Editor: Greg A. Fairbanks, J.D., LL.M.
Partners & Partnerships
Determining a partner’s tax basis in properties distributed from a partnership to the partner can be a complicated endeavor. The analysis typically involves more than just ascertaining the basis of the properties in the hands of the partnership and the partner’s basis in the partnership interest and knowing whether the properties have appreciated or depreciated.
Numerous provisions (e.g., Secs. 707(a)(2)(B), 704(c)(1)(B), 737, 751(b), 736, and 731(c)) may apply in determining the tax consequences of the distribution and, in turn, affect the bases of the distributed properties. Once the Sec. 732 basis rules come into play, there may still be unanticipated complications in the form of Sec. 732(d). In particular, the mandatory piece of the provision, which is often overlooked, contains uncertainties in its application and can be difficult to apply as a practical matter.
Sec. 732(d) applies to situations in which a partnership does not have a Sec. 754 election in effect and a partner who would have a positive Sec. 743(b) adjustment if the partnership had a Sec. 754 election in effect receives a current or liquidating distribution of property from the partnership. When Sec. 732(d) applies, the adjusted partnership basis of the property distributed to the transferee partner is treated as the adjusted partnership basis the property would have if the adjustment in Sec. 743(b) were in effect.
This treatment is provided as either an elective or a mandatory application under Sec. 732(d). A partner may elect, under regulations prescribed by Treasury, to apply the special basis adjustment of Sec. 732(d) in determining its basis of the distributed property under the rules of Secs. 732(a), (b), and (c). However, Treasury may by regulations require such application of the Sec. 732(d) special basis adjustment if at the time of the transfer the fair market value (FMV) of the property (other than money) exceeded 110% of its adjusted basis to the partnership. As discussed below, in 1956, Treasury issued regulations concerning the mandatory application of Sec. 732(d). This item focuses on the latter (mandatory) piece of Sec. 732(d) and issues in applying it.
Background to Sec. 732(d)
Some background on Sec. 732(d) may assist in understanding its purpose and also whether it continues to prevent the perceived tax-advantaged result that it was originally intended to address. Sec. 732(d) appears initially to have been intended to prevent distortions caused by Sec. 732(c) that might inflate the basis of depreciable, depletable, or amortizable property above its FMV. When Sec. 732(d) was originally enacted in 1954, the basis allocation rules under Sec. 732(c) looked to the relative bases of the distributed assets regardless of whether the assets’ bases were increased or decreased from the partnership’s bases in those assets under Sec. 732(a)(2) or Sec. 732(b), as relevant.
Prior to 1997, after allocation of the partner’s basis in its partnership interest to unrealized receivables and inventory items distributed in an amount equal to the adjusted basis of each property to the partnership (or if the basis to be allocated was less than the sum of the adjusted bases of those properties to the partnership, in proportion to those bases), any remaining basis was to be allocated to any other distributed properties in proportion to their adjusted bases to the partnership. In 1997, Sec. 732(c) was amended in the Taxpayer Relief Act of 1997, P.L. 105-34, to read as follows:
(c) Allocation of basis.
(1) In general. The basis of distributed properties to which subsection (a)(2) or (b) is applicable shall be allocated—
(A) (i) first to any unrealized receivables (as defined in section 751(c)) and inventory items (as defined in section 751(d)) in an amount equal to the adjusted basis of each such property to the partnership, and
(ii) if the basis to be allocated is less than the sum of the adjusted bases of such properties to the partnership, then, to the extent any decrease is required in order to have the adjusted bases of such properties equal the basis to be allocated, in the manner provided in paragraph (3), and
(B) to the extent of any basis remaining after the allocation under subparagraph (A), to other distributed properties—
(i) first by assigning to each such other property such other property’s adjusted basis to the partnership, and
(ii) then, to the extent any increase or decrease in basis is required in order to have the adjusted bases of such other distributed properties equal such remaining basis, in the manner provided in paragraph (2) or (3), whichever is appropriate.
(2) Method of allocating increase. Any increase required under paragraph (1)(B) shall be allocated among the properties—
(A) first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase (but only to the extent of each property’s unrealized appreciation), and
(B) then, to the extent such increase is not allocated under subparagraph (A), in proportion to their respective fair market values.
(3) Method of allocating decrease. Any decrease required under paragraph (1)(A) or (1)(B) shall be allocated—
(A) first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation before such decrease (but only to the extent of each property’s unrealized depreciation), and
(B) then, to the extent such decrease is not allocated under subparagraph (A), in proportion to their respective adjusted bases (as adjusted under subparagraph (A)).
The legislative history of the original enactment of Sec. 732(d) provides as an example of its application a situation in which land and depreciable property are distributed in a liquidating distribution to a partner (C) who purchased a partnership interest from another partner. Under the example’s facts, the partnership’s basis in the depreciable property was substantially higher than the partnership’s basis in the land, though the respective values were vice versa, as shown in Exhibit 1.
The legislative history explains that because the partnership’s basis in the depreciable property ($45,000) was substantially higher than the partnership’s basis in the land ($5,000), though the value of the land ($55,000) was higher than the value of the depreciable property ($45,000), the bulk of C’s basis in its partnership interest of $100,000 would be allocated to the depreciable property ($90,000). The legislative history states, “As a result, C would, in effect, apply as the basis of depreciable property the amount which he had paid for nondepreciable property.” The legislative history adds that, to prevent this result, the regulations may require the partner to allocate to the land that portion of the basis of his interest properly allocable thereto, $55,000, and the depreciable property would take a basis of $45,000 (S. Rep’t No. 1622, 83d Cong., 2d Sess., 394 (1954)).
Thus, under a mandatory application of Sec. 732(d), the result would be as shown in Exhibit 2 for the example in the legislative history.
Regulation on the Mandatory Application of Sec. 732(d)
Regs. Sec. 1.732-1(d)(4) provides a three-prong test for when Sec. 732(d) is required to be applied. Under the regulation, a partner who acquired any part of his partnership interest in a transfer to which the election to adjust basis under Sec. 754 was not in effect is required to apply the special basis rule of Sec. 732(d) if at the time of his acquisition of the transferred interest all of the following three tests are met:
- The FMV of all partnership property (other than money) exceeded 110% of its adjusted basis to the partnership;
- An allocation of basis under Sec. 732(c) upon a liquidation of the partner’s interest immediately after the transfer of the interest would have resulted in a shift of basis from property not subject to an allowance for depreciation, depletion, or amortization, to property subject to such an allowance; and
- A basis adjustment under Sec. 743(b) would change the basis to the transferee partner of the property actually distributed.
The test under Regs. Sec. 1.732-1(d)(4) originated in 1956 (see T.D. 6175). Since then, the regulation has not been substantively changed, though there was consideration given in the late 1990s (during work on revisions to regulations under Secs. 743 and 755 regarding adjustments following sales of partnership interests) to reviewing the proper scope of Sec. 732(d), and, specifically, under what circumstances, if any, Treasury should exercise its authority to mandate the application of Sec. 732(d) to a transferee (see the preamble to the notice of proposed rule-making (REG-209682-94)). Because Sec. 732(c) was legislatively amended in 1997 to make the allocation rules look to the relative values, rather than the relative bases, of distributed assets with an overall increase to the tax bases in the hands of the distributee partner, it appeared that the mandatory piece of Sec. 732(d) might not have continuing vitality. The preamble to those proposed regulations explained its purpose as follows:
The purpose of §1.732-1(d)(4) was to prevent distortions caused by section 732(c) that might inflate the basis of depreciable, depletable, or amortizable property above its fair market value. At the time that the regulations were adopted, such distortions might occur because section 732(c) allocated basis among distributed properties based on their relative bases. The changes made to section 732(c) by the Taxpayer Relief Act of 1997 . . . make the distortions targeted by the regulations less likely to occur.
Practitioners noted that the potential for abusive transactions involving the shifting of basis was substantially minimized by the 1997 amendment to Sec. 732(c) (see, e.g., AICPA, “Comments on Proposed Regulations on Adjustments Following Sales of Partnership Interests” (4/21/99)). Nonetheless, based apparently on a perception that distortions might still result, the IRS and Treasury decided to retain Regs. Sec. 1.732-1(d)(4) (T.D. 8847).
The regulations do not provide guidance on how to determine if a shift in tax basis has occurred under Regs. Sec. 1.732-1(d)(4)(ii). One possible approach to determining whether a shift in tax basis has occurred is to compare the basis result with and without a Sec. 754 election in a pro rata liquidation. There is an argument that if the tax basis of depreciable property is higher in the hypothetical pro rata liquidation without a Sec. 754 election than with an election, then a “shift” has occurred. Another approach to determining whether a shift in tax basis has occurred is to view such a shift as occurring only if a hypothetical pro rata liquidation would result in an allocation of basis that exceeds the FMV of the assets distributed and that causes the basis of the property to exceed its basis in the hands of the partnership (see McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners (Warren, Gorham & Lamont 4th ed. 2007), describing various approaches for analyzing the tax basis shift question and the latter approach as a “more supportable view”).
In view of the legislative change in 1997 to Sec. 732(c) and the IRS’s own explanation in the preamble to the proposed regulations (on adjustments following the sale of partnership interests) that the purpose of Sec. 732(d) was “to prevent distortions caused by section 732(c) that might inflate the basis of depreciable, depletable, or amortizable property above its fair market value,” looking at whether the basis on a hypothetical pro rata liquidation would exceed the FMV appears to be a supportable starting point.
The uncertainty in how to evaluate when a shift in tax basis has occurred for purposes of Regs. Sec. 1.732-1(d)(4), combined with the practical difficulty of knowing factually whether the FMV of all partnership property (other than money) exceeded 110% of its adjusted basis to the partnership at the time the distributee partner acquired its transferred partnership interest (which could have occurred many years back), may make complying with the regulation a difficult task. Every property distribution in which the distributing partnership does not have a Sec. 754 election in effect and the distributee is a partner who purchased its interest or received it upon a partner’s death (regardless of when the transfer occurred) needs to be examined to determine whether the regulation applies. Even where a partnership agreement includes an explicit provision for the partnership not to make a Sec. 754 election, the distributee partner may not be exempt from the application of Sec. 732(d).
Such property distributions presumably include the deemed liquidating distribution to the transferee purchasing partner in a transaction analyzed under Situation 1 of Rev. Rul. 99-6. In Situation 1, A and B are equal partners in AB, a limited liability company that is treated as a partnership for federal income tax purposes. A sells all of its interests in AB to B for $10,000. After the sale, the business is continued by the LLC, which is owned 100% by B.
The IRS concluded that the AB partnership terminates under Sec. 708(b)(1)(A). Additionally, citing McCauslen, 45 T.C. 588 (1966), and Rev. Rul. 67-65, the IRS took an asymmetrical approach to analyzing the tax consequences to the seller and the purchaser. The IRS stated that A is treated as selling a partnership interest to B, and “for purposes of determining the tax treatment of B, the AB partnership is deemed to make a liquidating distribution of all of its assets to A and B, and following this distribution, B is treated as acquiring the assets deemed to have been distributed to A in liquidation of A’s partnership interest.” The IRS indicated that B’s basis in the assets attributable to A’s one-half interest in the partnership equals the amount of B’s purchase price for A’s partnership interest, under Sec. 1012. Additionally, B receives a new holding period for those assets, which begins on the day immediately following the date of the sale. B is also treated as receiving a liquidating distribution of partnership assets attributable to B’s presale interest in the LLC.
The ruling states that B’s basis in the assets received in the deemed liquidation of B’s partnership interest is determined under Sec. 732(b). The reference to Sec. 732(b) presumably means Sec. 732(d) must be considered as well, given that Sec. 732(d) applies for purposes of Secs. 732(a), (b), and (c).
In an analogous context, in Letter Ruling 9232022, which involved a technical termination of a partnership under Sec. 708(b)(1)(B), under the regulations then in effect, the terminated partnership was treated as distributing its assets to its two purchasing partners, C and D, in liquidation. The IRS concluded that Sec. 732(d) applied to the “deemed” liquidating distributions on a mandatory basis, provided that only the usual conditions to its application were satisfied: (1) The FMV of partnership assets was greater than 110% of their adjusted basis to X; (2) an allocation of basis under Sec. 732(c) would shift basis from nondepreciable property to depreciable property; and (3) application of Sec. 743(b) would change the basis of property “actually distributed.”
An interesting facet of Sec. 732(d) is that it does not appear on its face to prevent shifts of basis from longer-lived to shorter-lived property. In Technical Advice Memorandum 9734003, the IRS National Office concluded that if an allocation of basis under Sec. 732(c) upon the partnership’s technical termination would result in a basis shift from property not subject to an allowance for depreciation, depletion, or amortization to property that would be subject to such an allowance, then the basis adjustment rule of Sec. 732(d) would apply in determining the basis of the partnership property deemed to have been received by the distributee partner. The TAM adds, however, that the application of Sec. 732(d) is not mandatory if there is a substantial business purpose for the transaction and the effect of the Sec. 732(c) basis allocation rules is merely to shift basis from longer-lived to shorter-lived property.
Sec. 732(d) can be overlooked quite easily, and obtaining the information needed to evaluate compliance with it (e.g., information concerning the value of partnership property at the time of a prior transfer of a partnership interest) might be a challenge. Fortunately, with the 1997 amendment to Sec. 732(c), the basis shift that apparently was the focus of Sec. 732(d) may often not be present. Thus, there may in many instances be a supportable argument that the mandatory piece of Sec. 732(d) and Regs. Sec. 1.732-1(d)(4) does not apply to a particular set of facts.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.