August 2013
Partnership Distributions
Present Hidden Traps
By James R. Hamill
James R. Hamill discusses the general rules that apply to
partnership distributions as well as the special situations that can
create hidden traps for the unwary.
Introduction
The tax treatment of partnership distributions generally follows an aggregate approach, resulting in
no immediate tax effect to the partnership or to the
distributee partner. This result is in contrast to the
entity approach followed by C and S corporations,
which treats the distribution as a deemed sale to the
eho
olderr an
shareholder
and also requires the shareholder’s tax
ea
atme
t ntt tto
o b
e measured by reference to the fair
treatment
be
mar
rket vvalu
e (FM
MV of distributed pr
market
value
(FMV)
property. T
The ffavorble
e par
rtnerrship
p re
nerally de
pend on
able
partnership
result does not ge
generally
depend
he FMV
V of distributed
distr
d ibu
ute property,
operty, and
and instead
instead assigns
si s a
the
rrryoveer ba
asis tto the
he distributed
ributed property,
perty pre
erving
carryover
basis
preserving
herent gain or loss to the time that the property
any inherent
partner. With few excepis sold by the distributee partner.
artnership distribution
tions, the tax treatment off a p
partnership
can be determined by reference to the basis rules. In
general, the partner’s basis in his partnership interest
is reduced by any basis assigned to distributed money
or property. If the basis of the partner’s interest is
insufficient to allow a carryover basis to be assigned
to distributed property, that property may take a basis
less than carryover. If a distribution is in liquidation
of a partner’s interest, then the basis of the interest
is substituted for the basis of money and property
received, so that it is possible that property may be
allocated more or less than a carryover basis. An
exception exists for ordinary income property, which
James R. Hamill, CPA, Ph.D., is the Director of Tax Practice
at Reynolds, Hix & Co. in Albuquerque, New Mexico.
©
TAXES—THE TAX MAGAZINE
®
may never be allocated more than carryover basis to
preserve the full amount of potential ordinary income
inherent in the property.
The operation of these basis rules creates one scenario when gain may be recognized and one where
loss may be recognized by the distributee partner.
Where the partnership has in effect a Code Sec. 754
election, a Code Sec. 734 adjustment to the basis of
undistributed partnership properties will occur when
ecognize a gain or loss. The potential
the partner recognizes
for distri
d
d p
e y to eeither
ith r ““gain”
ain” or “lose”
lose
distributed
property
ba
red re
ati e to th
op
basis,, me
measured
relative
the basis of the pr
property
to the
e par
ship ccreates
ea es two other
ther sc
arios wh
partnership,
scenarios
where
a Code Sec. 734 adjustment may occur at the partnership level. Because all four of these adjustment
scenarios occur as a result of the basis provisions,
knowledge of how basis is assigned to a partnership
distribution allows a tax advisor to determine the
tax effect both to the partner and to the partnership.
This article will address the basis assignment rules
and how the partner’s basis in distributed property
also determines the potential for a Code Sec. 734
adjustment to the partnership. Because this article
deals with the effects of property distributions, all
payments to withdrawing partners will be treated as
Code Sec. 736(b) “property” payments.
Although partnership distributions generally have
no immediate tax effect unless otherwise dictated by
the basis assignment provisions, a partnership distribution may have ancillary effects to both the partner
and the partnership resulting from the operation of
several anti-abuse rules. These include a provision
2013 J.R. Hamill
25
Partnership Distributions Present Hidden Traps
allowing a distribution to be recast as a sale and another creating potential for early recognition of Code
Sec. 704(c) gain. Finally, when a partner receives a
disproportionate share of “Code Sec. 751” assets of
the partnership a deemed purchase-sale transaction
can create tax consequences for all partners. This
article will also address these anti-abuse rules.
Assignment of Basis to
Distributed Property and
Resultant Partner Tax Effect
Distributions of Money
The basis of a partnership interest can never be
negative, and the basis of money can never be less
than its face amount. Money, therefore, will always
acquire a carryover basis from the partnership. The
basis of a partnership interest must first be reduced by
the amount of any money distributed.1 If the money
distributed exceeds the basis of the interest immediately before the distribution, the partner recognizes
gain and the basis of the interest in the partnership
becomes zero. The term “money” includes the FMV
of certain marketable securities distributed to a
ner.2 Th
Thus,
us, a partner may recognize gain from a
partner.
stribut
ib ttion
ti off m
ma
distribution
marketable securities, and the basis of
uch
h sec
curitties w
wil
he no
such
securities
will be that determin
determined by the
normal
asiis ru
ule of
o Co
ode Sec.. 732 incre
ased b
ny ggain
ain
basis
rule
Code
increased
by aany
eco
ognized as a re
esu off the dist
bution T
e ttreatatrecognized
result
distribution.
The
en
nt off marketable
maarkettable
le securities
urities as
a money
mone does
does not
not
ment
or pu
apply ffor
purposes of determining whether a loss may
ating
g dis
ribut
be recognized in a liquidating
distribution.
ketab
ble ssecurities”
ecuri
The definition of “marketable
is quite
broad, and includes a variety of traded financial
instruments and may also include precious metals.3
However, it does not include any securities that
were contributed by the partner who receives the
distribution, nor does it include any security that was
not traded at the time it was contributed to the partnership. If the marketable securities have a FMV in
excess of basis, the amount of the distribution treated
as money is reduced by the distributee partner’s share
of the partnership unrealized gain. This rule allows a
partner to withdraw her share of the appreciation on
partnership marketable securities without recognition
of gain. It is only when a partner increases her share
of partnership marketable securities in exchange for
her share of other partnership property that the antiabuse rule applies. A partner’s share of unrealized
appreciation in partnership securities is based on all
26
securities held by the partnership, not just one class
of security.4
Example. In liquidation of his interest in the partnership, Jeff receives a distribution of marketable
securities with a FMV of $30,000 and a tax basis
to the partnership of $10,000. Jeff’s basis in his
partnership interest is $20,000 and his share of
the partnership’s $20,000 unrealized gain with
respect to the marketable securities is $5,000.
The amount of the deemed cash distribution
is $25,000, the FMV of the distributed securities reduced by Jeff’s share of the partnership’s
unrealized gain [$30,000 – $5,000]. Jeff then
recognizes only $5,000 of gain [$25,000 cash
distribution – $20,000 basis of partnership interest]. The basis of the marketable securities to Jeff
is $25,000, the sum of the substituted $20,000
basis determined under Code Sec. 732 and the
$5,000 gain recognized.
Exceptions apply to securities that were not marketable when acquired by the partnership and to
distributions by an investment partnership (one that
is not engaged in a trade or business). In addition,
securities contributed by the partner receiving the
securities as a distribution are exempt.
rtner re
co
When a partner
recognizes
gain from a distribution
of m
oney in exc
asis of his intere
t, th
money
excess o
of the b
basis
interest,
the
tra
actio is treat
d ass a de
med sale or exc
ha
transaction
treated
deemed
exchange
of the
e pa
ship in
ter st Th
at the gain
a is
partnership
interest.
This means that
typically capital in nature, except to the extent Code
Sec. 751 provides otherwise.5 The 3.8-percent Code
Sec. 1411 surtax may apply to the gain unless the
partnership is engaged in a trade or business (other
than trading in financial instruments or commodities)
in which the partner materially participates.6 The
applicability of the surtax is determined from a hypothetical sale of partnership properties immediately
before the distribution.7 To be eligible for the trade or
business exception, the partner must attach a statement to his tax return for the year of the deemed sale
showing the information required by Proposed Reg.
§1.1411-7(c)(5). If a high-income partner does not
materially participate in the partnership’s business,
gain will be subject to the 3.8-percent surtax, but it
may also qualify as passive income. To determine the
amount of passive income will require an allocation
of the income among all activities of the partnership
that would produce net gain if they were sold at FMV
on the applicable valuation date.8
August 2013
Basis of Property Received in a
Partnership Distribution
Unless one of the anti-abuse rules discussed later in
this article applies, the distribution of property will
not cause a partner to recognize gain. Generally, the
basis of property distributed from a partnership will
carry over to the distributee partner.9 This complements the provision that property contributed to the
partnership will have the same basis as it had to the
contributing partner. Two special rules can cause
the basis of a distributed asset to the partner to differ
from that to the partnership (it can be either more or
less). First, the basis of a partner’s interest limits the
amount of basis that may be assigned to distributed
property, a rule which can result in a decrease in the
basis of a distributed asset.10
Example. Laura has a $23,000 basis in her partnership interest. In a nonliquidating distribution,
she receives property with a basis of $30,000 to
the partnership. The basis allocated to the property to Laura is limited to $23,000, the basis of
her interest immediately before the distribution.
The asset “loses” $7,000 of tax basis. Laura’s
rtne
ership iinterest will have a basis of zero folpartnership
lo
owin
ing th
e di
st
lowing
the
distribution.
Se
econ
nd, w
n a distribution
ribution is in
n liquidation
liqui a on of
of a
Second,
when
arttner’’s int
teresst, the basis
sis of the liquidated
iquida ed interest
nt est
partner’s
interest,
ggenerally
rallyy sub
b titut
tu
for the basis
sis of dist
ibuted
is gene
substituted
distributed
This could result in an increase or decrease
assets.111 Thi
tributed asset
in the basis of certain distributed
assets.
Example. Kelly has a basis in her partnership
interest of $40,000. The partnership distributes
capital gain property with a basis of $30,000
in liquidation of Kelly’s interest. The distributed
property will acquire the $40,000 basis of Kelly’s
partnership interest. In this case, the asset “gains”
$10,000 of basis.
Ordinary income assets may not be allocated basis
in excess of the basis of such assets to the partnership.12 This rule exists to prevent the distributee
partner from reducing his allocable share of ordinary
income from the partnership. If the distribution is not
in liquidation of the partner’s interest, the general rule
of Code Sec. 732(a)(1) will prevent any distributed
property from acquiring a basis in excess of that
property’s basis to the partnership. It is only when
TAXES—THE TAX MAGAZINE®
a distribution is in liquidation of a partner’s interest
that basis might be assigned basis in excess of the
basis of assets to the partnership. Code Sec. 732(c)
(1) prevents this result if the distributed property is
an ordinary income asset.
Ordinary income assets include partnership unrealized receivables and inventory items.13 While
it may be tempting to refer to these assets as “Code
Sec. 751” assets, the definition is more inclusive than
that. Code Sec. 751, as it relates to distributions of
property, requires that inventory be “substantially
appreciated,” requiring a comparison of the FMV
and the basis of the inventory. But for purposes of
the basis allocation provisions, the definition includes any inventory of the partnership. The term
“unrealized receivables” includes a wide variety of
assets with ordinary income potential. For example,
assets with depreciation recapture potential are classified as unrealized receivables to the extent of the
recapture potential. The restriction on the amount
of basis that may be allocated to ordinary income
assets requires that basis be allocated to such assets
before it is allocated to other property received in
the same distribution.
Example. Jeff has a basis of $12,000 in his partnership interest. In a liquidating distribution, he
3,000 in
n cash, inventory with a basis
receives $3,000
$1,0
t partnership
p rt rship and capital
caapital gain
of $1,000
to the
opert with
th a basis
b sis of $4,000
4,0 0 to the partnership.
artner h
property
asis is first allocated
alloca ed to the money
oney ($3,000),
($ 000) then
h
Basis
to the inventory (limited to $1,000), and finally to
the capital gain property (the remaining $8,000).
If the only property distributed in liquidation of
a partner’s interest is money and ordinary income
property, the restriction on the amount of basis that
may be assigned to those assets can result in the
recognition of a loss by the distributee partner. This
occurs when the basis of the interest exceeds the
sum of the money distributed plus the carryover
basis of the ordinary income property distributed in
liquidation of the partner’s interest. As noted earlier,
marketable securities are not treated as money for
the loss recognition provision.
Example. Continue the facts of the preceding example, but assume that Jeff receives only $3,000
in cash and inventory with a basis of $1,000 to the
partnership. First, $3,000 of basis is allocated to
the cash and then $1,000 to the inventory. There
27
Partnership Distributions Present Hidden Traps
is still $8,000 of basis to account for. Since the
interest is liquidated, no basis may remain with
the interest, and the remaining basis produces
a loss of $8,000. This loss arises from a deemed
sale or exchange of the partnership interest and
is likely capital in nature.
In the above example, the taxpayer trades an immediate capital loss for future ordinary income. If
the remaining $8,000 of basis had been allocated to
inventory, no immediate loss would have resulted.
Thus, the loss occurs to preserve the ordinary income potential associated with the inventory.14 A
loss cannot result from a distribution that is not in
liquidation of the partner’s interest in the partnership because any excess basis would then remain
with the partnership interest. Similarly, if any asset
other than money and ordinary income property is
distributed, no loss results because any remaining
basis is allocated, without restriction, to the nonordinary income asset.
Partnership Distribution Code
Sec. 734 Adjustments
To this
his point,
poin
nt, the article has focused only on the
x effe
ff ctt o
the
e distribution on the partner. This is
tax
effect
off th
ypically
y th
e fo
ocu of tax planning for partnership
ar e
typically
the
focus
istributtions, be
eca
he partners
hip itse
oes not
n
distributions,
because
the
partnership
itselff does
eco
ognize gain
g
or los
om a dist
bution H
w ver,
recognize
loss from
distribution.
However,
th
he partnership
partne
ershi has
h a Code Sec.
ha
S
lec ion in
if the
754 election
for the
th
h year of the distribution, there is the
effect for
aadjustment
tmen to the basis
potential for a Code Sec. 734 adjus
ip aassets.
ssets A C
of undistributed partnership
Code Sec. 734
adjustment occurs in four situations, each of which
begins with a change in tax result at the partner’s
level. If a distribute partner recognizes a gain or loss
as a result of the distribution, or if any distributed
property has a basis to the partner that is different
than the basis that property had to the partnership,
then a Code Sec. 734 adjustment will result. Code
Sec. 734 may be regarded as a “zero sum game,” in
which an adverse tax result to the distributee partner
is offset by an equivalent positive adjustment to the
basis of partnership properties, and a positive result
at the partner level is offset by a negative adjustment
to the basis of partnership properties.
A positive adjustment is made to the basis of undistributed partnership properties in two situations:
1. When the distribution results in the distributee
partner recognizing gain
28
2. When the basis of distributed property in the
hands of the partner is less than the basis of
that property to the partnership
Both of these situations may occur in either liquidating or nonliquidating distributions, and they may
be regarded as adverse to the partner, one because
gain is reported, the other because the distributed
property “loses” basis as a result of the distribution.
If a Code Sec. 754 election is in effect for the year
of the distribution, the partnership may increase the
basis of undistributed assets, in a sense offsetting the
negative tax effect at the partner level.
Example. Deena, a partner in the DEF partnership, has a basis in her partnership interest of
$50,000. In the current year, Deena receives a
distribution of $80,000 of money. Deena must
recognize a gain of $30,000. If the partnership
has a Code Sec. 754 election in effect for the
year, DEF will increase the basis of undistributed property by the $30,000 gain recognized
by Deena. This adjustment will be allocated to
capital gain property.15
Example. Deena, a partner in the DEF partnership, has a basis of $50,000 in her partnership
interest. In the current year Deena receives a
ap
distribution of a ccapital
asset that has a basis of
$80,00
ar e ip. N
o ggain
ain or lo
$80,000 to the partnership.
No
losss is
ogn
by D
e a, but the
he basis of the disd
recognized
Deena,
buted capital
pital asset
a se is lim
ed to tthe $50
00
tributed
limited
$50,000
basis of her partnership interest, which is $30,000
less than the partnership’s basis in that asset. If
the partnership has a Code Sec. 754 election in
effect for the year, DEF will increase the basis
of undistributed property by $30,000 to offset
the effect of the distribution basis adjustment.
This adjustment will be allocated to capital gain
property because the asset that gave rise to the
adjustment was a capital asset.16
A negative adjustment is made to the basis of undistributed partnership properties in two situations:
1. When the distribution results in the distributee
partner recognizing a loss
2. When the basis of distributed property in the
hands of the partner is more than the basis of
that property to the partnership
Both of these situations may occur only in distributions in liquidation of a partner’s interest, and they
may be regarded as favorable to the partner, one
August 2013
because a taxable loss is reported, the other because
the distributed property “gains” basis as a result of the
distribution. If a Code Sec. 754 election is in effect
for the year of the distribution, the partnership must
decrease the basis of undistributed assets, in a sense
offsetting the favorable tax effect at the partner level.
Example. Deena, a partner in the DEF partnership, has a basis in her partnership interest of
$50,000. In the current year, Deena receives
a distribution in liquidation of her interest that
consists of $20,000 of money and partnership
inventory with a tax basis of $20,000 to the
partnership. Deena must assign $20,000 of
basis to the money, leaving $30,000 to assign
to property, but she is limited to assigning a
carryover basis of $20,000 to the inventory. She
will then recognize a loss of $10,000 for the
basis that cannot be assigned to any other asset.
If the partnership has a Code Sec. 754 election
in effect for the year, DEF will decrease the basis
of undistributed property by the $10,000 loss
recognized by Deena. This adjustment will be
allocated to capital gain property.17
Example.
ample. De
Deena, a partner in the DEF partnersh
hi has
hip,
h ab
ba
as of $50,000 in her partnership
ship,
basis
in
ntere
est In
est.
n thee ccu
nt year, Deena receives
ve a d
interest.
current
distr
ibution in
i liq
qui
n of her int
erest of a capital
apital
tribution
liquidation
interest
as
sset that hass a basis
ba of $30,000
$30,000 to the partnerp tn rasset
sh
hip. No gain
hip
n orr lloss iss recog
zed b
ena
ship.
recognized
by D
Deena,
he b
but th
the
basis of the distributed capital asset is
hich is a substituted
ubst
adjusted to $50,000, which
basis
st. If the partnership
partn
of her partnership interest.
has a
Code Sec. 754 election in effect for the year, DEF
will decrease the basis of undistributed property
by $20,000 to offset the basis adjustment made
to the distributed property. This adjustment will
be allocated to capital gain property because
the asset that gave rise to the adjustment was a
capital asset.18
When determining the existence and amount
of any Code Sec. 734 adjustments, as well as
the basis of distributed property under Code Sec.
732, any existing Code Sec. 743 adjustment that
belongs to the distributee partner with respect
to the distributed property will be added to the
partnership’s basis in that property immediately
before the distribution.19 If the distribution is in
liquidation of the partner’s interest, the adjustment
TAXES—THE TAX MAGAZINE®
to the partnership basis in property received by the
distributee will also include any Code Sec. 743
adjustment with respect to property in which that
partner has relinquished an interest.20 If partners
not involved in the distribution have a Code Sec.
743 adjustment with respect to the distributed
property, their adjustment will be reallocated to
other assets of the partnership.21
Example. Refer to the facts of the preceding
example, but assume that Deena has a Code
Sec. 743 adjustment of $13,000 with respect to
a prior transaction. For purposes of determining
the Code Sec. 734 adjustment, the distributed
property will be treated as if it had a basis of
$43,000 to the partnership. Because the distribution liquidates her interest, the $13,000
adjustment is made to the only asset distributed
even if all or a portion of the Code Sec. 743
adjustment relates to other property. The Code
Sec. 734 adjustment will then be $7,000, the
reduction in the basis of the property caused by
the distribution after consideration of the Code
Sec. 743 adjustment.
Early Recognition of
Code Sec.
ec 70
704(c)
04 Gains
Code
Co
de Sec.
c. 7
704(c)(1)(B)
(c (1)(B)
C e Sec.
Code
Se 704(c)(1)(B)
704(c)( )( ) requires
req res the contributing
ontri u
partner subject to Code Sec. 704(c) to recognize
any remaining Code Sec. 704(c) gain or loss when
previously contributed property is distributed to a
partner other than the contributing partner within
seven years of the contribution.22 The amount of
Code Sec. 704(c) gain or loss is determined as if the
property had been sold to the distributee partner at
FMV, with the resulting gain or loss allocated using
Code Sec. 704(c) principles.23
Example. Partner Alex joins the AB partnership by
contribution of property with a FMV of $40,000
and a tax basis of $20,000. The property is depreciated on a straight-line basis over five years.
Within the first three years of operations, the
partnership reports book depreciation of $24,000
and tax depreciation of $12,000. The book depreciation is shared equally by the two partners, and
the tax depreciation is allocated entirely to the
noncontributing partner, as is appropriate under
29
Partnership Distributions Present Hidden Traps
Code Sec. 704(c). The depreciation allocation
reduces the Code Sec. 704(c) gain from $20,000
to $8,000 by the end of the third year. At that
time, Alex’s contributed property is distributed
to the other partner. The FMV of the property
is $23,000 at the time of the distribution. If the
property were sold for $23,000, the partnership
would report a taxable gain of $15,000 ($23,000
minus $8,000 adjusted tax basis) and the first
$8,000 of that gain would be allocated to Alex
pursuant to Code Sec. 704(c). Code Sec. 704(c)
(1)(B) will then require Alex to report an $8,000
taxable gain when the property is distributed to
the other partner.
The character of Code Sec. 704(c)(1)(B) gain or
loss is determined as if the property were sold to the
distributee partner.24 If the distributee partner controls
the partnership, Code Sec. 707(b)(2) or 1239 may
characterize the gain as ordinary income.25 The applicability of the 3.8-percent Code Sec. 1411 surtax
should also be determined as if the property had actually been sold by the partnership. Code Sec. 704(c)
(1)(B) applies only if the transaction is characterized
as a distribution. Thus, income payments to retiring
nerss (Co
ode Sec. 736(a) payments), distributions
partners
(Code
eated
t d as
a di
sguiise sales (Code Sec. 707(a)(2)(B))
(
treated
disguised
and
Cod
de Se
ec 7
ec.
751(b
b) distributions
ibutions that create a deemed
ee
Code
Sec.
751(b)
urcchasse-saale ttransaction
ran
on do not trigger
rigger Co
de SSec.
ec.
purchase-sale
Code
04
4(c)(1
1)(B)). Mo
ore
eov to the ext
nt that the
h ov
rall
704(c)(1)(B).
Moreover,
extent
overall
ect o
off a dist
r buti
ut
preserve the potential
p ten ial for
or
effect
distribution
preserves
tribut
the contributing
partner to recognize the Code Sec.
e Sec
704(c) gain or loss, then Code
Sec.. 704
704(c)(1)(B) will
ribu ion iis in complete
not apply. For example, if a dist
distribution
liquidation of the partnership, and the contributing
partner and other partners receive undivided shares
in the Code Sec. 704(c) property, Code Sec. 704(c)(1)
(B) will not apply to the extent that the contributing
partner’s share of the Code Sec. 704(c) property has
an inherent gain or loss equal to or greater than the
unrecognized Code Sec. 704(c) amount.
Both the contributing partner’s basis in his partnership interest and the partnership’s basis in the
property distributed to the noncontributing partner
are increased (or decreased) for any Code Sec. 704(c)
gain (or loss) recognized.26 The adjustment to the
partnership’s basis in the distributed asset occurs
immediately before the distribution and may affect
the distributee partner’s basis in that property under
the rules of Code Sec. 732 as well as any potential
Code Sec. 734 adjustment.
30
Code Sec. 737
Code Sec. 737 applies when a partner who contributed Code Sec. 704(c) property receives a distribution
of property other than the contributed asset within
seven years of the date of contribution.27 In such a
case, the contributing partner recognizes gain equal
to the lesser of the “excess distribution” or the net
precontribution gain.28 The excess distribution is the
FMV of the distributed property over the partner’s
basis in his partnership interest.29 If both Code Secs.
704(c)(1)(B) and 737 can apply to the same distribution, Code Sec. 704(c)(1)(B) is applied first.30
Example. Marla contributes three assets to the
KLM partnership, each with precontribution
gain of $10,000. Three years later, when the
basis of her partnership interest is $20,000 and
the precontribution gain is unchanged, Marla
receives a distribution of property, other than her
contributed property, with a FMV of $60,000.
As part of the same distribution, another partner
receives one of Marla’s contributed assets, which
has a FMV of $40,000 and a tax basis of $20,000
to the partnership. The distribution of one of her
contributed assets to another partner will cause
Marla to recognize the $10,000 Code Sec. 704(c)
gain attributable to that asset (Code Sec. 704(c)
es on aan
n asset-by-asset basis). Marla’s
(1)(B) applies
rem
main
net precontribution
cont ut on ga
00,
remaining
gain is $20,
$20,000,
ich iis triggered
ggere by Code Sec.
ec. 737 as
a a result
resu t of
which
e dist
tion of the asset valued
alued aat $60,000.
60 0 0 31
the
distribution
Gain recognized under Code Sec. 737 has the same
character as the partner’s precontribution gain with
respect to the contributed asset, computed as if that
asset had been sold to an unrelated party in an arm’slength transaction.32 Code Sec. 737 gain increases
the contributing partner’s basis in her partnership
interest and also increases the partnership’s basis in
the contributed Code Sec. 704(c) property retained
by the partnership.33 These basis adjustments are not
elective and do not rely on the existence of a Code
Sec. 754 election.
Disguised Sale Provisions
Code Sec. 707(a)(2)(B) states that if there is a direct
or indirect transfer of money or other property to
a partnership, and there is a related direct or indirect distribution of money or other property to the
transferor partner, and the two transactions when
August 2013
viewed together are properly characterized as a sale
or exchange of the property, then the transfers shall
be treated consistent with their substance—that is,
as a sale rather than a contribution. The general
rules applicable to partnership distributions will be
overridden by the disguised sale rules if the overall
transaction satisfies the definition of a disguised sale.
The challenge is in determining when a contribution
and distribution are both related and part of a sale
or exchange. The answer is found not in the statute,
but in the regulations.
If a transfer of property to a partnership occurs
within two years of the date of a distribution to the
contributing partner, without regard to the order of
the two transactions, there is a presumption that a
sale has occurred.34 Further, there is a presumption
that if such transfers are not within two years, that
no sale has occurred.35 When the distribution is not
contemporaneous with the contribution, but falls
within the two-year presumption, the transaction may
be a deferred payment sale in which interest must be
imputed.36 Also, any Code Sec. 704(c) allocations
made with respect to the contributed property before
it is subject to a disguised sale characterization should
be reversed because the property will be deemed to
e be
een ssold
have
been
sold, and not contributed, to the partnerhip
p as off th
h da
he
d
ship
the
date of the original transfer. Whether
istrib
butio
on to
o a partner
rtner is prope
a aas the
ad
distribution
properly recast
pay
ymen
nt off salee p
eds depend
acts aand
nd
payment
proceeds
dependss on th
the ffacts
irccumsstanc
ces o
of eac
ase. The regulations
gulations identify
de tify
circumstances
each case.
ffactors
ors to
ors
o co
onside
d 37
10 facto
consider.
When
nap
partner contributes encumbered property
rtnership’s assumption
as
to a partnership, the partnership’s
of
dered to be ssale proceeds.
the liability may be considered
For example, assume that a partner borrows against
property and then immediately transfers the property
and the related debt to a partnership. Because the
partner has retained control of the borrowed funds,
but the partnership is obligated to repay the debt, the
pre-contribution borrowings may be regarded as sale
proceeds from the partnership, generally measured
by reference to the share of the debt shifted to the
other partners. The regulations exempt “qualified”
liabilities from treatment as disguised sale proceeds.
A qualified liability is one that, if recourse, does not
exceed the FMV of the transferred property, and that
meets one of the following four requirements38:
1. The liability was incurred more than two years
before the partner transfers the property or, if
earlier, before the date on which the partner
agrees to transfer the property.
TAXES—THE TAX MAGAZINE®
2. If the liability falls within the two-year period
specified in (1), it was not incurred in anticipation of the transfer.
3. The liability is allocable to capital expenditures
with respect to the property, that is, it is acquisition debt, including refinanced acquisition
debt.
4. The liability was incurred in the ordinary course
of business and all material business assets
were transferred to the partnership.
If a transfer of property is treated as a disguised
sale for some reason other than assumption of
a qualified liability, then all or a portion of the
qualified liability may nonetheless be treated as
disguised sale proceeds.39 This rule is often called
the “drag along” rule because the otherwise qualified liability becomes part of the sale proceeds by
being dragged along with other tainted distributions. Liabilities other than qualified liabilities are
generally treated as disguised sale proceeds to the
extent that the amount of the liability exceeds the
contributing partner’s share of that liability. If the
liability is recourse, the partners’ shares are determined using the rules of Code Sec. 752 applicable
to such liabilities. If the liability is nonrecourse, the
partners’ shares are determined using step 3 of the
rules applicable under Code Sec. 752, the partners’
rofit shares.
shar 40
respective profi
There
Th
ere are four types
pe o
of di
distributions
str uti ns that are,
re, in
sp
ified circumstances,
cums n es, no
u
specifi
not treated as dis
disguised
sa
s The saf
e harbors,
harb s whi
sale proc
proceeds.
safe
which appl
apply eeven
to distributions within two years of a contribution of
property, follow:
1. A guaranteed payment for capital, that is, one
that is not determined with reference to partnership income and that is for the use of the
partner’s capital. The safe harbor applies if the
guaranteed return is not unreasonable.41 A guaranteed payment is not unreasonable if it is part of
the partnership agreement and does not exceed
150 percent of the highest applicable federal rate
at the time the guarantee is first established.42
2. A preference return that is not unreasonable. A
preference return is a preferential distribution
of cash made with respect to partnership capital
that will be matched, to the extent possible,
with an allocation of income or gain. The safe
harbor may be lost if the subsequent allocation
of income, including the timing of that allocation, appears to be part of a disguised sale.43
To be reasonable, the preference return cannot
31
Partnership Distributions Present Hidden Traps
exceed 150 percent of the highest applicable
federal rate at the time the agreement to pay a
preference is made, and the agreement must
be a written part of the partnership agreement.
3. An operating cash flow distribution that does
not exceed the product of the partnership’s
operating net cash flow for the year and the
lesser of the partner’s profits interest for the year
or the partner’s overall interest in profits over
the life of the partnership. Operating cash flow
distributions do not include any distributions
that would be classified as either guaranteed
payments or preference returns.44
4. A reimbursement of preformation expenses.
Such expenses must be incurred within two
years of the transfer of property from the partner to the partnership, and are limited to (i)
partnership organization and syndication costs,
and (ii) expenses associated with contributed
property, except that if the FMV of the contributed property exceeds 120 percent of its basis,
the reimbursements cannot exceed 20 percent
of the FMV of the property.45
To the extent that the partnership fails to pay guaranteed payments, preference returns, or operating
d
dist
cash flo
ow distributions
in the year to which they
la
ate,
t th
h aamount
he
mou
un of any protected distributions will
relate,
the
arrry fo
orward to
o fu
e years.46
carry
forward
future
Pro
Provisions
oviisio
onss Pr
Pre
P
Preserving
erving a Partn
Partner’s
nerr’s
Share
hare
e of
o O
Ordinary
d
Income
Code Sec. 751 is designed
d to avoid
avo d a conversion
c
of
butable tto a partner’s
the character of income attri
attributable
interest from ordinary to either capital or Code Sec.
1231 gain. It can apply when a distribution results
in a partner receiving more or less than his share
of Code Sec. 751 assets. Code Sec. 751 assets,
as defined with respect to distributions, include
partnership unrealized receivables and partnership
inventory items that have substantially appreciated
in value.47 The subchapter K concern with preservation of a partner’s share of partnership ordinary
income is supported by two other provisions. The
Code Sec. 732 basis rules applicable to distributions, as previously discussed, ensure that ordinary
income assets of a partnership do not “gain” basis
as a result of a distribution, preserving the total ordinary income to be recognized with respect to such
assets. Code Sec. 735 also provides that distributed
ordinary income property will retain its ordinary
32
income taint regardless of the character of the asset
to the distributee partner.
Code Sec. 735(a)(1) provides that a partner receiving a distribution of “unrealized receivables” will
recognize ordinary income when the receivables are
disposed of in a taxable transaction. Code Sec. 735(a)
(2) provides that a partner receiving a distribution of
partnership inventory items will recognize ordinary
income if the inventory is disposed of in a taxable
transaction within five years of the distribution.
Combined with the Code Sec. 732 basis rules, these
provisions delay the ordinary income recognition
event until the date of an actual sale or exchange.
Code Sec. 751 is a more extreme provision, as it can
create a deemed purchase-sale transaction at the
date of distribution that affects all partners before
any actual sale proceeds are received.
Code Sec. 751 can, in appropriate circumstances, create a fiction of a purchase-sale transaction
when a partner receives a disproportionate share
of Code Sec. 751 assets of the partnership. For
example, if a partnership has 20 percent of its
assets classified as Code Sec. 751 assets, and a
partner receives a distribution in liquidation of his
interest that does not include any Code Sec. 751
assets, that partner will be deemed to have sold
his share of Code Sec. 751 assets in exchange for
ionate share
s
a disproportionate
of non–Code Sec. 751
assets. The
T
part
sh p wil
med to hav
assets.
partnership
will be deem
deemed
have
so a share
sh
th non–Code
non–Cod Sec. 751
751 assets
asse s and
sold
of the
ave purchased
p hased a share
share (the
(t liquidated
liquid ed partner’s
pa tn
to have
share) of Code Sec. 751 assets. Reg. §§1.751-1(a)
(3) and (b)(5) require certain information reporting
when Code Sec. 751 applies to a distribution or
to a transfer of a partnership interest.
For purposes of applying Code Sec. 751 to distributions, the term “unrealized receivables” includes
any rights to payments that would constitute ordinary income to the partnership. This could include
rights to payments for services and also for goods,
if the goods do not qualify as capital or Code Sec.
1231 assets, but it also includes potential depreciation recapture. For example, if a partnership holds
a Code Sec. 1231 asset with Code Sec. 1245 or
Code Sec. 1250 recapture potential, the potential
recapture income (measured as if the assets were
sold for FMV) would constitute an unrealized
receivable. Substantially appreciated inventory includes any property that would be either inventory
or property held primarily for sale to customers in
the ordinary course of a trade or business (“dealer”
August 2013
real property). To qualify as a Code Sec. 751 asset,
such inventory must, in the aggregate, have a FMV
in excess of 120 percent of the basis of the property.
Code Sec. 751(b)(2) excludes from the definition of
Code Sec. 751 assets any property originally contributed to the partnership by the partner receiving
such property in the distribution and any Code Sec.
736(a) “income” payments made in liquidation of
a partner’s interest.
Example. The HJK partnership balance sheet
appears as illustrated in Chart 1.
Chart 1.
Fair Market Value
Tax Basis
$ 60,000
$ 60,000
Unrealized Receivables
100,000
40,000
Inventory
100,000
70,000
Capital Assets
340,000
190,000
$ 600,000
$ 360,000
Cash
Total
The agreement allocates one third of items of
ofit and
d lo
profi
loss to each of three partners. Partner
H
Henry
y’s
’ iinterest
in
ntere
t es has a tax basis of $120,000.
,
Henry’s
In
liq
quid
datio
on off h
terest, Henry receives
e al
liquidation
his interest,
all of
th
he in
venttory an
realized rec
eivables aand
nd n
o
the
inventory
and unrealized
receivables
no
ot
ther asse
ets. The
T e ge
ggeneral
ral rules o
ec 7
1
other
assets.
of Code SSecs.
731
an
nd 732
732 wou
w
ld cr
cre
ng re
ult
and
would
create the foll
following
result:
vab es aare assigned
(1) The inventory and rece
receivables
70,000 and
and $40,000
$
a carryover basis of $70,000
respectively.
(2) Henry recognizes a loss of $10,000 from
the distribution because the basis of his interest
($120,000) exceeds the basis assigned to the distributed properties, and no other properties were
received to absorb the remaining basis.
(3) When Henry later sells the ordinary income
assets, if there is no change in value, he recognizes $90,000 of ordinary income. Thus, overall,
he recognizes net gain of $80,000 (capital loss
of $10,000 and ordinary income of $90,000).
This result shifts all of HJK’s potential ordinary
income to Henry. To prevent this result, Code Sec.
751 will recharacterize the transaction as follows48:
TAXES—THE TAX MAGAZINE®
(1) Henry exchanges a one-third interest in
cash and capital assets (FMV = $133,333) for a
two-thirds interest in inventory and unrealized
receivables (FMV = $133,333).
(2) The two remaining partners exchange a
two-thirds interest in inventory and unrealized
receivables (FMV = $133,333) for a one-third
interest in cash and capital assets (FMV =
$133,333).
(3) The above transactions are treated as taxable sale or exchange transactions. Thus,
Henry recognizes a gain on the transfer of the
capital assets (his one-third share) equal to
$50,000 ($113,333 – $63,333). The basis of
the ordinary income assets to Henry is determined in two parts. First, he has a carryover
basis of $36,667 in one-third of the ordinary
income assets, determined under the provisions of Code Sec. 732. Second, he has a cost
basis ($133,333) in the two-thirds deemed
purchased from the partnership. Thus, his
overall basis is $170,000. When he later sells
the ordinary income assets, he will recognize
ordinary income of $30,000. The partnership
has transferred a two-thirds interest in ordinary
sets in eexchange for a one-third inincome assets
terest in capital
apit as
et T
us, the p
artner hip
assets.
Thus,
partnership
mount realized
e iz d off $133,
33 in eexhass an amount
$133,333
hange for assets w
th a b
is of $
333 T
change
with
basis
$73,333.
The
partnership recognizes $60,000 of ordinary
income, allocated between the two continuing
members, resulting in each recognizing their
$30,000 share of the ordinary income potential
in partnership assets. The basis of undistributed
assets is then also determined in two parts. The
initial basis is $250,000, of which two-thirds, or
$166,667 belongs to the continuing members.
The remaining one-third was purchased by the
partnership for the FMV of $133,333. Thus, the
aggregate basis is $300,000, with $60,000 assigned to the money and $240,000 to capital
assets. A later sale will result in $100,000 of
capital gain, which would be divided $50,000
to each of the two continuing members. The net
result of the deemed purchase-sale transactions
is that each member will report $30,000 of
ordinary income and $50,000 of capital gain,
in proportion to their respective interests in
partnership properties.
33
Partnership Distributions Present Hidden Traps
Partnership Capital
Account Adjustments
If the partnership maintains Code Sec. 704(b)
capital accounts, adjustments must be made when
property is distributed to the partner. Code Sec.
704(b) capital is intended to reflect the economics of the arrangement between the partners, and
is most commonly used to satisfy the safe harbor
for economic effect or the deemed in accordance
with the partner’s interest tests of the Code Sec.
704 regulations. When property is contributed to a
partnership, the partner’s capital is increased by the
FMV of the property net of liabilities. To maintain
symmetry in result, when property is distributed
the partner’s capital is decreased for the FMV of
the distributed property net of liabilities. Because
the property is not likely to be recorded at its FMV
immediately before the distribution, it is necessary
to first restate the value to FMV through a deemed
sale adjustment (DSA).49
Example. Deena, Emily and Frank form the DEF
partnership, with each contributing $100,000.
The partnership purchases various assets, and
time when
wh the partners’ capital accounts
at a time
ar
re still
sttill $100,000,
$
$100
0,0
are
DEF distributes a land parce
el to
o De
eena
a A
a.
he date of th
ib tio
cel
Deena.
At the
the distribution,
th
he land
laand has
h a FMV
F
b sis to
o
the
of $60,000 and a basis
th
he partnership
paartneership of $30,000.
0,000. The
The partners
partner have
ha e
the
ag
greed
d to share
shaar all
a profi
al
ofits
osses one-third
ne third
agreed
ts and losses
h The Code
C
each.
Sec. 704(b) capital accounts are
n Chart
Ch
hart 2,
2, to reflect how
adjusted, as illustrated in
d if the
th
he distributed
distrib
gain would be allocated
parcel
were sold at FMV, and then to reflect the value
distributed to Deena.
Chart 2.
Contribution
DSA
Distribution
Ending
Deena
Emily
Frank
100,000
100,000
100,000
10,000
10,000
10,000
110,000
110,000
<60,000>
50,000
The purpose of the deemed sale adjustment in the
above example is to record the distributed property
at its FMV, with that value agreed to by the three
partners. Where the capital accounts establish the
34
rights to the asset upon liquidation, Deena would
prefer to assign the smallest possible value to the
distributed property so as to maintain the highest
end-of-period capital. Conversely, Emily and Frank
would like to assign the highest possible value to the
distributed property as that value serves to reduce
Deena’s capital and therefore increase the rights
that Emily and Frank have to undistributed properties. Arm’s-length bargaining between parties with
adverse interest would generally establish FMV.50
The economic effect of the distribution should be
recorded as a charge to Deena’s capital for the
economic value of the property, which first requires
that property to be restated to its agreed-to FMV.
At the end of the period, the capital accounts reflect that Emily and Frank have rights to the assets
of the partnership that are $60,000 greater than
Deena’s rights, which is the appropriate result of
Deena unilaterally withdrawing $60,000 of FMV
in partnership properties.51
Conclusion
Distributions from a partnership generally result in
no recognition of gain or loss to the partner under
the “aggregate” approach. The partner’s basis in
y is typically a carryover from
distributed property
hip, unless
un e limited by the basis of the
the partnership,
partn
ner’s interest.
erest Distributions
is ib ions in
n liquidation
quidatio of a
partner’s
pa
er’s interest
rest result
r su in the
th property acquiring
acqu in a
partner’s
ba
sub
ted from
from tthe
he bas
rtner’ in
basiss substituted
basis of the partner’s
interest. With the exception of ordinary income assets, a
distribution in liquidation may result in distributed
property taking a basis in the partner’s hands that
exceeds the basis of that property to the partnership. The basis assignment provisions may result in
gain being recognized where the amount of money
distributed exceeds the basis of the partner’s interest, or loss where the distribution is in liquidation
and consists solely of assets that cannot take a basis
in excess of that to the partnership. Where the distribution creates a tax effect to the partner, be that
gain or loss recognition, or a change in the basis of
distributed property as compared to the basis to the
partnership, a Code Sec. 754 election will create a
Code Sec. 734 adjustment to the partnership.
Unexpected tax consequences may arise when
the distribution triggers early recognition of Code
Sec. 704(c) gain or loss, which may include gain
recognition by a partner who did not receive a distribution, or where the distribution is recast as part of
August 2013
a disguised sale. Finally, distributions that change the
partners’ shares of ordinary income properties may
create a deemed purchase-sale transaction that affects
all partners, including those who did not receive a
distribution. This article discusses the general rules
that apply to partnership distributions as well as the
special situations that can create hidden traps for
the unwary.
ENDNOTES
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
7
18
8
19
Code Sec. 733(1).
Code Sec. 731(c)(4)(A).
Code Sec. 731(c)(2).
Code Sec. 731(c)(3)(B).
Code Sec. 741.
Code Sec. 1411(c)(2).
Code Sec. 1411(c)(4).
Rev. Rul. 95-5, 1995-1 CB 100. See Reg.
§1.469-2T(e)(3)(ii)(A) for the determination
of passive income or loss when an interest
in a partnership is sold.
Code Sec. 732(a)(1).
Code Sec. 732(a)(2).
Code Sec. 732(b).
Code Sec. 732(c)(1).
Code Secs. 751(c) and (d)(2).
Note that Code Sec. 735 provides that
the distributee recognizes ordinary gain
if distributed partnership inventory is disposed of within five years of the date of
distribution. This prevents a conversion of
the character of income for a partner who
does not hold distributed property as stock
in trade or property held primarily for sale
to customers
omers in the ordinary course of a
trade
ade orr busi
business.
ness.
Reg.
Re
eg. §1
§1.755-1(c)(1)(ii).
.755-1(c)(1)(i
Reg.
Re
eg. §1
§1.755-1(c)(1)(i).
.755 1(c)(1)(i).
.755)(i)
Supra
Su
upra note
note 15
15.
5.
Supra
Su
upra n
note
ote 16
16.
6.
Reg.
Re
eg. §§
§§1.743-1(g)
1.743
3-1(g) an
and
d1
1.7
1.732-2(b).
(b).
20
21
22
23
24
25
26
27
28
29
30
31
32
33
Reg. §§1.743-1(g)(3) and 1.743-1(g)(5),
Example (v).
Reg. §§1.743-1(g)(2)(ii) and 1.743-1(g)(5),
Example (iv).
Reg. §1.704-4(c) illustrates several distributions that will not trigger gain, including
deemed transfers under Code Sec. 708(b)
(1)(B) “technical” terminations, transfers to
another partnership, and incorporation of a
partnership.
Code Sec. 704(c)(1)(B)(i).
Code Sec. 704(c)(1)(B)(ii).
See Reg. §1.704-4(b)(2), Example.
Reg. §1.704-4(e).
See Reg. §1.737-2 for examples of distributions that will not trigger Code Sec. 737,
including transfers to another partnership,
incorporation of the partnership, and
deemed transfers pursuant to a Code Sec.
708(b)(1)(B) “technical” termination.
Code Sec. 737(a).
Code Sec. 737(a)(1).
See Reg. §1.737-1(e), Example 3, for an illustration of the interactions between Code
Secs. 704(c)(1)(B) and 737.
If Martha’s Code Sec. 704(c) gain had been
reduced
uc by pre-distribution allocations, both
the C
Code
e Sec. 704(c)(1)(B) and 737 gains
n
would
w
uld have b
been
een reduced.
red ced.
Reg.. §§1.737-1(d).
Re
73 (d).
Reg.. §§1.737-3.
Re
737-3.
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
Reg. §1.707-3(c).
Reg. §1.707-3(d).
See Reg. §1.707-3(f), Example 2, for an illustration of this rule.
Reg. §1.707-3(b)(2).
Reg. §1.707-5(a)(6).
Reg. §1.707-5(a)(5)(i).
Reg. §1.707-5(a)(2).
Reg. §1.707-4(a)(1).
Reg. §1.707-4(a)(3).
Reg. §1.707-4(a)(2).
Reg. §1.707-4(b)(2). The partnership’s net
cash flow is defined in this regulation and a
safe harbor for determination of a partner’s
profits interest is also provided.
Reg. §1.707-4(d).
Reg. §1.707-4(c).
Code Sec. 751(b)(1)(A).
Reg. §1.751-1(b)(2).
Reg. §1.704-1(b)(2)(iv)(e)(1).
Reg. §1.704-1(b)(2)(iv)(h).
Adjustments to capital may also be made for
Code Sec. 734 adjustments. If the distribution
giving rise to the adjustment is in liquidation
of a partner’s interest, the Code Sec. 734
adjustment is made only to the distribute
partner’s capital immediately before the
p
liquidating distribution; if the adjustment
li
relates
re
te to a nonliquidating distribu
distribution,
on, it is
sshared
re by aall partners
partners. Se
See Reg. §1
§1.704-1(b)
70
(2)(iv)(m)(4).
(2
v)(m)(4)
This article is reprinted with the publisher’s permission from the
TAXES–THE TAX MAGAZINE, a monthly journal published by CCH, a part of Wolters Kluwer.
Copying or distribution without the publisher’s permission is prohibited.
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TAXES—THE TAX MAGAZINE®
35