New Partnership Basis Rules

The IRS issued final regulations in December 1999, which, among other things, change the way taxpayers account for the difference between their outside bases in their partnership interests and their proportionate share of the partnership's inside basis of its assets. These differences occur when a partner dies and the basis of that interest is stepped up to its fair market value (FMV), or when a partner sells or exchanges an interest to either another partner or an outside third party. In certain circumstances, distributions of partnership property can also cause these differences.

A three-step process must be followed to protect partners from the adverse tax consequences that result when differences arise between inside and outside bases:

1. Partnerships must make a valid Sec. 754 election to adjust the inside basis of partnership property.

2. They must calculate an adjustment to reconcile inside and outside bases differences. Sec. 743(b) provides the mechanism to calculate this adjustment when a sale of an interest or partner's death occurs, and Sec. 734 when a property distribution causes the adjustment.

3. The adjustment calculated in the second step must be allocated to partnership assets under Sec. 755.

Sec. 754 Elections

A partnership, not individual partners, makes this election on a timely filed return (including extensions) for the adjustment year. Once made, this election is applicable to all subsequent years and future transactions, unless the partnership can obtain the Service's permission to revoke it. An election cannot be used to step up the basis of partnership assets in the first year, and then ignored in the second year when a step-down is required. Ordinarily, permission to revoke an election is difficult to obtain and is granted only when there is a significant change to partnership operations.

Regs. Sec. 1.754-1 provides taxpayers with a short window of opportunity in which to revoke a current Sec. 754 election. It can be accomplished by attaching a statement to the partnership's return for the year that includes Dec. 15, 1999. This revocation only applies to transfers or distributions occurring after Dec. 14, 1999. The IRS feels that, due to the significant changes made, it is appropriate to grant taxpayers a one-time revocation (see Regs. Sec. 1.754-1(c)(2) for details).

Sec. 743(b) Basis Adjustments

The major difference under the new regulations is in the calculation and allocation of the basis adjustment. Generally, the old rules allocated overall increases in basis only to assets whose FMVs exceeded their tax bases. Assets that declined in value were not be adjusted. Inversely, negative overall adjustments were allocated only to assets whose FMVs fell below their bases; appreciated assets were left untouched. Sometimes, this resulted in an overall distortion of the character of gains and losses to a partner over the life of the partnership. Under new Regs. Sec. 1.743-1, all assets are adjusted (both up and down) to reduce the difference between their tax bases and their FMVs, regardless of overall adjustments being positive or negative.

An overall adjustment is calculated using the formula provided in Regs. Sec. 1.743-1. A partnership increases its property's adjusted basis when a positive result occurs, and decreases it when there is a negative result. The transferee's basis in the acquired partnership interest, less the transferee's share of the adjusted basis to the partnership's property, equals the net Sec. 743(b) adjustment.

A transferee's basis in the acquired interest is defined as the amount of cash or other property paid to obtain the partnership interest plus partnership liabilities assumed by the transferee partner. A transferee's share of the partnership's adjusted basis in its assets is defined as the cash a partner would receive in a liquidating distribution, assuming all of the partnership assets were sold for their FMVs in a hypothetical taxable transaction. This amount is then increased by tax loss or decreased by the tax gain allocated to that partner, plus the transferee's share of partnership liabilities.

Example 1: A and B form Partnership AB, with each partner having an equal interest in partnership profits and capital. A contributes $20,000 in cash, while B contributes marketable securities with a $20,000 FMV and a $5,000 tax basis. AB incurs $10,000 of debt and uses $15,000 cash to purchase $25,000 of inventory. After the first year of operations, partnership revenues and expenses are equal, while the marketable securities appreciate in value to $31,000 and inventory depreciates to $24,000. T wishes to acquire B's interest and pays $25,000 cash at the end of the first year.

	Adjusted basis	FMV
Assets:
Cash	$  5,000	$  5,000
Inventory	25,000	24,000
Marketable securities	5,000	31,000
Total assets	$35,000	$60,000
Liabilities and capital:
Note payable	$10,000	$10,000
Capital-A	20,000	25,000
Capital-B	5,000	25,000
Total liabilities and capital	$35,000	$60,000

The basis adjustment made under Sec. 743(b) in Example 1 would be as follows:

T's basis in the acquired partnership interest:
Amount paid to B	$ 25,000
Plus: T's share of partnership liabilities	5,000
Total			$30,000
T's share of the adjusted basis to the partnership's property:
Amount of cash received on liquidation after hypothetical sale	$ 25,000
Plus: T's share of loss on sale of inventory	500
Less: T's share of gain on disposition of marketable securities	0
T's share of Sec. 704(c) gain from B's original contributionof appreciated property ($20,000 – $5,000)	(15,000)
T's share of appreciation on marketable securities held by the partnership ($31,000 – $20,000)/ 2	(5,500)
Plus: T's share of partnership liabilities	5,000
T's share of basis in partnership property			$10,000
Net Sec. 743(b) adjustment			$20,000

   

Allocation of Sec. 743(b) Basis Adjustments under Sec. 755

Once the total adjustment has been calculated, Regs. Sec. 1.743-1(e) requires an allocation of the adjustment to each of the partnership's assets under Sec. 755. This allocation is a two-step process, the first of which requires the partnership to characterize each of its assets as either capital and Sec. 1231(b) property or other (ordinary income) property. At this point, the major changes made by the current rules come to light. Under the former rules, positive adjustments could only be allocated to a class of property if the FMV of that class exceeded the partnership's basis in those assets. A Sec. 743(b) negative adjustment could only be allocated if the assets' value depreciated in that particular class.

The partnership calculates the basis adjustment to its ordinary income property by deeming a hypothetical sale of all its ordinary assets at their FMV, generating a taxable gain or loss. This gain or loss is the total adjustment allocated to the ordinary income class of property and is subtracted from the total adjustment to derive the amount allocated to the capital gain property.

Example 2: The facts are the same as in Example 1.

T's acquired partnership interest:

T's share of ordinary income assets actually depreciated in value, resulting in a hypothetical allocation of loss and a negative basis adjustment equal to $500. This negative amount is then subtracted from the $20,000 total adjustment, to arrive at a $20,500 positive allocation to the capital assets. Under the former regulations, $20,000 of the positive adjustment would have been allocated to marketable securities, because the Sec. 743(b) adjustment is positive. The partnership would not make any basis adjustment to its ordinary income assets.

Finally, an analysis of each class of property is made and each individual asset receives a basis adjustment. This allocation is based on the hypothetical gain or loss to be allocated to the transferee partner on the sale of each asset. Adjustments will be made both upward and downward. For example, if the capital-gain class had appreciated in total, but one of the assets within that class had depreciated, the depreciated asset would receive a negative adjustment. Under the former regulations, positive adjustments would only affect assets within the class that had appreciated in value. No adjustment would be made to the depreciated assets. In the examples, this is an easy process, because each class has only one asset. The inventory would receive a negative basis adjustment of $500 and the marketable securities a positive adjustment of $20,500.

In most situations, partners purchase interests for an amount slightly different from their FMVs.

Example 3: The basic facts are the same as in Example 1, except that, in addition to the securities, AB owns vacant land held for investment and T's share of the FMV and tax basis of the land are $20,000 and $15,000 respectively.

Capital assets	Adjusted basis		FMV
Marketable securities	$ 5,000		$25,500
Land	15,000		20,000
Total	$20,000		$45,500

Although the total hypothetical gain on these facts is $25,500, the total positive Sec. 743(b) adjustment allocable to the capital assets is $20,000. The adjustment would be allocated as follows:

Sec. 734(b) Basis Adjustments

Two types of distributions can trigger a Sec. 734(b) basis adjustment:

1. Liquidating or nonliquidating distributions that cause a partner to recognize income or loss or

2. Partnership property distributions, with a basis to the partner receiving the distribution different from the basis in the property held by the partnership.

The first type of distribution occurs, for example, when a partner, with an outside basis of $10,000 receives a $15,000 cash distribution. The partner receiving the cash must recognize $5,000 of income. In this case, the partnership may be entitled to step up the basis of its assets by $5,000. The second distribution occurs when a partner having a $10,000 basis receives a distribution of land with an FMV of $20,000 and a basis to the partnership of $15,000. In this instance, the basis in the land to the receiving partner would be limited to the $10,000 of outside basis immediately prior to the distribution. Again, the partnership may be entitled to step up the basis of its assets by $5,000, the difference between the basis in the land held by the partnership and the basis in the land held by the receiving partner ($15,000 – $10,000).

Similar to the rules under Sec. 743(b), the calculation of basis adjustments under Sec. 734(b) is a three-step process. First, the partnership must make a valid Sec. 754 election. Next, the total basis adjustment must be calculated under Sec. 734(b). Finally, the total adjustment calculated in the second step must be allocated to the partnership's individual assets under Sec. 755.

Allocation of Sec. 734(b) Basis Adjustments under Sec. 755

The method of allocating Sec. 734(b) adjustments depends on the event causing the adjustment. Regs. Sec. 1.755-1(c)(1)(i) requires that adjustments due to the distribution of partnership property, whose basis in the distributee partner's hands is different from the basis in the partnership's hands, must be allocated to remaining partnership property "of a character similar to that of the distributed property." If the partnership makes a capital asset distribution, it must adjust the basis of capital gain property remaining in the partnership. If the partnership distributes its only asset of a particular class (either ordinary or capital), it retains no similar property to which an adjustment can be made. Therefore, the adjustment must be carried forward until a similar asset is obtained. A partnership can make a negative adjustment only to the extent of its remaining basis in assets of a similar character. For example, a partnership distributes a capital asset resulting in a $5,000 negative Sec. 734(b) adjustment. The only remaining capital asset of the partnership is vacant land with a $2,000 basis. Under this scenario, the partnership reduces its basis in the land to zero and carries forward the $3,000 adjustment until it acquires another capital asset.

Example 4: A, B and C form equal partnership P. A and B each contribute $6,000, while C contributes $3,000 and marketable security R, with a $1,500 basis and a $3,000 FMV. P uses the cash to acquire a parcel of vacant land for $10,000 and marketable security N for $5,000. After five years, P's balance sheet is as follows:

At the end of the fifth year, P distributes N to C in complete liquidation of C's P interest. C's basis in his interest is $4,500 ($3,000 + $1,500 basis of R). Sec. 732 requires C's basis in N to be $4,500. Because the basis of this security to the partnership immediately before the distribution is $5,000, the basis of the undistributed capital gain property remaining in the partnership must be increased by $500. The total Sec. 734(b) adjustment must then be allocated to the remaining capital assets, in proportion to the amount of each asset's unrealized appreciation.

R has unrealized appreciation of $3,500 ($5,000 – $1,500), and the land has appreciated by $5,000 ($15,000 – $10,000), for a total unrealized appreciation in remaining partnership capital assets of $8,500.

The positive adjustment is allocated as follows:

If a Sec. 734(b) adjustment is caused by the recognition of gain by a partner, Regs. Sec. 1.755-1(c)(1)(ii) mandates that the adjustment is allocated only to capital gain property. However, once the total adjustment has been calculated, the allocation to partnership assets is identical to that Example 4.

Sec. 755 Prop. and Temp. Regs.

Prop. Regs. Sec. 1.755-2 and Temp. Regs. Sec. 1.755-2T were issued to coordinate Sec. 755 with the rules and residual allocation method contained in Sec. 1060. When the basis of a transferee partner's partnership interest exceeds its proportionate share of the FMV of all other partnership property, this excess must be allocated to goodwill. (A full explanation is beyond the scope of this discussion.)

Summary

Numerous factual situations require the application of the new regulations to arrive at a solution to a particular transaction. Although more complex, these regulations resolve some of the problems that existed under the former rules.

From Thomas Jurewicz, Rehman Robson P.C., Jackson, MI