Treatment of Ownership Changes for EIPs under Notice 2005-32

Section 833 of the American Jobs Creation Act of 2004 (AJCA) amended Secs. 704(c) (1)(C) and 743 to limit a partnerships ability to duplicate or shift losses between taxpayers with respect to losses on built-in loss (BIL) property held by the partnership. The new law accomplishes this by restricting a partnerships ability to allocate deductions and losses from BIL property and to avoid a step-down in asset basis under Sec. 754. These provisions are supposed to eliminate loss duplication via use of a partnership and apply to substantial BILs on partnership property. Notice 2005-32 addressed some of these issues.

Example 1: Partners A, B and C form Partnership ABC, each contributing $800,000. ABC uses the $2.4 million to purchase X Corp. stock. In year 2, the shares decrease in value to $1.8 million. C sells his interest to D for a fair market value (FMV) of $600,000. Ds inside basis in ABCs assets is $800,000, while his outside basis in ABC is $600,000. C would recognize a $200,000 loss on the sale.

In year 3, ABC sells the X stock for $600,000. It recognizes a $1.8 million loss and allocates $600,000 of it to D, who recognized a true economic loss of only $400,000. The $200,000 remainder was recognized by C on the sale to D. Ultimately, this loss duplication will reverse.

In year 4, ABC liquidates; A, B and D each receive $200,000 in liquidation of their ownership interests. Because A and B have $200,000 of outside basis, they recognize no capital gain, but D, whose outside basis is zero, recognizes $200,000 (the $200,000 he received in the liquidation, less his remaining zero basis in his partnership interest).

Under ACJA provisions, ABC has to adjust Ds basis in the partnership property under Sec. 754, to the amount that D paid for his ABC interest. Sec. 754 becomes mandatory when there is a substantial BIL in the partnerships assets. A BIL exists when a partnerships tax basis in its assets exceeds their FMV by more than $250,000 in aggregate. Because ABCs adjusted basis in its property ($2.4 million) exceeded the propertys FMV ($1.8 million) by more than $250,000 at the time of Cs sale to D, the Sec. 754 basis adjustment is mandatory.

Interim Guidance

Notice 2005-32 provides interim guidance on the AJCAs provisions for both regular partnerships and electing investment partnerships (EIPs). Generally, for transfers occurring after Oct. 22, 2004, if there is a substantial basis reduction under Sec. 734(d) at the time of an ownership transfer or a substantial BIL under Sec. 743 at the time of a distribution in liquidation of a partners partnership interest, the partnership has to treat the ownership change as if a Sec. 754 election had been in effect.

As evidenced by the Committee Reports, Congress was aware that many investment partnerships would incur significant administrative difficulties in making partnership-level basis adjustments in the event of a transfer of a partnership interest. Recognizing this and knowing that many investment partnerships do not currently elect to make partnership basis adjustments (even upward adjustments), Congress provided a partner-level loss limit as an alternative to the mandatory basis adjustment for transfers of ownership in EIPs. Sec. 734(d)s mandatory basis step-down rules for transfers of partnership ownership apply to both regular partnerships and EIPs. However, AJCA Section 833(b) does not treat EIPs as having a substantial BIL under Sec. 743(e) related to a redemption of a partnership interest.

Defining EIP

Under Sec. 743(e)(6), as added by AJCA Section 833(b)(4)(A), an EIP is defined as any partnership that elects to be treated as such and meets the following requirements:

1. Such partnership would be an investment company under Section 3(a)(1)(A) of the Investment Company Act of 1940 (1940 Act), but for an exemption under Section 3(c)(1) or (7) of the 1940 Act (i.e., the company holds itself out as being primarily engaged in the business of investing, reinvesting or trading in securities and meets the 1940 Acts requirements, notwithstanding the rules requiring (1) 100 minimum beneficial owners and (2) qualified purchasers).

2. Such partnership has never been engaged in a trade or business (Note: under Sec. 731(c)(3)(C)(ii), a partnership is not deemed to be engaged in a trade or business if it only undertakes activity as an investor, trader or dealer of specified investment-type assets).

3. Substantially all of the partnerships assets are held for investment.

4. At least 95% of the assets contributed to such partnership consist of money.

5. No assets contributed to the partnership had an adjusted basis in excess of FMV on contribution.

6. All the partnership interests are issued by the partnership pursuant to a private offering before the date that is 24 months after the date of the first capital contribution to the partnership.

7. The partnership agreement has substantive restrictions on each partners ability to cause redemption of the partners interest.

8. The partnership agreement provides for a term not in excess of 15 years (for EIPs in existence on June 4, 2004, the term may not exceed 20 years).

EIPs will generally include venture capital funds, buyout funds and funds of funds formed to raise capital via a private offering and to make investments during the partnerships term, with the intention of holding them for capital appreciation. Due to the stringent requirements for EIP treatment, many hedge funds will not qualify, primarily due to the fact that, generally, they have terms exceeding 15 years and issue additional units beyond 24 months.

Under the Sec. 743(e) loss disallowance rules, a partner may not claim losses, except to the extent that they exceed the loss recognized by the transferor partner. Such disallowed losses will not reduce the transferees basis in its partnership interest.

Example 2: The facts are the same as in Example 1, except that ABC elects EIP treatment. Thus, Ds allocable share of the loss on the X stock sale is recognized only to the extent that it exceeds the loss C previously claimed on transferring ownership to D. As such, D can claim only a $400,000 loss on the stock sale, which is the amount in excess of Cs $200,000 loss that C recognized on the sale. As Ds basis in his ABC interest is not reduced by the $200,000 disallowed loss, he has $200,000 of remaining basis in ABC at the end of year 3. On ABCs liquidation, D recognizes no gain or loss, because his basis in the partnership equals the amount he receives in the partnership liquidation.

  

Qualifying as an EIP

To be treated as an EIP, a partnership must attach a written statement to an original or amended return for the tax year in which the election is to be effective. The statement must include (1) the partnerships name, address and tax identification number (TIN); (2) a representation that the partnership is eligible to make the election under Sec. 743(e)(6)(A); and (3) a declaration that the partnership elects EIP treatment under Sec. 743(e). This election is effective for the year made and all subsequent years, and is revocable only with IRS consent (obtainable only through a letter ruling request). A partnership may also revoke an EIP election without official consent by filing an election under Sec. 754 to apply Secs. 734 and 743 to all partnership interest transfers, as partnerships with a Sec. 754 election in effect are not eligible for EIP treatment. The election will also terminate if the partnership fails to meet the definition of an EIP. Further, if a partnership has substantial BILs, it will be subject to the mandatory basis adjustment rules on the first ownership transfer after failing to qualify as an EIP.

Information Reporting

Notice 2005-32 also provides guidance on information reporting requirements for transfers of EIP interests. Until further guidance is provided, the transferor must notify the transferee and the EIP in writing within 30 days after the date on which the transferor receives Schedule K-1 from the EIP for the partnerships tax year in which the transfer occurred. This notice must provide (1) the name, address and TIN of both the transferee and the transferor; (2) the partnerships name; (3) the transfer date; (4) the amount of loss recognized, if any, by the transferor on the transfer, including the computation of the loss; (5) the amount of losses (if any) recognized by any prior transferors to the extent that they were subject to the disallowance under Sec. 743(e)(2) and have not been offset by prior loss disallowances; and (6) any other information needed for the transferee to calculate any losses disallowed under Sec. 743(e)(2).

If the transferor does not provide such notice to the transferee, the transferee must treat all losses allocated from the EIP as disallowed under Sec. 743(e)(2). Alternatively, if the transferee can obtain the information needed to calculate actual or maximum losses that could be disallowed, the transferee may use these calculations in determining the losses disallowed under Sec. 743(e)(2).

The notice also places information reporting burdens on the EIP. For example, losses disallowed under Sec. 743(e) are computed without regard to gains. Thus, an EIP must separately state on Schedules K and K-1 all allocations of losses to its partners, including losses that could be netted against gains at the partnership level if Sec. 743(e) had not been enacted. This requirement continues after an EIP election is terminated, if the partnership has any transferee partners subject to Sec. 743(e)(2).

Under Notice 2005-32, until further guidance is issued, to the extent losses of different character (e.g., ordinary and Sec. 1231) are allocated to a transferee and limited by Sec. 743(e)(2), a proportionate amount of each such loss must be disallowed to the transferee.

From Robert A. Velotta, CPA, MT, Cohen & Company, Ltd., Cleveland, OH