DETERMINATION OF A PARTNER'S BASIS IN A PARTNERSHIP:
ACQUISITIONS, SUBSEQUENT CHANGES, AND ALLOCATIONS
GERALD H. HANSEN
Independent Research
Law 721
Professor Phelan
0011.3
INTRODUCTION
The adjusted basis of a partner's interest in a partnership
is important for a number of reasons.
Under the Internal Revenue
Code 1 section 704(d) , the adjusted basis of a partnership interest
serves to limit the deduction a partner may take for his distributive share of partnership losses (including capital losses).
The adjusted basis of a partnership interest is important in
di'loj in i n j ikj the adjusted basis of property distributed by a
partnership to a partner since the adjusted basis of property
distributed by a partnership to a partner can never exceed the
partner's adjusted basis for his partnership interest reduced
2
by any money distributed in the same transaction.
Also, a part-
ner's adjusted basis for his partnership interest is used to
determine the extent of gain or loss recognized by the
partner
3
in a distribution by a partnership to such partner.
When must a partner determine the adjusted basis of his
partnership interest?
A partner is required to determine the
adjusted basis of his interest in a partnership only when necessary
4
to determine his tax liability or that of any other person.
This
iK'Lormination will ordinarily be made as of the end of a partnership taxable year.
However, where there has been a sale or
1. Unless otherwise indicated, all references to the Internal
Revenue Code (or Code) are to the Internal Revenue Code of 1954 as
in effect January 1, 1982.
2.
I.R.C. § 732 (a) (2)-(b) .
3.
I.R.C. § 731 (a) .
4.
Treas. Reg. § 1.705-1(a)(1).
9
00114
exchange of a partnership interest or a complete liquidation of
a partner's interest, the adjusted, basis of the partner's interest
should be determined as of the date of sale or exchange or
liquidation.
SOME GENERAL RULES
The initial determination of a partner's basis for his
interest in a partnership depends on how he acquired it.
If a
partner acquires his partnership interest by contributing property,
including money, to the partnership, the basis of his interest in
the partnership is determined under section 722 of the Code.
The
basis of an interest in a partnership not acquired by contribution
is governed by the regular basis rules under part II of subchapter
0 (Sections 1011 - 1023).
Thus, the basis of a purchased interest
will be its cost, while the basis of a partnership interest acquired from a decedent will be its fair market value at the date
of death or at the alternative valuation date, increased by the
estate's or other successor's share of partnership liabilities, if
any, on the valuation date, and reduced to the extent that such
value is attributable to items constituting income in respect of
a decedent.^
Regardless of the manner in which the basis of a partner's
interest in a partnership is initially determined (i.e. whether
under section 722 or section 742), the provisions of section 705(a)
5.
6.
1014(a).
14
Id.
I.R.C. § 742; Treas. Reg. § 1.742-1.
00115
See I.R.C. §§ 1012,
require that adjustments
be made to the partner's interest to
7
reflect the results of partnership operations.
ACQUISITION OF A PARTNERSHIP INTEREST
Section 721(a) of the Code provides generally that no gain
or loss shall be recognized by a partnership or any of its partners in the case of a contribution of property in exchange for
g
an interest in the partnership.
The nonrecognition rule applies
to contributions of property made to a partnership in the process
9
of formation and to contributions made at subsequent times.
Section 721(a) does not prevent recognition of gain or loss
forever; it simply defers such recognition.
Deferral is accom-
plished by section 721(a) in conjunction with sections 722 and
723.
Section 723 provides that the basis of property contributed
to a partnership by a partner is the adjusted basis of the
property in the hands of the contributing partner at the time of
contribution increased by the gain (if any) recognized to such
7.
See Treas. Reg. § 1.705-1.
8.
This statutory nonrecognition provision was not in the
19 39 Code. However, even prior to adoption of the 1954 Code, the
transfer of property to a partnership in exchange for a partnership interest was held to be a nontaxable event. See Edward B.
Archbald, 27 B.T.A. 837 (1933), aff'd, 70 F.2d 720 (2d Cir.), cert,
denied, 293 U.S. 594 (1934). When property is contributed to a
partnership there is a change only in the form of ownership; the
assets once owned directly by the partner are now owned indirectly
by virtue of his partnership interest. This rationale provides
the policy for extending nonrecognition treatment to such a contribution. See 27 B.T.A. at 844; Contributions of Property to a
Partnership: A Primer (And Beyond), 33 U. Fla. L. Rev. 33 (1980).
9.
Treas. Reg. § 1.721-l(a).
3
9
00116
partner at the time of contribution.
Section 72 2 completes the
statutory scheme by providing that a partner's basis in a partnership interest acquired by a contribution of property is the amount
of money contributed.and the adjusted basis (determined at the
time of contribution) of the property contributed increased by
the amount (if any) cf gain recognized to such partner at the time
of contribution.
For example, assume A contributes property with a fair market
value cf $100 and an adjusted basis of $60 to a partnership in
exchange for a 50 percent interest in the partnership.
Under
section 721(a), neither A nor the partnership recognizes gain on
the contribution.
The partnership's basis for the contributed
property is $60,^"° and A's basis for his partnership interest is
$60 (the adjusted basis of the property contributed)."^
This is
true even though A may be credited with a capital account of $100
on the partnership books.
12
If the partnership subsequently sells
10. I.R.C. § 723. See also Oliver v. Commissioner, 218 F.2d
352 (5th Cir. 1955) (partner contributed land to a partnership; the
partnership's basis in the land was the contributing partner's cost,
not the FHA appraisal value); Culley v. Commissioner, 29 T.C. 1076
(1958) (for tax purposes, the partnership has a carryover basis in
contributed land even though the land is carried at a higher value
on the partnership books); Rev. Rul. 77-458, 1977-2 C.B. 220 (ten
partnerships merged into one; the adjusted basis of the contributed
property carried over into the new partnership).
11.
I.R.C. § 722.
12. Treas. Reg. § 1.705-1(a)(1) provides as follows: "The
adjusted basis of a partner's interest in a partnership is determined
without regard to any amount shown in the partnership books as the
partner's 'capital,' 'equity,' or similar account."
9
00137
the property for $100, it will realize the pre-contribution
appreciation as a gain (i.e. $40), and A will report 50 percent
13
(A's distributive share) of such gain
absent an agreement to
the contrary.1^
If non-business property is converted into business property
by contributing it to a partnership for use in its trade or
business, the partnership's basis for the property is the lesser
of its fair market value at the time of contribution
or its adjusted
1c
basis in the contributing partner's hands.
The nonrecognition rule of section 721(a) does not apply to
contributions of property to all
16 types of partnerships.
Congress enacted section 721(b)
In 1976,
which provides that the nonrecog-
nition rule of section 721(a) shall not apply to a partnership
which, if incorporated, would be treated as an investment company
under section 351.
This provision was designed to alleviate the
ability of an investor to use the partnership form to obtain a
tax-free diversification of his portfolio."'"'
13.
See I.R.C. § 702(a).
14.
See I.R.C. § 704.
15. Au v. Commissioner, 40 T.C. 264 (1963), aff'd per curiam,
330 F.2d 1008 (9th Cir. 1964), cert, denied, 379 U.S. 960 (1965).
16.
Pub. L. No. 94-455, § 2131(b), (f), 90 Stat. 1924 (1976).
17. See S. Rep. No. 938 , 94th Cong., 2d Sess. 41 (1976);
H.R. Rep. No. 94-1049,_94th Cong., 2d Sess. (1976).
5
00118
Note, section 721(a) prescribes nonrecognition treatment only
upon the contribution of "property" to the partnership in exchange
for a partnership interest.
Services are not property for pur-
poses of section 721(a), and therefore may not be contributed
to a partnership without recognition of gain.1^
provide:
The Regulations^"9
"To the extent that any of the partners gives up any
part of his right to be repaid his contributions . . .
in favor
of another partner as compensation for services . . . section 721
does not apply."
20
In United States v. Frazell
the taxpayer agreed to perform
services in exchange for an interest in the partnership.
In addi-
tion, geological maps created by the taxpayer's personal efforts
were contributed to the partnership in exchange for a partnership
interest.
The court held that the partnership interest received
by the taxpayer in exchange for his services did not qualify for
section 721(a) nonrecognition treatment.
However, the court
viewed the geological maps as property and, consequently, held that
the portion of the taxpayer's partnership interest that could be
attibuted to contribution of the geological maps was not taxable
under section 721(a).
18. United States v. Frazell, 335 F.2d 487 (5th Cir. 1964),
cert, denied, 380 U.S. 961 (1965); Diamond v. Commissioner, 56 T.C.
530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974). See 1 W. McKee,
W. Nelson & R. Whitmire, Federal Taxation of Partnerships and^Partners
1 4702[1] at 4-7 (1977) [Hereinafter cited as~McKee]. Cf. I.R.C. § 83.
Section 8 3 of the Code governs the tax consequences of receipt of a
partnership interest in exchange for the performance of services. In
general, if the unqualified receipt of such property is subject to a
substantial risk of forfeiture, it will not be immediately taxable
unless the recipient so elects. See I.R.C. § 83(a)-(b).
14
19.
Treas. Reg. § 1.721-1(b) (1) .
20.
335 F.2d 487 (5th Cir. 1964), cert, denied, 380 U.S. 961 (1965]
00119
Section 721(a) might not provide nonrecognition treatment for
a transfer of property by a partner to a partnership followed by a
2~
distribution of money to the contributing partner. ~
In such a
case, the substance rather than form of the transaction will be
closely scrutinized to determine if there
22 has been a sale or a
contribution.
In Otey v. Commissioner,
no g a m or loss was
recognized by a partner who transferred real property to a partnership and subsequently received a cash distribution substantially
equivalent to the value of the real property.
The Tax Court found
the substance and form of the transaction to be a contribution to
capital, not a sale.
To support its decision, the Tax Court
relied on several factors:
(1)
The partners treated the transfer as a contribution;
(2)
The property comprised the only contributed capital of
the partnership; and
(3)
Since Otey was personally liable on the liabilities of
the partnership, there was no guarantee that he would
not have to use the cash distributed to him to pay
23
the partnership liabilities.
21. See Treas. Reg. § 1.721-1(a) which provides that in
such a case "the transaction will be treated as a sale or exchange
under § 707 rather than as a contribution under § 721."
22. 70 T.C. 312 (1978) aff'd per curiam, 634 F.2d 1046 (6th
Cir. 1980).
23. Id. 70 T.C. at 319-321. See also Park Realty Co. v.
Commissioner, 77 T.C. 412 (1981) (holding the transfer of property
to a partnership under an agreement entitling the transferor partner
to reimbursement of an agreed amount if certain financial conditions
were met was a nontaxable contribution of property under section 721);
Rubinstein, Transfers of Property to a Partnership: Contributions
or Sales and Related Uncertainties, 34 Tax Law. 371, 372 (1981).
9
00120
In cases such as Otey, the Commissioner will argue that the
transaction is, in substance, a taxable sale that should be
24
25
governed by section 707(a)
rather than section 721.
Although
this argument was rejected in Otey and Park Realty Co. v. Commissioner,
it should be remembered that such a transaction will be subject
to strict scrutiny by the Service and the courts.
A source of controversy that may arise under section 722
(relating to basis of a contributing partner's interest) is when a
partner contributes a personal note to the partnership.
In Oden v.
27
Commissioner,
the taxpayer transferred a personal note to the
partnership and attempted to increase his basis in the partnership
by the face amount of the note.
Since the taxpayer incurred no
cost in making the note, the court held its basis to him was zero
and, therefore, he was not entitled to increase his basis in the
partnership by the face amount of the note.
If the taxpayer had
shown that payments had been made on the note, his basis in the
partnership would increase by the amount of such payments. 2 8
24. I.R.C. § 704(a) provides, in general, that a partner who
engages in a transaction with a partnership other than in his
capacity as a partner will be treated as though he were an outsider.
25. See Otey v. Commissioner, 70 T.C. 312 (1978), aff'd
per curiam, 634 F.2d 1046 (6th Cir. 1980).
26.
77 T.C. 412 (1981) .
27.
41 T.C.M. (CCH) 1285 (1981).
28.
Rev. Rul. 80-235, 1980-2 C.B. 229.
8
9
00121
Under section 722, when the fair market value of propertysecuring a nonrecourse note has not been shown to at least approximate the face amount of the note, the note may not be included in
29
the basis of a partner's interest in a partnership.
HOLDING PERIODS FOR PARTNERSHIP INTERESTS
AND PARTNERSHIP PROPERTY
If a partnership interest is acquired by contributing
property which is either a capital asset under section 1221 or a
section 1231 asset, section 1223(1) provides that the holding
period of the partnership interest includes the period the contri30
butor held the contributed property.
Note, m
order ror section
1223(1) to apply, the property contributed to the partnership must
be either a capital asset or section 1231 property.
When neither
a section 1221 nor a section 1231 asset is contributed to a partnership, the holding period of a partnership interest begins on the
date of its acquisition, and does not include the
31 period for which
the contributor held the contributed property.
Thus, if property
29. Rev. Rul. 81-278, 1981-2 C.B. 159; Rev. Rul. 77-110,
1977-1 C.B. 58.
30. I.R.C. § 1223(1) provides that when a taxpayer receives
property in an exchange, the holding period of the property received
includes the holding period of the property exchanged, if the
basis of the property received has "the same basis in whole or in
part" as the basis of the property exchanged and the property exchanged was a capital asset or a § 1231 asset at the time of the exchange. Since § 722 provides that the basis of a partnership interest acquired by a contribution of property shall be the adjusted
basis of such contributed property, § 1223(1) will apply.
31.
See Treas. Reg. § 1.1223-l(a).
9
00122
which has been held primarily for sale to customers is contributed
to a partnership, the holding period of the partnership interest
32
begins on the date of its acquisition.
Of course, the holding
period of a partnership interest acquired by purchase will generally
begin on the date of such purchase.
A partnership's holding period for contributed property
includes 3the
r> period such property was held by the contributing
partner.
Section 1223(2) provides for tacking of holding periods
when property acquired has the same basis "in whole or in part"
as it would have in the' hands of the person from whom it was
acquired.
TREATMENT OF LIABILITIES
The treatment of partnership and partner liabilities is handled
35
under section 75 2 of the Code.
Any increase in a partner's share
32.
Id.
33.
I.R.C. § 1223(2); Treas. Reg. § 1.1223-l(b).
34. Since § 723 provides the partnership with a carryover
basis for property received by way of contribution, § 1223(2) will
apply.
35. I.R.C. § 752 provides as follows:
(a) Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's
individual liabilities by reason of the assumption by
such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the
partnership.
(b) Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the
partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the
partnership.
(c) For purposes of this section, a liability to
which property is subject shall, to the extent of the
fair market value of such property, be considered as a
liability of the owner of the property.
9
00123
of partnership liabilities is treated as a contribution of money
36
by him
which, consequently, increases the basis of his partner-
ship interest. 37 Any decrease in a partner's share of partnership
38
liabilities is treated as a distribution of money to him
which,
under section 733, results in a corresponding decrease (but not
below zero) in the distributee partner's basis for his partnership
3Q
interest. "
Any distribution of money in excess of the partner's
basis for his partnership interest produces gain under section
731(a) in the amount of such excess.
Gain under section 731(a) is
treated as gain from the sale or exchange of the distributee partner's interest in the partnership, which is treated as gain from
the sa le or exchange of a capital asset (except to the extent of
unrealized
receivables and substantially appreciated inventory
i 40
items).
35.
(Cont.)
(d) In the case of a sale or exchange of an interest
in a partnership, liabilities shall be treated in the same
manner as liabilities in connection with the sale or
exchange of property not associated with partnerships.
36.
I.R.C. § 752 (a) .
37. I.R.C. § 722. Under § 722, a contribution of money
increases the basis of a partnership interest.
38 .
I.R.C. § 752 (b) .
39. I.R.C.
by a partnership
reduces (but not
ship interest by
40.
§ 733 provides that money distributed to a partner
other than in liquidation of such partner's interest
below zero) such partner's basis for his partnerthe amount of money distributed.
I.R.C. §§ 731(a), 741.
80124
When a partner contributes, to a partnership, property which
is subject to a liability, the nonrecognition rule of section 721(a)
nevertheless applies, but the adjusted basis of all partners'
interests in the partnership will be affected. To the extent the
41
liabilities transferred to the partnership
are allocable to other
partners, the transferor partner will be treated as receiving a
42
distribution of money
which reduces (but not below zero) the
43
transferor partner's basis for his partnership interest.
Under
section 752 (a) , the other partners' are deemed to have made a
contribution of money to the partnership
due to the increase in
44
liabilities allocable to them.
Under section 722, the section
752(a) deemed contribution of money increases the partners' basis
for their partnership interests.
For example, assume A contributes property with a fair market
value of $100,000, a basis of $100,000, and subject to a mortgage
of 540,000 to partnership AB in exchange for a 50 percent interest
in AB.
B contributes $60,000 to partnership AB in exchange for a
50 percent interest in AB. 4Neither
A nor the partnership recog5
nizes gain on the transfer.
41. See I.R.C. § 752(c). For purposes of applying § 752, it
is immaterial whether the partnership assumes the liability or merely
takes the property subject to that liability.
42.
I.R.C. § 752 (b) .
43.
See supra note 39.
44. Treas. Reg. § 1.752-1 (e) provides: "A partner's share of
partnership liabilities shall be determined in accordance with his
ratio for sharing losses under the partnership agreement."
45.
I.R.C. § 721(a).
00125
22
A's basis for his partnership interest is $80,000, computed
as follows:
Adjusted Basis to A of the property
transferred46
Increase in A's share of the partnership liability on the $40,000
mortgage 47
Decrease in A's individual liabilities
due to assumption of the mortgage
(or taking the property subject to
the mortgage) by the partnership48
Adjusted Basis of A's interest
B's basis is $80,000, computed as follows:
49
Money contributed by B
Increase in partnership liabilities
allocable to B (50 percent) 50
Adjusted Basis of B's interest
$100,000
20,000
(40 ,000)
$80,000
$60,000
20,000
$80 ,000
If the contributed property is subject to a mortgage in excess
of its basis, the contributing partner may recognize gain.
For
example, assume A contributes property subject to a mortgage of
$6,000 and an adjusted basis of $4,000 in exchange for a 20 percent
interest in a partnership.
The basis of A's partnership interest
would be zero, computed as follows:
46.
I.R.C. § 722.
47.
I.R.C. § 752(a).
48 . I.R.C. § 752 (b) .
49.
I.R.C. § 722.
50. I.R.C. § 752(a); Treas. Reg. § 1.752-1(e).
the partnership agreement provides for equal sharing in profits and
losses.
9
126
Adjusted basis to A of property
contributed (section 722)
$4,000
Increase in A's share as a
partner of the partnership
liability on the $6,000 mortgage (section 752(a))
1,200
Decrease in A's individual liabilities due to assumption of the
mortgage (or taking the property
subject to the mortgage) by the
partnership (section 752(b))
6,000
($
800)
Since A's basis in his partnership interest cannot be less than
zero, A's initial partnership basis is zero. 51
The $800 in excess
of basis is converted into a recognized gain by virtue of sections
752(b), 731(a), and 741.
Under section 752(b), $4,800 (80 percent)
of the liability, which is allocated to the other partners, is
treated as a contribution of money to A by the partnership.
The
$4,800 deemed contribution of money to A is $800 in excess of
A's partnership interest immediately preceding such distribution
and is gain under section 731(a).
The gain is treated as gain
from the sale or exchange of A's newly acquired partnership
52
interest.
The gain from the sale or exchange of a partnership
interest is considered as gain from sale or exchange of a capital
asset (except to the extent of 53
unrealized receivables and substantially appreciated inventory).
Thus, A recognizes a capital
54
gain of $800.
If subsequently, A's partnership basis is adjusted
upward for additional contributions of property, his distributive
51. See I.R.C. § 733.
52.
I.R.C. § 731(a).
53.
I.R.C. § 741.
54.
See Treas. Reg. § 1.722-1 Example (2).
00127
14
share of partnership income, etc., the starting point is zero
even though previous decreases would have otherwise produced a
,.
55
negative figure.
In the previous example, A recognized a gain of $800.
Commen-
tators suggest that such gain would not increase A's basis in his
partnership interest.
Section 722 was amended in 1976 to
provide that a contributing partner's basis in his partnership
interest shall be the amount of money and the adjusted basis of
contributed property to the contributing partner "at the time of
contribution increased by the amount (if any) of gain recognized
to the contributing partner at such time."
The amendment to
section 722 resulted solely from Congress' decision to exclude
transfers of property to "investment company" partnerships from
the nonrecognition treatment of 721(a), and was intended to allow
a contributing partner to increase the basis in his partnership
interest by the amount of gain he recognizes due to the inapplicability of section 721(a).
Therefore, it is suggested that a
contributing partner should be permitted to increase his basis
only by the amount of gain recognized due to the inapplicability
of section 721(a), and not by the amount of gain recognized as a
57
result of the applicability of section 731(a) and 752(b).
55.
Falkoff v. Commissioner, 62 T.C. 200, 209 (1974).
56. 1 McKee, supra note 18, at f 4.03[1], 4-15 n.44; 1 A.
Willis, J. Pennell & P. Postlewaite, Partnership Taxation § 25.01,
at 25-2 (3rd ed. 1981) [hereinafter cited as Willis].
57.
See McKee, supra note 18, at SI 4.03[1], 4-15 n.44.
00128
14
Another way to view the issue is to regard A as recognizing
no gain at the time of contribution.
Rather A recognizes gain on
a separate, simultaneous deemed distribution of money to him
under section 752(b).
Since this deemed distribution of money
exceeded A's basis, he recognized a gain by virtue of section 731(a)
which occurred not at the time of contribution, but at the time of
the section 752(b) deemed distribution of money.
Since the adjust-
ment to basis under section 722 is for the amount of gain recognized
58
"at the time of contribution," it is inapplicable.
The Internal Revenue Service has ruled that where two pieces
of encumbered property are distributed to two different partners
as part of the same transaction, the resulting liability adjustments will be treated as occurring simultaneously, and the properties will also be 6treated
as having been distributed simultaneously.
0
For example,
partnership M distributed property in a single
transaction to A and B.
Immediately prior to the distribution A
had an adjusted basis for his interest in M of $1,000, and B had
an adjusted basis for his interest in M of $1,500.
The property
distributed to A had an adjusted basis to M of $2,000 and was
subject to liabilities of $1,600.
The property distributed to B
had an adjusted basis to M of $3,200 and was subject to liabilities
of $2,800.
58. See Contributions of Property to a Partnership:
(And Beyond), 33 U. Fla. L. Rev. 33, 68 (1980).
59.
Rev. Rul. 79-205, 1979-2 C.B. 255.
60.
Id.
A Primer
Treatment of A:
Adjusted basis before distribution
$1,000
Liabilities on property distributed to
A (sections 752(a) and 722)
1,600
less 1/2 of liabilities on property
distributed to A (sections 752(b) and 733)
(800)
less 1/2 of liabilities on property
distributed to B (sections 752(b) and 733) (1,400)
Basis in M before taking into account the
adjusted basis of the property distributed
to A
400
less the lesser of M's adjusted basis in
the property distributed to A (i.e. $2,000)
or A's basis in M after liability adjustments have been made (i.e. $400) (section
732(a)(2))
A's adjusted basis in M after the distribution
$
400
0
Treatment of B:
Adjusted basis before distribution
Liabilities on property distributed to
B (sections 752(a) and 722)
$1,500
2,800
less 1/2 of liabilities on property distributed to B (sections 752(b) and 733)
(1,400)
less 1/2 of liabilities on property distributed to A (sections 752(b) and 733)
(800)
Basis in M before taking into account the
adjusted basis of the property distributed to B
less lesser of M's adjusted basis in
property distributed to B (i.e. $3,200)
or B's basis in M after liability adjustments have been made (i.e. $2,100)
(section 732(a)(2))
B's basis in M after the distribution
2,100
2,100
$
0
Neither A nor B recognizes a gain on the distribution and both
have a zero basis in M after the distribution.
9
130
Under Revenue
Ruling 79-205,
61
a partner will not recognize a taxable gain if
the net decrease in his share of the liabilities (i.e. the amount
by which his share of the liabilities attached to all the distributed property exceeds the liability attached to the property distributed to him) does not exceed his adjusted basis in the partnership immediately before the distribution.
62
Revenue Ruling 81-242,
distinguished Revenue Ruling 79-20 5
in a case involving a tax-free exchange of partnership interests
(including the liabilities).
separate transactions.
The transactions were viewed as
Although the exchange itself was tax-free,
the presence of liabilities (treated as a separate transaction)
caused recognition of gain.
Also, it should be noted that contingent, specultative, or
contested liabilities cannot be included in a partner's basis for
his partnership interest until they have become fixed or liquidated.
Another potential problem concerning liabilites is when partner
ship interests are sold while the partnership property is subject
to a nonrecourse debt in excess of its fair market value. Tufts
64
v. Commissioner,
presented this precise issue, and the Court of
65
Appeals for the Fifth Circuit reversing the Tax Court ~ held that
61.
Id.
62.
1981-2 C.B. 147.
63. Gibson Products Co. - Kell Blvd. v. United States, 460
F. Supp. 1109 (N.D. Tex. 1978), aff'd, 637 F.2d 1041 (5th Cir. 1981);
Long v. Commissioner, 71 T.C. 1 (1978).
64. 651 F.2d 1058 (5th Cir. 1981), cert, granted, 50 U.S.L.W.
3881 (May 3, 1982) (No. 81-1536).
65.
70 T.C. 756 (1978) .
the amount realized on the sale included the nonrecourse debt only
to the extent the debt did not exceed the fair market value of the
66
partnership property.
Crane v. Commissioner
established the
rule that, when property subject to a mortgage on which the owner
of the property assumes no personal liability is sold, the amount
realized includes the amount of the unassumed mortgage.
The court
of appeals in Tufts relied on footnote 37 in the Crane case in
holding that a nonrecourse debt is included in the amount realized
67
only to the extent of the fair market value of the property.
Finally, a transaction which occurs solely between a partner
and the partnership may result in a decrease in the basis of
another partner's interest in a partnership.
For example, assume
the equal partnership of ABC distributes, to A, property encumbered
with a $3,000 liability.
Regardless of the tax consequences to A,
the basis of the partnership
interests of both B and C will be
68
reduced by $1,000.
If immediately prior to the distribution to
A either B or C has an adjusted basis in his partnership interest
69
of less than $1,000, he will recognize a g a m .
66.
331 U.S. 1 (1947).
67. Contra Millar v. Commissioner, 577 F.2d 212 (3rd Cir.),
cert, denied, 439 U.S. 1046 (1978) . The Tufts and Millar decisions
conflict with each other. The United States Supreme Court has
decided to hear Tufts in order to resolve this conflict. See supra
note 64.
68. See I.R.C. §§ 752(b), 733.
56, at § 41.04.
69.
See also 1 Willis, supra note
See I.R.C. §§ 752(b), 731(a).
06132
SUBSEQUENT ADJUSTMENTS TO BASIS
As noted previously, the starting point for determination
of basis of a partner's interest in a partnership is governed by
section 722 (relating to contributions to a partnership) or by
70
section 742 (relating to transfers of partnership interests).
Once the original basis determination is made under either section
722 or section 742, that basis must be adjusted in accordance
with the provisions of section 705(a). 71
70.
See supra text accompanying notes 6-7.
71.
I.R.C. § 705(a) provides:
(a) the adjusted basis cf a partner's interest
in a partnership shall, except as provided in subsection
(b), be the basis of such interest determined under
section 722 (relating to contributions to a partnership)
or section 742 (relating to transfers of partnership
interests) —
(1) increased by the sum of his distributive
share for the taxable year and prior taxable years
of —
(A) taxable income of the partnership as
determined under section 703(a),
(B) income of the partnership exempt from
tax under this title, and
(C) the excess of the deductions for depletion over the basis of the property subject
to depletion;
(2) decreased (but not below zero) by distributions by the partnership as provided in section
733 and by the sum of his distributive share for
the taxable year and prior taxable years of —
(A) losses of the partnership, and
(3) expenditures of the partnership not deductible in computing its taxable income and not
properly chargeable to capital account; and
(3) decreased (but not below zero), by the
amount of the partner's deduction for depletion
under section 611 with respect to oil and gas wells.
9
00133
Under section 705(a)(1)(B), a partner's basis is increased
72
by his distributive share of the partnership's nontaxable income.
This adjustment is necessary to prevent recognition of gain on the
disposition of a partnership interest
attributable to what would
73
otherwise be tax-exempt income.
Likewise, the negative adjust-
ment to basis required under section 705(a)(2)(B) is necessary
because, without such an adjustment, an amount equal to the nondeductible expense would increase the loss or decrease the gain
otherwise recognizable upon a taxable disposition of the partnership interest.^^
Section 705(b) provides an alternative rule under which the
adjusted basis of a partner's interest in a partnership may be
determined by reference to his proportionate share of the adjusted
basis of partnership property which would be distributable upon
termination of the partnership.
The alternative rule may be used
only where circumstances are such that the partner cannot practicably apply the general rule set forth in section 705(a) or where
the Commissioner is satisfied that the result produced will not
substantially vary from the result obtainable under the general
i
75
rule.
72. Presumably, this refers to such items like nontaxable
life insurance proceeds and nontaxable interest. See I.R.C. §§
101, 103.
73. See S. Rep. No. 1622, 83d Cong., 2d Sess. 384 (1954).
See a lso Coustan & Conley, Special Problems in Determining Basis
of Partnership Interests, 38 Inst, on Fed. Tax'n § 12.01, § 12.04,
at 12-18 (1980) .
74.
See S. Rep. No. 1622, 83d Cong., 2d Sess. 384 (1954).
75.
Treas. Reg. § 1.705-l(b).
00134
14
Section 705(a)(2) provides for a reduction (but not below
zero) of a partner's interest in the partnership due to distributions by the partnership.
Under section 73 3, a distribution by a
partnership other than in liquidation of a partner's interest
reduces (but not below zero) such partner's interest in the partnership by the amount of money he receives, and by the basis
(determined under section 732) to such partner in the distributed
property.
Under section 732(a), the basis of property (other than money)
distributed to a partner other than in liquidation of his partnership
interest is generally its adjusted basis to the partnership
76
immediately before such distribution.
However, the basis of
the distributed property in the distributee partner's hands shall
never exceed the adjusted basis of such partner's interest in the
partnership reduced by any money distributed in the same transac77
tion.
Thus, when a partner receives only property in a distri-
bution by the partnership, his basis in the partnership is reduced
by the lesser of:
(1) the partnership's adjusted basis in the
property distributed, or (2) the partner's adjusted basis in his
partnership interest.
In determining the basis of a partner's interest in a partnership under section 705(a) for purposes of determining the gain
realized by a partner upon a distribution of money to him by the
partnership, such basis is computed without taking into account
76.
I.R.C. § 732 (a) (1).
77.
I.R.C. § 732(a)(2).
00135
22
distributions made by the partnership during the taxable year
for which the partner's gain is
being determined.
78
In computing a partner's adjusted basis for his partnership
interest under section 705(a), distributions are deducted before
79
losses.
A partner's distributive share of partnership loss
(including capital loss) is deductible only to the extent of the
adjusted basis of such partner's interest in the partnership at
the end of the partnership
taxable year in which such loss occurred.
81
For example,
assume that during the year, A, a member of
the partnership, contributed $50 to the partnership as his initial
contribution, and received $30 as a cash distribution from the
partnership.
A's distributive share of partnership losses at the
end of the taxable year was $60.
(1)
A's basis for purposes of determining the extent to
which his distributive share of partnership losses will be
allowed
a deduction:
A's as
contribution
to the partnership
Deduct cash distributed to A 8 2
A's basis for purposes of determining
the amount of allowable partnership
losses
78.
Rev. Rul. 66-94, 1966-1 C.B. 166.
79.
Id.
80.
I.R.C. § 704(d).
81.
Rev. Rul. 66-94, 1966-1 C.B. 166.
$50
30
$20
82. The rule that, for purposes of determining the extent to
which partnership losses may be deducted, the adjusted basis of a
partner's interest in a partnership must be reduced first by the
amount of distributions received during the year is supported by
the Regulations. See Treas. Reg. § 1.704-1(d)(2).
9
136
(2)
A's basis for purposes of determining the extent to
which gain will be realized by A upon distribution of cash
to him by the partnership:
A's contribution to the partnership
Deduct A's distributive share of
partnership losses to the extent
allowed by section 704(a) (see (1)
and (3))
A's basis for determining the amount
of gain he realized upon the distribution of cash to him by the partnership
(3)
$50
(20)
$30
A's adjusted basis for his partnership interest under
section 705(a) should be decreased by first deducting distributions made to A and thereafter, by deducting his distributive share of partnership losses. A's partnership
basis may not be reduced below zero:
A's contribution to the partnership
Deduct cash distributions made to A by
the partnership (section 733)
$50
(30)
$20
Deduct A's distributive share of losses
($60) but only to the extent that A's
basis is not reduced below zero (section
704(d))
(20)
A's basis for his interest in the
partnership (section 705(a))
$ 0
Since losses are deductible only to the extent of a partner's
adjusted basis in a partnership reduced by distributions received
83
during the year,
it may be wise to hold off on distributions
See supra notes 79-82 and accompanying text
00137
14
until after the close of the partnership's taxable year.
Under
this method, the deductibility of current losses will not be
reduced by distributions.
If the current loss deduction reduces
the partner's basis to zero, distributions received in the next
year will cause recognition of gain (assuming the partner's basi
has not been subsequently increased); however, the gain will
84
generally be characterized as capital gain
while the loss
(assuming it resulted from ordinary partnership operations) will
be ordinary.
PARTNERSHIP
ALLOCATIONS WITH
AND WITHOUT AGREEMENT:
THE MECHANICS
Since a partnership is not a separate taxpaying entity,
85
each partner is required to report his distributive share of
partnership income or loss.
86
A partner's distributive share of
income or loss is determined in accordance with the partnership
37
agreement.
However, if there is no partnership agreement as
to the partner's distributive share, or if the agreement lacks
substantial economic effect, a partner's distributive share of
income or loss will be determined
in accordance with the partner
interest in the partnership. 8 8
84.
See I.R.C. §§ 731(a), 741.
85.
I.R.C. § 701.
86.
I.R.C. § 702(a).
87. I.R.C. & 704(a). The partnership agreement is defined
to include any modifications made prior to., or at, the due date
for filing the partnership return. See I.R.C. § 761(c).
88. I.R.C. § 704 (b) .
9
00138
When a partner contributes property to a partnership,
section 704(c)(1) provides that depreciation, depletion, or gain
or loss with respect to the contributed property shall "be
allocated among the partners in the same manner as if such property
had been purchased by the partnership," unless the partnership
agreement provides otherwise.
The deemed purchase price is the
adjusted basis of such property in the hands of the contributing
89
partner at the time of contribution.
The general rule of
section 704(c)(1) may be illustrated by the following example:
A and B form an equal partnership.
B contributes $10,000 cash
and A contributes depreciable property with a fair market value
of $10,000 and an adjusted basis of $6,000.
There is no partner-
ship agreement relating to contributed property.
Assume the con-
tributed property depreciates at an annual rate of 10 percent.
Under section 723, the partnership has an initial basis in the
property of $6,000.
Section 722 gives A an initial basis in the
partnership of $6,000.
At the end of the first year, the adjusted
basis of the property will be $5,400 resulting from a $600 depreciation deduction.
If the partnership had no other taxable income
or loss for that year, each partner will have a deduction of $300
representing his distributive share of partnership loss for the
year. A's adjusted basis for his interest will be $5,700 ($6,000,
90
the original basis of his interest, reduced by $300);
B's adjusted
89.
See I.R.C. § 723.
90.
See I.R.C. § 705(a)(2)(A).
9
139
basis will be $9,700 ($10,000 reduced by $300).
91
Assume that the
property is sold at the beginning of the second year of partnership operation for $10,000.
The partnership gain will be $4,600
($10,000 amount realized less the adjusted basis of $5,400).
partner's share of the $4,600 gain will be $2,300.
Each
If the partner-
ship has no other taxable income or loss for that year, each
partner will have a gain from the partnership of $2,300
repre-
senting his distributive share of gain from the sale of the property.
A's adjusted basis for his interest will be $8,000 (the adjusted
basis of $5,700 increased by the gain of $2,300);
92
B's adjusted
basis for his interest will be $12,000 (the basis of $9,700
93
increased by the gain of $2,300).
Note, in the prior example, when B contributed $10,000 and
A contributed property with a fair market value of $10,000, B, in
effect, purchased a one-half interest in the property for $5,000.
It was assumed that the property depreciated at an annual rate
of 10 percent.
Economic reality would dictate that B's depre-
ciation deduction be $500 annually.
Under the general rule of
section 704(c) (1), B's depreciation deduction was $300.
When the
property was sold, the partnership recognized a gain of $4,600.
The economic gain to the partnership was only $1,000 (the initial
fair market value of $10,000
based on such value
reduced by 10 percent depreciation
resulting in an adjusted basis of $9,000 at
91.
92.
Id.
See I.R.C. § 705(a)(1)(A).
93.
Id.
00140
the time of sale).
B's share of the economic gain would be $500;
instead, B was allocated gain of $2,300.
In effect, A has
shifted recognition of $1,800 of the pre-contribution appreciation to B.
If the partnership is liquidated and the $20,000
distributed, the disparities will be eliminated.
a $2,000 loss,
94
while A recognizes a $2,000 gain.
B recognizes
95
If the
sale of the property and the liquidation of the partnership occur
in different taxable years, a timing problem results.
Moreover,
the sale of depreciable property may produce ordinary income
under section 1245 or section 1250 while the loss upon liquidation
of a partnership interest is generally characterized as capital
Section 704(c)(2) allows the partners to ameliorate the
results produced under the general rule of section 704(c)(1).
Under section 704(c)(2), if the partnership agreement so provides,
depreciation or gain or loss with respect to property contributed
to the partnership by a partner may be allocated among the partners
so as to take account of the variation between the basis of the
94. B's loss is determined as follows: As illustrated in
the example, B's basis for his partnership interest had been adjusted
to $12,000. Upon liquidation of the partnership, § 731(a)(2) provides that a partner recognizes loss to the extent of the excess of
the adjusted basis of such partner's interest in the partnership
($12,000) over the amount of money distributed to him ($10,000).
95. A's gain is determined as follows: Prior to liquidation,
A's basis for his partnership interest was $8,000. Under § 731(a)
(1), a partner recognizes gain to the extent the amount of money
distributed to him ($10,000) exceeds his basis in his partnership
interest ($8 ,000) .
96. See I.R.C. §§ 731(a), 741.
28
00141
property to the partnership and its fair market value at the time
of contribution.
The allocation may take into account, "all or
any portion of the difference between the adjusted basis and the
fair market value of contributed property at the time of contri97
bution."
It may apply to all contributed property or to speci98
fic items.
For example, assume the same basic facts as in the prior
example.
Assume further that partners A and B have agreed under
section 704(c)(2) to allocate to A, the contributor of the property,
the potential gain of $4,000 represented by the pre-contribution
appreciation in value of the property ($10,000 fair market value
less $6,000 adjusted basis).
With his contribution of $10,000
cash, B has, in effect, purchased a one-half interest in the
property for $5,000.
Since the property depreciates at an annual
rate of 10 percent, B is entitled to a depreciation deduction of
$500.
The total depreciation deduction available is $600, there-
fore B is allocated depreciation of $500, and A is allocated the
remaining $100 of depreciation.
is now $5,400.
The adjusted basis of the property
If the partnership has no other taxable income or
loss, B will have a deduction of $500, and A will have a deduction
of $100.
B's basis for his interest
will be $9,500 ($10,000 origi99
nal basis less $500 deduction),
and A's basis for his interest
will be $5,900 ($6,000 less $100 deduction). 100
97. Treas. Reg. § 1.704-1(c)(2)(i).
98.
Id.
99.
See I.R.C. § 705(a)(2)(A).
100.
Id.
ocy.42
If the property is
sold at the beginning of the second year of partnership operation
for $9,000, the partnership gain of $3,600 ($9,000 amount realized
less the adjusted basis of $5,400) will be allocated to the partners under the terms of the agreement.
The fair market value
of the property as depreciated is $9,000 ($10,000, the fair market
value on date of contribution, less $1,000 the accumulated depreciation on such value).
Under the terms of the partnership agree-
ment and section 704(c)(2), the $3,600 difference between $9,000,
the fair market value as depreciated, and $5,400, the adjusted
basis of the property, represents the portion of gain attributable
to the pre-contribution appreciation of the property, and is
therefore allocated to A.
None of this gain is allocated to B.^"^
If the partnership engaged in no other transactions that year, A
will report gain of $3,600, and B will report no gain or loss.
A's adjusted basis for his interest will then be $9,500 ($5,900
102
determined above plus $3,600 gain),
at $9,500 (as determined above).
and B's basis will remain
If the partnership is immediately
liquidated and the $19,000 cash distributed equally to each partner,
neither A nor B will recognize gain or loss.^0"^
101. If the property were sold for more than $9,000, the
portion of the gain in excess of $3,600 would be allocated equally
between A and B in accordance with their agreement for sharing
gains. See Treas. Reg. § 1.704-1(c)(2) Example (2).
102. See I.R.C. § 705(a)(1)(A).
103. I.R.C. § 731 (a).
$0143
Under section 704(c)(2), the total depreciation that may be
allocated is limited to a "ceiling" which cannot exceed the amount
104
of depreciation allowable at the partnership level.
For example,
if the adjusted basis of the property in the prior example had
been $4,000, the total depreciation that could be allocated would
be limited to $400, therefore, all the depreciation would be
allocated to B.
Even though the above examples involved property which had
appreciated in value, the allocation rules under section 704(c)(2)
are equally applicable to property which
is contributed at a
105
value less than its adjusted basis.
Another exception to the general rule of section 704 (c) (1)
is provided by section 704(c)(3).
That section provides that,
with respect to undivided interests in property contributed to
a partnership, depreciation or gain or loss with respect to such
undivided interests shall be determined as though the undivided
interests continued to be held by the partners outside the partnership, unless the partners otherwise agree.
This rule applies only
where the relative undivided interests of the partners in the
property prior to the contribution are in the same ratio as their
interests in the capital
10 6 and profits of the partnership subsequent
to the contribution.
104. Treas. Reg. § 1. 704-1 (c) (2) (i) .
105. See 1 Willis, supra note 56, at § 25.07, 25-11.
106. See S. Rep. No. 1622, 83d Cong., 2d Sess. 379 (1954).
9
00144
For example, assume A and B are tenants in common owning
undivided one-half interests in improved real estate, consisting
of land and a factory.
A's basis for his undivided interest is
$5,000, allocable $1000 to the land and $4,000 to the factory.
B's basis for his undivided interest is $10,000, allocable $4,000
to the land and $6,000 to the factory.
A and B contribute their
undivided interests to a new partnership in which the profits
are to be equally divided.
The partnership agreement contains
no provision respecting allocation of depreciation or gain or
loss, therefore section 704(c)(3) applies.
ciates at an annual rate of 10 percent.
The factory depre-
The annual partnership
allowance for depreciation of $1,000 (10 percent of $10,000 total
basis for the factory) is allocable $400 to A (10 percent of A's
$4,000 basis in the factory), and $600 to B (10 percent of B's
$6,000 basis in the factory).
A's adjusted basis for his undivided
interest in the factory is reduced to $3,600 and B's adjusted
basis in the factory is reduced to $5,400.
If the partnership
then sells the land and factory for $19,000, each partner's share
of the gain or loss would be as follows:
A's gain is $4,900, the
difference between his share of the proceeds ($9,500) and his
basis in the land and factory ($4,600); B's gain is $100, the
difference between his share of the proceeds ($9,500) and his
basis in the land and factory ($9,400).
Where the conditions of section 704(c)(3) are met, the allocation of depreciation or gain or loss will be in accordance with
that section, unless the partnership agreement provides otherwise.
If the partner's interests in the capital and profits are changed
from their undivided interests in the property
previously con-
tributed to the partnership (for example, a partner makes a
further contribution to the partnership), section 704(c)(3) no
longer applies.
However, the partners may agree to continue the
107
same allocation under section 704(c)(2).
In addition, section
704(c)(3) allocations differ from section 704(c)(2) allocations
in that the allocation under section 704(c)(3) contains no
"ceiling" rule.
The rationale behind section 704(c)(3) is that under certain
circumstances co-ownership cf property may give rise to an unintentional partnership.
In the absence of section 704(c) (3), the
general rule of section 704(c)(1) would apply requiring that
depreciation or gain or loss be computed as if the co-owned
property had been purchased by the partnership at its adjusted
basis.
Since section 704(c) gives partners the ability to allocate
among such partners gain, loss, and depreciation with respect to
contributed property, the partnership agreement should specifically
enumerate the existence vel non of any intended allocations.
In addition to the allocation provisions under section 704(c)
with respect to contributed property, the Code contains complex
rules for the allocation of basis when an election for optional
107. Treas. Reg. § 1.704-1(c)(3)(ii).
$00146
adjustment
to basis of partnership property is in effect. 108
While a detailed exposition of the intricacies of these Code
109
provisions is beyond the scope of this paper,
a discussion
of some general rules will follow.
Section 734 allows a partnership to adjust the basis of
its remaining assets following a distribution of property to a
partner.
Section 74 3 allows the basis of partnership property to
be adjusted following the transfer of a partnership interest by
sale or exchange or on the death of a partner.
Neither the
section 734 adjustment nor the section 743 adjustment is available unless an election under section 754 is in effect.
More-
over, if the election is in effect, it shall apply to all distributions of property by the partnership and to all transfers of
interests in the partnership during the taxable year (i.e. the
election must apply to both sections 734 and 743).^^
Both section 734(b) and section 743(b) simply prescribe the
total amount of increase or decrease that shall be made to the
partnership property. Section 755 specifies how that increase or
decrease must be
allocated among the various partnership
properties. 112
108. See I.R.C. §§ 734, 743, 754, 755.
109. For a more thorough treatment, see 2 Willis, supra note
56, at §§ 103.01, 104.01, 115.01? 2 McKee, supra note 18, at
24.
- 26.01.
110. I.R.C. §§ 734(a), 743(a).
111. I.R.C. § 754; Treas. Reg. § 1.754-1(a).
112. See Treas. Reg. § 1.755-1.
00,147
The amount of the adjustment under section 734 (b) affects the
basis of partnership property with respect to all partners remaining
in the partnership after the distribution.
The amount of increase
cr decrease in basis under section 743(b) affects the basis of
113
partnership property with respect to the transferee partner only.
Under section 734(b), the basis of partnership property
remaining after the distribution is increased by:
(1) the amount
of gain recognized to the distributee partner under section 731(a)
(1), and
(2) the excess of the adjusted basis to the partnership
immediately before the distribution over the basis under section
732 of such property to the distributee partner.
basis of the partnership property is decreased by:
The adjusted
(1) the amount
of loss recognized to the distributee under section 731(a)(2), and
(2) the excess of the basis of the distributed property to the
distributee under section 732 over the adjusted basis of such
property to the partnership immediately before such distribution.
The adjustment
under section 743(b) requires an increase in
the adjusted basis of partnership property by the excess of the
basis to the transferee partner for his partnership interest over
his proportionate share of the partnership's basis for its property,
or a decrease by the excess of the transferee partner's proportionate share of the partnership's basis for its property over
the basis of his interest in the partnership.
113. Treas. Reg. § 1.743-1(b)(1).
00148
14
Even if the partnership has not made the election under
section 754, a partner who receives a distribution of property
(other than money) within two years after the partnership interest
was transferred to him may elect, or may be required to, adjust
the basis of such property as if the adjustment
under section
114
743(b) were in effect.
This adjustment may be required if,
at the time of the transfer, the fair market value of the partnership property exceeds 110 percent of its adjusted basis to the
partnership.
Once the amount of increase or decrease in the basis of
partnership property has been determined under section 734(b) and
743(b), the allocation of the basis adjustment to specific partnership property is governed by section 755.
In general, the partner-
ship properties are classified into the two categories specified
in section 755(b), and the allocation is designed to effect a
reduction in the difference between the fair market value and the
adjusted basis of partnership properties. 116
CONCLUSION
In order to properly compute a partner's basis in his partnership interest and to determine the effect related transactions have
114. I.R.C. § 732(d); Treas. Reg. § 1.732-1(d).
115. Id.
116. See Treas. Reg. § 1.755-1(a)(1)(i),(b).
36
on such basis, it is necessary to thoroughly study the statutory
provisions and the guidance provided by the Regulations and
related materials.
The rules pertaining to basis of a partner-
ship interest are rather mechanical in their application; therefore, the determination of specific tax consequences to a partner
can generally be made without a great deal of difficulty.
Although most of the provisions in this area seem rather
rigid, the partnership agreement can be designed to provide
considerable flexibility under the statutory guidelines.
The
rules respecting partnership basis can operate to impose significant tax consequences upon the unsuspecting partner; therefore,
the partnership agreement should be drawn to specifically enumerate
the intended results in as many areas as the Code will allow.
00150
14