Each partner has separate
capital accounts that
represent the equity that
the partner has in the
partnership. It relates
back to a basic concept:
Assets – Liabilities = Equity.
The partners’ share of
equity is the amount that
would be received if the
partnership was liquidated
and all of the assets were
sold at their book value,
all liabilities paid, and
the net proceeds
distributed. As the
partnership carries on the
trade or business, these
capital accounts will change
depending on the agreement
between the partners as to
how they will share in the
profits and losses. The
capital accounts should
reflect the economic
arrangement between the
partners.
Many partnerships allocate
their income, losses, and
deductions on a
straightforward pro rata
basis, but some partnerships
make special allocations.
In cases where special
allocations are made, it may
be important for the
partnership to gain access
to the safe harbor provided
in Treas. Reg. section
1.704-1(b)(2). One of the
safe harbor provisions is
that the partnership must
maintain its capital
accounts in accordance with
the capital account
maintenance rules found in
Treas. Reg. section
1.704-1(b)(2)(iv). A
partnership does not have to
maintain book capital
accounts in this manner.
However, if special
allocations are made, there
is a higher risk that upon
audit these allocations will
not be respected. The
partnership agreement is
critical to determine how
the accounts are being
maintained. See Chapter 6
for a detailed explanation
of IRC section 704(b).
When safe harbor rules are
followed the book capital
accounts will be maintained
using FMV (fair market
value) of assets contributed
net of liabilities. It is
important to understand the
relationship between the
financial accounting of the
books and records, book
capital accounts, and the
Form 1065 balance sheet.
The partnership books and
records may be kept using
various methods, such as
GAAP; however, they should
be stated at FMV. The book
capital accounts and the
Form 1065 balance sheet
should state the assets at
FMV (net of liabilities) as
of the date of contribution
by the partner. The FMV of
partnership assets may, over
the passage of time, reflect
a different amount than the
partnership books and
records at the date of
contribution due to the
appreciation or depreciation
in assets. Few partnerships
will obtain appraisals on a
constant basis to keep the
books and records at FMV.
When this occurs, the Form
1065 balance sheet, the
books and records, and the
book capital accounts will
now reflect partnership
assets at what is called
“book value.” This is the
historical cost which
reflects the FMV at the date
of contribution and the cost
to the partnership of
property purchased during
the course of their trade or
business. FMV becomes a
different value. At this
point in time, the book
capital accounts, the
partnership books and
records, and the Form 1065
balance sheet will all
reflect the “book value.”
The Form 1065 M-2 and Line J
on the Schedule K-1 should
reflect book capital
accounts at FMV or in
subsequent years “book
value.”
What examiners may see in
the field is that many times
the books will be maintained
on the tax capital account
basis which will reflect the
A/B (adjusted basis) of the
assets contributed instead
of FMV. Because the tax
capital account reflects the
A/B, there is a close
relationship to a partner’s
outside basis for tax
purposes which is discussed
below. It will be necessary
for the examiner to find out
which accounting method is
being used on the balance
sheet and Schedule K 1. For
the remainder of the
discussion, the balance
sheet and Schedules K-1 will
be considered kept according
to book capital accounts
that reflect FMV at the date
of contribution. Keep in
mind that the tax capital
accounts play a very
important role in accounting
for taxable gains. For
example, the tax capital
accounts are used to resolve
the book/tax disparities
discussed later in the
chapter. The computations
below reflect the difference
between the book capital
account and the tax capital
account basis.
FMV of asset or cash
contributed -Liability on asset
assumed by the Partnership
= Initial Book Capital
Account Balance
Then Partnership Operations
are taken into account
during the year.
Beginning Capital Account
Balance
+ Additional Cash and
Property (at FMV)
Contributed by Partner
+Allocations of Partnership
Income or Gain
+Allocations of Partnership
tax exempt income
-Cash distributed to the
partner
-FMV of property distributed
to partner net of
liabilities secured by the
property
-Allocations of
nondeductible partnership
expenses -Allocations of
partnership losses and
deductions = Book Capital Account
Balance at the End of the
Year
This should be
reflected on the tax return
balance sheet and Line J on
the Schedule K-1. This can
be a negative figure because
the liabilities are not
included here.
A/B of asset or cash
contributed
-Liabilities on asset
assumed by the Partner +Gain Recognized by the
Partner (if any) on
Contributed Property
= Beginning Tax Capital
Account
Then Partnership Operations
are taken into account
during the year.
Beginning Tax Capital
Account Balance
+ Additional Cash and
Property (at A/B)
Contributed by Partner
+Allocations of Partnership
Income or Gain
+Allocations of Partnership
tax exempt income
-Cash distributed to the
partner
-A/B of property distributed
to partner net of
liabilities secured by the
property
-Allocations of
nondeductible partnership
expenses -Allocations of
partnership losses and
deductions = Tax Capital Account
Balance at the End of the
Year
The tax capital account
balance at the end of the
year can also result in a
negative figure because
liabilities are not included
here, either.
How Do Book Capital
Accounts Compare To Tax
Capital Accounts?
Book capital
accounts
reflect the
FMV of the
property at
the date of
contribution
and tax
capital
accounts
reflect the
adjusted
basis of the
property at
the date of
contribution.
Book capital
accounts
reflect the
FMV of the
property at
the date of
distributions
and tax
capital
accounts
reflect the
adjusted
basis of the
property at
the date of
distribution.
Book capital
accounts and
tax capital
accounts do
not include
liabilities
of the
partnership.
They are
reflected
net of
liabilities.
Book capital
accounts and
tax capital
accounts may
both reflect
a negative
balance.
Note: It is
important to
keep in mind
that outside
basis, which
will be
discussed
later in
this
chapter, can
not have a
negative
balance.
Outside
basis
includes
liabilities.
Also, see
Chapter 5 -
Loss
Limitations.
Outside basis
is found in IRC section 722
and is the individual
partner’s adjusted basis in
his or her partnership
interest. In general, a
partner’s outside basis is
his or her separate
tax capital
account, which reflects
adjusted basis, plus
his or her share of the
partnership’s debt.
Since both of these elements
are quite involved, they
will be discussed
separately. The discussion
of determining a partner’s
debt share is discussed
later in this chapter.
Initially, outside basis is
determined by including the
amount of the adjusted basis
in the property contributed
plus any cash contributed by
the partner. If
there are liabilities,
outside basis includes the
partner’s share of all
liabilities assumed.
In subsequent years, the
outside basis is increased
and decreased by partnership
operations.
Outside basis is maintained
by each individual partner
outside of the partnership
books. Outside basis is the
computation that most
examiners are concerned with
because it is the basis that
the taxpayer uses to limit
losses, determine the
taxability of partnership
distributions, and compute
gain/loss on the disposition
of their partnership
interest. Outside basis is
calculated at the end of the
partnership tax year.
The following is the
computation of a partner’s
outside basis based on IRC
section 722 and IRC section
705(a).
A/B in asset or cash
contributed by the partner
- Liabilities of the partner
assumed by the Partnership
+ Liabilities of the
Partnership assumed by the
partner
= Basis
+ Any Gain recognized by the
Partner on the Contribution
of Assets to
the Partnership, See
contributions, below.
= Beginning Tax Basis
Then partnership operations
during the year.
+ Taxable Income
+ Tax exempt Income
+ Excess percentage of
depletion
- Distributions from the
Partnership of Cash or
property
- Partnership expenditures
that are neither deductible
or capitalized by the
partnership
-Oil and Gas Depletion,
computed at the partner’s
level
-Losses
= Ending Tax Basis at
year-end
This cannot be a
negative balance. If it is,
then losses must be carried
forward to a subsequent year.
See Chapter 5 for a
discussion on loss
limitations.
Note:
Outside basis is increased
by syndication costs paid at
the partner level. IRC
section 709(a)
The purpose of
outside tax basis
is to keep track of the
partner’s adjusted basis in
his or her partnership
interest. It is the
partner’s after tax
investment. It is also used
to determine gain or loss on
the sale or other
disposition of a partnership
interest.
In general, to the extent
that the partner withdraws
his or her after tax
investment in the
partnership, there is no
gain or loss, it merely
reduces the outside basis by
the amount of the
withdrawal. However, some
exceptions to this general
rule include:
If
a partner receives a
distribution of cash
in excess of his or
her outside basis,
then the partner
must report a gain
for the excess. IRC
section 731(a)(1).
Reduction of
liabilities is
considered a deemed
cash distribution.
IRC section 752(b).
If
the partner receives
a distribution of
property in which
the adjusted basis
to the partnership
(inside basis in the
property) is more
than the partner’s
outside basis in his
or her partnership
interest, then the
property takes a
substituted basis
equal to the outside
basis amount. The
gain is deferred
until the partner
later disposes of
the property outside
of the partnership.
IRC section
732(a)(2). In
addition, the
partner's outside
basis is reduced to
zero.
If
a partnership
interest is disposed
of and the partner
receives more or
less than his or her
after tax investment
in the partnership,
he or she will
report a gain or
loss, respectively.
IRC section
731(a)(1) and (2)
and IRC section 741.
If the partnership attempts
to allocate more losses to a
partner than the partner’s
outside basis, these losses
will be suspended until a
subsequent year when the
partner’s basis increases
due to contributions,
income, gains, etc. This
follows the rule that
outside basis may never be
reduced below zero. IRC
section 704(d), IRC section
705(a)(2) and IRC section
733. (See Chapter 5
regarding loss limitations.)
As discussed earlier, book
capital accounts can be
negative and there still may
be sufficient outside basis
to take distributions,
losses, etc. This is
because outside basis
includes the partner’s share
of partnership liabilities,
while book capital accounts
are reflected net of
liabilities. This is an
important distinction to
keep in mind.
The Schedule K-1 does not
compute the outside basis.
However, a quick test for
outside basis can be done by
adding the ending capital
account and the liabilities
reflected on the Schedule
K-1. This should result in
a positive figure. The
results may be distorted
when the tax return reflects
the book capital accounts at
FMV because of the
difference in the FMV and
adjusted basis. If the tax
return is prepared using the
tax capital account basis,
which is reflected at
adjusted basis, then it is
easier to make a better
“best guess” estimate
because outside basis is
also based on adjusted
basis. If the results are a
negative figure then there
is a potential outside basis
problem.
Partnership’s inside basis
is found in IRC section 723
and is the partnership’s tax
basis in its assets. For
tax purposes a partnership
takes a carryover basis in
contributed property equal
to the contributing
partners’ adjusted bases in
the property at the time of
the contribution.
Qualifying contributions are
discussed later in the
chapter. Inside basis is
the aggregate adjusted bases
of all property contributed
by all partners.
There is a close
relationship between inside
and outside basis. They
both reflect the adjusted
basis of assets versus the
FMV. However, outside basis
deals with each partner’s
interest in partnership
assets they contributed and
inside basis deals with all
partners’ interests in
partnership assets
aggregated together. It is
logical then that the sum of
the partnership’s inside
basis in all of its assets
should equal the aggregate
of all partners’ outside
bases at formation.
Example 2-1
Facts: PRS partnership
is formed. P
contributes land with a
basis of $100. R
contributes a building
with a basis of $200. S
contributes $200 cash.
P’s outside basis is
$100. R’s outside basis
is $200. S’s outside
basis is $200. PRS has
an inside basis in the
partnership assets of
$500 ($100 in the land,
$200 in the building,
and $200 in cash). The
total of all partners’
outside bases is $500,
also.
After formation,
subsequent transactions
may change this
equality. These may
include:
Acquisition of a
partnership
interest at the
FMV
Death of a
partner causing
a basis
adjustment to
FMV
Property
(including cash)
is distributed
and the outside
tax basis does
not equal the
partnership’s
basis in the
property.
These situations all
cause differences
between inside and
outside basis. An
election under IRC
section 754 for an
optional basis
adjustment will
alleviate these
discrepancies. This
election will be
discussed later.
The examination techniques
used should serve, in the
end, to answer the
following:
Does the Form 1065
balance sheet on
Schedule L reconcile
to the partnership
books and records?
Does it reflect FMV
or adjusted basis?
Is
the taxpayer
maintaining book
capital accounts
according to the
safe harbor rules
under the
substantial economic
effect test in the
704 regulations?
(See Chapter 6.)
Does it appear from
a quick review of
the Schedules K-1
that the partners
have bases in their
partnership
interests?
Does it appear from
the Schedule M-2 and
Schedule K that
there have been
distributions of
cash in excess of a
partner’s basis? If
so, then gain must
be recognized for
the excess.
Does it appear from
the Schedule M-2 and
Schedule K that
there was a property
distribution? If
there was, then was
there sufficient
outside basis to
reduce it by the
full amount of the
adjusted basis of
the partnership
asset? If not and a
substituted basis
was used, then was
the property later
disposed of and the
correct amount of
gain reported on the
partner’s return?
If there was a
potential loss from
the disposition,
then was it disposed
of to a related
party? If it was,
then the loss rules
under IRC section
267 apply and it
must be deferred
until the related
party disposes of
the property to an
unrelated party.
Ask the taxpayer if the
Balance sheet is reflected
at FMV or A/B. The
preparers sometimes refer to
the balance sheet using A/B
as the “Balance Sheet on the
Tax Basis.” Many times this
will be the situation
because it easier to keep
their records in this
manner. This will be useful
in applying the “best guess”
test on the Schedule K-1 for
basis. If the A/B is used
then it is easier for the
taxpayer and the examiners
to estimate outside basis.
If FMV is used then the
“quick test" for basis on
the Schedule K-1 is not as
accurate because the FMV
will be either higher or
lower than cost and this
will distort what the
outside basis may be at
first glance.
If the partnership has
audited financial
statements, then it is more
likely that the tax return
balance sheet will be
reflected at FMV due to GAAP
considerations. Audited
financial statements are
required in many instances
by a provision in the
partnership agreement, or
when there are SBA loans,
HUD loans, or other
regulatory requirements.
Request a basis calculation,
if it appears that there is
insufficient basis for
losses, distributions, etc.
Request a copy of the
partnership agreement. It
includes essential
information for the
operations of the
partnership from the
beginning formation to a
potential sale/liquidation
of an interest. It is your
road map for the partnership
books and tax return. If
the partnership is
maintaining capital accounts
according to the safe harbor
rules under IRC section
704(b), it will be reflected
in this document. Request
any amendments to the
partnership agreement,
also. The partners’
percentage of profit sharing
and loss sharing ratios will
be reflected here, as well
as the ownership in capital.
Match the beginning and
ending capital accounts on
Line J of the Schedule K-1
with the partnership balance
sheet. All Schedules K-1
should be added together to
arrive at the total
partnership capital accounts
on the balance sheet. If
they do not match then
request the taxpayer to
reconcile them to the
Schedules K-1.
Reconcile the balance sheet
on Schedule L to the
Partnership accounting
records.
Match the beginning of the
tax year figures to the
prior year return’s end of
the year figures. If it
does not match request an
explanation.
Review the Schedule M-1 to
ensure that it reconciles
the partnership income per
the accounting records with
the income or loss shown on
line 1 on the tax return.
Request explanations
regarding any unusual
items. Normally the
difference between book
depreciation and tax
depreciation will be entered
here. Also, as discussed
below any IRC section 704(c)
depreciation allocations
should be reflected here.
If not, why not?
Review the Schedule M-2 to
ensure it reflects the
changes in the partnership
capital accounts. The
Schedule M-2 would reflect
the amount of cash or the
net FMV of property
contributed during the
year. It is also increased
for the allocation of
partnership income,
including tax-exempt income
or gain. It is decreased
for any cash distributed to
a partner. Remember that
cash distributed in excess
of outside basis is a
taxable gain. IRC section
731(a). It is also
decreased for the net FMV of
property distributed. It is
also decreased by the
allocations to the partner
of partnership expenses that
cannot be deducted or
capitalized and any
partnership losses and
deductions.
Reconcile the partner’s
share of items on Schedule K
with the partner’s Schedule
K-1. This is also required
for administrative purposes
such as PCS controls and
linkage.
Partnership Books
and Records (that
is, working trial
balance,
depreciation
schedules, income
statements, balance
sheets, general
ledger, etc.)
Prior and Subsequent
year partnership tax
returns
Current year
financial statements
Partnership Book
Capital Account
Calculations
Partner Basis
Calculations (if the
quick test reveals
lack of basis)
Copies of all Loan
Documents including,
but not limited to,
Promissory Notes,
Deeds of Trust,
Mortgages, Loan
Payment Histories,
Loan Guarantees,
and/or Loan
Indemnification
Agreements.
Calculations of
adjusted basis in
property contributed
Proof of ownership
by the partnership
in property
contributed
Is
the Balance sheet on
the Form 1065
reflected at FMV or
at A/B?
Is
the partnership
maintaining book
capital accounts in
accordance with IRC
section 704(b)
regulations?
Does the partnership
maintain book
capital account
workpapers?
Does the Schedule
M-2 reflects the
book capital
accounts?
Have there been any
distributions in the
current year?
Were the assets
reflected on the
balance sheet on the
Form 1065
contributed by the
partners or
purchased by the
partnership?
Were there any
subsequent events
that occurred that
would cause the
inside and outside
basis to not equal?
If so, was there an
IRC section 754
election made?
Supporting regulations and
specific regulations cited
above.
Revenue Ruling 66-94, 1966-1
C.B. 166 – In determining
the basis in a partnership
interest under IRC section
705(a) distributions will be
taken in account before
losses of the partnership.
IRC section 721 states that
the contribution of property
to the partnership in
exchange for a partnership
interest is generally a
nontaxable transaction to
the contributing partner and
the partnership. This
applies to both
contributions at the time of
formation of the partnership
and upon subsequent
contributions. The
partnership’s basis in the
contributed property (inside
basis) is equal to the
contributing partner’s
adjusted basis. IRC section
723. The contributing
partner’s adjusted basis in
its partnership interest is
increased by the adjusted
basis in the contributed
property. IRC section 722.
The holding period of the
partnership includes the
contributing partner's
holding period. IRC section
1223.
To receive non-recognition
treatment there must be an
exchange of property for a
partnership interest. It
includes a very broad range
of assets, including
intangibles, however, it is
important to note that
services are not considered
qualifying property. See
below for a short discussion
on the contribution of
services.
Non-recognition treatment
applies only to
contributions of property.
Transactions that are in
substance a sale or exchange
of property do not qualify.
See Chapter 4 for a
discussion of disguised
sales.
If property is contributed
that has a FMV different
than its adjusted basis,
then it is considered to
have a pre-contribution
built-in gain or loss and is
referred to as 704(c)
property. At the time of
contribution there will
usually be no gain or loss
recognized by the
contributing partner or the
partnership, but this
pre-contribution built-in
gain or loss in the property
will be allocated to the
contributing partner at a
later date. This gain or
loss is recognized when the
property is disposed of, or
if it is depreciable
property, through yearly
depreciation allocations.
As a result of this delayed
recognition, the book
capital accounts will
reflect FMV and the tax
capital accounts will
reflect A/B. This creates a
book/tax disparity. This
disparity must be accounted
for. See a short discussion
later relating to book/tax
differences and the methods
to account for these
differences.
The examiner must be alert
to contributions of IRC
section 704(c) property and
any subsequent events that
may trigger a taxable event
such as a disposition. It
is important to keep in mind
when dealing with IRC
section 704(c) property
there is potential for
disguised sales and “mixing
bowl” transactions that may
trigger immediate
recognition of IRC section
704(c) gain under IRC
section 704(c)(1)(B) and IRC
section 737. See Chapter 4
for this discussion.
When a partner contributes
property subject to a
liability to a partnership,
two transactions are deemed
to occur at the same time.
Rev. Rul. 87-120, 1987-2
C.B. 161
Each partner is
considered to make a
cash contribution
equal to the
partner’s share of
the liabilities
assumed by the
partnership.
Each contributing
partner is
considered to
receive a cash
distribution equal
to the entire
liability assumed by
the partnership.
Non-recognition treatment
under IRC section 721 may
not apply if property is
contributed that is
encumbered with debt. If
the contributing partner of
the encumbered property is
relieved of more liabilities
than there is basis in his
or her partnership interest,
then the contributing
partner will recognize a
gain. This is considered a
deemed cash distribution
under IRC section 752(b) and
is considered cash
distributed in excess of the
partner’s basis in the
partnership under IRC
section 731(a).
In general, depreciation
recapture is not recognized
on contributions of
depreciable property.
However, the agent may want
to consider the depreciation
recapture rules as they
relate to the contribution
of depreciable encumbered
property when a gain is
recognized by a contributing
partner. Treas. Reg.
section 1.1245-4(c)(4),
Examples 2 and 3.
Note: If
the liability is
non-recourse it is highly
unlikely that there will be
gain recognized because the
operation of the
non-recourse debt allocation
rules. To determine if the
liability has been correctly
allocated for this purpose,
see the discussion below on
liabilities. Also, see
Chapter 6.
Non-recognition treatment is
allowed in most cases for
the contribution of
unrealized receivables from
a cash basis partner to a
cash basis partnership. The
assignment of income
principles apply to these
type of transactions. The
income collected from the
receivables is always
recognized as ordinary and
allocated to the
contributing partner under
IRC section 704(c) to the
extent that the FMV exceeds
the basis at the time of
contribution.
Non-recognition treatment is
allowed for the contribution
of inventory. If property
that is considered inventory
in the contributor’s hands
immediately before the
contribution is disposed of
within 5 years of the
contribution date, any gain
or loss by the partnership
is characterized as ordinary
income and is allocated to
the contributing partner.
IRC section 724(b) and IRC
section 704(c). Even
outside the 5 years, the
built-in gain is allocated
back to the contributing
partner.
In general, the partner who
contributes services for a
capital interest recognizes
ordinary income equal to the
FMV of the partnership
interest received. See IRC
section 83, Treas. Reg.
1.721-1(b), Lehman v.
Commissioner, 19 T.C. 659
(1953), and Revenue
Procedure 93-27, 1993-2 CB
343 for guidance. The
contribution of services for
a profits interest may
result in different
consequences. There are
various nuances to the
contribution of services for
a capital or profits
interest. See Chapter 11
for a discussion of this
topic.
The contribution of a
partner’s own promissory
note may cause concern. It
does not increase the
partner’s tax basis and the
partnership also acquires no
tax basis in the note at the
time of contribution.
However, as payments are
made by the partner on the
note it will constitute
contributions for the amount
actually paid. Rev. Rul.
80-235, 1980-2 C.B. 229
Generally, contributions
made to an investment
partnership do not qualify
for non-recognition
treatment. Under IRC
section 721(b) gain (not
loss) must be recognized on
these contributions. A
partnership is considered an
investment partnership when
more than 80 percent of the
value of the assets are
stocks and securities held
for investment. The theory
behind this is that the
partner has achieved
diversification and has
essentially sold his
investments for other
investments. These are
called swap funds. The
character of the gain is
determined by the nature of
the property in the
contributing partner’s hands
immediately before the
contribution. Treas. Reg.
section 1.351-1(c)(1).
The examination techniques
used should serve, in the
end, to answer the
following:
Was
there a subsequent
event that would
trigger a taxable
gain or loss to the
contributing partner
on the
pre-contribution
gain or loss in IRC
section 704(c)
property? See
Chapter 4.
When the partner
contributes
encumbered property
is the partner
relieved of more
liabilities than the
adjusted basis in
his or her
partnership
interest? This
triggers a deemed
cash distribution to
the partner under
IRC section 752(b)
and a taxable gain
under IRC section
731(a).
Were services
contributed to the
partnership for a
profits interest or
a capital interest?
A determination
between these types
of exchanges of
interest must be
made to determine if
there was a taxable
transaction.
(IRC section 3).
See Chapter 2.
Were contributions
made to a
partnership that
holds mostly stocks
and securities?
This may trigger
gain on
contribution. IRC
section 721(b).
Was
a promissory note
contributed to the
partnership? The
contributing partner
receives basis as
payments are made.
Issue Identification
Determine if there was IRC
section 704(c) property
contributed to the
partnership. The book
capital accounts and the tax
capital accounts should
reflect a different value
for the contributed
property. The examiner may
look to the outside basis
computation, if it is more
readily available, for the
adjusted basis in the
asset. The examiner should
verify the adjusted basis
and the FMV of contributed
property.
Review subsequent
transactions to determine if
the pre-contribution gain or
loss should be recognized.
It may be missing from a
subsequent balance sheet or
the Schedule M-2 may notate
a distribution of property
to a partner. This could be
a distribution of the IRC
section 704(c) property to
another partner or the
distribution of other
property to the contributing
partner of the original IRC
section 704(c) property.
There may be a disposition,
a disguised sale, or a
“mixing bowl” type of
transaction that will all
trigger gain recognition.
Also, if the property was
depreciable property, the
separately stated
depreciation deduction will
not be present in subsequent
Schedules K-1.
Review other types of
contributions into the
partnership. Be aware that
if Unrealized Receivables
and Accounts Payable are
contributed by a cash basis
taxpayer to the accrual
basis partnership, that when
the partnership collects the
receivables and pays the
payables, the ordinary
income and deduction are
allocated to the
contributing partner.
Accounts payable, under
these circumstances, are not
considered liabilities for
purposes of IRC section
752. Accounts payable
contributed by an accrual
basis taxpayer is considered
a liability for purposes of
IRC section 752.
Request all of the
information regarding the
contribution of services to
the partnership at formation
for both a profits interest
and a capital interest so a
determination can be made if
this is a taxable
transaction.
Review the balance sheet for
the type of assets held by
the partnership. If the
partnership holds assets
that are mostly stocks and
securities, then gain may be
recognized on the
contributions. Losses are
not recognized.
Request the valuation method
and appraisal for any
property contributed to the
partnership. The valuation
method used should be
documented. If a third
party appraisal was not
done, consider if you need
to request the services of
an IRS engineer to determine
the FMV of the property at
the time of contribution.
Request a copy of any
promissory note contributed
by a partner.
Prior and subsequent
year partnership tax
returns.
Was
any property
contributed subject
to a liability? Was
it depreciable
property? What
method of
depreciation? How
much depreciation
was previously
claimed?
Copies of all Loan
Documents including,
but not limited to,
Promissory Notes,
Deeds of Trust,
Mortgages, Loan
Payment Histories,
Loan Guarantees,
and/or Loan
Indemnification
Agreements.
Appraisals and
valuations for
contributed
property.
Partnership
correspondence and
management
agreements
discussing
contribution of
services.
Outside basis
computations.
Invoices and
billings as they
relate to unrealized
receivables and
payables.
Interview Questions
What type of
property was
contributed to the
partnership?
How
was the value the
property determined
at the time of the
contribution? Was
an appraisal
performed?
Was
there a significant
difference in
adjusted basis and
FMV at the time of
the contribution of
the property to the
partnership?
Was
any of the
contributed property
subsequently
distributed to
another partner?
Were services
contributed for a
profits interest or
a capital interest?
Did
any partner
contribute his or
her own promissory
note?
Were any unrealized
receivables or
payables contributed
to the partnership?
Supporting regulations and
specific regulations cited
above.
Revenue Ruling 87-120,
1987-2 C.B. 161 – Increases
and decreases in partnership
liabilities occurring upon
distribution of encumbered
property are treated as
occurring simultaneously for
purposes of determining gain
or loss to partners.
Revenue Ruling 80-235,
1980-2 C.B. 229 – A
contribution of a partner’s
written obligation, his or
her personal note, to the
partnership does not
increase the basis of the
partner’s interest under IRC
section 722 because the
partner has a zero basis in
the written obligation.
Revenue Procedure 93-27,
1993-2 C.B. 343 – This
procedure provides guidance
on the treatment of the
receipt of a partnership
profits interest for
services provided to or for
the benefit of the
partnership.
Lehman v
Commissioner, 19
T.C. 659 (1953) – Under the
partnership agreement, the
Lehmans became entitled at
the end of the partnership
year to credits totaling
$10,000 on the partnership
books, this sum to be
debited from the other
partners’ capital accounts.
The tax court stated that
this was ordinary income.
It was the same as though
the other partners had paid
them $10,000 in cash to be
placed in their capital
accounts.
A partner’s outside basis is
made up of his tax capital
account which reflects the
adjusted basis of assets
contributed and his or her
share of the partnership’s
liabilities. Determining a
partner’s debt share is
critical to determining his
or her basis in his
partnership interest.
First the examiner needs to
determine if a liability
actually exists. Revenue
Ruling 88-77 discusses the
definition of a partnership
liability. In general, if
the liability provides basis
in a partnership asset or
gives rise to a current
partnership deduction, then
it is a partnership
liability. Once it is
determined that a liability
exists then IRC section 752
applies.
IRC section 752 is
structured to keep a close
correlation between inside
and outside basis. If
deductions are funded by
partnership debt within the
partnership, then IRC
section 752 increases the
outside basis to allow the
partners the benefit of the
deduction. In this way it
could be said that
“liabilities follow the
losses and the deductions.”
Losses and deductions are
essentially funded either by
the partner’s own capital
contributions or by borrowed
funds. When a partnership
borrows money with which to
purchase assets or pay for
operating expenses IRC
section 752 considers it to
be the same as if the
partners had contributed the
money to the partnership.
This principle is based on a
landmark Supreme Court case,
Crane v.
Commissioner, 331
U.S. 1, 67 S.Ct. 1047
(1947). The taxpayer
borrowed funds to acquire an
asset. The court stated
that the taxpayer was
entitled to basis in the
asset immediately. The
taxpayer did not have to
repay the debt currently to
obtain outside basis as long
as it could be reasonably
expected that the taxpayer
would repay the loan in the
future.
There are two ways to repay
a loan:
The
partner can
contribute cash to
repay the loan, or
The
partnership is
profitable and
repays the loan
These two ways reflect a
relationship between
recourse and non-recourse
debt. The question is, if a
loan defaults, who bears the
ultimate economic risk of
loss and has the
responsibility to repay the
loan? It is determined by
the nature of the debt.
In determining the partner’s
share of the partnership
debt, it is critical to
identify the nature of the
debt.
A recourse debt
is one in which the creditor
can pursue the partners. If
the partnership is not
profitable and does not make
payments on the loan, then
the partners are required to
take cash
out of their pocket to repay
the loan. They will either
have to make a contribution
to the partnership or repay
the loan directly. The
partners
who are responsible to repay
the debt bear the economic
risk of loss. These are
usually the general partners
who are jointly and
severally liable for
partnership debt.
If a limited or general
partner guarantees the
recourse debt, there would
be no special allocation of
debt to that partner’s basis
because the guaranteeing
partner could still pursue
the general partners for
reimbursement. This holds
true unless the guarantor
waives all rights of
subrogation, and then the
liability may be allocated
to that partner. There
should be written
documentation to
substantiate this.
In general, we ultimately
look to the partners’ loss
sharing ratios to allocate
the recourse liabilities.
The partner’s share of
recourse liabilities are
reflected on Line F under
“other” on the Schedule K-1.
A non-recourse debt
is one in which the property
may be the only security for
the loan, therefore the
creditor cannot pursue the
partners, individually. In
this case, the creditor can
only hope for the
partnership to be
profitable so the
debt will be repaid. The
creditor
bears the economic risk of
loss. None of the partners
bear the economic risk of
loss. If the partnership is
not profitable and cannot
repay the loan, then the
partners are not obligated
to take cash out of their
pocket to repay the loan.
If a limited or general
partner guarantees the
non-recourse debt or makes a
direct loan to the
partnership, they would
ultimately be economically
at-risk because there would
be no chance of
reimbursement by the other
partners. This is barring
any side agreement with
another partner for
reimbursement. The
liability would be allocated
in its entirety, for outside
basis purposes, to the
partner guaranteeing the
loan.
In general, we ultimately
look to the partners’
profits sharing ratios to
share in the non-recourse
liabilities. The partner’s
share of non-recourse
liabilities are reflected on
Line F under “Non-recourse”
on the Schedule K-1. The
partner’s share of
non-recourse loan guarantees
and any non-recourse direct
loans by the partner to the
partnership should be
reflected on Line F under
“other” on the Schedule
K-1. Also, included on Line
F on the Schedule K-1 is
Qualified Non-recourse
Financing. This is
discussed in Chapter 5 on
At-Risk Limitations.
The
partnership agreement
will contain the profit
and loss sharing
ratios. Remember that
the ratios must have
substantial economic
effect under IRC section
704(b). IRC section
704(b) may override the
partnership agreement.
(See Chapter 6 for
details on IRC section
704(b)).
Whether the debt is
recourse or non-recourse
determines which of the
two different avenues
that the examiner must
take through the
regulations.
Recourse Liabilities
– Repayment by Contributions.
The regulations lead the
examiner through a
“hypothetical constructive
liquidation” to determine a
partner’s risk of loss.
Treas. Reg. section
1.752-2(b)(1).
Constructive Liquidation –
All of the following are
deemed to happen.
All
partnership
liabilities become
due and payable in
full.
All
of the partnership
assets are worth $0.
All
of the partnership
assets are sold for
$0 with a loss
recognized to the
extent of the entire
basis in each asset.
All
items of income,
gain, loss, or
deduction are
allocated under the
partnership
agreement to
partners according
to their loss
sharing arrangement
which must have
substantial economic
effect under the IRC
section 704
regulations. The
allocation of loss
reduces the capital
accounts and results
in negative capital
accounts which
represents the
partner's risk of
loss. This is the
amount of recourse
debt that is added
to their outside
basis.
Evaluate the
partners’
contribution
obligations based on
their resulting
capital account
balances.
General Partnership
Situation - A and B are
general partners and
share in profits and
losses equally. They
each initially
contribute $20 of cash.
The partnership
purchases a tract of
land for $200. It uses
the $40 for a down
payment and finances
$160 with recourse debt.
Limited Partner
Situation - A is a
General Partner and B is
a limited partner. A
contributes initially
$10 and B contributes
$90. The partnership
purchases a tract of
land for $1000. It
makes a down payment of
$100 and finances $900
with recourse debt. B
is not obligated to
contribute any further
to the partnership,
general partner A, or
the creditors.
* Under Treas. Reg.
section 1.704-1(b)(2)
there must be
substantial economic
effect which ties to IRC
section 752. IRC
section 704 overrides
the partnership
agreement. So B only
has basis in the initial
contribution of $90.
If
B had been obligated
to restore $100
beyond his
contribution per the
partnership
agreement, then $100
more of the losses
would be allocated
to B’s outside
basis. B’s outside
basis would increase
to $190 and A’s
outside basis would
decrease to $810.
If
B had assumed the
liability and will
pay the entire
amount when it comes
due, then Treas.
Reg. section
1.752-1(d)(3) states
that 3 conditions
must be met. The
assumption is tied
to Treas. Reg.
section
1.704-1(b)(2)(iv)(c).
The 3 conditions are
the following:
B must be
personally
liable.
Creditor
must know of
B’s
assumption
and can
enforce it.
There is no
reimbursement
to anyone –
Important!
There should be a
separate side agreement
for the assumption.
Non-recourse
Liabilities – Repayment by
Profits. When a
creditor is limited to
repayment only through the
property securing the debt
and cannot pursue A or B,
then no partner bears the
economic risk of loss. The
creditor is the only one
that bears the economic risk
of loss and could lose money
upon default of the loan.
Since the creditor cannot
look to the partners, then
profits of the partnership
must repay the loan.
Under former Treas. Reg.
section 1.752-1(e), a
partner’s share of
non-recourse debt was based
purely on the partners’
profit sharing ratios. The
rationale was that only
partnership profits would be
used to repay the debt. The
regulations were revised to
describe three different
categories or layers of debt
allocation that must be used
in allocating the
partnership’s non-recourse
debt to the partners.
Final Treas. Reg. section
1.752-3 (Effective October
31, 2000), Revenue Ruling
92-97, and Revenue Ruling
95-41 discuss 3 layers that
must be applied in order to
allocate the non-recourse
debt to basis properly.
These 3 layers are as
follows:
Partner’s share of
IRC section 704(b)
partnership minimum
gain
Partner’s share of
IRC section 704 (c)
minimum gain
Partner’s share of
excess non-recourse
debt – The partner
is allocated any
excess non-recourse
liabilities not
allocated to layers
1 and 2 under one of
several methods that
the partnership may
choose. They may
choose to allocate
with the partner’s
share of partnership
profits per the
partnership
agreement or
allocate based on
certain reasonably
expected
deductions.
Additionally, per
the final
regulations, the
partnership may
first allocate an
excess non-recourse
liability to a
partner up to the
amount of the
built-in gain that
is allocable to the
partner on IRC
section 704(c)
property or property
for which reverse
section 704(c)
applies, where such
property is subject
to the non-recourse
liability to the
extent that such
built-in gain
exceeds the gain
described in layer 2
with respect to such
property. This
additional method
does not apply for
purposes of Treas.
Reg. section
1.707-5(a)(2)(ii)
and does not apply
to any liability
incurred or assumed
by a partnership
prior to October,
31, 2000. To the
extent that a
partnership uses
this additional
method and the
entire amount of the
excess non-recourse
liability is not
allocated to the
contributing
partner, the
partnership must
allocate the
remaining amount of
the excess
non-recourse
liability under one
of the other methods
described in the
regulations for the
third layer. Final
Treas. Reg. section
1.752-3(c), Example
3, describes in
detail how this
method applies.
What is IRC section
704(b) partnership minimum
gain? It is the
amount of gain that would be
recognized if the
partnership disposed of the
property in full
satisfaction of the
non-recourse liability and
for no other consideration.
Refer to Treas. Reg. section
1.752-3, Example 1.
What is IRC section
704(c) minimum gain?
It is the amount of gain
that would be recognized if
the partnership disposed of
IRC section 704(c)
appreciated property in full
satisfaction of the debt and
for no other consideration
(Non-recourse liability on
the contributed property
over the adjusted basis in
that property). Refer to
Treas. Reg. section 1.752-3,
Example 1.
What are excess
non-recourse liabilities?
These are all non-recourse
liabilities not accounted
for in layers 1 and 2. The
allocations are determined
in accordance with the
partners’ share of
partnership profits that may
be allocated differently per
the partnership agreement
for layer 3. This happens
because there may be special
allocations for non-recourse
deductions (that is,
depreciation) that are
allocated to one particular
partner. The corresponding
non-recourse liability must
be allocated to that
particular partner to allow
outside basis to take the
deduction. If these types
of allocations are made they
must have substantial
economic effect under IRC
section 704(b). If they do
not, then the non-recourse
liabilities should be
allocated by the profits
interest in effect for other
items per the partnership
agreement or allocated up to
the amount of the built-in
gain that is allocable to
the partner of IRC section
704(c) property or reverse
IRC section 704(c)
allocations that exceed
layer 2 gain. Refer to
Treas. Reg. section
1.752-3(c), Examples 2 and
3.
The allocation of excess
non-recourse liabilities can
change every year so
examiners need to request
the partnership agreement
and any amendments. If the
partnership agreement is
silent in this area then the
profits interest ratios
should be used per the
Schedules K-1.
If
any partner
guarantees the loan
then this will
override the
non-recourse
liability scenario
and it will be
considered a
recourse liability
in which the partner
would bear the
economic risk of
loss and the new
recourse liability
would be allocated
to that partner
on
