Divided Holding Periods for Partnership Interests

New Regs. Sec. 1.1223-3 provides for divided holding periods for partnership interests. These rules, effective for transfers of partnership interests and partnership distributions occurring after Sept. 20, 2000, affect the character of capital gain recognized on the sale of partnership interests and Sec. 731 distributions exceeding basis. When applicable, the regulations divide the recognized gain into long-term and short-term capital gain.

Long-term gain is determined by multiplying the percentage of a partnership interest that has been held for more than one year by the total gain. Likewise, short-term gain is determined by multiplying the percentage held for one year or less by the total gain. This bifurcation can easily occur when a partner of an existing partnership contributes a substantial amount of property to a partnership and then disposes of his partnership interest shortly thereafter.

Background

Under Sec. 1223(1) and Regs. Sec. 1.1223-1(a), a partner's holding period for his partnership interest includes the holding period of noncash capital assets or Sec. 1231 property that the partner contributed to the partnership in exchange for such interest.

In view of the long-established principle that a partner has a single basis in a partnership interest (see Rev. Rul. 84-53), there was some confusion as to how the statutory and regulatory rule applied to the sale of all or part of a partnership interest.

Holding Periods under the New Regulations

Under Regs. Sec. 1.1223-3(a), a partner has a divided holding period for his partnership interest if:

• Portions of the interest were acquired at different times; or
• Portions of the interest were acquired for property transferred at the same time, but resulted in different holding periods under Sec. 1223.

Under Regs. Sec. 1.1223-3(b)(1), the portion of a partnership interest to which a holding period relates is expressed as a fraction. The numerator is the fair market value (FMV) of the portion of the partnership interest received in the transaction to which the holding period relates. The denominator is the entire interest's FMV (immediately after the transaction).

Example: Taxpayer B contributes $10,000 cash for a portion of his partnership interest. He also contributes a building that he has held for three years. The building's adjusted basis is $15,000 and its FMV is $30,000. The interest's total FMV is $40,000 immediately after the transaction. B's holding period for one-quarter ($10,000/$40,000) of the partnership interest begins on the day after the cash is contributed. The holding period for three-quarters ($30,000/$40,000) of the interest is three years.

Special Rules for Certain Contributions and Distributions

If a partner, in the year preceding the sale of a partnership interest or the recognition of gain or loss under Sec. 731, makes one or more cash contributions to (and receives one or more cash distributions from) the partnership, he may reduce the cash contributions made during the year by cash distributions received on a last-in, first-out basis, treating all cash distributions as if they were received immediately before the transaction generating the gain or loss. This special rule normally causes more long-term capital gain recognition, because the fraction of the partnership interest related to the cash contribution is reduced. This rule applies generally only to actual cash distributions; Regs. Sec. 1.1223-3(b)(3) disregards Sec. 752 deemed cash contributions and distributions (to the same extent that they are disregarded under Regs. Sec. 1.704-1(b)(2)(iv)(c)).

Other Rules

Under Regs. Sec. 1.1223-3(d)(1), a partner's holding period for a partnership interest is not affected by partnership distributions, except for the treatment of distributions under the special rules discussed. However, if a partner has to recognize capital gain or loss on a partnership distribution, Regs. Sec. 1.1223-3(d)(2) requires such gain or loss to be divided between long- and short-term capital gain or loss. This division is in the same proportions as the long- and short-term capital gain or loss that the distributee partner would have realized if his entire partnership interest were transferred in a fully taxable transaction immediately before the distribution.

For Regs. Sec. 1.1223-3 purposes, properties and potential gain treated as Sec. 751(c) unrealized receivables are considered separate assets, not capital assets or Sec. 1231 property; see Regs. Sec. 1.1223(e).Caution: The proposed regulations' preamble concludes:

These proposed regulations do not contain a specific anti-abuse rule regarding holding periods. However, there may be situations where taxpayers will attempt to undertake abusive transactions using the rules in these regulations. For instance, taxpayers may attempt to shift gain from property with a short-term holding period to property with a long-term holding period by contributing the short-term property to a partnership and selling the partnership interest. Because the basis of a partnership interest cannot be segregated to a portion of an interest, basis in the portion of a partnership interest with a long-term holding period could reduce gain attributable to the portion of a partnership interest with a short-term holding period in situations where such interest was recently received in exchange for contributed short-term capital gain property. In appropriate situations, the IRS may attack such abusive transactions under a variety of judicial doctrines, including substance over form or step transaction, or under 1.701-2 of the regulations.

Because the final regulations are substantially the same as the proposed, this warning continues to be relevant.

From Donovan Lightbourne, MBT, Los Angeles, CA