Getting the benefit of your bargain in partnership acquisitions: proposed regulations under sections 743(b) and 755.

• Author: Sloan, Eric B.
• Position: IRC s. 743(b

1. Introduction

   1. Generally. Little more than a decade ago, the vast majority of businesses organized as partnerships(1)(*) were real estate ventures and professional services firms. As a result, partnership taxation was largely a backwater discipline. Now, due to widespread acceptance of the limited liability company and promulgation of the "check-the-box" regulations(2) (signaling the IRS and Treasury's concession of defeat in the entity classification wars), partnerships and partnership taxation are hot.

      As a result, taxpayers and their advisers now approach transactions with the same question those versed in the mysteries of subchapter K have been asking for years: why incorporate?(3) This growth in the use of partnerships has led to increasing frustration with the outdated subchapter K regulations (many of which were promulgated in 1955). Among the most vexing regulations are those governing basis adjustments on the sale or exchange of a partnership interest. Indeed, those regulations -- which permit the purchaser of a partnership interest to reflect the purchaser's acquisition cost in partnership assets -- are among the most confused and deeply flawed aspects of partnership taxation.

      In January 1998, to address these problems, the IRS and Treasury issued proposed regulations under section 734(b) (basis adjustments on certain distributions),(4) section 743(b) (basis adjustments on transfers of partnership interests), section 751(a) (the "collapsible partnership rule" requiring recognition of ordinary income on the disposition of certain partnership interests), and section 755 (allocation of basis adjustments under sections 734(b) and 743(b))? This article focuses on the proposed regulations under section 743(b) and section 755 (the "Proposed Regulations").

   2. Sections 743 and 755. The basis of partnership property is generally unaffected when a partner sells or exchanges its interest.(6) As a result, if a person acquires a partnership interest by sale or exchange for an amount that exceeds the transferee's share of the adjusted basis of partnership property, the excess purchase price is not reflected in the partnership's asset basis, i.e., the purchaser is not able to "push down" its purchase price to the partnership's assets.(7) When a partnership makes a timely election under section 754, however, a transferee partner's share of the partnership's adjusted basis in its assets ("inside basis") is adjusted to reflect the partner's basis in the acquired partnership interest ("outside basis").(8)

      The rules for computing the amount of the adjustment and allocating the adjustment among the partnership's assets are set forth in sections 743(b) and 755, respectively. In enacting these sections, Congress intended to permit taxpayers acquiring partnership interests to eliminate any disparity between their outside bases and their inside bases.(9) The underlying Treasury Regulations(10) -- scarcely adequate when written in 1956(11) -- provide little assistance to the tax professional dealing with contemporary partnerships, particularly those with complex provisions regarding the sharing of profits and losses or with "section 704(c) property."(12)

      The Proposed Regulations dramatically improve the current regulations. While merely clarifying the current rules would have been cause enough for celebration, the Proposed Regulations go farther, adopting new rules that should prevent some of the income distortions that occurred in the past. Thus, the Proposed Regulations not only include long-awaited guidance on how to determine a partner's share of inside basis and how to report basis adjustments, but also amend the previous rules to allow partnerships: (i) to allocate a net basis adjustment among both loss and gain properties; (ii) to recover basis adjustments from certain section 704(c) property at the same rate as built-in gain from the property is recognized; and (iii) to treat a negative basis adjustment as an item of built-in gain that can presumably be amortized over a longer period than the remaining useful life of the property.

2. Transfers Giving Rise to Basis Adjustment

   Although only a transfer constituting a "sale or exchange" gives rise to a basis adjustment,(13) the Proposed Regulations surprisingly do not define the term "sale or exchange." While a taxable transfer should qualify as a sale or exchange,(14) the status of nontaxable transfers is less clear. Each of the following nontaxable transfers has been held to constitute a sale or exchange for certain purposes: (i) the distribution by a corporation of a partnership interest;(15) (ii) the distribution by a partnership of an interest in a different partnership;(16) (iii) the contribution of a partnership interest to a corporation in a section 351 exchange;(17) (iv) the contribution of a partnership interest to another partnership in a section 721 exchange;(18) and (v) the transfer of a partnership interest in a tax-free reorganization.(19) Whether such transactions also constitute sales or exchanges for purposes of section 743(b) is less clear, although most advisers believe they should.(20)

   Treating nonrecognition transactions as sales or exchanges for purposes of section 743(b) provides significant planning opportunities. For example, assume a transferee acquires its partnership interest but is unable to persuade the partnership to make a section 764 election. If the partnership later makes a section 754 election, the transferee can obtain a basis adjustment at that later time merely by contributing its interest to a corporate or partnership subsidiary. This tax planning technique remains available under the Proposed Regulations. Moreover, because the Proposed Regulations permit basis adjustments even if the net adjustment is zero,(21) this planning technique permits taxpayers to shift basis between assets in a manner not available under current law. The authors understand that the IRS is considering addressing this issue in the final regulations.

3. Determining the Section 743(b) Adjustment

   1. Overview. If a transferee acquires a partnership interest in a transaction qualifying as a "sale or exchange" under section 743 and the partnership has a section 754 election in effect, then the transferee must adjust the basis of partnership property under section 743(b). The amount of adjustment is equal to the difference between the transferee's "outside basis" and its "inside basis." If the transferee's outside basis is greater than its inside basis, then the transferee will have a positive adjustment that increases the basis of partnership property. On the other hand, if the transferee's inside basis is greater than its outside basis, then the transferee will have a negative adjustment that decreases the basis of partnership property. Once the amount of adjustment is determined, it is allocated among the partnership's assets: first, to ordinary income assets, then, to capital gain assets.

      One of the flaws in the current regulations is that they do not account effectively for a transferee's varying interests in different partnership properties. The amount of a transferee's basis adjustment is based simply on the difference between the transferee's outside basis and its share of inside basis, which the regulations do not define. The adjustment is then allocated among the partnership properties -- not based on the transferee's share of gain or loss from those properties, but on the difference between the adjusted basis and the fair market value to the partnership of those properties. Under these rules, determining the amount of the basis adjustment is more of an art than a science, leading to varying -- and often inaccurate -- results.(22) This inaccuracy is magnified when the adjustment is allocated among the partnership's properties, because, for example, a transferee's snare of gain from contributed property or property subject to a minimum gain chargeback may be greater than its share of gain from partnership properties as a whole.

      To remedy some of these problems, the Proposed Regulations adopt a new construct called a "hypothetical transaction," which is defined as the disposition by the partnership of all of the partnership's assets, immediately after the transfer of the partnership interest, in a fully taxable transaction for cash equal to the fair market value of the assets.(23) The amount of the basis adjustment, as well as the allocation of that basis adjustment among the partnership properties, is based on the transferee's distributive share of gain or loss from this hypothetical transaction.

      The importance of the hypothetical transaction cannot be understated. Under this construct, if the amount the transferee pays for its partnership interest equals the fair market value of its share of the partnership's assets, the transferee's share of any gain or loss on a subsequent sale of partnership assets should be limited to its share of any increase or decrease in the value of the partnership assets that occurs after the transferee's entry into the partnership.(24) This should be the case even if the partnership agreement includes minimum gain chargebacks(25) or other complicated profit-and-loss-sharing ratios. When the transferee pays less for the partnership interest than its share of the fair market value of the partnership assets, the transferee may be taxed on the gain attributable to the discount. The rules for computing and allocating a basis adjustment under the Proposed Regulations are discussed below.

   2. Determining the Amount of the Basis Adjustment. Like the current regulations, the Proposed Regulations provide that a transferee's outside basis is equal to the transferee's adjusted basis in the transferred partnership interest.(26) Replacing the uncertainty of the current regulations, however, the Proposed Regulations provide that a transferee's inside basis is equal to the sum of (i) the transferee's interest as a partner in the...