Chapter 4 - Table of Contents
As a general rule when a partner transfers property to a partnership gain or loss is not recognized. Additionally, partners generally do not recognize gain or loss when they receive distributions from a partnership unless it is cash in excess of the outside basis.
Although the general rule aims to treat partnership distributions as nontaxable events, the exceptions can quickly overshadow the general rule. The possibility of moving property in and out of partnerships unimpeded by tax considerations creates potential for abuse. Transactions, which are essentially sales, can masquerade as tax-free distributions. To prevent income or basis shifting among partners, several provisions track property movements. It is not possible, for example, for partners to use their partnership as a device to “swap” appreciated or depreciated property among themselves. It is in these areas that examiners may find the most potential for adjustments.
This Chapter will describe:
ISSUE: BASICS –- CURRENT AND LIQUIDATING DISTRIBUTIONS
Distributions fall into two categories under IRC section 731(a)(1):
In a current distribution, the partnership is simply distributing money or property to a continuing partner. On the other hand, a liquidating distribution completely terminates the partner’s interest in the partnership. A single distribution or a series of distributions can liquidate the interest.
It is important to remember that the reporting of partnership income and the actual distribution of cash may not occur simultaneously. A partner must report his distributive share of partnership income in his taxable year in which (or with which) the partnership’s taxable year ends. That may or may not be the same year in which he or she receives a distribution of partnership profits.
As with sales of partnership interests, distributions can be complicated by the presence of IRC section 751 assets (unrealized receivables and inventory) which have ordinary income potential. Whether or not this complication must be considered depends on whether the partner receives a proportionate or disproportionate share of these assets. If the distribution does not upset the partners’ original share of the partnership’s ordinary income assets, it is a proportionate distribution and the regular distribution rules apply. If, on the other hand, a partner receives more or less than his or her share of IRC section 751 assets, the transaction will be treated as a sale or exchange. IRC section 751 must be considered for both current and liquidating distributions. The determination of a proportionate share is determined based on the fair market value of the assets instead of the bases of the assets. See the discussion later in this chapter regarding disproportionate distributions.
This section of the chapter will only consider proportionate (pro rata) distributions. These are distributions in which the partner’s share of IRC section 751 and Non-IRC section 751 assets remain unchanged after the distribution. The regular distribution rules will apply in these instances.
Proportionate Current Distributions
A current distribution is one in which the partner’s interest in the partnership continues. The following items must be considered:
Example 4-1
Mike and Lenny are partners in an investment partnership. They each have a basis in their partnership interest of $2,000. The partnership distributes $1,500 to each partner. They would each have a tax- free distribution of $1,500 and their capital accounts would be reduced to $500.
Loss is never recognized by the partner in a current distribution. IRC sections 731(a)(2) and 732(a)(1) and (2).
There is a close inter-relationship between the partner’s amount of outside basis in the partnership interest and the basis that is assigned to distributed assets. Distributions of cash and property reduce outside basis. The total amount of basis that can be assigned to property distributed is limited to the partner’s outside basis in the partnership interest prior to the distribution.
Basis of Distributed Property in Current Distributions
Generally, the basis of distributed property to the partner is the adjusted basis of the property to the partnership immediately before the distribution. Assuming that the partner has enough outside basis, property distributed will have a straight carryover basis. IRC section 732(a)(1) and (2).
The exception to this general rule occurs when the partnership’s adjusted basis in the property distributed exceeds the partner’s basis in his or her partnership interest. When this occurs, the basis in the distributed property will be limited to the partner’s adjusted basis in his or her partnership interest reduced by any money received in the same transaction. The distributee’s outside basis is allocated among the distributed items in the following order:
If cash, the relief of liabilities, or the FMV of marketable securities exceeds the partner’s outside basis, no basis will be available to allocate to either IRC section 751 assets or other property. Depending on the fair market value of the distributed assets, it is possible for a partner to have an ongoing interest in a partnership, but a zero outside basis. A liquidating distribution will always result in a zero outside basis, while a current distribution may or may not.
When the basis assigned to distributed assets (either IRC section 751 or Non-IRC section 751) is limited by the partner’s outside basis, IRC section 732(c)(3) provides a method for decreasing the bases of distributed assets. The decrease is first allocated to properties with unrealized depreciation. Any remaining decrease is allocated among properties in proportion to their respective fair market values. This method applies to distributions occurring after August 5, 1997. Prior to this date, this decrease was allocated based on the partnership’s adjusted bases in the properties.
Effect of an IRC section 754 Election – Optional Basis Adjustment
IRC section 734(a) states that the basis of undistributed property shall not be adjusted as the result of a distribution of property to a partner unless an IRC section 754 election is in effect. If an IRC section 754 election is in effect, then there shall be an increase to the adjusted basis of the undistributed properties equal to the gain recognized by the partner under IRC section 731(a) (money, relief of liabilities, and FMV of marketable securities in excess of partner’s partnership basis).
Additionally, the IRC section 734(b) adjustment will increase the bases of the partnership’s remaining properties by the amount by which the adjusted basis in the property distributed exceeds the adjusted basis of the partner’s outside basis in his or her partnership interest as described in IRC section 732(a)(2). In other words, if the partner takes more basis out of the partnership than the amount of the partner’s outside basis, IRC section 734(b) will rectify the resulting disparity between inside and outside basis. For examples of how IRC section 734(b) operates in the context of distributions, see Chapter 3.
Character and Holding Period of Distributed Property
When the distributed property is disposed of at a later date, the character of the gain or loss on disposition is governed by IRC section 735.
Example 4-2
B is a partner in ABC partnership. B received a current distribution of $90,000 cash and land with an adjusted basis to the partnership of $60,000. B’s outside adjusted basis in his partnership interest is $100,000. This was considered a pro rata distribution.
Note: There is no gain recognized because the money distributed was not in excess of the partner’s basis in his partnership interest. IRC section 731(a)(1).
What will be the distributee partner’s basis in the property received? Under IRC sections 732(a)(1) and (a)(2), it is the carryover basis in the hands of the partnership
Except: Basis cannot exceed the SMALLER of:
In this case, when applying the above formula, the land now has a basis of $10,000 in the distributee partner’s hands. The holding period tacks generally unless it is unrealized receivables or inventory. Treas. Reg. section 1.735-1(b) and IRC section 1223(2).
What if the property distributed to the partner involved either debt assumed by the partner or relief of debt to the partner? The following would result:
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IRC section 752(a) states that any debt assumed by a partner is considered a contribution of money to the partnership. A contribution of money adds to the partner’s basis in his or her partnership interest.
-
IRC section 752(b) states that any debt relieved to a partner by the partnership is considered a distribution of money. A distribution of money subtracts from the partner’s basis.
What is the effect to the partnership? None. IRC section 731(b).
Example 4-3
Same facts as Example 4-2 except what if B received $101,000 cash instead? There would be a gain recognized of $1,000 under IRC section 731(a)(1) because there was a distribution of cash in excess of the adjusted basis in the partner’s interest in the partnership. The character of the gain can be found in IRC section 731(a)(2) which states that the gain is treated as a sale of a partnership interest. A sale of a partnership interest is governed by IRC section 741 which states that the character is like the sale of a capital asset.
What is the effect to the partnership? None. IRC section 731(b).
Example 4-4
On January 1, 1995, ABC partnership distributes cash of $5 to each partner and $30 of inventory to each partner. This is considered a pro rata distribution.
Note: There would be no gain recognized by any of the partners because the cash received was not more than the outside basis of any of the partners. Partners A and B would receive the inventory with a $20 carryover basis. The carryover basis as you recall is the adjusted basis the partnership had in the asset immediately before the distribution. Partner C would be limited to the basis in his partnership interest of $15. Therefore upon later disposition, the inventory would have an adjusted basis to Partner C of $15, and to Partners A and B of $20 each.
Later: January 1, 1997 – Partner C sells the inventory for $40.
What if Partner C sells the inventory for $40 on January 1, 2001? This would be more than 5 years from the original distribution. In this case under IRC section 735(a)(2) the character of the gain would depend on the character of the asset in the hands of the seller/distributee partner. If the asset was now being held as a capital asset or a trade or business asset, it would be capital gain or IRC section 1231 gain. If the asset was still held as inventory, then it would be considered ordinary income. The holding period begins at the date of the original distribution. IRC section 1223.
Proportionate Liquidating Distributions
The treatment of proportionate liquidating distributions is similar to current distributions. Gain is only recognized if money distributed (including relief of liabilities and FMV of marketable securities) exceeds the partner’s basis in his partnership interest prior to the distribution. Additionally, the liquidating partner’s outside basis is allocated among the distributed items in the same order (money, IRC section 751 assets, and other assets).
Because the partner is exiting the partnership, a liquidating distribution will always result in a zero outside basis. Since the partner receives his share of the partnership’s value, a liquidating distribution will terminate the partner’s interest in the partnership.
Recognition of Loss
Unlike current distributions, losses can be recognized from a liquidating distribution. This can happen only if the partner receives no property other than money, unrealized receivables, or inventory. In other words, the receipt of a capital asset will prevent the recognition of loss. The amount of any loss recognized is the difference between the partner’s outside basis in his partnership interest before the distribution and the sum of money and the partnership’s adjusted basis of distributed receivables and inventory.
Example 4-5
Lee’s interest in the XYZ partnership is terminated when her outside basis is $100,000. She receives a liquidating distribution of $20,000 cash and inventory with a basis to the partnership of $70,000. She recognizes a loss of $10,000 ($100,000 partnership basis less $90,000 basis in assets received).
A loss is permitted in these types of circumstances because the basis of an IRC section 751 asset is never increased beyond the basis it had inside the partnership. Since the Code preserves the ordinary income potential of IRC section 751 assets, Lee’s remaining partnership basis in the above example cannot be assigned to the inventory distributed. Therefore, she recognizes a capital loss upon the termination of her partnership interest. IRC section 741
Allocation of Basis Among Distributed Assets
The determination of basis in the distributed property in a liquidating distribution is somewhat different than in a current distribution because the partner is exiting the partnership and will no longer have any outside basis. In a liquidating distribution, the exiting partner is said to take a substituted basis in the property distributed. Outside basis must be $0 after the distribution of property.
After the liquidating partner’s outside basis is allocated to cash and ordinary income assets, any remaining basis is allocated to other property received. The basis allocated to other distributed property can either be:
A decrease can occur in either a current or liquidating distribution. The method for allocating a decrease in basis, defined in IRC section 732(c)(3), is the same for both current and liquidating distributions of property.
An increase in the basis of other non-IRC section 751 property will occur only in the context of a liquidating distribution. The remaining outside basis is first allocated to properties with unrealized appreciation. Any remaining outside basis is then allocated among all properties in proportion to their fair market values.
The following two examples illustrate the allocation of basis in distributed assets in a liquidating distribution.
Example 4-6
AB Partnership is completely liquidating. A and B are both equal partners. The partnership distributes to A the land, one-half of the unrealized receivables, and one-half the inventory. The partnership distributes to B all of the cash, one-half of the unrealized receivables, and one-half the inventory. These are proportionate distributions because both A and B both receive their pro rata share of the FMV of IRC section 751 property upon liquidation.
Note: The ending outside bases for both A and B must be $0 because the AB Partnership is completely liquidating.
Note: If there was only one partner liquidating his or her interest from a partnership, the examiner would need to consider IRC section 736 rules relating to the retirement of a partner which is discussed in Chapter 7.
Consequences to Partner A:
Consequences to Partner B:
Upon a later disposition of the assets by A or B, IRC section 735 will apply in the same way as in Example 4-4 for current distributions. It is important to note that the regular distribution rules described in this section are the only rules followed unless there is a disproportionate distribution of IRC section 751 assets (unrealized receivables, depreciation recapture, and inventory). When this occurs the treatment of the distribution is bifurcated between sale and exchange treatment and the regular distribution rule treatment. So the regular distribution rules described in this section are still the framework of a disproportionate distribution. In a disproportionate distribution there is just a portion carved out of the regular rules and treated under sale and exchange rules.
The following example reflects the increase in assets allocated according to the unrealized appreciation in the remaining assets. Remember this occurs when the partner’s outside basis is larger than the inside basis of the partnership asset distributed in the liquidating distribution.
Example 4-7
Stewart, Rod, and Mike are equal 1/3 partners in a real estate development partnership. In complete liquidation of his interest, Stewart receives relief of liabilities of $1,000, a land lot (inventory) with a basis of $1,000, a sculpture that was in the lobby of one of the partnership’s properties, and shares of XYZ Inc., a publicly traded company. The sculpture, purchased as an investment, has a fair market value of $9,000 and a basis of $3,000 (unrealized appreciation of $6,000). The share of XYZ Inc. have a basis of $1,000 and a fair market value of $3,000 (unrealized appreciation of $2,000). Assume that the distribution is a proportionate distribution.
Initial Allocation of Basis: Stewart has an outside basis of $16,000. After it is reduced for the relief of liabilities ($1,000), the basis of the inventory ($1,000), and the carryover bases of the other properties ($3,000 for the sculpture and the $1,000 for the stock), the excess remaining basis is $10,000.
Allocation of Remaining Basis: The excess remaining basis is first allocated to reduced unrealized appreciation. Therefore, the basis of the sculpture is increased by $6,000 and the basis of the stock is increased by $2,000. The remaining excess basis of $2,000 is allocated in proportion to the fair market value of the other properties. Thus, 75 percent of the remaining basis is allocated to the sculpture ($9,000/$12,000) and 25 percent is allocated to the stock ($3,000/$12,000). Thus the basis of the sculpture in Stewart’s hands is $10,500 and the basis of the stock is $3,500.
As seen in the above example, the excess remaining basis is allocated solely to non-IRC section 751 assets. Even if the inventory (the land lot in this example) had an extremely high fair market value, its basis would not be increased.
The rules of IRC section 735 apply to liquidating distributions as well as current distributions. In Example 4-6, the distributed land lot, since it was inventory to the partnership, would carry an ordinary income taint in Stewart’s hands for 5 years following the year of distribution.
Disproportionate Distributions will be discussed in the last section of this chapter. Liquidating distributions are also discussed in Chapter 7.
The examination techniques used should serve, in the end, to answer the following:
Are there distributions reported on the Schedules K-1? The Schedule M-2 should also reflect any distributions. This will alert the examiner that there has been either a current or liquidating distribution. Does the Schedule K-1 reflect a cash distribution? If so then, cash received in excess of the partner’s basis in his partnership interest is taxable under IRC section 731(a).
What type of property has been distributed? The changes in the assets and liabilities on the balance sheet should help in this identification. If there was a disproportionate amount of IRC section 751 property distributed in the transaction, there may be a gain that must be recognized. This is true if there is a partial liquidation or a complete liquidation.
Has there been a change in ownership on the Schedule K-1? If there has then there is a potential partial liquidation or complete liquidation.
Are losses being claimed from a current distribution or in a partial liquidation to a partner? Losses are not allowed in these instances.
Are losses being claimed from a liquidating distribution when the partner still holds another interest in the partnership? All interests must be liquidated before losses may be taken. Check the Schedules K-1 for a limited and general partnership interest held by the same partner.
Are distributions under IRC section 752(b), debt relief, being considered in either a current or liquidating distribution? Debt relief is treated like money. Money received in excess of the partner’s adjusted basis in his partnership interest results in a taxable gain. IRC section 731(a).
Were marketable securities distributed? These are also treated as money received. This could also result in a taxable gain.
Issue Identification
Review the partner’s Schedule K-1 for any change in ownership, change in liabilities, and distributions of cash or property. This will alert the examiner to any potential taxable gains.
Compare the balance sheet at the beginning of the year with the end of the year. If there has been a distribution of assets, the examiner may be able to determine which category of assets was distributed.
Review the ending capital account on the Schedule K-1. If the ending capital account is zero, then a partnership interest was completely liquidated. Make sure the partner has no other interests in the partnership. All interests must be liquidated.
Request a calculation of the partner’s outside basis to determine the consequences of the distribution.
Documents to Request
Interview Questions
IRC, Subchapter K:
section 702
section 731
section 732
section 733
section 734
section 735
section 741
section 751
section 752
section 754IRC section 1223
Supporting regulation and specific regulations cited above.
RIA U.S. Tax Reporter – Income Taxes
CCH Standard Federal Tax Reporter
McKee, William S., Nelson, William F., and Whitmire, Robert L. Federal Taxation of Partnership and Partners, Boston MA: Warren Gorham & Lamont, publisher.
Cunningham, Laura E., Cunningham Noel B., The Logic of Subchapter K, A Conceptual Guide to the Taxation of Partnership
Definition
Examiners reviewing distributions from partnerships should be sensitive to the issue of disguised sales. An outflow of cash or property, which is labeled as a “distribution”, could in substance be part of a sales transaction.
Example 4-8
John contributes land with a fair market value of $150,000 and a basis of $100,000 to his partnership. In the same year, the partnership distributes $100,000 of cash and marketable securities worth $50,000 to John. John would not have contributed the land in the absence of the expected distribution. The substance of this transaction is a sale and not a tax-free contribution and distribution of property.As illustrated above, the disguised sales rules apply to situations where property – not only cash – is distributed to a partner in connection with property contribution by that partner.
IRC section 707(a)(2)(B), the disguised sales provision, was enacted as part of the Tax Reform Act of 1984. Congress believed that transactions that were the economic equivalent of sales were being treated as nontaxable contributions and distributions under IRC section 721 and IRC section 731.
IRC section 707(a)(2)(B) provides that:
The enactment of IRC section 707(a)(2)(B) and related regulations seek to clarify which contribution/distribution transactions will be viewed as substantive sales.
Identifying a Disguised Sale
Obviously not all contributions followed by distributions are disguised sales. Whether or not the transaction is a disguised sale or a legitimate contribution/distribution depends on all the facts and circumstances. Care should be given to fully develop all aspects of the case.
The regulations finalized in 1992 under IRC section 707(a) provide a two-part test for determining when a transaction should be recharacterized as a sale.
Two-Part Test:
Thus, for a simultaneous transfer, there is really only one condition. The examiner is faced with analyzing whether or not the money or property transferred to the partner would have happened regardless of the partner’s contribution. Additionally, in analyzing non-simultaneous transfers, the examiner is faced with documenting the nature of the business and the level of risk connected with whether or not the partner would be “paid”.
It is also possible that the contribution/distribution transaction should be recharacterized as a partial sale and partial contribution.
Example 4-9
Kelly, a scientist, contributes a patent he developed to XYZ Pharmaceutical Partnership in exchange for a partnership interest. At the time of the contribution, Kelly could have sold the patent to XYZ for $5 million. Kelly has a $1 million adjusted basis in the patent. On the date of the contribution, XYZ distributes $2 million to Kelly. The distribution was agreed to in advance.
Result:
In the above example, the gain could not be properly calculated without knowing the fair market value of the patent. In such situations, the examiner would make an engineering referral.
Ten Factors
Fortunately, the regulations list ten primary but non-exclusive factors that should be considered in determining whether or not there was a sale:
Treas. Reg. section 1.707-3(b)(2).
Two Year Presumption
The timing of the potentially related contribution and distribution is critical. The regulations describe two presumptions to be considered:
Presumptions
In sum, the examiner is to determine if the partner’s contribution was placed at the risk of the venture or if the contributing partner was “cashing out”. Of course, the partnership could be the party “cashing out” by distributing property to the partner in exchange for payment disguised as a contribution.
Exceptions to the Two-Year Presumption: “Normal Distributions”
Certain types of distributions or payments are presumed not to be part of a disguised sale even though occurring within a 2 years of a contribution. To protect “normal” periodic partnership distributions from falling within the scope of IRC section 707(a)(2)(B), the following types of payments do not trigger the two-year presumption:
Liabilities
As explained in Chapter 3, when a partner’s share of partnership liabilities decreases, it is considered to be a deemed distribution of money. A partner who contributes mortgaged property will have such a distribution when the other partners pick up a share of the contributed liability.
Any liabilities that are not considered qualified liabilities may constitute the proceeds of a disguised sale. A qualified liability is one that is not incurred “in anticipation of the transfer”. On the other hand, a nonqualified liability is one which was incurred in anticipation of transferring the property to the partnership and is a device used by the partner to “cash out” his investment in the contributed property. The portion of the nonqualified liability shifted from the contributing partner to the other partners constitutes payment for a disguised sale.
Qualified Liabilities
There is a conclusive presumption that a liability is qualified if it was incurred more than 2 years prior to the transfer of the property to the partnership. These liabilities are thought to be “old and cold” and outside the scope of the disguised sales rules. Conceivably, with planning and foresight, a taxpayer could create a “legal” disguised sale. Treasury has, at any rate, concluded that these types of liabilities were probably not incurred in anticipation of the transfer of the property to a partnership.
If a liability was incurred within 2 years of the transfer, it could still be considered to be qualified depending on the use of the proceeds of the debt. First, if the proceeds were used to acquire or improve the contributed property, the liability is still qualified. This is because the contributing partner has used the loan proceeds to increase his or her investment rather than cashing out. Second, if the liability is incurred in the ordinary course of the business and substantially all of the business assets are contributed to the partnership, the liability is still qualified. This rule addresses trade payable and other liabilities whose purpose is not to cash out the contributing partner’s interest in the property.
Nonqualified Liabilities
A nonqualified liability is fully subject to the disguised sales rules. If a liability was incurred less than 2 years before transferring the property, it is presumed to be a nonqualified unless the facts and circumstances indicate that it was not incurred in anticipation of the transfer.
Under the disguised sales rules, the contributing partner is treated as having an amount realized equal to the amount that was shifted away to other partners under IRC section 752(b). This is the excess of the total liability contributed over the contributing partner’s remaining share of the liability post-contribution. Thus, to determine the amount realized, it is necessary to apply the rules under 752 to determine the post-contribution debt share.
In the case of recourse liabilities, the normal rules under IRC section 752 apply. For non-recourse liabilities, the first two tiers listed in 1.752-3 are ignored and only the third tier, excess non-recourse liabilities are taken into consideration. Excess non-recourse liabilities are generally shared based on profit sharing. Thus, for determining the amount realized under IRC section 707(a)(2)(B), a partner’s share of non-recourse debt is computed in the same manner as “excess recourse liabilities,” that is, based on profit share.
Disguised Sales of Partnership Interests
Although the previous discussion has focused on disguised sales of property, a contribution and related distribution could also pertain to the disguised sale of a partnership interest.
Disclosure Requirements
For certain transfers that are presumed to be sales, the partnership and the partners must comply with the disclosure requirements found in Treas. Reg. section 1.707 8.
Scrutinize any distributions of cash or property from the partnership, separating “normal distributions” per Treas. Reg. section 1.704-1
Inspect previous years’ tax returns and Schedules K-1 for evidence of a contribution from the same partner who received a distribution
Review the partnership agreement, amendments, and any correspondence pertaining to the contribution and the distribution
Document the timing of the contribution and distribution
Issue Identification
Does the Schedule K-1 or the Schedule M-2 reflect a contribution or a distribution? If it does then request what property was contributed or distributed? All factors will need to be considered if there was a disguised sale.
If there was a contribution or a distribution, were there liabilities involved? Determine if they were nonqualified liabilities that would result in a disguised sale.
Review the 10 factors to consider if there is a disguised sale present. Be prepared to ask questions according to these factors to develop the facts and circumstances surrounding any contribution and subsequent distribution.
Documents to Request
Interview Questions
Interview questions should be designed to answer the following questions:
What was the business purpose for the contribution and distribution?
IRC, Subchapter K: 707(a)(2)(B)
Supporting regulation and specific regulations cited above including the following:
General Rules Treas. Reg. section 1.707-3
“Normal” Distributions Treas. Reg. section 1.707-4
Special Rules for Liabilities Treas. Reg. section 1.707-5
Sales by Partnership to Partner Treas. Reg. section 1.707-6Note: Final regulations apply to transactions occurring after April 24, 1991.
Otey v. Commissioner, 70 TC 312 (1970), Jupiter Corporation v. United States, Park Realty Co. v. Commissioner, and Communications Satellite Corporation v. United States. Prior to the enactment of 707(a)(2)(B), IRS unsuccessfully attempted to recharacterize transactions as disguised sales.
Goudas v. Commissioner, T.C. Memo 1996-555, aff’d, 137 F.3d 368 (6th Cir. 1998), the taxpayer was a 25 percent partner in the Pecaris Partnership which owned a shopping mall. The taxpayer formed Coastal Investments Partnership in which he was a 90 percent partner. The Pecaris Partnership sold the shopping mall to Coastal Investments and reported the transaction as a sale. The taxpayer did not report his 25 percent distributive share of the gain on his individual return. Instead, he characterized the transaction as a nontaxable distribution of a 25 percent undivided interest in the mall followed by a nontaxable contribution of the 25 percent interest to Coastal.
The taxpayer did not inform the other Pecaris partners of his 90 percent interest in the purchasing partnership. Neither the Pecaris tax return nor the partnership agreement reflected a distribution of an interest in the mall to the taxpayer. The court refused to recharacterize the taxpayer’s share of the gain as a nontaxable distribution of an interest in the mall.
ISSUE: DISTRIBUTIONS OF PROPERTY WITH BUILT-IN GAIN OR LOSS
In certain situations, distributions of IRC section 704(c) property to a noncontributing partner will cause the partner who contributed the property to recognize gain. As explained in Chapter 3, section 704(c) property is property that had a built-in gain or loss at the time of its contribution to the partnership.
Under IRC section 704(c), gain or loss inherent in contributed property must be allocated back to the contributing partner when the property is sold, or over time as depreciation or amortization deductions are allocated away from the contributing partner. Prior to October 3, 1989, IRC section 704(c) could be circumvented simply by distributing the section 704(c) property rather than selling it. Therefore, Congress established IRC section 704(c)(1)(B) to eliminate the inconsistent treatment between sales and distributions of section 704(c) property.
Distribution Treated as a Sale
If section 704(c) property is distributed within a 7 year period to any partner other than the contributing partner, IRC section 704(c)(1)(B) treats the distribution as if it were a sale taking place on the date of the distribution. This forces the contributing partner to recognize any gain that was inherent in the property at the time of its contribution to the partnership and alters the inside basis of the property prior to its distribution. Others partners are not affected by the deemed sale.
Example 4-10
Biotech Corporation and Giant Pharmaceuticals Inc. form a partnership on January 1, 1999. Biotech contributes a patent for Drug X which has a basis of $2 million and a FMV of $10 million. Giant Pharmaceuticals Inc. contributes its own stock, which has a value of $20 million. On January 15, 1999, the patent is distributed to Giant Pharmaceuticals.
In the above example, Biotech has in substance exchanged its patent for an undivided 50 percent interest in a partnership. Note that the disguised sales rules under IRC section 707 would not apply in this case because Biotech did not receive a distribution. Nonetheless, it essentially sold its patent for $10 million of Giant Pharmaceutical stock.
IRC section 704(c)(1)(B) prevents partners from engaging in swaps through a partnership that would not qualify for section 1031 like-kind treatment outside the partnership. In this case, the distribution of the patent would be treated as a sale and Biotech would realize gain of $8 million. Biotech’s capital account would be increased by $8 million and the partnership would also increase its basis in the patent by that amount. Thus, Giant Pharmaceutical’s basis in the distributed patent would be $10 million under IRC section 732 and not $2 million.
By triggering gain recognition to Biotech, IRC section 704(c)(1)(B) has not only prevented income shifting from Biotech to Giant (the gain that had accrued on the patent in Biotech’s hands), but also the deferral of gain. If IRC section 704(c)(1)(B) were not in effect, Giant could manufacture Drug X under the patent indefinitely, and the gain might never be taxed, in spite of the fact that Biotech closed out its economic position in the patent.
Seven Year Period
It is important to bear in mind that the provision only applies to distributions made within the 7 year period, which is the 7 years following the contribution of the built-in gain or loss property. With this in mind, the examiner must be especially sensitive to considering and documenting the origins of distributed property. The original partnership agreement and its amendments are critical in determining what property was contributed.
The time period, which was originally five years, was extended to seven years for property contributed to a partnership after June 8, 1997.
Calculation of Gain or Loss
The gain or loss allocated to the contributing partner is the same amount that would be allocated under IRC section 704(c)(1)(A) and Treas. Reg. section 1.704-3 had the partnership sold the property to the distributee partner for its fair market value on the date of the property’s distribution. Thus, the contributing partner will recognize the lesser of:
Example 4-11
Chris contributes north land lot and south land lot to an equal partnership formed with Diane. Both land lots have a basis of $40 and a fair market value of $100. Diane contributes $200 cash. Both land lots are IRC section 704(c) property because they each have a built-in gain of $60. The partnership uses the cash to subdivide the lots.
After 3 years, when it is worth $150, the north land lot is distributed to Diane. Chris, the contributing partner must recognize the lesser of:
Thus, Chris would recognize a $60 gain upon the distribution. The gain would increase both her outside basis and the inside basis of the north land lot just prior to its distribution. Thus, Diane's basis in the land would be $100.
Example 4-12
Same facts as the above example, except that on the date of distribution the north land lot has a fair market value of $60. The hypothetical sale would therefore produce a tax gain of $20 (sales price of $60 less adjusted tax basis of $40) and a book loss of $40 (sales price of $60 less book basis of $100).
Under the Methods described Chapter 3, the following would result:
Exception for Like-Kind Exchanges
Since the aim of the provision is to prevent a partner from closing out an economic position in contributed property without recognizing gain, it makes sense that an exception should apply for situations that would qualify for the like-kind exchange rules. If, within a certain time period of distributing the IRC section 704(c) property, the partnership also distributes like-kind property to the contributing partner, the contributing partner will be treated as having engaged in an IRC section 1031 exchange and not a sale. The amount of gain or loss that the contributing partner would normally recognize under IRC section 704(c)(1)(B) is reduced by the amount of built-in gain or loss in the distributed like-kind property.
De Minimis Rule
A partnership may disregard the application of IRC section 704(c) if the fair market value of the contributed property does not differ from the tax basis by more than 15 percent of the adjusted tax basis, and the total gross disparity does not exceed $20,000. Treas. Reg. section 1.704-3(e).
Anti-Abuse Rule
An anti-abuse rule is found in Treas. Reg. section 1.704-4(f). It states that if a principal purpose of a transaction is to achieve a tax result that is inconsistent with the purpose of IRC section 704(c)(1)(B), the Commissioner can recast the transaction for federal income tax purposes. This prevents the contributing partner from closing out his or her economic position in the distributed property prior to the end of the 7 year period, but before the distribution actually takes place.
In Example One in Treas. Reg. section 1.704-4(f)(2), the partners amend the partnership agreement during the 7 year period and “take steps to provide that substantially all of the economic risks and benefits” of the contributed property are borne by the future distributee partner. Thus, before the actual distribution, the future distributee essentially owns the property. In such a situation, IRC section 704(c)(1)(B) would call for the contributing partner to recognize gain on the date that the economic risks and benefits of the contributed property are transferred to the future distributee.
To ensure consistent application, examiners should involve one of the national Partnership Technical Advisors before proposing an adjustment based on the anti-abuse rule in Treas. Reg. section 1.704-4(f).
Determine if there has been a distribution of property to a partner. Request a schedule of contributions that have been made by the partners in the last 7 years. If the distributed property is IRC section 704(c) built-in gain property then ensure that the contributing partner has recognized the inherent gain in the property. This rule applies only if the property has been distributed to a different partner than the original contributing partner. If this property is being distributed back to the partner that originally contributed it, then this rule does not apply.
Issue Identification
Scrutinize the Partnership Schedule M-2 and the Schedules K-1 for any distributions during the partnership year.
Review prior year’s partnership returns and Schedules K-1. If there was IRC section 704(c) depreciable property present then the Schedules K-1 and the M-1 should reflect a special allocation of the depreciation using one of the methods described in Chapter 3 relating to IRC section 704(c) principles. This will alert the examiner to the fact that IRC section 704(c) property does exist within the partnership.
Documents to Request