I. Partnership Formation – Sections 721, 722, 723
Contribution of appreciated property
No gain or loss under § 721(a) – general rule (like §351, but no control requirement)
Exception under § 721(b) – certain types of securities cannot be transferred – can not create an investment company – do not want the partnership to be used to diversify the partners’ assets
Without this section – under § 1001 – realize gain to the extent of the value of the property received in excess of basis
Trumps assignment of income rules (but other provisions, such as 704(c) ensure that income is recognized by the proper taxpayer)
Basis rules defer recognition
§ 722: Partner – exchanged basis
i. Outside basis = cash plus adjusted basis of property contributed
ii. Inside basis – reflects the book value of the interest – the capital account
iii. Taxation depends on outside basis (distribution is taxable when a partner receives cash in excess of basis – 731)
iv. Also add any gain recognized under § 721(b) – for class purposes, we will not deal with § 721(b)
Holding period of the partnership interest: § 1223(1) – if property is received in an exchange in which the property received takes the same basis as the property transferred, then the holding period tacks to the property received to the extent that the property transferred is a capital asset or a § 1231 asset
i. Partner will not lose the long-term character of assets that were capital
ii. § 1221: capital asset excludes inventory, accounts receivable, and trade or business assets that are subject to depreciation
1. Watch for transactions that could trigger recapture – such as § 1245, tax credits, etc…
2. Look for assets with odd attributes, like installment notes
iii. Where more than one asset is contributed – split holding period prevents the partner from picking and choosing with part of the partnership interest has the longer holding period
1. Use FMV allocation –
2. Result is a ratio – applied to entire partnership interest
iv. § 1245 gain – per regulations, § 1245 recapture is not triggered if the transferee takes the same basis as the transferor had
v. Installment obligations – § 453 – disposition can trigger gain
vi. § 741: The sale of a partnership interest is a capital transaction
§ 723: Partnership – transferred basis
i. Partnership takes the partner’s adjusted basis in assets contributed
ii. Holding period to the partnership: § 1223(2) applies (Reg 1.723-1) the holding period of the contributing partner tacks to the holding period of the partnership regardless of the nature of the property
Other provisions – discussed in detail later
i. § 704(c) – allocating gain back to contributing partner
ii. § 731: when property is subject to a liability and contributing partner is relieved of part of the liability
iii. § 704 – special allocations and substantial economic effect
Tracking the inside and outside bases
§ 705: Partner basis rules (outside basis)
i. Treatment of a distribution
1. § 705(a)(2): Reduce outside basis of the partner by the basis of the asset (§ 733)
2. Partner takes tax basis equal to the partnership’s adjusted basis (732(a)(1))
3. Partnership does not recognize gain (731(b))
4. If the partner receives a distribution in excess of basis – taxed
ii. Treatment of income/loss – Increase/decrease outside basis – 705(a)(1)
iii. § 752(a): Increase in partner’s share of liabilities is treated as a contribution of cash to the partnership by the partners
1. Combine with § 722 – the result is an increases the outside basis of the partner(s)
2. No increase in net partnership value, or capital accounts
3. 752(b): Decrease in liabilities of a partner – treated as a distribution of cash to the partner
Inside basis – capital account rules – under the regulations – 1.704-1(b)(2)(iv)
i. Capital account is increased by the FMV of the property contributed
ii. Increase by partnership book income, not taxable income
iii. If the partnership sells contributed assets, and tax basis is less than FMV, there will be taxable income, but no book income
iv. Adjusted basis accounting – will reflect cash transactions at FMV but all other transactions at tax basis
v. Inside basis should never be out of balance (although outside basis can be out of balance)
Revaluation of capital accounts
i. Prior to a distribution the partnership can revalue assets from book value to FMV – if there is an economic disparity between the book value and the FMV of an asset that is to be distributed to a partner
ii. May also do this prior to admitting another partner – bringing in a equal partner to a partnership whose assets have appreciated
1. Bring partnership assets to FMV
2. Calculate how much the new partner needs to contribute (economically) to get status as an equal partner
iii. Capital accounts are about the relationship between the partners, but do not affect the tax consequences
II. Partner’s Share of Debt
Recourse debt: if assets of the p’ship don’t cover, the partners are liable
Shared according to the ratio for sharing losses – Reg 1.752-2
Limited partners –
i. Limited as to the losses (not profits) they can take
ii. Not liable for recourse debts
Not necessarily what the agreement says – but the losses the partner would be able to take in a “worst case scenario”
i. Example – in a partnership where three limited partners contribute 25K, a GP contributes 25K and the partnership takes out a 900K recourse loan, the full 900K is allocated to the GP, even though the agreement says losses & profits are divided equally because the limited partners cannot get losses allocated in excess of the 25K that they contributed
Nonrecourse debt: Creditor is limited to partnership assets…no partner is individually liable
Shared according to the partners’ ratio for sharing profits – Reg 1.752-3 (limited partners – not limited as to profits they can take)
Reg 1-752-3(a) – partner’s share of nonrecourse liabilities is the total of
i. Minimum gain chargeback [other than 704(c)]
ii. Gain (not loss) that would be allocated to partner, includes 704(c), if the asset were sold for the amount of the debt
iii. Partner’s share of remaining nonrecourse debt based on profit sharing –
Contributions of encumbered property
A partner contributes property subject to a debt -includes nonrecourse debt
i. Before contribution, partner is 100% liable for the debt –
ii. After contribution to the partnership other partners are
i. Use the value of the interest when the risk of forfeiture passes
ii. Value might be higher – meaning more ordinary income
iii. Assets should be revalued to reflect the increased value of the assets at the time the new interest is earned – so that the ratio of the capital accounts works
Election under § 83(b) – partner can recognize the income now
i. Recognize the income when the value is low – appreciation of assets will be capital
ii. Downsides
1. No deduction to the partner if the interest is forfeited
2. The partnership loses the deduction that was taken the first year – 1.83-2(c)
3. but still has the gain to recognize
Neither applies if a partner has to work for a certain number of years before getting his interest
Receipt of a Profits Interest for Services
Proposed regs say that the service partner has income equal to the liquidation value – which is zero for an interest in future profits – so the result is the same
i. Usually, the problem with a profit interest is valuation – can determine the PV of the income stream but since profits are taxed as earned, it would be double tax to tax the PV of the future income stream
ii. Alternative – could amortize the initial value – but IRS said too complicated
iii. Sol Diamond – problematic because the service partner sold the interest right after receiving it – meant that it was worth more than zero
Rev Proc 93-27 is a safe harbor: profits interest not taxed as income (no basis to the partner) if received for services unless:
i. Substantially certain and predictable stream of income, like from bonds
ii. Partner sells the interest in two years (Sol Diamond)
iii. Profits interest is a limited partnership interest in a publicly traded partnership
IV. Operations
Reporting
All items of partnership income, deduction, gain, loss, etc., must be reported at the P/S level – Form 1065.
Any items that may have different tax effects among the partners [e.g. investment interest], and any item that is being specially allocated [e.g. gain subject to 704(c )], must be listed separately,
i. Illustrates entity/aggregate hybrid
1. Aggregate – partnership pays no tax
2. Entity – Character determined by the partnership
ii. Income might not be income to a particular partner
iii. Character of gain is based on the partnership – see Rev Rul 68-79
iv. See § 702 and regs
Otherwise each partner’s share of the “bottom line”.
Each partner then reports his, her or its share of each item (including the bottom line net) on his, her or its income tax return
