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:: Partnership - Audit Technique Guide - Chapter 7 - Dispositions of Partnership Interest (12-2002)   Chapter 7 - Table of Contents Introduction Issue: Sale or Exchange of a Partnership Interest Calculation of Gain or Loss       Characterization of Gain or Loss       Additional Filing Requirements       Exchanges of Partnership Interest       Examination Techniques        Supporting Law         Resources          Issue:  Liquidation of a Partner’s Interest in the Partnership     Examination Techniques        Supporting Law         Resources          Issue:  Retirement or Death of a Partner       Pre-TRA ’97         Post TRA ‘ 97         Examination Techniques       Supporting Law        Resources        Issue:  Gift or Contribution of a Partnership Interest     Gifting of a Partnership Interest      Gifts of a Partnership Interest Encumbered by Debt    Gifts of a Partnership Interest Not Encumbered by Debt   Effect on Passive Losses      Contribution of a Partnership Interest to a Charitable Organization  Examination Techniques       Supporting Law        Resources        Issue:  Abandonment of a Partnership Interest     Examination Techniques       Supporting Law        Resources    back to the top INTRODUCTION A partner can dispose of a partnership interest in the following ways: By sale to one or more of the other partners. By sale to a third party. By exchange of the partnership interest for other property. By transfer back to the partnership in return for at least one liquidating distribution leading to a complete liquidation of the partnership interest. By retirement. By gift or contribution. By death. By surrendering the partnership interest through abandonment, forfeiture, or worthlessness of the partnership interest. Each of the above methods for disposing of a partnership interest is covered in this chapter. This chapter also addresses: The character of the gain or loss on the disposition of a partnership interest. The effect of related debt disposition. The recognition of accumulated suspended passive losses associated with a partnership interest. ISSUE:  SALE OR EXCHANGE OF A PARTNERSHIP INTEREST Under subchapter K, the rules for the disposition of a partnership interest follow the entity theory of partnership taxation.  All determining factors of the disposition (for example, basis, holding period, and character of the gain or loss) are considered with respect to the partnership interest without reference (except for IRC section 751 assets) to the underlying assets of the partnership.[1] IRC section 741.  Recognition and character of gain or loss on sale or exchange In the case of a sale or exchange of a partnership interest, gain or loss shall be recognized by the transferring partner.  Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in IRC section 751 (relating to unrealized receivables and inventory items which have appreciated substantially in value).  However, the substantially appreciated requirement under IRC section 751(a), relating to the sale or exchange of a partnership interest, has been repealed by the TRA ‘97 (Refer to 1997 TRA for effective dates), therefore, disregard that requirement. back to the top Calculation of Gain or Loss The gain or loss from the disposition of a partnership interest is the difference between the amount realized and the partner’s adjusted basis (outside basis) in the interest immediately before the disposition.  Although the formula for calculating gain or loss is simply stated, addressing each component in detail is essential. The amount realized consists of cash plus the fair market value of property received plus the selling partner’s share of partnership liabilities assumed by the buyer (IRC section 752(b)). The adjusted basis of the partnership interest begins with the original partnership basis as determined under IRC sections 722 or 742, relating to the original acquisition of the partnership interest.  It is increased by those items specified in IRC sections 705(a)(1) and 752(a) and decreased by those specified in IRC sections 705(a)(2) and 752(b).  At the time of the sale or exchange, IRC section 752(d) treats the selling partner’s share of partnership liabilities in the amount realized in much the same way as IRC section 752(b) treats a deemed distribution. Because the transferring partner’s basis in the partnership must be determined as of the date of disposition, any adjustments to basis must also include the transferring partner’s share of partnership income or losses from the beginning of the partnership year to the date the partner ceases to be a partner. Characterization of Gain or Loss In conjunction with the determination of any gain or loss to be recognized by the disposing partner, in the presence of IRC section 751 assets, a separate calculation will be required to determine the portion of the transaction to be considered capital and the portion to be treated as ordinary.  When the sale of the partnership interest includes both cold assets (capital assets) and hot assets (assets with built in ordinary income potential), the sale is said to be bifurcated (split) into two components, capital gains and losses from the cold assets, and ordinary gains and losses from the hot assets. Further complications arise when a single asset has both hot and cold asset attributes subject to the recapture provisions of IRC section 751(c).  IRC section 751(c) treats the amount to be recaptured as an unrealized receivable.  Upon the sale of a partnership interest, recapture will generate ordinary income even though depreciable assets are capital assets (Treas. Reg. section 1.751-1(c)(4)).  The ordinary income component of the gain is computed first.  Any remaining amount of the gain is capital.[2] The disposing partner’s ordinary gain or loss is the difference between the amount realized attributable to IRC section 751 assets less the partnership’s adjusted basis associated with these items. The sale of a partnership interest resulting in a gain can be reported under the installment method under IRC section 453 if at least one payment is received after the year of sale.  A sale resulting in a loss cannot be reported under the installment method (IRC section 453(a)). Additional Filing Requirements Generally, IRC section 6050K requires that a Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, must be filed for each sale or exchange of a partnership interest which contains IRC section 751 property.  (The Forms 8308 are to be filed as an attachment to the partnership's Form 1065.)  The penalty for the partnership's failure to file Form 8308 is governed by IRC section 6721.  There is generally a $50 penalty imposed for each infraction or violation.[3] IRC section 706(c)(2)(A) provides that the taxable year of a partnership shall close with respect to a partner whose entire interest in the partnership terminates.  Additionally, IRC section 708(b)(1)(B) generally provides for the taxable year of the partnership to close if there has been a sale or exchange of 50 percent or more of the total interest in partnership capital and profits within a 12-month period. Exchanges of Partnership Interest There are many ways to exchange partnership interests.  The most common ways are to: Exchange an interest in one partnership for an interest in another partnership. Exchange a limited partnership interest for a general partnership interest in the same partnership. Exchange a partnership interest for a direct ownership right to all or part of a partnership asset. Exchange a partnership interest for a member interest in a successor LLC or LLP. Exchange of a partnership interest for corporate stock while incorporation of the partnership. The exchange of a partnership interest in one partnership for an interest in another partnership will result in gain or loss recognition, even if both partnerships own like-kind property.  IRC section 1031(a)(1) generally provides for non-recognition of gain or loss on exchange of particular properties of like kind.  Exchanges of partnership interests, however, are specifically excluded from IRC section 1031 by IRC section 1031(a)(2)(D). The exchange of a partnership interest for a different partnership interest in the same partnership as part of a conversion of the partnership from general liability to limited liability or vice-versa, is generally a non-recognition event.  See Rev. Rul 84-52, 1984-1 C.B. 157.  Also, the conversion of an interest in a domestic partnership into an interest in a domestic LLC classified as a partnership for federal tax purposes (and visa-versa) is treated generally like a partnership to partnership conversion pursuant to Rev. Rul. 84-52.  See Rev. Rul. 95-37, 1995-1 C.B. 130. The exchange of a partnership interest for a direct ownership right to all or part of a partnership asset is essentially a distribution in liquidation of the partnership interest.  Such an exchange was at issue in Chase v. Commissioner, 92 T.C. 874 (1989).   The Tax Court determined that the substance over form doctrine applied and the transaction failed to qualify for non-recognition under IRC section 1031.  See IRC section 1031(a)(2)(D).  Chase v. Commissioner should be cited in situations where the form of the transactions fail to reflect the economic realities of the transactions. The exchange of a partnership interest for corporate stock can result in taxable income to the transferring partner if the FMV of the stock received exceeds the adjusted basis of the partnership interest transferred.  If IRC section 351 is applicable, the exchange may not be taxed.  In a qualified IRC section 351 exchange, however, liabilities assumed by the corporation that are in excess of the partner’s tax basis in the partnership interest and other assets contributed to the corporation for the stock will trigger a gain under IRC section 357(c).[4] Note: Unless there is an IRC section 754 election in effect, the inside basis of partnership assets are not changed as a result of the sale or exchange of a partnership interest.  If there is an IRC section 754 election in effect, the inside basis of partnership assets is adjusted to reflect the purchase price but only for the partner who acquired the partnership interest.  Application of the adjustment serves to eliminate the discrepancy between the purchasing partner’s inside and outside bases.[5] Examination Techniques As can be expected from the myriad of tax consequences that may result from the sale or exchange of a partnership interest, the selling partner will be looking to reduce the tax effects of any gains and to stretch the tax benefits of any losses on the sale. After determining that there has been a sale or exchange, the character of the gain or loss must be determined.  This is accomplished through an analysis of each asset transferred in the transaction or series of transactions. What did the seller/transferring partner receive?  What did the taxpayer relinquish?  What additional benefits accrue as a result of the sale or exchange?  Review the facts and circumstances surrounding the partnership interest and the taxpayer's relationship to the recipient of the partnership interest and the remaining partners.  Do not let the elaborately structured form of the transaction overshadow its actual substance. back to the top Issue Identification The initial indication that a partner has disposed of a partnership interest should be evident from the partner’s Schedule K-1.  A change in a partner’s ownership percentages of profits, capital, or losses from the beginning of the tax year to the end of the tax year as reported on the Schedule K-1, may indicate either a disposition of part or all of the partner's ownership interest.  A reduction of a partner's ownership interest to an amount other than zero may be indicative of a partial sale, exchange, or liquidation.  It should be noted, however, that such a reduction may also be related to changes in the partnership agreement or a partnership's attempt to reflect more accurately the intent of the partnership agreement. Exchanges between partners of their ownership interest in profits, losses, and capital, as reported on their Schedules K-1, should be scrutinized as they may alter the allocation of distributive items.  In short, these exchanges may not be supported by bona fide transactions between the affected partners.[6] If there is any increase in a partner’s ownership interest in profits, losses, or capital or the addition of a new partner, the Schedule K will generally identify the parties involved. Review item J of theSchedule K-1, Analysis of partner’s capital account, especially when there is a negative capital account interest at the beginning of the year and a zero capital account interest at the end of the year.  This review, along with a scrutiny of partnership debt appearing on the balance sheet, and a review of more than one year's Schedule K-1, Item F, Partner’s share of liabilities, may lead to a conclusion that there have been events that qualify as deemed distributions pursuant to IRC section 752(b). If the partner’s capital account was reduced to zero, check for amounts on any of the distribution lines on the Schedule K-1.  No distribution may be an indication that there was a sale, while a distribution may be a sign of a liquidation by way of a distribution. Does the balance sheet show inventory?  If it does, consider the ordinary income component (IRC section 751) of the sale. If the partnership is on the cash method, determine if it has contracted for services to be performed in the future or for goods to be delivered at a later date.  The value of these contracts may have been imputed to the selling price of the partner’s interest in recognition of the value of an unrealized receivable. The presence of depreciable assets on the balance sheet should raise questions as to whether there is a potential for depreciation recapture.  Depreciation recaptured under IRC section 1245 or IRC section 1250 is treated as an unrealized receivable under IRC section 751(c) and any gain or loss recognized by the disposition of the property is traced as ordinary income or loss pursuant to IRC section 724(a). Was Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, filed with the partnership Form 1065?  The presence of hot assets on the balance sheet, along with the understanding that there had been a sale or exchange of a partnership interest should raise a red flag that a Form 8308 should have been filed. A comparison of the beginning and ending balance sheets can disclose a step-up in basis.  Alternately, amounts appearing on the "Other deductions" line of Schedules K and K-1 may be an indication of additional depreciation calculated on the step-up.  This item should be distributive to the purchasing partner only.  This item may also be separately reported to partners who acquired their interest by purchase in prior years, at which time they received a step-up. Transfers between family members which are identified as a gift may trigger sale or exchange treatment for the donor to the extent partnership liabilities are assumed by the donee.[7]   Under IRC section 704(e)(3), the purchase of a partnership interest from a family member is treated as if created by a gift.[8] If there has been an optional basis adjustment, look for the IRC section 754 election. The selling partner’s tax return should be reviewed.  If necessary, it should be examined to determine if the sale or exchange was reported correctly. back to the top Documents to Request Partnership agreement Prior and subsequent years' partnership tax returns Calculation of the selling partner’s basis. Agreement of sale between the selling partner and purchaser, including any provisions for debt assumption. Calculation of built-in depreciation recapture potential. Contracts for future services and/or delivery of goods to be performed by the partnership at the time of the disposition. Calculation of optional basis adjustment, if any. Disposing partner’s tax return for the year of the disposition. Interview Questions Interview questions are contingent on the extent to which the documents requested present a clear picture as to how the disposition and its tax consequences were reported; specifically: Were all types of IRC section 751 hot assets taken into account? How were hot assets valued with respect to the selling partner’s interest? To what extent was the transferring partner’s share of partnership non-recourse liabilities assumed by the transferee? Was the disposing partner liable for recourse debt?  Did the partner remain liable for the debt after disposing of the partnership interest?  If the transferee takes the partnership interest subject to recourse debt, are there any agreements between the transferee and transferor which give the appearance that the transferor may nevertheless pay off the debt in the future?  Consider that the obligation to the transferor may be too contingent.  If that is the case, the debt becomes part of the amount realized from the sale. If there has been an optional basis adjustment and there is no indication of an IRC section 754 election on the partnership return currently under exam, on what year’s return, if ever, was the election first made?  Is the election still in effect? Any discrepancies between the determination made by the examining agent and the results of the disposition reported by the disposing partner would require an examination of the disposing partner’s tax return.[9]   Questions should be designed to reconcile to the correct amount. Did the transferor and transferee treat the sales price consistently with respect to hot and cold assets? back to the top Supporting Law IRC, Subchapter K:  Section 704 - 706 Section 708 Section 722 Section 724 Section 731 Section 741 Section 743 Section 751 Section 752 Section 754 IRC section 1001 IRC section 1031 IRC section  223 IRC section  050K IRC section 6722 Supporting regulation and specific regulations cited above. Revenue Ruling 84-52, 1984-1 C.B. 157 The conversion of a general partner interest into a limited partner interest, and vise versa, within the same partnership, generally will result in no gain or loss recognition by the partner under section 741 or 1001 of the Code.  If, as a result of the conversion, there is no change in the partner’s share of liabilities section 1.752-1(e) of the Treasury Regulations, there is no change to the partner's partnership interest's adjusted basis.  If there is a change in the partner's share of partnership liabilities under Treas. Reg. section 1.752-1(e), and such change causes a deemed contribution of money under IRC section 752(a) then IRC section 722 will increase the partner’s adjusted basis in the partnership.  If the conversion causes a deemed distribution of money under IRC section 752(b) then the partner's partnership basis shall be reduced by IRC section 733, but not below zero.  The amount by which the deemed distribution exceeds the partner's adjusted basis in the partnership, will generate a gain to be recognized by the partner, as provided for in IRC section 731. IRC section 1223(1) holds that the holding period of the acquired partnership interest becomes that of the interest converted. Revenue Ruling 84-53, 1984-1 C.B. 159 This Revenue Ruling illustrates, by way of four examples, various basis allocations and adjustments that may occur when a partner owns multiple interest in a partnership and disposes of only a portion of such interests. When considering sales and exchanges by a partner with multiple interests, the partner is deemed to have a single basis in the partnership.  If the partner disposes of less than the entire partnership interest owned, then the basis allocated to the interest disposed of is determined with reference to fair market values of the interests retained and disposed.  See Treas. Reg. section 1.61-1(a). Revenue Ruling 95-37, 1995-1 C.B. 130 This ruling treats the conversion of a partnership interest into an LLC interest in much the same manner as conversions described in Revenue Ruling 84-52. Crenshaw v. Commissioner, 450 F.2d 472; 1971 U.S. App. (5th Cir.) The Court of Appeals for the Fifth Circuit, in reviewing the facts surrounding a complex, multi-tiered transaction, found, in a case of substance versus form, that the series of transactions amounted to nothing more than a sale of a partnership interest subject to IRC section 741.  The taxpayer had argued for tax-free liquidation treatment under IRC section 736(b) followed by a tax-free exchange of like-kind property under IRC section 1031. Pollack v. Commissioner, 69 T.C. 142 (1977) The Tax Court ruled that the loss resulting from the disposition of a partner’s interest in a partnership should be characterized as a capital loss pursuant to IRC section 741 rather than an ordinary business loss, as the taxpayer had claimed.  Characterization of a partnership interest as a capital asset neither depends on the taxpayer’s motive when acquiring the interest nor the fact that treatment would be different if the taxpayer had established the enterprise as a business other than a partnership. Collapsible Partnerships A collapsible partnership is the sale or exchange of an interest in a partnership by a partner prior to receipt by the partnership of unrealized receivables or inventory items which have appreciated substantially in value.  See S. Rept. No. 1616, 86th Cong., 2d Sess., p. 77 1960; S. Rept. No. 1622, 83rd Cong., 2d Sess., p. 98 (1954).  Any consideration attributable to such unrealized receivables or inventory items considered to be property received from the sale or exchange of property other than a capital asset.  See IRC section 751(a). It should be noted that the following cases, involved tax years that predate the 1954 Code, but the findings are consistent with the intent behind enactment of IRC sections 741 and 751. Trousdale v. Commissioner, 219, F.2d 563 (9th Cir. 1955) In this case, the partners wanted to terminate their partnership.  Essentially all of the services to be performed by the partnership had already been performed.  The only assets remaining in the partnership were accounts receivable.  The partnership then disguised its dissolution as a sale.  The Tax Court held and the Court of Appeals for the Ninth Circuit affirmed that the payments received were in fact for services rendered by the partnership and not for a sale of the partnership.  As a result, the income was held to be ordinary income. Haggard v. Wood, 298 F.2d 24 (9th Cir. 1961) The sole business of the partnership was the cultivation of a cotton crop.  At the time of the sale, the crop was ready for harvest and market.  The partners and purchaser, who were all related, took particular care, through correspondence and the agreement of sale, to depict the transaction as the sale of partnership interests and not the sale of partnership assets.  The partners were paid for their partnership interests out of the proceeds the purchaser received from the sale of the cotton crop. The Court of Appeals for the Ninth Circuit affirmed the district court’s determination that the partners should recognize ordinary income from the sale of the partnership's only asset rather than capital gain from the sale of a partnership interest.  In reaching its decision, the court discussed Trousdale v. Commissioner. Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter Thomas Crichton, IV et al., 712 Tax Mgmt., Partnerships - Taxable Income; Allocation of Distributive Shares; Capital Accounts. Kevin N. Kemp et al., 718 Tax Mgmt., Dispositions of Partnership Interests - Termination of a Partnership. 2 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners sec. 15.07 (3d ed. 1997). 2 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners, ch. 17 (3d ed. 1997). Steven C. Thompson, Partnership Taxation – Fundamentals, Englewood, CO; MicroMash, Chapter 6, Sale of Partnership Interests. Geoffrey F. Grossman, Choosing the Most Advantageous Method for Disposing of a Partnership Interest, 3 J. P'ship Tax'n 219 (Fall 1986). Doug W. Banks & David E. Karr, Sale of Partnership Interest Can Produce Unexpected Tax Results Without Proper Planning, 38 Tax'n for Accts. 92 (Feb. 1987) back to the top ISSUE:  LIQUIDATION OF A PARTNER’S INTEREST IN THE PARTNERSHIP There is little, if any, economic difference between a pro rata sale of a partnership interest to the remaining partners and a liquidation of the interest by way of liquidating distributions from partnership assets.  Ultimately, the departing partner’s interest is terminated in favor of the remaining partners.  The tax effects are, however, quite different, depending on the path taken. The following points highlight how the liquidation of a partner’s interest in a partnership differs from the sale of such an interest. In a liquidation, the “buyer” is the partnership rather than any of the existing partners or a third party (who replaces the partner). In a liquidation, the partnership makes a distribution, or series of distributions, in the form of cash and/or partnership assets to the liquidating partner.  IRC section 761(d). In a liquidation, a series of distributions may take place over a period of one or more year. In a liquidation, the partner’s interest will not be considered liquidated until the final distribution has been made.  IRC section 736(b). A partner owning more than one interest must terminate all of its interests in the partnership in order to qualify any distributions received as liquidating distributions.  IRC section 761(d). A distribution not in liquidation of a partner’s entire interest, is a current distribution.  Current distributions include distributions in partial liquidation of a partner’s interest as well as distributions of the partner’s distributive share of current partnership income. Liquidation of a partnership interest does not trigger a technical termination of the partnership under IRC section 708(b)(1)(B) even when the liquidated interest represents 50 percent or more of the total interest in partnership capital and profits.  Treas. Reg. section 1.708-1(b)(2). For taxable years beginning after December 31, 1997, IRC section 706(c)(2)(A) provides that the taxable year of a partnership will close with respect to a partner whose entire interest is terminated as a result of death, liquidation, or otherwise.  For taxable years beginning before January 1, 1998, IRC section 706(c)(2(A) provided that the partnership's taxable year closed with respect to a partner whose entire interest was terminated as a result of sales, exchanges, or liquidation, except that the taxable year of a partnership with respect to a partner whose interest terminated as a result of death did not close prior to the end of the partnership's taxable year. back to the top Liquidating Distributions[10] The following points relate to distributions in complete liquidation of an interest in a partnership (although some may also apply to non-liquidating/current distributions): Where money (including marketable securities as per IRC section 731(c)) is distributed by a partnership to a partner, no gain shall be recognized to the partner, except, to the extent that the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.  See Treas. Reg. section 1.731-1(a)(i). A deemed distribution under IRC section 752(b) is considered a distribution of money.  IRC section 752(b). Generally, no gain shall be recognized to a distributee partner with respect to a distribution of property (other than money) until the partner sells or otherwise disposes of the property.  Treas. Reg. section 1.731-1(a)(1)(i).  Exceptions to this rule are provided in IRC sections 736 and 751. A loss is recognized by a partner only upon liquidation of the partner's entire interest in the partnership, and only if the property distributed to the partner consists solely of money, unrealized receivables (as defined in IRC section 751(c)), and inventory items (as defined in IRC section 751(d)(2)).[11] Upon a liquidating distribution, loss is recognized by the distributee partner to the extent of the excess of the adjusted basis of the partner’s interest in the partnership at the time of the distribution over the sum of any money distributed to the partner and the basis of any IRC section 751 assets distributed.  Treas. Reg. section 1.731-1(a)(2). Note, the treatment of IRC section 751 assets under Treas. Reg. section 1.731-1(a)(2) serves to prevent the partner from converting capital loss to ordinary loss when disposing of IRC section 751 assets.  Similar treatment does not apply if the result of the liquidation, after the distribution of money, is a gain. Any gain realized or loss sustained by a partner on a sale or exchange of inventory items (as defined in IRC section 751(d)) received in a distribution from a partnership shall, if sold or exchanged within 5 years from the date of the distribution, be considered ordinary gain or ordinary loss.  IRC section 735(a)(2); Treas. Reg. section 1.735-1(a)(2). Any gain realized or loss sustained on the disposition by the distributee partner of unrealized receivables (as defined in IRC section 751(c)) distributed by a partnership, shall be considered as ordinary income or ordinary loss.  IRC section 735(a)(1). The holding period of the distributed property to the distributee includes the holding period of the partnership, except in the case of inventory items.  IRC section 735(b). Any gain realized or loss sustained by a distributee partner in complete liquidation of a partnership interest is treated as a gain or loss from the sale or exchange of a capital asset.  IRC sections 731(a) and 741. Under IRC section 731(b), no gain or loss is recognized by the partnership on a distribution to a partner of property, including money.  However, the partnership may recognize gain or loss from certain distributions which, under IRC section 751(b), are treated as a sale or exchange of property between the distributee partner and the partnership. Generally, in most instances of distributions of property the partner takes a carryover basis in the property distributed.  However, in a liquidating distribution, the basis of distributed property in the hands of the distributee is limited to his or her outside basis after it has been reduced by money received. Example 7-1 A partner with an outside basis of $1000 before distribution receives, in liquidation of his or her partnership interest, a cash distribution of  $300 and partnership equipment with a basis to the partnership of $800.  Since the partner has a reduced outside basis of $700 ($1000 less the cash received of $300), the equipment will have a basis of $700 to the distributee.  Conversely, if the equipment had a basis to the partnership of only $200 it would still receive a basis of $700 in the hands of the distributee.  No gain or loss is reported until the distributee disposes of the equipment. If the distribution includes both hot and cold assets any unrealized loss would be allocated to the cold asset(s), increasing the basis of such property in the hands of the former partner.  IRC section 732(c) covers the allocation of basis on distributed property.  The requirement of allocating unrealized loss to cold assets only serves to prevent ordinary income from being converted to capital gain upon disposition of the hot assets by the distributee.[12] If the partnership makes an IRC section 754 election, optional basis adjustments can be made to the undistributed partnership property under IRC section 734(b), in accordance with the rules of IRC section 755.  Such adjustments can serve to correct for differences that have arisen as a result of property distributions. These differences are triggered by the distributee taking a basis in the distributed property that is different from the basis of the property in the hands of the partnership or when the distributee recognizes gain or loss on the distribution.  For further discussion of optional basis adjustments see Chapter 3 and the underlying Regulations as well as texts cited as Resources, all of which provide several good examples. back to the top Examination Techniques In the matter of liquidating distributions the examiner should be wary of instances where the partner whose interest has been liquidated may be attempting to: Claim losses from his or her liquidated interest at a time when the interest had not yet been fully liquidated. Claim a loss from a fully liquidated interest in the partnership while holding yet another interest in the partnership. Claim losses from a liquidated interest while ignoring deemed distributions under IRC section 752(b).  Or, in general, exclude deemed distributions under IRC section 752(b) from the computation of the amount realized as distributed. Claim losses from distributed cold assets prior to disposing of those assets. Allocate basis to distributed IRC section 751 hot assets in a manner designed to reduce the impact of ordinary income recognition or convert ordinary income into capital gain. While no gain or loss is recognized by the partnership on a distribution to a partner, with the exception of distributions under IRC section 751(b), the examiner should be alert to the following possibilities: The partnership may make a disproportionate distribution to avoid the full impact of IRC section 751(b). The partnership may attempt to expense certain items of the distribution. Optional basis adjustments to undistributed assets under IRC section 734(b) may be allocated in a manner designed to benefit the remaining partners in a way not intended by the statute. If the partnership has an IRC section 754 election in place, it may have failed to make optional basis adjustments under IRC section 734(b) which serve to reduce the basis of property remaining in the partnership. If there has been a deemed distribution under IRC section 752(b), the partnership may have allocated the debt in favor of a particular partner rather than proportionately. back to the top Issue Identification The first hint that a partner’s interest had been liquidated, or is in the process of being liquidated, can be seen on the partnership return.  Does the partner’s Schedule K-1 contain a distribution?  If it does, then it should also break down the distribution as to cash and property.  This information is also available on Schedule M-2. Does the partner’s Schedule K-1 end with zero capital and no remaining share of partnership liabilities?  If the Schedule K-1 shows that the partner is no longer treated as a partner at the end of the partnership year, then there may have been a complete liquidation of the partner's interest.  If it is found that the partner has another interest in the partnership, as evidenced by an active Schedule K-1, then the partner's interest has not been completely liquidated. The examiner should review the balance sheet, Schedule M-2 and other partners' Schedule K-1.  If the balance sheet shows that a partner has loaned money to the partnership, or if the Schedule M-2 shows contributions to capital (Treas. Reg. section 1.731-1(c)(3)), and/or the remaining partners' Schedule K-1 show a disproportionate reallocation of the liquidating partner’s profit and loss interests and capital interest, then the transaction may have been a sale rather than a liquidation. One of the critical differences between a sale of a partnership interest and distributions in liquidation of the partnership interest is the ability to defer gain on the distribution in liquidation. Example 7-2 If a partner with an adjusted basis in the partnership of $100,000 and a partnership interest with a FMV of $150,000 sells half of his interest for $75,000, the partner will be required to report a capital gain of $25,000 ($75,000 - $50,000), pursuant to IRC section 741.  However, if $75,000 was distributed to the partner in partial liquidation of his partnership interest, then no current income is recognized since the total received ($75,000) is less than the adjusted basis of the partner’s interest in the partnership ($100,000), immediately before the distribution.  See IRC section 731(a)(1). It is, therefore, essential that the examiner determine the source of the funds distributed by the partnership.  In an issue of substance versus form, the examiner should question the validity of any amendments to the partnership agreement, or any side agreements, which cast the transaction as a distribution in liquidation. Issue identification regarding deemed distributions under IRC section 752(b), optional basis adjustments under IRC section 734(b), consideration of IRC section 751 assets and recapture provisions are similar to those used for sales and exchanges. The partner’s return should be reviewed for possible issues regarding the distributee’s treatment of gains or losses reported and basis applied to distributed property resulting from the distribution in partial or complete liquidation. Documents to Request Generally, the documents requested for an examination of the issue of distribution in partial liquidation or a distribution in complete liquidation should mirror that of a sale or exchange, with the exception of the documents which spell out the plans for liquidation of the partner’s interest.  Documents requested are in many ways similar to those requested for the retirement of a partner.  The reader is referred to the “Sale and Exchange of a Partnership Interest” section of this chapter, as well as the section on “Retirement or Death of a Partner.” Interview Questions Is the distribution a distribution in liquidation of a partner’s interest (IRC section 731(a)(2)) or payments to a retiring partner or deceased partner’s successor in interest under IRC section 736?  There are significant differences, as you will see, in the section of this chapter, which covers retirement of a partner. Generally, any questions directed at resolving issues of basis, capital gain and loss versus ordinary gain or loss, optional basis adjustments (with the understanding that there are differences between IRC sections 734(b) and 743(b)), etc., should be similar to questions raised for sales and exchanges of partnership interests. Any discrepancies between the determination made by the examining agent and the results of the liquidating distributions or distributions in complete liquidation reported by the distributee partner require an examination of the seller’s tax return. back to the top Supporting Law IRC, Subchapter K:  Sections 731 through 737 Section 751 Section 752 Section 754 Section 755 Section 761 Supporting regulation and specific regulations cited above. Treatment of Payments for Goodwill Service partnerships often make payments for goodwill to liquidating partners.  IRC section 736 provides that the liquidating partner and partnership may execute an agreement regarding how such payments are to be treated.  IRC section 736(a) allows the partner to treat the payment for goodwill as ordinary income and the partnership to treat it as deductible.  IRC section 736(b) allows for the partner to treat such payment as capital gain and the partnership is left without a deduction. If the partnership is sold, however, IRC section 741 governs.  IRC section 741 declares that the selling partner's interest in the partnership's goodwill is a capital gain to the partner and nondeductible by the partnership, regardless of any agreements between the parties. Cases to review in this area include: Smith v. Commissioner, 37 T.C. 1033, aff’d 313 F.2d 16 (10th Cir. 1962) (providing for the agreement between the liquidating partner and the partnership to be controlling with respect to whether a payment is for goodwill). Cooney v. Commissioner, 65 T.C. 101 (1975) (stating that since the agreement provided that no part of a payment in liquidation was to be attributed to goodwill, the court found that it had "no latitude" and no part of such payment could be treated as goodwill). Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter 2 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners; part VI: Distributions and Part VII: Death or Retirement of a Partner (3d ed. 1997). Steven C. Thompson, Partnership Taxation – Fundamentals, Englewood, CO; MicroMash, Chapter 7B, Liquidating Distributions Laura E. Cunningham & Noel B. Cunningham, The Logic of Subchapter K: A Conceptual Guide to the Taxation of Partnerships, Chapters 11 through 13. James A. Doering, Disposition of Less than an Entire Partnership Interest: What are the Tax Effects? 15 J. P'ship Tax'n 141 (Summer 1998) Janet B. Wright, Liquidating the Partnership: An Analysis of the Issues and Opportunities, 14 J. P'ship Tax'n 229 (1998). back to the top ISSUE:  RETIREMENT OR DEATH OF A PARTNER Any of the methods for disposition of a partnership interest presented in the chapter on sales and exchanges is available to a retiring partner.  The two methods most commonly employed are: By sale to one or more of the existing partners or to a third party. By sale direct to the partnership. The second method of disposition, liquidation, is discussed above.  Payments in complete liquidation of a retiring partner’s interest in the partnership, or a deceased partner’s successor in interest, are governed by IRC section 736.  Were it not for IRC section 736, retirement of a partnership interest would be indistinguishable from liquidation. Since IRC section 736 applies to payments to both retiring partners and a deceased partner’s successor in interest, any discussion in this section is applicable to both, even when only one or the other is indicated. Payments to a retiring partner or deceased partner’s successor in interest consist of: Payments for the partner’s interest in the partnership (IRC section 736(b)). Payments that are considered distributive shares of partnership income if the amount is determined with regard to the income of the partnership (IRC section 736(a)(1)). Payments that are considered guaranteed payments described in IRC section 707(c) if the amount is determined without regard to the income of the partnership (IRC section 736(a)(2)). back to the top It is important to recognize that the purpose of IRC section 736 is to categorize payments to the partners identified in its title, and only those partners (see Treas. Reg. section 1.736-1(a)(1)(ii)).  After the categorization is made, the rules of the various other subchapter K sections serve their function. Certain provisions of IRC section 736 were amended by the Revenue Reconciliation Act of 1993 (RRA ’93).  The changes were effective for payments to partners retiring or dying on or after January 5, 1993.  There is a transition rule stating that the new rules will not apply to partners who retire or die after January 5, 1993, if there was a binding contract in effect on January 4, 1993.  In these instances, the deduction of IRC section 736(a) payments made to such qualified partners will continue to be allowed to the partnership, while RRA ’93 places a limitation on deductibility. For years before the enactment of RRA ’93 the tax rate gap between capital gains and ordinary income was minimal.  Generally, retiring partners were indifferent as to the treatment of payments they received under IRC section 736 in those years.  So, for example, payments to the departing partner for his or her share of goodwill were treated as IRC section 736(a) payments even though goodwill is a capital asset.  This allowed the partnership to take a deduction for the payment rather than treat it as a nondeductible capital expenditure.  The distributive income of the remaining partners was reduced, while the departing partner did not experience any significant economic adversity from reporting this payment as ordinary income due to the insignificant tax difference between ordinary income and capital gain. RRA ’93 altered the treatment of payments under IRC section 736 by limiting the types of payments that could be classified as made under IRC section 736(a) and classifying all other payments made under IRC section 736(b), payments for the interest of the retiring partner in partnership property.  RRA ’93 requires that the partnership and the retiring partner agree to the inclusion of a reasonable amount of the goodwill as an IRC section 736(b) payment, thereby reducing deductions to the partnership for its payments for a capital asset.  On the other hand, RRA ’93 eliminates unrealized receivables (IRC section 751(c)) from IRC section 736(b) payments, thus preventing the conversion of ordinary income to capital gain.  This section will concentrate on the post RRA ’93 application of IRC section 736. Payments under IRC section 736(a) are liquidating payments.  These payments are unrelated to a retiring partner’s interest in partnership property.  Rather than being considered distributions, payments are for part of the retiring partner’s distributive share of partnership income or guaranteed payments to the partner, as determined by IRC section 736(a)(1) and 736(a)(2). The characteristics of payments under IRC section 736(a) for the departing partner, the partnership and its remaining partners are: Payments under IRC section 736(a)(1) are generally ordinary income to the retiring partner or deceased partner’s successor in interest; Payments under IRC section 736(a)(2) are always ordinary income to the retiring partner or deceased partner's successor in interest; Payments under these two subsections serve to reduce the distributive shares of the remaining partners; Payments under IRC section 736(a)(1) are included in the income of the recipient for his taxable year with or within which ends the partnership taxable year for which the payment is a distributive share; Payments under IRC section 736(a)(2) are included in the income of the recipient for his taxable year in which the partnership is entitled to deduct the guaranteed payment (Treas. Reg. section 1.736-1(a)(5)). Payments made under IRC section 736(a)(2) are deductible by the partnership (Treas. Reg. section 1.736-1(a)(4)); and, A payment under IRC section 736(a)(1) retains its character for purposes of determining the taxation of the recipient (IRC section 702(b)). The characteristics of IRC section 736(b) payments are: Payments made in exchange for the partner’s interest in partnership property are distributions; All payments to a retiring limited partner in a partnership in which capital is not a material income-producing factor and all payments to all partners in a partnership where capital is a material income-producing factor are IRC section 736(b) payments.  Exception: payments for the partner’s interest in unrealized receivables (IRC section 751(c) – depreciation recapture) which are in excess of the partnership's basis in such receivables are IRC section 736(a) payments (Treas. Reg. section 1.736-1(b)(2)). IRC section 736(b) payments do not include any amount paid for the partner's share of goodwill in excess of the partner's basis in the partnership interest; unless specifically provided for in the partnership agreement. (Treas. Reg. section 1.736-1(b)(3)). IRC section 736(b) payments are reported in the taxable year in which received, regardless of the departing partner’s or the partnership’s method of accounting (Treas. Reg. section 1.736-1(a)(5)). If an IRC section 754 election is in place, the partnership can receive a step-up in basis under IRC section 734(b) for the excess amounts paid for the retiring partner’s interest in the partnership property. The rules for the allocation of payments between IRC section 736(a) and IRC section 736(b) are contained in section 1.736-1(b)(5) of the Treasury Regulations. If the payments are fixed in amount and made over a number of years, section 1.736-1(b)(6) of the Treasury Regulations allows the partner to elect to attribute an amount of gain to each installment payment instead of first recovering basis.  Examples are provided in section 1.736-1(b)(7) of the Treasury Regulations. The following points are made regarding the death of a partner: Death of the partner does not ordinarily result in the termination of the partnership under IRC section 708(b).  Termination of a partnership interest by reason of death does not result in the closing of the partnership taxable year (IRC section 706(c)(1)). The taxable year of the partnership closes with respect to a partner whose interest in the partnership terminates by reason of death (IRC section 706(c)(2)(A)).  This rule represents a change included in the Taxpayer Relief Act of 1997 (TRA ’97) and is effective for partnership taxable years beginning after December 31, 1997. The amount includible in the gross income of a successor in interest of a deceased partner under IRC section 736(a) is considered income in respect of a decedent under IRC section 691 (IRC section 753). Pre-TRA ‘97 The decedent’s individual return closed as of the date of death (Treas. Reg. section 1.443-1(a)(2)).  This does not mean that an individual files his Form 1040 for a period other than his normal calendar year. (See next item). The final return of a deceased partner does not include any partnership distributive items (income, loss, deductions and credits).  IRC section 706(a) governed here because the death of the partner caused the partner's year to end earlier than that of the partnership. The deceased partner’s share of partnership distributive items was included in the return of the successor, even if income was distributed during that part of the year which pre-dated the partner’s death (IRC section 731(a)(1) and Treas. Reg. section 1.731-1(a)(1)(i)). back to the top Post TRA ‘ 97 TRA ’97, IRC section 1246(a), amended IRC section 706(c)(2) requiring that the partnership year close with respect to the deceased partner as of the date of death.  As a result, the partner’s share of income, losses, deductions and credits are included in the partner’s final income tax return, as determined from the beginning of the partnership year to the date of the partner’s death. The person named in the partnership agreement as successor partner in the event of death is recognized as the successor for federal income tax purposes (Treas. Reg. section 1.706-1(c)(3)(ii)). A sale of the entire deceased partner’s partnership interest as of the date of death will not cause a partnership termination (IRC section 706(c)(2)(A)(i)).  The decedent and the new partner must each include their proportionate share of partnership income, loss, deductions and credits. Transfer, upon death, of the partner’s interest in the partnership does not result in disposition gain.  That is, no gain is attributed to the decedent even if the interest entails a share of partnership debt or unrealized receivables. No gain is recognized on the transfer to the decedent’s estate, or to a successor by bequest (IRC section 752(d), Treas. Reg. section 1.752-1 and Crane v. Commissioner, 331 U.S 1 (1947)). Any suspended passive activity losses will be allowed on the decedent’s final return.  However, the suspended loss is reduced by the amount by which the basis of the partnership interest to the successor (stepped-up basis) exceeds the adjusted basis of the partnership interest to the decedent immediately before death  (IRC section 469(g)(2)).  If, as a result of this provision, any part of the suspended passive activity loss is not allowed on the decedent’s final return, it will not be allowed to anyone, ever (IRC section 469(g)(2)(B)). The basis of the partnership interest to the successor is the FMV as of the date of death or alternate valuation date (IRC section 1014(a)), reduced by income in respect of a decedent and, increased by the successor’s share of liabilities as of the date of death or alternate valuation date (Treas. Reg. section 1.742-1)).  Refer to IRC section 691 for rules relating to income in respect of a decedent (IRD). The successor partner’s basis in the partnership interest will be its FMV per IRC sections 742 and 1014.  This may result in the successor having an outside basis in excess of the partnership’s inside basis.  If an IRC section 754 election is in place, the partnership can step-up the basis of assets under IRC section 743(b) solely for the benefit of the successor. If the IRC section 754 election is in place and the successor’s outside basis is less than the partnership’s inside basis, a step-down in basis will be required. A successor may continue as a partner. A successor may sell the partnership interest to the existing partners or a third party.  See the “Sales and Exchanges” section of this chapter. A successor may have his partnership interest liquidated.  See the discussion of IRC section 736, above. Examination Techniques Examination techniques and issue identification focus on post RRA ’93, for transactions involving partners who retire or die on or after January 5, 1993. Aside from the allocation of payments under IRC sections 736(a) and 736(b), payments made in retirement of a partner’s interest or deceased partner’s successor in interest bear numerous similarities to payments in complete liquidation of a partner’s interest under IRC section 731. IRC section 736 is designed to prevent tax avoidance by requiring the departing partner and the partnership to treat the payments consistently.  This was reinforced by RRA ’93 which requires that payments must be treated as made in exchange for the partner’s interest in partnership property under IRC section 736(b) and not as a distributive share or guaranteed payment that gives rise to partnership deductions. IRC section 736(b) payments must equal the fair market value of the terminating partner’s share of partnership assets.  This represents payment for the partnership interest.  Identify unrealized receivables for potential ordinary income. In addition to the fair market value of partnership assets, the taxpayers can allocate a reasonable amount to goodwill.  This amount must be specified in the partnership agreement. Any payments in excess of the IRC section 736(b) payments described above must be allocated to IRC section 736(a) payments. Apply new IRC section 736(b)(3), in cases where the allocation of payments does not comply with the new provisions under RRA ’93. In terms of properly applying the new rules under RRA ’93, determine whether capital is or is not a material income-producing factor. In terms of the decedent and the successor, a determination should be made regarding the allocation of distributive partnership items (pre- versus post TRA ’97).  Also, determine if there has been a proper step-up or step-down basis adjustment. To the extent that IRC sections 469(g)(2) and 469(g)(2)(B) are applicable, make sure that neither the decedent nor the successor have claimed a deduction for suspended passive activity losses. back to the top Issue Identification The underlying inducement for unreasonable allocations between IRC section 736(a) and IRC section 736(b) payments may be the disparity of current tax rates for ordinary income and capital gains.  The issues to be raised will revolve around the proper character of the payments, as well as the allocation between IRC sections 736(a) and 736(b). Items that represent payments for the departing partner’s FMV of partnership property should be classified as an IRC section 736(b) payment.  Items that are specifically identified by statute as being in the nature of an IRC section 736(a) payment should be classified as an IRC section 736(a) payment.  Items over which the partnership and partner have discretionary authority for determining how payments will be allocated will require a determination as to reasonableness. Knowing the tax position of the departing partner, as well as significant remaining partners, is advantageous from the standpoint of identifying a motive for the agreed upon treatment and allocation. Does the departing partner have a large and otherwise unused capital loss?  Do the remaining partners have net operating losses or are they in low tax brackets for the year?  In this scenario, the purported allocation may be in favor of IRC section 736(b).  If the departing partner has a large or expiring net operating loss and the remaining partners are in a high tax bracket for the year, the shift may be in favor IRC section 736(a). The treatment of IRC section 752(b) – decrease in a partner’s share of liabilities, as a constructive receipt of cash, applies in calculating the amount of payments received.  Identification of this issue was covered in other parts of this chapter. Substance versus form: as in the section on liquidation of a partner’s interest, look for any indication that might serve to characterize the transaction as a sale despite any precautions by the parties to cast it differently.  Remember, among other differences, liquidating payments do not result in gain to the partner except to the extent they exceed his basis, while a sale over a period of time will require an apportionment of gain to the yearly payments received. On partnership returns with a departing partner, look for a reduction to goodwill on the balance sheet and guaranteed payments on the departing partner’s Schedule K-1. Watch for a Notice of Inconsistent Treatment, Form 8082, (TEFRA partners) or Disclosure Statement, Form 8275, (non-TEFRA partners) that refers to IRC section 736.  This may be an indication that the retiring partner is allocating retirement payments between IRC sections 736(a) and 736(b) in a manner differing from that of the partnership or other partners. Documents to Request Partnership agreement Property fair market value determinations Copy of departing partner’s return Copy of the remaining partners’ returns (or at least those with the greater participation) If necessary, substitute RTVUE/BRTVUE or MACS print Partnership 736(a) and 736(b) allocation worksheet Interview Questions Question any allocations which seem misclassified or unreasonable. Question FMV determinations which do not appear to be economically grounded (over or undervalued). Question the FMV placed on major assets of the partnership.  Submit valuation referral, if required. Question any sign that the departing partner has been relieved of debt but has not properly treated the relief under IRC section 752(b). Question the extent to which the retiring partner is severed from the partnership (complete liquidation required). back to the top Supporting Law IRC, Subchapter K: Section 704 Section 706(a) Section 707(c) Section 708(b) Section 731-736 Section 751 Section 752(b) & (c) Section 753 - 755 IRC section 443 IRC section 469 IRC section 691 IRC section 1014 Supporting regulations and specific regulations cited above. Revenue Reconciliation Act of 1993 (RRA ’93) Taxpayer Relief Act of 1997 (TRA ’97) The issue of allocating all or most of the payments to IRC section 736(a) has not been litigated.  This is likely attributable to the relative newness of the changes brought about by RRA ’93.  There have been several cases litigated on the absence of a provision in the partnership agreement stipulating that distribution in liquidation of a partnership interest includes payments for goodwill. See cases cited in the section of this chapter covering liquidations. Crane v. Commissioner, 331 U.S. 1 (1947) No gain is recognized on the transfer of property to the decedent’s estate, or to a successor by bequest. Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter BNA, Tax Management Portfolio, Vol. 716 Gunn, Federal Tax Problems of Income in Respect of a Deceased Partner, 3 J. P'ship Tax'n 23 (Spring 1986) Tousey & Wallis, Liquidation of a Partnership Interest of a Deceased Partner, 10 J. P'ship Tax'n 272 (Fall 1993) Yuhas & Fellows, Gain on Partnership Interest Is Now More Likely to Be Ordinary, 52 Tax'n for Accts 146 (March 1994) Carmen & Dance, New Provisions of RRA’93 Will Have a Major Impact on Partnerships and Partners, 11 J. P'ship Tax'n 3 (Spring 1994) Partnership Industry Program, Significant Issues Alert, “Payments to a Retiring Partner” 2 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners, Part VII, Death or Retirement of a Partner (3d ed. 1997). Steven C. Thompson, Partnership Taxation – Advanced, Englewood, CO; MicroMash, Chapter 7, Special Problems of Retiring and Deceased Partners back to the top ISSUE:  GIFT OR CONTRIBUTION OF A PARTNERSHIP INTEREST The gifting of a partnership interest and the contribution of a partnership interest to a charitable organization can result in the recognition of income to the donor.  This section covers both transactions. Gifting of a Partnership Interest The gifting of an interest in a partnership is usually a family affair.  IRC section 704(e)(3) concludes that the purchase of a partnership interest in a family partnership by one member of a family from another shall be considered to be created by a gift from the seller.  IRC section 704(e)(2) addresses the allocation of distributive share where the partnership interest is created by gift.  Refer to Chapter 11, Family Partnerships, for an understanding of transactions between family members.  Of course, the gifting of a partnership interest to a family member can be other than an interest in a family partnership. The gifting of a partnership interest involves the consideration and determination of several factors which may have a tax effect for the donor: Fair market value of the partnership interest Adjusted basis of the partnership interest Allocation of distributive share (donor/donee) Debt relief to the donor Gain on a deemed sale as a result of debt relief   Ordinary income versus capital gain on the deemed sale The allowance of suspended passive activity losses Gift tax The gifting of a partnership interest which is free of liabilities (that is, the partnership has no liabilities or the donor has no share of partnership liabilities under IRC section 752) would not be subject to income taxes.  If the partnership interest is encumbered by debt, or the donor partner shares in partnership liabilities pursuant to IRC section 752, there is a taxable event. back to the top Gifts of a Partnership Interest Encumbered by Debt Basis of the gift in the hands of the donee when the partnership interest is encumbered by debt: The unadjusted basis to the donee is the greater of the amount “paid” by the transferee, which is the debt assumed by the donee in the instance where it exceeded the transferor’s adjusted basis at the time of the gift, or the transferor’s adjusted basis at the time of the gift. After making the above calculation, apply the general rules of IRC section 1015. When the partnership interest, which is encumbered by debt, is transferred to a donee who accepts the gifted interest subject to the debt and thereby assumes the liability of the donor, a taxable event occurs.  Either IRC section 752(b) or IRC section 752(d) apply in the instance of a gifted partnership interest. When there is a taxable gain to be considered, the gift of the partnership interest is split into two parts, one part gift and the other part sale.  Where a transfer of property is in part a sale and in part a gift, the transferor has a gain to the extent that the amount realized by him (the debt relief) exceeds his or her adjusted basis in the property.  However, no loss is sustained in such a transfer if the amount realized is less than the adjusted basis (Treas. Reg. section 1.1001-1(e)(1)).  Section 1.1001-1(e)(2) of the Treasury Regulations provides an assortment of examples.  Refer to the discussion of bargain sales which appears later in this section. While the above gain is capital gain, some of it may have to be classified as ordinary income if there are IRC section 751 assets involved.  If the partnership interest included depreciable assets that were subject to depreciation recapture (an IRC section 751(c) asset), the recapture amount would be ordinary income. The basis of the partnership interest to the recipient (donee) is determined with reference to the general guidelines of IRC section 1015, Basis of property acquired by gifts and transfers in trust. Gifts of a Partnership Interest Not Encumbered by Debt Basis of the gift in the hands of the donee when the partnership interest is not encumbered by debt: Basis for the purpose of determining future gain, would be the same as in the hands of the donor; the donor’s adjusted basis. Basis, for the purpose of determining future loss, would be the same as for determining gain except that if the donor’s adjusted basis is greater than the fair market value of the property at the time of the gift, the basis to the donee is the fair market value at the time of the gift. back to the top Effect on Passive Losses The gifting of a partnership interest, with respect to which there are accumulated suspended passive activity losses, will not trigger an allowance of the losses to the donor.  The total of the suspended passive activity losses are instead added to the adjusted basis of the partnership interest (IRC section 469(j)(6)(A)) and thus will affect the basis of the donee.  The suspended passive activity losses are not allowable as a deduction for any taxable year (IRC section 469(j)(6)(B)). The suspended passive activity loss carryover will produce a step-up in basis that would not otherwise be available for a gifted partnership interest as IRC section 743(b) does not apply to gratuitous transfers.  Any tax benefits to the donee are deferred until such time as the interest is disposed of in a taxable transaction. If this “bloated” basis exceeds the FMV of the partnership interest at the time of the gift, and the donee subsequently disposes of the interest in a taxable transaction resulting in a loss, no loss is allowable.  The PAL carryover can reduce gain but it cannot create a loss. Gift tax is calculated on the amount by which the FMV of the gifted property exceeds the debt relief to the donor.  It should be noted that the gift tax paid serves to increase the basis (IRC section 1015(d)).  If the gift tax is paid by the donee, the donor must realize taxable income (see Diedrich v. Commissioner in the Supporting Law section). Contribution of a Partnership Interest to a Charitable Organization A partner may contribute a partnership interest to a charitable organization.  When that partnership interest is encumbered by debt or the partnership interest includes IRC section 751 assets, the donor will be required to recognize income, even though the partner is giving the interest away to charity. How do you compute the amount of the charitable contribution? How can the partner have a gain when making a charitable contribution? Before you can determine the amount of the allowable deduction for the charitable contribution of property, you must determine if the property is ordinary income property or capital gain property.  Any ordinary income portion will reduce the charitable contribution, under IRC section 170.  If the property is ordinary income property the amount that can be deducted as a contribution is its fair market value, less the amount that would be recognized as ordinary income.  This generally limits the contribution deduction to the basis in the property.  Examples of ordinary income include inventory, capital assets held less than a year, and the portion of depreciation recapture on depreciable business property that would be treated as ordinary income if the property were sold at its fair market value at the time of the contribution. If the property is capital gain property, the amount that can be deducted as a charitable contribution is its fair market value.  Certain adjustments are required if the property (other than qualified stock) is; (a) given to certain private non-operating foundations, (b) put to an unrelated use by the charity, or (c) the 50 percent limitation is used. When a partner contributes his or her partnership interest to a charitable organization, he or she receives a charitable contribution deduction for the amount by which the fair market value of the partnership interest exceeds any relief of debt.  The amount of the debt relief is considered the amount realized from a bargain sale. back to the top IRC section 752(b) treats the partner’s decrease in his or her share of liabilities, as a deemed distribution of cash to the partner.  Therefore, when the interest is donated to the charitable organization, any balance of debt allocable to the donating partner is deemed to be a cash distribution and is then properly included in the amount realized on the bargain sale. IRC section 752(d) treats the decrease in the partner’s share of partnership liabilities as part of the amount realized in much the same way as IRC section 752(b) treats it as a deemed distribution.  Again, any balance of debt allocable to the donating partner at the time of the contribution is included in the amount realized on the bargain sale. This creates the situation where, even though the donating partner receives no cash or other assets, he or she is deemed to have received cash/compensation for that part of his or her partnership interest which is determined to be encumbered by debt, under the bargain sale computation. IRC section 1011(b) provides that the donor’s basis be prorated between the portion deemed contributed and the portion deemed sold.  The equation for the proration under IRC section 1011(b) is the amount realized from the debt relief divided by the FMV times the total basis equals the portion of basis allocable to the portion deemed sold.  If IRC section 751(c) assets are involved, the gain may be part ordinary and part capital.  Sections 1.1011-2(c) and 1.170A-4(d) of the Treasury Regulations provide several examples.  Also, see Example 3 below. If the amount of the debt relief exceeds the fair market value of the partnership interest being contributed, bargain sale rules will not apply.  The amount realized will be the amount of the debt relief and the difference between this amount and the partner’s adjusted basis in the partnership interest is the amount of the gain on disposition.  Since the FMV of the partnership interest is less than the debt by which it is encumbered, the partner has no equity in the partnership interest and should receive no charitable deduction. The contribution of a partnership interest to a charitable organization, on which there is accumulated suspended passive activity losses, will not trigger an allowance of the loss to the donor.  The donor may never deduct the accumulated passive activity losses in such a situation.  The suspended PAL is added to the donor’s basis at the time the partnership interest is contributed.  If there is any tax benefit to be gained, it will be through a larger basis offset in a bargain sale calculation. back to the top Example 3 On December 31, 1999, D, an individual, contributes his partnership interest in XYZ, a general partnership, to a recognized charitable organization under IRC section 170(c).  At the time of the contribution the fair market value of D's interest is $50,000.  The partnership contains no assets that would generate ordinary income if sold.  D has held his partnership interest for more than one year.  Per IRC section 752(d), the reduction in liabilities due to the disposition of the partnership interest is $30,000.  Therefore, the bargain sale amount realized is $30,000.  (1) Allocation:   Amount Realized/Fair Market Value X Basis                              (30,000/50,000) X 40,000  = 24,000 (2) The contribution amount per IRC section 170 is equal to the fair market value of the portion donated.  Note however, that if there were any ordinary income assets (IRC section 751) in the partnership (and there generally is) the gift must be reduced under Treas. Reg. section 1.170A-4(c)(3). (3) Likewise, in this example, the gain is capital gain.  However, if any portion of the partnership interest were considered an ordinary income asset under IRC section 751, the gain would have to be allocated between ordinary and capital. back to the top Examination Techniques Since the gifting of a partnership interest typically takes place in the context of the family unit, as defined by statute, refer to Chapter 11, “Family Partnerships,” and other available sources. The contribution of a partnership interest should be viewed in terms of the FMV determination, with consideration given to bargain sales, and the rules contained in IRC section 170.  Contributions to a private charitable foundation should be scrutinized for the degree to which control of the interest has been relinquished, as well as other issues inherent in contributions of this type.  Related issues may be developed under IRC sections 501(c) and 507 - 509.  If necessary, seek the assistance of Exempt Organization. Obtain the facts regarding the donation.  To whom, when, FMV determination, etc. Determine if the donation is allowable under IRC section 170 as a charitable contribution, if not, IRC section 1011(b) is not applicable. Verify the partner’s basis in the partnership. Determine the partner’s share of debt, if any. Determine if the partner has been relieved of debt as a consequence of donating the property.  Apply the bargain sales rule, if warranted. Determine the ordinary income portion attributable to the donated interest. Allocate the sale portion between ordinary and capital. After bargain sale consideration, determine the amount allowable as a contribution. As with any type of disposition that represents a final disposition of a partnership interest, the examiner should investigate how the partner has treated any accumulated passive activity losses. Issue Identification For purposes of a gift or charitable contribution, issue identification will involve determining the presence of debt associated with the partnership interest and the underlying IRC section 751 assets. The issue of fair market value of the partnership interest, if significant, may be a matter for referral. The initial indication that a partner has contributed his or her partnership interest should be evident from the appearance of a contribution deduction on the partner’s return.  In the instance of a gift or contribution of a partnership interest, the partnership return will contain corresponding changes to item J of the Schedule K-1 for the gifting/contributing partner and the donee/charity.  This may include increases to existing partners or the addition of new partners.  Also, the donor’s Schedule K-1 may be checked as final. The likelihood that the donor partner may not have considered the gain from making the gift or gain on the bargain sale will be evidenced by the absence of the transaction on the partner’s Schedule D. If the partner is a limited partner, look for passive activity loss adjustments. The former partner should not be allowed to claim a deduction for accumulated PAL. If the partnership agreement prohibits the contribution or gifting of a partnership interest, the departing partner may be treated as having abandoned the partnership interest, which may qualify as a sale.  Refer to the section on “Abandonment of a Partnership Interest”. Where there is a gift of a partnership interest with a negative capital account, it will be encumbered by debt and, therefore, the bargain sale rules will always be implicated. back to the top Documents to Request The following assumes the issue of gift or contribution of the partnership interest is identified at the partnership level. Partnership agreement Prior and subsequent year partnership tax returns Review any Form 8308.  It is required to be filed when a partnership interest is transferred and the partnership has IRC section 751 assets. Calculation of the donor partner’s basis Documents concerning FMV determination Transfer agreement between the donor and the donee, including any provisions for debt assumption Donor partner’s tax return for the year at issue Copy of donee’s return Partner’s bargain sale calculation including calculation for built-in depreciation recapture and other IRC section 751 considerations Copy of Gift Tax return(s) filed Interview Questions What was donated and to whom? How was the partnership interest valued?  FMV? Question the relationship between the donor and donee. What happened to the donor partner’s share of liabilities? Was the donor partner liable for recourse debt?  Did the partner remain liable for the debt after donating the partnership interest? Question factors inherent in a contribution made to a private foundation or secure enough information for a referral to Exempt Organization, if necessary. Question the FMV of the donated partnership interest, if necessary, and all other calculations. back to the top Supporting Law IRC, Subchapter K: Section 704 Section 705 Section 731 Section 751 Section 752 IRC section 170 IRC section 469 IRC section 501(c) IRC section 507 – 509 IRC section 1001 IRC section 1011 IRC section 1015 Supporting regulations and specific regulations cited above. Revenue Ruling 75-194 The donation of a partner’s interest in a limited partnership to a charitable organization was deductible after reductions required by IRC section 170(e)(1).  The FMV of the donating partner’s share of partnership assets exceeded his or her share of partnership liabilities thereby creating a charitable contribution deduction under IRC section 170.  However, at the time of the contribution, the amount of the contributing partner’s share of partnership liabilities should be treated as an amount realized by the partner in a bargain sale transaction.  The contribution results in both a gain from a bargain sale and a charitable contribution deduction. This ruling has been codified as Treas. Reg.section 1.1011-2(c), example 4. Diedrich v. Commissioner, 457 U.S. 191 (1982), aff’g 643 F.2d 499 (8th Cir. 1981), Rev’g T.C. Memo 1979-441. The Supreme Court affirmed the determination of the Court of Appeals for the 8th Circuit.  The donor of a gift realized taxable income to the extent that the gift taxes paid by the donee exceeded the donor’s adjusted basis in the property.  The court deemed this to be consistent with IRC section 1001.  “The fact that the gift tax obligation was discharged by way of a conditional gift rather than from funds derived from a pre-gift sale did not alter the benefit to the donor.” Although the property in this case was corporate stock rather than a partnership interest, the result should not differ in the case of a partnership interest or LLC membership interest. Maxine Goodman, et al., v. United States, 2000-1, U.S.T.C. (1999) The U.S. District Court for the Southern District of Florida decided that IRC section 752(d) and IRC section 1011(b) required an individual to treat as a bargain sale the contribution of a partnership interest to a charitable organization.  The taxpayer’s argument that IRC section 1011(b) only applies to sales, and not to gifts, was rejected. Revenue Ruling 75-194 was a supporting document to the court’s determination. Resources RIA U.S. Tax Reporter - Income Taxes CCH Standard Federal Tax Reporter BNA, Tax Management Portfolio, Vol. 718   McKee, William S., Nelson, William F., and Whitmire, Robert L.   Federal Taxation of Partnerships and Partners, Boston, MA; Warren, Gorham & Lamont, Publisher.  Part V, Chapter 15.05: Gratuitous Transfers of Partnership Interests. back to the top ISSUE:  ABANDONMENT OF A PARTNERSHIP INTEREST There are three methods by which a partner can surrender a partnership interest: forfeiture, abandonment, or worthlessness. The partnership agreement may contain a set of specifications whereby the partnership will consider the partner to have forfeited the partnership interest. This may include, but is not limited to, failure to keep up with payments under the subscription agreement.  Forfeiture of a partnership interest can have the same consequences as abandonment, which this section covers in detail. The recognition of a partner’s ability to consider his or her partnership interest worthless relies heavily on timing and the measure by which a partnership is determined to be worthless in a closed and completed transaction.  Worthlessness is often an effect of hopeless insolvency.  Walking away from the partnership in this manner will cast the transaction as a sale resulting in capital loss.  See Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), for a comprehensive discussion on worthlessness of a partnership interest. Abandonment affords a partner the opportunity to derive ordinary loss from what is generally considered a capital asset - the partnership interest.  Abandonment of an asset occurs when a taxpayer abandons property and receives nothing in return.  Abandonment of a partnership interest will be characterized as an ordinary loss under the general rule of IRC section 165(a) which states that “There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise”. An understanding of the facts, conditions and circumstances present at the time of the abandonment is crucial in determining whether the actions of the partner constitute abandonment or sale of the partnership interest. There is no definitive way to abandon a partnership interest.  Neither the Code sections nor the regulations provide guidance as to a procedure for abandonment.  It is generally accepted that there must be some overt action on the part of the partner that can be construed as an attempt to make clear to the partnership, general partner and other involved third parties, the intent to surrender the partnership interest. Once it is established that the partner abandoned the partnership interest, the issue of a closed and completed transaction must be settled.  Section 1.165-1(b) of the Treasury Regulations states that, in order to be allowed, the loss must be evidenced by a closed and completed transaction, fixed by identifiable events and actually sustained during the year.  In the instance of a qualified abandonment, the partner has surrendered all legal rights to the partnership interest with the expectation of receiving nothing in return.  Under these conditions, the very act of abandonment, absent any related matter that may continue to bind the partner to the partnership, should satisfy the closed and completed transaction requirement. Characterizing the loss as either ordinary or capital is contingent on the various attributes of the partnership interest.  Generally, a partner who abandons a partnership interest, with no debt allocation, will be afforded ordinary loss treatment under IRC section 165(a).  However, a partner whose partnership interest includes an allocation of debt for which he or she does not remain liable will be deemed to have received a distribution (IRC section 752(b)) upon surrendering his or her interest in the partnership and the transaction will be viewed as a sale of a capital asset. The presence of accrued liabilities for which the partnership reduced distributive income to the partner would give rise to a deemed distribution and thus be treated as a sale. The courts have ruled that even a de minimus amount determined in any way to be compensation for the partnership interest will cast the transaction as a sale. The amount of loss is calculated as the total of the abandoning partner’s unrecovered basis.  The abandonment may even result in gain if the partner had a deficit capital account at the time of the abandonment. At the time of the abandonment, the partnership may be holding IRC section 751 assets.  If the abandonment is treated as a sale, and the partnership holds IRC section 751 assets, the amount realized would not be derived exclusively from the sale of a capital asset. Finally, keep in mind that losses allowed under IRC section 165(a) are limited for individuals by IRC section 165(c)(1) to losses incurred in a trade or business; or losses incurred in any transaction entered into for profit, though not connected with a trade or business, as stated in IRC section 165(c)(2). Examination Techniques The examination techniques used should serve, in the end, to answer the following: Do the underlying partnership transactions have economic substance?  The issue regarding the determination of economic substance, or lack thereof, is not a matter for discussion in this chapter.  Refer to Chapter 9. Was the partnership interest abandoned (in a closed and completed transaction)? Was the abandoning partner relieved of his or her share of partnership debt? Was the abandoning partner, in any way, compensated for his or her partnership interest? Was the gain or loss properly calculated? Issue Identification back to the top The issue of abandonment can be identified on either the partner’s individual tax return or the partnership return.  The partner should be expected to report the transaction on Schedule D or E, depending on how the transaction has been treated (capital v. ordinary).  If the activity was passive, the balance of carryover passive activity losses from this particular entity will be deducted in full under IRC section 469(g)(1) and Treas. Reg. section 1.469-2T(d)(5). The partnership return may not actually spell out the fact that the interest has been abandoned.  At a minimum, a screening of a partner Schedule K-1, item J, Analysis of Partner’s Capital Account, can reveal that a partner’s capital account has been cancelled.  Review the prior year’s Schedule K-1 for the partner in question.  Did item F, Partner’s Share of Liabilities, contain an allocation of partnership debt?  If so, then compare it to the current year’s entry in item F.  If the partner’s final Schedule K-1 still reports non-recourse debt in item F, determine why it has not been reallocated among the remaining partners.  If the partner’s final Schedule K-1 reports recourse debt, does his or her liability extend beyond participation in the partnership?  Any reallocation from non-recourse to recourse debt allocable to the departing partner should be questioned, since it may have been intended to eliminate a deemed sale. Also consider the step transaction doctrine whereby certain transactions executed by the partnership, in anticipation of the abandonment, may have cleared the path for treating the loss as ordinary instead of capital.  The issue here is one of substance versus form.  (Rev. Rul. 93-80). Compare the balance sheet for the year under examination with that of the subsequent year.  Has the correct amount of debt been retained by the partnership?  The balance sheet should also be screened for the presence of IRC section 751 assets at the time of abandonment. Review Schedule M-2 for the reconciliation of capital accounts in the absence of the departing partner. Flip through the Schedules K-1 contained in the partnership tax return for the year subsequent to the alleged abandonment.  The inclusion of a Schedule K-1 for the “abandoning” partner is evidence that the partnership and other partners continue to treat the taxpayer as a partner.  The preparation of a Schedule K-1, along with a failure to recognize the abandonment by amendment to the partnership agreement, should raise doubts as to whether any alleged, recognizable, manifestation or overt conveyance of intent to abandon occurred or existed and should be grounds for denial of the abandonment loss. Generation of the Schedule K-1 may have been caused by a breakdown in communication between the partnership and the return preparer.  How did this partner treat the receipt of the Schedule K-1?  Did he or she file a Form 8082 as a Notice of Inconsistent Treatment (TEFRA partners only) or a Form 8275, Disclosure Statement, (Non-TEFRA partners) or was receipt of the Schedule K-1 ignored? If the issue is worthlessness of a partnership interest, how have the other partners treated their partnership interest?  If the facts relevant to worthlessness are the same for all partners in the partnership, a claim of worthlessness by just one partner is suspect and may constitute a whipsaw issue.  If, on the other hand, the examining agent determines that all partnership interests are worthless, consider whether the partnership return gives the appearance of being a “zombie”.  If a “zombie” partnership issue is to be developed, contact the Partnership Technical Advisor. back to the top Documents to Request Partnership agreement Prior and subsequent year partnership tax returns Correspondence submitted by the abandoning partner to the partnership in which the expression of abandonment is set forth. Copy of partnership response, if any. Debt instruments Interview Questions Is there a provision in the partnership agreement that provides a means by which a partner can abandon his or her partnership interest or will be deemed to have forfeited his or her partnership interest? Was the departing partner allocated a share of partnership debt? Was the debt recourse or non-recourse or both? How was the departing partner’s allocation of unsatisfied debt treated by the partnership upon departure of the partner? Was the departing partner compensated for his partnership interest by the partnership or any of its partners? At the time of abandonment, did the departing partner have any claims against the partnership or any of its partners in respect of his partnership interest? Supporting Law IRC, Subchapter K: Section 705 Section 731 Section 741 Section 751 Section 752 IRC section 165 Supporting regulation and specific regulations cited above. back to the top Revenue Ruling 93-80 A loss incurred on the abandonment or worthlessness of a partnership interest is an ordinary loss if sale or exchange treatment does not apply.  If there is an actual or deemed distribution to the partner, or if the transaction is otherwise in substance a sale or exchange, the partner’s loss is capital (except as provided in section 751(b) of the Code). For purposes of determining whether or not IRC section 752(b) applies to create a deemed distribution upon abandonment or worthlessness, liability shifts that take place in anticipation of such event are treated as occurring at the time of the abandonment or worthlessness under general tax principles. Echols v. Commissioner, 935 F.2d 703 (5th Cir. 1991), Rev’g 93 T.C. 553 (1989) The Court of Appeals for the Fifth Circuit, in overruling a decision of the Tax Court, discussed the application of the worthlessness and abandonment doctrines.  The court characterized the determination of worthlessness as having both objective and subjective elements. Citron v. Commissioner, 97 T.C. 200 (1991) The Tax Court ruled that the partner had abandoned his interest and, in the absence of partnership liabilities, the loss on abandonment was an ordinary loss under IRC section 165(a). O’Brien v. Commissioner, 77 T.C. 113 (1981); Aff’d per cu. 693 F.2d 124 (CA–11, 1982) The Tax Court ruled that the decrease in a taxpayer’s individual liabilities by reason of the partnership’s assumption of debt could be a deemed distribution under IRC section 752(b).  The deemed distribution, in turn, gives rise to a sale or exchange under IRC section 731(a), resulting in capital loss under IRC section 741. La Rue v. Commissioner, 90 T.C. 465 (1988) The Tax Court stated that the touchstone for sale or exchange treatment is consideration.  If in return for assets, any consideration is received, even if nominal, the transaction will be classified as a sale or exchange. Wright v. Commissioner, T.C. Memo 1994-288 The taxpayers conceded that they were not entitled to flow-through losses, deductions or credits from the partnership, however, they argued in favor of claiming a loss based on the purported worthlessness of their interest in the same partnership.  The Tax Court found that the taxpayers were not liable for penalties under IRC sections 6653 (negligence) and 6661 (substantial understatement) due to what the court viewed as their good faith intentions in making an investment motivated by profit objectives.  The court ruled that, notwithstanding the taxpayers’ subjective intent of making a profit, the investment will not be recognized for tax purposes if the overall transaction lacks economic substance and business purpose. Marinovich v. Commissioner, T.C. Memo 1999-179 In a case similar to Wright v. Commissioner, the Tax Court ruled that even if taxpayers invested in the partnerships with the individual objective of making a profit, taxpayers are not entitled to deduct out-of- pocket cash invested in the partnerships as losses under IRC section 165(c)(2) if the partnership transactions lack economic substance. Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter Kevin N. Kemp et al., 718 Tax Mgmt., Dispositions of Partnership Interests - Termination of a Partnership Williford, New Ruling Clarifies the Tax Consequences of Abandoning a Partnership Interest, 52 J. P'hip Tax'n 39 (Spring 1994) Liveson, Loss On Abandonment of Partnership May Be Ordinary, 52 Tax'n for Accts 132 (March 1994) Kramer & Kramer, “Withdrawal From a Partnership After CITRON and ECHOLS'’ 24 Tax Advisors 386 (June 1993) Pusker, Losses on Partnership Interests May Be Ordinary, 51 Tax'n for Accts 78 (August 1993) back to the top __________FOOTNOTES__________ [1] Because IRC section 741 sets the framework for the tax treatment of the sale or exchange of a partnership interest, it has been incorporated herin, as an essential part of this text. [2] IRC section 751 is discussed more fully in Chapter 4. [3] IRC section 1.6050K-1(a)(3) provides filing alternatives for partnerships required to make 25 or more Form 8308 filings in one tax year. [4] IRC section 351 will not be discussed in this ATG but should be researched in other sources.  See 2 William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships §15.07 (3rd edition 1997). [5] For a discussion of optional basis adjustments, see Chapter 3. [6] See Chapter 6, Income Allocation, for a discussion of substantial economic effect. [7] See Chapter 11, "Family Partnerships" and the discussion of bargain sales in this chapter. [8] This feature is covered in the "Gift or Contribution" section of this chapter. [9] See Chapter 13, TEFRA, regarding partnership items and nonpartnership items. [10] A discussion of partnership distributions is presented in Chapter 4.  Here, however, we focus on liquidating distributions, which differ in some respects from distributions made to partners who will continue as partners after the distribution. [11] The term "liquidation of a partner's interest", as defined in IC section 761(d), is the termination of the partner's entire interest in the partnership by means of a distribution or series of distributions.  Treas. Reg. section 1.731-1(a)(2). [12] The concepts of allocation of basis under IRC section 732(b) and disproportionate distributions under IRC section 751(b) can become extremely complex and, therefore, beyond the scope of this section of the Guide.  The reader is referred to Chapter 4 of this MSSP Guide and is advised to consult the underlying regulations as well as the texts cited as Resources.  Both the regulations and the referenced texts provide an excellent assortment of examples to aid in understanding these complex sections.

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