Partnership Basis Concepts Adjusted basis of a partnership interest held by a partner Adjusted basis of assets held by the partnership
Significance of Partner’s Basis Significant whenever the interest is transferred or liquidated Used in determining consequences of nonliquidating partnership distributions under § § 731 and 732.
Entity vs. Aggregate Approach Entity Approach - Basis in interest is separate and apart from share of the basis of each underlying partnership asset Aggregate Approach – Basis of interest is increased or decreased by partner’s share of partnership income, loss, distributions, etc. (§705(a))
§705 The aggregate of the partners’ adjusted bases in their partnership interest generally equals the aggregate of the adjusted bases of partnership assets. §705(b) – Provides for the determination of a partner’s basis in this interests by reference to partner’s proportionate share of the basis of partnership assets
Example Exception to §705’s Generality §743(a) – Upon the sale of a partnership interest, purchaser’s initial basis is cost, but purchaser’s share of the partnership’s basis is not adjusted to reflect the cost of the interest §743(b) – Provides an elective method of retaining basis equality in such situations
Initial Basis §722 – Result of a contribution to the partnership §742 – Acquired by means other than the contribution of money or property to the partnership
Initial Basis (continued) Generally determined by cost method Exceptions: Acquired from decedent – value on the date of death or the alternative valuation date Acquired by gift – donor’s adjusted basis, increased by federal gift tax paid Acquired in connection with performance of services – the amount of taxable income realized by the performer in connection with the receipt of the interest
Adjustments to Basis - §705(a) Increased by distributive share of: Partnership taxable income Tax-exempt income of partnership Excess of deductions for depletion over the basis of the property subject to depletion Also increased by: Amount of any cash contributed, or adjusted basis of property contributed
Adjustments to Basis - §705(a) – con’t Decreased (not below zero) by: Amount of cash distributed Basis to partner of any property distributed to the partner by the partnership Depletion deduction Distributive share of partnership losses and nondeductible expenditures of the partnership
When Basis Computation is Necessary Only if necessary to determine tax liability when: End of partnership year during which it suffered a loss, to determine deductibility of partner’s share Upon liquidation or disposition of partner’s interest, to determine gain or loss Upon the non-liquidating distribution of cash or property to a partner, to find the basis of the distributed property
Purpose of Basis Computations Keep track of a partner’s “tax investment” Prevents double-taxation or exclusion from taxation
Less Common Basis Adjustments Tax-Exempt Income §705 (a)(1)(B) Gifts – tax free to the extent of the carryover basis, but tax-deferred to extent of market value over basis. Tax-deferred income does not affect basis. Discharged debts – Income to the extent debt is discharged. Exception - If an insolvent debtor (at the partner level), then recognize income only to extent that discharge creates solvency
Less Common Basis Adjustments (con’t) Nondeductible Expenditures - §705(a)(2)(B) Amounts not deductible in computing its taxable income and not properly chargeable to capital account
Prohibition Against Negative Basis § §705(a)(2) and 705 (a)(3) - prohibits reduction of a partner’s basis below zero §732(a)(2) – limits the basis of distributed property (other than money) to the partner’s basis for his partnership interest
Prohibition Against Negative Basis (continued) §731(a)(1) – Requires a distributee- partner to recognize gain to the extent money distributed to him exceeds the basis of his partnership interest.
Ordering of Basis Adjustments Increased and decreased by all adjustments under 705(a), except for losses of the taxable year and losses previously disallowed Reduced by any money distributions and distributions that includes both money and other property Any other adjustments relating to separate distributions of property made in the order distributions are made
Including Partnership Liabilities in Basis - §752 Increases in a partner’s share of partnership liabilities are treated as cash contributions by him (includes assumption of partnership liability by a partner) – Increases partner’s basis as a contribution to the partnership Decreases in his share of partnership liabilities are treated as cash distributions to him (includes assumption of partner’s liability by the partnership) – Decreases partner’s basis to extent of basis, then treated as taxable distribution
Allocation of Liabilities Recourse Debt – Allocated among the partners in the proportions that they bear the “economic risk of loss” for such liabilities Non-recourse Debt – Allocated in proportion to and to the extent of the partner’s shares of partnership minimum gain and §704(c) minimum gain, and then according to the partner’s interest in partnership profits
Contributions of Property Subject to a Liability The liability is passed to the partnership Three simultaneous basis adjustments occur to contributing partner, the partner’s basis is: Increased by the full basis in the contributed property Increased by any resulting increase in his share of partnership liabilities Decreased by the entire amount of the liability that the partnership takes in property subject to the liability. All other partners have an increase in basis for their proportion of the assumed liability
Current Distributions of Property Subject to a Liability Mirror image of contribution adjustments Distributee’s basis is: Increased by liabilities encumbering his property Decreased by his share of the resulting reduction in partnership liabilities Decreased by the basis of the distributed property to him All other partners have an decrease in basis for their proportion of the distributed liability Liability adjustments are given effect prior to computing the basis of the property distributed
Liquidating Distributions of Property Subject to a Liability It is not necessary to adjust the basis of the distributee-partner’s interest following a liquidating distribution By definition, the distribution results in the termination of the distributee’s entire partnership interest.
Sale and Exchange of Partnership Interests Upon the sale or exchange of a partnership interest, liabilities are treated in the same manner as upon the sale or exchange of non-partnership property The “amount realized” upon the sale or exchange of a partnership interest includes the transferor’s share of partnership liabilities
Alternative Rule for Determining Basis §705(b) Partner’s basis may be determined “by reference to his proportionate share of the adjusted basis of partnership property upon a termination of the partnership” In short, the percentage a partner would receive if the partnership liquidated
Situations Where Alternative Rule is Allowed If a partner cannot practicably apply the general rule set forth in §705(a) If in the opinion of the Commissioner, it is reasonable to conclude that the result produced will not vary substantially from the result obtainable under the general rule
Basis vs. Capital Account In many cases, a partner’s basis is equal to the sum of the §704(b) capital account and his share of partnership liabilities. Exception – for §704(b) purposes, partnership property is sometimes required or permitted to be reflected on the partnership’s books at a value that differs from tax basis. Note – While a negative basis is not possible, a negative amount is possible in a capital account
Definition of Liability For §752 purposes, a liability should include any obligation of the partnership or a partner to the extent that incurring or holding it results in the creation of, or an increase in, the basis of any property owned by the obligor; a deduction taken into account in computing taxable income; or a nondeductible, noncapitalizable expenditure.
Do Not Qualify as §752 Liabilities Cash-Method Payables Unpaid Expenditures – until they become deductible under the all events and economic performance rules Deferred compensation expenses – until they become deductible Contingent Obligations Options to purchase partnership property in exchange for cash premiums
Identifying Liabilities Once a nonrecourse obligation is recognized as a liability for purposes of the income tax laws in general and §752 in particular, it will continue to be treated as a liability until it is paid or until some intervening event justifies a reassessment of the obligation
“Wrapped” Liabilities “Wrapped” refers to when an encumbered property is sold or transferred to or by a partnership, pursuant to a contract under which the transferor purports to retain the primary and ultimate obligation to pay the encumbrance.
“Wrapped” Liabilities (continued) §752(c) issue – whether the “wrapped” liability that continues to encumber the transferred property is treated as assumed by the transferree or whether the transferor’s obligation to continue to service the indebtedness causes the obligation to remain an obligation of the transferor for basis purposes
“Wrapped” Liabilities-continued If a partnership is the transferor and its continuing obligation to service the wrapped indebtedness does not prevent §752(c) from applying, the transfer results in the liability ceasing to be a partnership liability and is reflected in each partner’s basis Conversely, if §752(c) is prevented from applying, it is a partnership liability and the partners receive no change in basis until the liability is paid down
Partner Loans as Partnership Liabilities Recourse loans – partnership liability and allocated among all the partners Nonrecourse loans – partnership liability, but entire liability is allocated solely to the lender-partner
FMV Limitation on Nonrecourse Liabilities §752(c) – A liability to which property is subject is considered a liability of the owner of the property “to the extent of the FMV of such property.” Only affects liabilities that the owner of the property does not expressly assume If a partnership has a nonrecourse liability that is secured by property having a value less than the liability, a partner who sells an interest in the partnership is treated as realizing his full share of the liability, without regard to the value limitation
FMV Limitation on Nonrecourse Liabilities (con’t) If property subject to a liability is contributed to, or distributed by, a partnership, the transferee is treated as having assumed the liability, to the extent that the amount of the liability does not exceed the FMV of the property at the time of contribution or distribution.
Limitation Timing Consideration The limitation applies only at the time property is transferred.
Liability Assumptions A person is considered to assume a liability only to the extent that: The assuming person is personally obligated to pay the liability If a partner assumes a liability, the person to whom the liability is owed knows of the assumption and can directly enforce the partner’s obligation for the liability, and no other partner would bear the economic risk of loss for the liability immediately after the assumption