Chapter 2
Partnership Formation and
Computation of Partner Basis
Partnership Interest
• When property is transferred to a partnership in
exchange for a partnership interest, generally no
gain or loss is recognized.
• General rule: This is treated as a tax-free exchange.
–
Contributions to an S corporation in exchange for stock are
taxable unless shareholders owning 80 percent or more of the
outstanding stock make contributions to the S corporation in
the same transaction
Partner’s and Partnership’s Basis
 The partner has an “exchanged basis” in the
partnership interest.

Equal to the combined bases of the contributed properties.
 The partnership takes a “transferred basis” in the
contributed property.

Equal to the contributing partner’s basis.
Code Sec. 754 Election
 This election allows the partnership to adjust the
basis of its assets to reflect the gain or loss
recognized by the contributor-partner on the sale of
his or her partnership interest.

This avoids recognizing a gain or loss twice (once when the
partner sells his or her interest in the partnership and another
time when the partnership disposes of the contributed asset.
Code Sec. 705 Basis Adjustments
• The partner’s partnership interest basis is increased
by the partner’s share of taxed income.
–
So, when the partner sells his interest in the partnership, the
previously taxed income isn’t taxed again.
• The partner’s partnership interest basis is also
increased by his share of tax-exempt income.
• Nondeductible non-capitalized expenditures reduce
the basis of partnership interest.
• Deductible losses or expenses reduce the basis of the
partnership interest.
Partnership Basis
 At formation, the total of the partnership’s basis in
its properties (“inside basis”) equals the total of the
partners’ bases in their partnership interest (“outside
basis”).
 However, many events can cause inequality between
the inside and outside bases.
Sale of Partnership Interest
• When a partnership interest is sold (absent a Code
Sec. 754 election), the partnership’s inside basis
remains unchanged but the outside basis is changed.
–
Usually the difference between the bases equals the seller’s
gain or loss on the sale.
• If a Code Sec. 754 election is made, equality between
the inside and outside basis usually continues.
Holding Period
 A partner must add the holding period of contributed
capital and Code Sec. 1231 assets to the holding
period of his or her partnership interest (which was
received for contributing the assets).

The partnership interest received for contributions of other
property starts the day after it’s received.
Depreciation Methods
 When depreciable property is contributed in a tax-
free exchange, the partnership must use the
transferor’s depreciation method and remaining
depreciable life.
 No basis increase is allowed if a partner recognizes
gain on a contribution of encumbered property to the
partnership.
Depreciation Methods (Cont.)
 If there’s a Code Sec. 754 election in effect to the
extent that a partner’s net debt relief causes gain to
be recognized on the contribution (and the
property’s basis in the partnership’s hands is greater
than its basis in the transferor’s hands), the increase
in basis is treated as a separate asset.
Contributions of Encumbered Property
• Both the contributing partner and the other partners
should treat the contribution of encumbered
property as consisting of 2 steps:
–
–
1) The existence of the debt is ignored and the contributing
partner increases his or her basis by the amount of the
contributed property’s basis.
2)The debt is taken into account.
•
Each partner has a deemed cash contribution or distribution.
Partners with deemed cash contributions will increase their basis
by that amount and partner’s with deemed cash distributions will
decrease their basis by that amount.
Contributions of Encumbered Property (Cont.)
• When encumbered property is contributed to a
partnership and the partnership becomes primarily
liable for paying the debt, the contributing partner’s
non-partnership-related liabilities for which he or
she is directly responsible decrease by the amount of
such debt.
–
–
This is treated as a cash distribution from the partnership.
However, in taking over this liability, the partnership’s
indebtedness increases by the same amount. This means that
each partner is treated as having made a cash contribution to
the partnership in the amount of his or her share in the new
debt.
Contributing Property Creating a Gain
 To determine a partner’s net debt relief:
 An increase in the partner’s share of debt from the previous
year-end to the current year-end is deemed a cash
contribution.
 The cash contribution is offset against the partner’s debt taken
over by the partnership and any net debt relief is deemed a
cash distribution.
 If this cash distribution exceeds his basis in the partnership
interest, the excess is gain.
Effect of Partnership Operations on Basis (Cont.)
 Income and Loss—Taxable and Tax-Exempt
 A basis increase is necessary when taxable income is earned,
otherwise it could be taxed a second time as gain from the sale
of the partnership interest when it’s eventually sold.
 A basis increase is necessary when tax-exempt income is
earned to avoid having the tax-exempt income result in
increased gain (or reduced loss) on the sale of the partnership
interest.
Effect of Partnership Operations on Basis (Cont.)
–
A partner’s basis must be reduced for his share of the
partnership’s losses. Otherwise, the partner would be allowed
a second loss (or reduced gain) on sale of the partnership.
•
–
If increased loss or reduced gain was allowed on tax-exempt
income, then the income would essentially no longer be tax-free.
Under Code Sec. 705(a)(3), a partner’s basis in their
partnership interest will also be increased for their share of the
excess of depletion over the basis of the property subject to
depletion.
•
However, a partner’s basis will not be affected by the production
activities deduction they are allowed to take as a result of
partnership activities.
Effect of Partnership Operations on Basis (Cont.)
• Contributions and Distributions
– Contributions result in an increased basis.
– Distributions result in a decreased basis.
•
–
Distributions may not make the basis go below zero.
The adjustments to basis are intended to ensure that:
•
•
•
1) A partner’s share of taxable income and deductions is taken into
account only once.
2) Nondeductible expenditures and tax-exempt income remain
characterized as such.
3) Distributions of previous contributions and previously taxed
income are not taxed.
Effect of Partnership Operations on Basis (Cont.)
–
–
Determining a partner’s basis in the partnership can be very
confusing if not impossible to determine by using past Form
1065s.
Code Sec. 705(b) provides an alternative rule for determining a
partner’s basis in his or her partnership interest.
•
•
The alternative rule initially consists of determining the partner’s
basis by reference to the adjusted basis of his or her pro rata share
of the partnership property. After making the necessary
adjustments, this is his basis.
A partner may also determine his or her basis by making certain
adjustments to the sum of his or her tax basis capital account and
share of the partnership’s liabilities
Contributions Requiring Special Considerations
• Property Subject to Depreciation Recapture
– The depreciation recapture provisions generally require that
when recapture property is transferred the potential recapture
amount is taxed.
– Code Sec. 1245 Gain on Contribution: The amount realized
(hypothetical distribution of cash) is divided between Code
Sec. 1245 and non-Sec. 1245 property based on the fair market
value of recapture property versus other property contributed.
Contributions Requiring Special Considerations
(Cont.)

Partnership Recognizes Code Sec. 1245 Gain: When the
partnership eventually sells the contributed property, it may be
required to recapture depreciation deductions previously
claimed either before or after the contribution.

To the extent the gain on a subsequent sale represents the
difference between the fair market value of the Code Sec. 1245
property and the adjusted tax basis at the time of contribution,
that gain including the recapture will be allocated to the
contributing partner.
Contributions Requiring Special Considerations
(Cont.)
 Accounts Receivable
 Considered property and may be transferred free of taxation
pursuant to Code Sec. 721.
 The contributor’s basis in the accounts receivable will become
the partnership’s transferred basis in the receivables.
 The partnership will report income if its collections of these
receivables exceed their transferred basis.
Contributions Requiring Special Considerations
(Cont.)
• Third-Party Notes Being Reported on the
Installment Method
–
–
Installment obligations, are property within the meaning of
Code Sec. 721. Therefore, the partner isn’t required to treat the
contribution of such notes as a disposition.
To the extent the value of the note exceeds its tax basis at the
time of contribution, gross profit subsequently recognized by
the partnership on receipt of payments on the note must be
allocated to the contributor. The remainder of the gross profit
can be allocated according to the partnership agreement.
Contributions Requiring Special Considerations
• Third-Party Notes Not Being Reported on the
Installment Method
–
–
–
–
Cash-basis Taxpayer: The note must be taken into income at
its fair market value on the date received.
Accrual-basis Taxpayer: Taxes the note into account at it’s
face amount.
The amount reported as income becomes the note’s basis. The
basis is recovered as payments are received.
The contribution of such a note to a partnership for
partnership interest is not taxable.
•
The note’s remaining basis will become part of the contributor’s
basis and the partnership’s basis. If collections on the note exceed
his basis, the excess is taxable income.
Contributions Requiring Special Considerations
(Cont.)
 Partner’s Personal Obligations
 The obligation is treated as a promise to provide funds in the
future. It does not constitute a current contribution of property
or money within the meaning of Code Sec. 721.
Contributions Requiring Special Considerations
(Cont.)
• Personal Use Property (A partner’s contribution of
property which, before the contribution, was not
considered investment or business property)
–
Partnership’s Basis: Takes the lower of the FMV at the time of
contribution or the contributing partner’s adjusted basis.
•
•
•
Basis for Loss Computations: Lower of FMV or the partner’s basis
at the time of contribution.
Basis for Gain Computations: Partner’s basis plus or minus
adjustments attributable to partnership’s ownership.
If using the loss basis produces a gain, or using the gain basis
produces a loss, then the partnership will not report a gain or a
loss.
Contributions Requiring Special Considerations
(Cont.)
–
Partner’s Basis: The partner’s basis in his partnership interest
shouldn’t include the amount by which the contributed
property’s basis exceeded its value at the time of contribution.
•
•
•
The exchanged basis should be limited to the FMV.
When computing a gain, both the partner’s basis in his interest,
and the partnership’s basis in its assets, include the contributor’s
entire basis.
When computing gain on the receipt of money in excess of the
partner’s basis in the partnership interest, the exchanged basis
should be the carryover basis without reference to the FMV of the
contributed property.
Contributions Requiring Special Considerations
(Cont.)
• Investment Partnerships
– Contributions to investment partnerships are ineligible for
non-recognition treatment.
– The partnership rule is similar to a rule for corporations:
•
Asset Ownership Test: A partnership isn’t classified as an
“investment company partnership” unless non-identical assets are
contributed, and then more than 80% of the assets consist of:
– Money (if it’s to be used for investing purposes), stocks and
other equity interests in a corporation., evidence of
indebtedness, options (forward or future contracts), other assets
considered investments under Code Sec. 351(e)(1).
Contributions Requiring Special Considerations
(Cont.)
Diversification Test: There must be meaningful diversification for
the investment company rule to come into play. Also,
diversification must not already be present before the
contributions.
 Ex: If all contributing partners contribute diversified portfolios
Code Sec. 721(b) doesn’t apply.
 Gain but not Loss: If appreciated property is contributed to an
investment company partnership, gain is recognized by the
partner upon contribution. The general non-recognition rule still
applies to a loss.

Contributions Requiring Special Considerations
(Cont.)
• Suspended Losses
– Any losses suspended by Code Secs. 465 or 469 prior to the
contribution of the related activity remain with the
contributing partner and are not transferred to the
partnership.
– If the activity produces income in the partnership’s hands, it
will be either passive income or “income from a former passive
activity” which can be offset by any of the activity’s unused
passive activity deductions from a prior year.
– All income generated by the activity on the partnership’s hands
results in an additional at-risk amount.
Chapter 9: Partner’s Share of
Partnership Debt
Partner’s Share of Debt: Adjustments
• The partnership must disclose on Schedule K-1 each
partner’s share of:
1.
2.
3.
•
Nonrecourse debt other than that considered qualified
nonrecourse debt under Code Sec. 465(b)(6).
Qualified nonrecourse financing.
Each partner’s share of the partnership’s recourse debt.
A liability for which any partner or party related to a partner bears
the economic risk of loss.
Partner’s Share of Debt: Adjustments (Cont.)
 Code Sec. 752 treats an increase or a decrease in a
partner’s share of partnership liabilities as a deemed
money contribution or distribution, respectively.



Contributions increase a partner’s basis.
Distributions decrease a partner’s basis (but not below zero).
Distributions in excess of the basis trigger a gain.
Partner’s Share of Debt: Adjustments (Cont.)
• A deemed contribution or distribution will arise only
if one or both of the following events occurs:
1.
2.
•
The total partnership debt changes; and/or
The method for sharing partnership debt changes.
A partner’s share of debt is calculated as of the last
day of the partnership year.
Partner’s Share of Debt:
Contributions & Distributions
• Contribution of Encumbered Property
– The contribution of encumbered property to a partnership
should be analyzed as two separate transactions:
The contribution of property by the partner to the
partnership, followed by
2.
A distribution of cash by the partnership to the partner.
– This is equal to the amount of the liability encumbering the
property less the contributing partner’s share of the transferred
debt.
1.
Partner’s Share of Debt: Contributions &
Distributions (Cont.)


Distributions of Encumbered Property
A partnership distribution of property encumbered by a
liability should be analyzed as two transactions:
1.
2.

The distribution of unencumbered property to the partner,
accompanied by
The contribution by the recipient-partner of money to the
partnership.
The assumption by the partner of partnership debt is treated
as a cash contribution to the partnership. As such, it increases
the partner’s basis in the partnership interest rather than his
or her basis in the distributed property.
What is a “Liability”? - Debt vs. Equity
• Many issues involved in determining the validity of a
debt are essentially the same as those involved in
determining whether the “lender” is really an equity
partner.
• The essential question is whether or not the “lender”
was participating in the enterprise as:
1.
2.
An entrepreneur providing risk capital, or
A creditor seeking a return on capital independent of the
success or failure of the venture.
What is a “Liability”? - Debt vs. Equity (Cont.)
• Debt Factors
–
The following factors are among those that have been used in
determining whether a transaction creates a bona fide “debt:
1.
2.
3.
4.
5.
6.
7.
Fixed payment date in the not-too-distant future.
Loan is secured by property with a value in excess of the loan
principal.
The extent to which the loan is subordinated to other liabilities of
the business.
Return on the loan is fixed and not dependent on profit from the
enterprise.
Borrower is not too thinly capitalized.
Control over daily business decisions is a partner characteristic.
Expectation of repayment and presence of security.
What is a “Liability”? - Additional
Code Sec. 752 Requirements
 A “liability” is any “obligation” that either:
 Creates/increases basis in a partnership asset (including cash),
 Is generated as part of a deduction taken into account in
computing the taxable income of the obligor, or
 Is an expenditure that is not deductible in computing the
obligor’s taxable income and is not properly capitalized.
What is a “Liability”? - Additional
Code Sec. 752 Requirements (Cont.)
• In preparing Form 1065, the partnership will in most
instances ignore cash basis accounts payable in
calculating partnership debt.
• Contingent liabilities do not affect basis until they
create an asset or are the source of a deduction.
• A nonrecourse obligation is treated as a “liability” for
Code Sec. 752 purposes to the same extent that it is
treated as a liability for purposes of determining the
basis of property or claiming a deduction.
Classification of Partnership Liabilities as
Recourse vs. Nonrecourse
• A partnership liability is deemed a recourse liability
to the extent that any partner bears the economic
risk of loss for that liability.
• A nonrecourse loan, in contrast, is one where the
lender has no right to demand payment from the
borrower in the event of default.
–
–
The nonrecourse lender’s only option is to take possession of
the property securing the loan.
If the value of the property is not sufficient to satisfy the
outstanding debt, the lender has no recourse against the
borrower or any other party.
Classification of Partnership Liabilities as
Recourse vs. Nonrecourse (Cont.)
 Recourse liabilities are shared among the partners in
accordance with the manner in which they share the
economic risk of loss associated with partnership
operations.
 Nonrecourse liabilities are generally shared in
accordance with the way the partners will share in
the gain from sale of the property securing the
nonrecourse liabilities.
Partner’s Share of Recourse Debt
 A partner bears the economic risk of loss for a
partnership liability only to the extent that the
partner:




Can be required to make a capital contribution to the
partnership
Restore a deficit in his or her capital account
Pay a creditor directly, or
Reimburse another partner for a payment made by such
partner to a creditor of the partnership.
Partner’s Share of Recourse Debt: Constructive
Liquidation of the Partnership
• The regulations require the partnership to analyze
the consequences that would result from a
hypothetical “constructive liquidation”.
–
–
A constructive liquidation is a hypothetical situation in
which all the partnership’s assets become completely
worthless and the partnership is left with no funds available
to pay its creditors.
The partnership’s assets are deemed to have been exchanged
for no consideration, and the resulting hypothetical losses
are allocated among the partners in accordance with their
loss-sharing ratios in the partnership agreement.
Partner’s Share of Recourse Debt: Constructive
Liquidation of the Partnership (Cont.)
• When these hypothetical losses are posted to the
partners’ capital accounts, the resulting balances
reflect the partners’ potential risk of loss at that
moment in time from partnership operations.
–
–
Partners with deficit balances in their capital accounts
following the hypothetical liquidation would be required to
make payments to the partnership.
Those payments serve as the measure of the partners’
individual risks of loss with respect to partnership liabilities.
Partner’s Share of Recourse Debt: Constructive
Liquidation of the Partnership (Cont.)
• Distributions and special loss allocations have the
effect of shifting debt, and therefore basis, to those
partners receiving the distributions or special loss
allocations (assuming such partners’ shares of
subsequent partnership loss are not affected by the
distribution or special allocation).
Partner’s Share of Recourse Debt: Nonrecourse
Loans Recharacterized as Recourse
• Nonrecourse Loans From Partners
– Generally speaking, a nonrecourse loan from a partner to the
partnership will be recharacterized as a recourse loan
allocable entirely to the partner who made the loan.
• Reimbursement Rights
– A partner’s obligation to pay a partnership liability is
reduced to the extent that the partner is entitled to
reimbursement from another partner or a person who is
related to another partner.
Partner’s Share of Recourse Debt: Nonrecourse
Loans Recharacterized as Recourse (Cont.)
• Plan to Avoid
– An obligation will be disregarded if the facts and
circumstances indicate a plan to circumvent or avoid such
obligation.
• Tantamount to a Guarantee
– If one or more partners or related persons undertake
contractual obligations that substantially eliminate a
creditor’s risk on an otherwise nonrecourse loan, the
arrangement may be considered tantamount to a guarantee
and treated for all purposes under the regulations as a
guarantee.
Partner’s Share of Recourse Debt: Nonrecourse
Loans Recharacterized as Recourse (Cont.)
• Guarantees
– The partners who bear the economic risk of loss are deemed
to bear the risk of loss constituting the obligation.
•
–
–
The person with the primary liability will be considered the
party with the risk of loss.
The guarantor of a partnership recourse liability generally
has a “reimbursement right” from the partnership’s general
partners and is therefore not the person with the ultimate
risk of loss.
The guarantor of a nonrecourse liability does not have the
right to reimbursement from the other partners and will be
treated as bearing 100% of the risk for the guaranteed
nonrecourse liability.
Partner’s Share of Recourse Debt: Nonrecourse
Loans Recharacterized as Recourse (Cont.)
• Interest Guarantees
–
If:
•
•
–
A liability would otherwise be a nonrecourse liability except that
one or more partners are obligated to pay more than 25 percent of
the total interest that will accrue on the liability if the partnership
fails to pay such interest, and
It is “reasonable” to expect that the guarantor will be required to
pay “substantially all” of the future interest if the partnership fails
to do so,
Then:
•
the guarantor partners will be treated as having an economic risk
of loss with respect to the liability to the extent of the present value
of the guaranteed interest payments, with the balance of the
liability being treated as nonrecourse.
Partner’s Share of Recourse Debt: Nonrecourse
Loans Recharacterized as Recourse (Cont.)
• It is “reasonable” to expect that the guarantor will
be required to pay substantially all of the
guaranteed interest if, upon default by the
partnership, the lender can enforce the interest
guaranty without foreclosing on the property and
extinguishing the underlying debt.
Partner’s Share of Partnership Nonrecourse Debt
• Nonrecourse liabilities are those liabilities for which
no partner (or related person) bears personal risk of
loss.
• If the loan is obtained from a partner then the
lender, who is a partner in the partnership, bears
personal risk of loss and the liability will be treated
as a recourse loan for purposes of Code Sec. 752.
• The debt is included in the basis.
Partner’s Share of Nonrecourse Debt (Cont.)
• Partners’ interests in partnership nonrecourse debt
are divided into three categories:
“Book” (Code Sec. 704(b)) minimum gain
1.
o
The partner’s share of “Code Sec. 704(b )” minimum gain
(nonrecourse debt minus book value);
Code Sec. 704(c) minimum gain
2.
o
The partner’s share of taxable gain (not already allocated
under (1) above) that would be allocated to the partner
under Code Sec. 704(c) if the property was disposed of in
full satisfaction of its nonrecourse debt. This equals the
partner’s share of any excess of book value over tax basis for
Code Sec. 704(c) assets, where the nonrecourse debt exceeds
book value), and
Partner’s Share of Nonrecourse Debt (Cont.)
Other profits
3.
1.
The partner’s share of the excess nonrecourse liabilities of the
partnership as determined in accordance with the partner’s
share of partnership profits.
Partner’s Share of Nonrecourse
Debt: Minimum Gain
• Partnership “minimum gain” is the amount of gain
which would be recognized by the partnership if it
surrendered the property to the nonrecourse lender
in satisfaction of the outstanding balance of the debt.
• This is an amount equal to the excess of the
outstanding balance of the loan over the book value
(adjusted for book depreciation deductions) of the
property.
–
The partnership could realize more gain on disposition of the
property but never less.
Partner’s Share of Nonrecourse
Debt: Minimum Gain (Cont.)
• If there is minimum gain the partners’ capital
accounts may fall below zero even in the absence of
any requirement on their parts to make additional
capital contributions to “restore” these deficit
balances.
–
–
As long as the deficits do not exceed the partners’ shares of
minimum gain, any deficit in their capital accounts can
theoretically be made up with an allocation of minimum
gain when the asset is sold or foreclosed on.
This later allocation of gain would offset the deductions
allowed that created the deficit capital balances.
Partner’s Share of Nonrecourse Debt:
Code Sec. 704(c)
 Code Sec. 704(c) minimum gain arises when a
partnership owns property encumbered by
nonrecourse debt which has a book value in excess of
its tax basis.


The total amount of “minimum gain” which would be
recognized by the partnership in the event of default and
foreclosure by the nonrecourse lender is in this case equal to
the excess of the principal amount of the note over the tax
basis of the property.
The excess of principal amount over book value would already
have been allocated as “Code Sec. 704(b)” minimum gain.
Partner’s Share of Nonrecourse Debt:
Code Sec. 704(c) (Cont.)
• It is possible to have Code Sec. 704(c) minimum
gain, but no “book” minimum gain.
• Similarly, it is possible to have “book minimum
gain, but no Code Sec. 704(c) minimum gain.
• Partnership nonrecourse liabilities in excess of the
partnership’s Code Sec. 704(b) and Code Sec.
704(c) minimum gains are allocated in accordance
with the partners’ interests in general partnership
profits.