense. Even prior to the enactment of the first version of section 1032, a corporation was never taxable on the issuance of its stock, and the government never claimed that it was. That makes sense, of course, because freshly issued stock is never appreciated in any reasonable sense of the word. To be sure, the underlying assets may be appreciated, but there has been no disposition of those assets simply by reason of admitting a new equitable owner to the venture.

Why then do we have section 1032? Some clever tax lawyers long ago determined that a corporation could be taxed on the gain or loss recognized on the disposition of treasury stock; that is, stock previously issued by the corporation and then repurchased by it. Because treasury stock and newly- issued stock are for almost all purposes completely interchangeable, this meant that if the corporation's stock went down the corporation could issue treasury stock for cash or property and claim a loss while if the value of the corporation's stock went up it could issue new stock for cash or property and avoid the gain. To prevent this whipsaw, Congress enacted section 1032 to treat treasury stock just like newly- issued stock.

Partnerships cannot hold partnership interests in treasury, and so there is simply no need for something like section 1032. A newly- issued partnership interest has not appreciated in the hands of the issuing partnership, and so unless Congress wishes to tax the other partners as if the assets of the partnership had been sold – something very different from the issuance of a partnership interest – the contribution of cash or property to a partnership should be tax- free to the partnership whether or not section 721(a) applies.

If one partner contributes cash or property to a partnership and one or more other partners receives a distribution in retirement of his partnership interest, the two transactions will be treated as the disguised sale of a partnership interest if they are properly considered a single transaction. §707(a)(2)(B) (final flush language). Indeed, the admission of new cash and the proportionate reduction of the interests of all partners could be treated as the disguised partial sale of multiple partnership interests if distributions near in time to the partnership interest reductions are made to the partners whose interests are reduced. To date, the Service has issued no guidance on this important issue. Yet, the tax consequences of such a recharacterization are substantial.

When a contribution of cash is recharacterized as the purchase of a partnership interest, the possibility of a partnership technical termination must be considered. A technical termination occurs if partnership interests representing more than 50% of the profits and capital are sold or exchanged in a twelve month period. §708(b)(1)(B). Note that liquidations of partnership interests do not count toward the 50% threshold so long as the form of the transaction is respected. Reg. §1.708-1(b)(1)(ii).

Because a technical termination under §708(b)(1)(B) does not terminate the partnership's activity under state law, a technical termination invariably is followed by a reformation of the partnership. Indeed, such a reformation often is invisible to the partners and to the world in general because nothing (aside from tax consequences) changes. Technically, however, the terminating partnership is deemed to contribute all of its assets to a new partnership in exchange for all of the interests in this new partnership, and the terminating partnership is then deemed to distribute those interests in the new partnership to its members in liquidation of the terminating partnership. Reg. §1.708-1(b)(1)(iv).

Although an actual partnership termination and reformation would affect the partners' capital accounts and introduce new §704(c)(1) problems, no such complexity results from a technical termination under §708(b)(1)(B) because a technical termination does not affect the partners' capital accounts. Reg. §1.704-1(b)(2)(iv)(l). In addition, a technical termination does not trigger recognition of income under §704(c)(1)(B), Reg. §1.704-4(c)(3), or under §737, Reg. §1.737-2(a). And while property in the newly- formed partnership will be treated as §704(c) property only if it was §704(c) property in the hands of the predecessor partnership, Reg. §1.704-3(a)(3)(i), the newly- formed partnership is not required to use the same method for addressing ceiling limitations as did the predecessor partnership, Reg. §1.704-3( a)(2). See Reg. §1.708-1(b)(1)(iv) for additional guidance. The most significant drawback of a technical termination is that any depreciable property owned by the partnership must be treated as newly-placed in service, see §168(i)(7)(B) (final sentence), thereby lengthening the period over which the partnership will recover its remaining basis in its property.

For the incoming partner, recharacterizing the contribution of cash as the purchase of a continuing interest means that the contributor's capital account is determined not by reference to the contributed cash but rather is carried over from the partner (or partners) treated as selling their interest (or interests). Reg. §1.704-1(b)(2)(iv)(l). This can limit the partnership's ability to allocate losses to the new cash partner because, under the alternate test for economic effect, losses cannot in general be allocated in excess of a partner's capital account (plus the amount, if any, that the partner can be forced to contribute to the partnership in the future). Reg. §1.704-1(b)(2)(ii)(d). Further, the regulations do not authorize a restatement of the capital accounts to reflect current assets values upon the transfer of a partnership interest. Thus, the incoming partner faces a very real possibility of an artificial loss limitation.

The incoming partner will also take a proportionate share of the deemed transferor partner's §704(c) and reverse-§704(c) income. To be sure, this generally can be avoided by ensuring that the partnership has an election under §754 in effect for the year of the transaction, but because such an election cannot be made retroactively, recharacterization of a cash contribution as the purchase of a partnership interest suggests such an election should be made prophylactically. Indeed, absent such an election the incoming partner could face problems under sections 704(c)(1)(B) and 737 (with respect only to true §704(c) items) and potentially under the disguised sale of property rule in §707(b)(2)(B) under the Service's new willingness (see Rev. Rul. 2000-44, 2000-41 I.R.B. 336) to treat a transferor and the transferee as a single taxpayer for purposes of §707(a)(2)(B).

A liquidating distribution of cash is easily recharacterized as part of a disguised sale if it occurs short before or after a contribution of cash, especially if the amounts distributed and contributed are approximately the same. Fortunately for the exiting partner, the recharacterization is unlikely to have significant negative consequences.

Whether the transaction is taxed as a liquidating distribution of cash or as a sale of the partnership interest for cash, the exiting partner will recognize gain equal to the excess of the amount realized over the partner's outside basis (or loss if outside basis exceeds the amount of cash).

That gain or loss will be capital, except to the extent that section 751 recharacterizes it as ordinary. However, section 751(a) applies to the sale or exchange of a partnership interest while section 751(b) applies to distributions in liquidation of a partnership interest, and these two provisions do not apply identically. In particular, section 751(a) will capture the partner's share of gain or loss from all the partnership's ordinary income assets while section 751(b) applies only to the partnership's unrealized receivables and its "substantially appreciated" inventory.

Inventory is "substantially appreciated" within the meaning of section 751(b) if its fair market value exceeds 120% of it s adjusted basis. §751(b)(3)(A). As a result, if the partnership's inventory items are only slightly appreciated, or if they have declined in value and so will generate a loss, section 751(b) will treat the gain or loss as capital while section 751(a) will treat it as ordinary.

Of more practical significance is the different tax rates that apply to the exiting partner's share of gain from depreciated real estate. Assuming that the real estate was placed in service after 1986, there will be no recapture at ordinary rates under section 1250. However, on the sale of a partnership interest the partner's share of depreciation recapture from the sale of such depreciated real estate is taxed at 25% under section 1(h). Reg. §1.1(h)-1(b)(3)(ii). Because this provision does not apply to partnership distributions, see id., the rate will be the general 20% capital gain rate.

If a partner exits the partnership in exchange for a distribution of property, recharacterization of the liquidating distribution as part of a disguised sale of a partnership interest will yield devastating tax implications for the exiting partner. While it seems unlikely that the contribution of cash could be combined with a distribution of property to form a single transaction (what was paid, cash or property?), there is a least one circumstance in which such a recharacterization is likely to occur.

Suppose a partnership incurs significant indebtedness to acquire certain property, and suppose that this property ultimately is distributed to a partner in a liquidating distribution. If a new partner contributes fresh capital to the partnership around the time of the exiting partner's exit, the exit and admission could be recharacterized as a single transaction, and this seems especially likely if the fresh cash is used by the partnership to retire the acquisition indebtedness. (The same problem could arise if one or more partners receive property in partial liquidation of their partnership interests and some new or continuing partner contributes fresh capital that is used to retire indebtedness incurred by the partnership to acquire the property distributed in redemption.)

If a liquidating distribution of property is recharacterized as part of a disguised sale of a partnership interest, the exiting partner will lose the benefit of taxation under section 731 and will instead be taxed under the general rule of section 1001 (as modified by application of section 751(a) for tainting some portion of the gain or loss as ordinary). In general, section 731 permits an exiting partner to receive any amount of property tax-free, subject only to the application of section 751(b) if the effect of the distribution is to work an exchange of the exiting partner's share of ordinary income assets for capital assets and cash. Thus, losing the benefit of section 731 upon the exit from a partnership (and especially from a real estate partnership having few ordinary income assets) is akin to losing the benefit of section 1031 on a like-kind exchange. That is, deferral is lost, replaced with immediate taxation.

In section 706(d), Congress has prohibited retroactive allocations. In this context, "retroactive" allocations do not refer to allocations made after the close of the taxable year (which are explicitly authorized by §761(c)) but rather allocations of items of partnership income and loss to persons who were not partners when the items accrued. For example, suppose that individual J joins the P partnership on December 15 by contributing cash of $15,000. Suppose further that the partnership has an interest deduction for the year of $15,000. Can that entire interest deduction be allocated to J?

Under section 706(d)(2), J can be allocated only so much of the interest deduction as accrues on or after December 15, the date of J's admission to the partnership. Note that this rule applies regardless of the accounting method used by the partnership and is independent of when the interest is actually paid. In particular, if the interest is paid on December 20, and even if the partnership uses the cash receipts and disbursements method of accounting (so that none of the interest expense is recognized by the partnership prior to actual payment), J can be allocated no more than 1/24th (one half of one month) of the interest expense.

Suppose that J had joined the partnership on July 1 as a 50% partner. While the partners could not allocate to J any of the interest expense accruing between January 1 and June 30, they are free under section 704(b) to allocate as much of the interest accruing on or after July 1 to J. For example, an allocation of all the interest accruing after June 30 would be valid even though the effect of such an allocation is the same as allocating half of the entire year's interest expense to J. Yet, this latter allocation would run afoul of the rules in section 706(d)(2). Astute lawyers, in other words, can accomplish by means of special allocations much of what seemingly is prohibited by the anti- retroactive limitation.

As a second example, consider new partner P who formally joins a partnership on July 1 in exchange for a contribution of cash. Negotiations for the admission of P began in April, and the parties wish to treat P's admission as effective as of May 1. Back-dating documents risks prison, and the partners wisely refrain from making a mistake of that magnitude. Is there any legitimate way to accomplish their goal?

Probably. Suppose P was to become a 15% partner. While they cannot simply provide that P will be allocated 15% of all items of income, deduction, credit and loss accruing on or after May 1 (because of the anti-retroactive limitation in section 706(d)), they can provide the follow: "all partnership items of income, deduction, credit and loss accruing on or after July 1 shall be allocated to P in such an amount as would equal an allocation of 15% of such items as accrued on or after May 1." On the dates used in this example, that would simply mean that instead of P being allocated 15% of seven-twelfths of the partnership tax items, P will instead be allocated 21% of five-twelfths of the items for the year of P's admission.

The anti-retroactive limitation in section 706(d) applies only to a partnership's "cash-basis" items. Such items include interest, taxes, payments for services or for the use of property, and "any other item of a kind specified in regulations prescribed by the Secretary as being an item with respect to which the application of this paragraph is appropriate to avoid significant misstatements of the income of the partners." To date, no regulations have been promulgated under this authority expanding the definition of a partnership's "cash-basis" items. Note that allocations of gains and losses from the disposition of partnership assets are not captured by the anti-retroactive rule of section 706(d).

In certain circumstances, a partnership is permitted to revalue it assets to fair market value and restate the capital accounts to reflect those values. See generally Reg. §1.704-1( b)(2)(iv)(f)-(g). One such circumstance, assuming the revaluation is made "principally for a substantial non-tax business reason", is "[i]n connection with a contribution of money or property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership." Reg. §1.704-1( b)(2)(iv)(f)(5)(i).

To view this article in its full entirety (and any diagrams/footnotes), please enter the following link into a fresh browser:
http://www.steptoe.com/publications/PLI_-_Contribution_of_Cash.pdf