Current developments.

• Author: Burton, Hughlene A.
• Position: Provisions on partnership taxation

EXECUTIVE SUMMARY

* The AJCA requires a negative basis adjustment when there is a transfer of a partnership interest.

* The IRS issued final regulations on revaluations of capital accounts and contributions of long-term contracts and proposed regulations on gain deferral on a sale of QSB stock, debt of disregarded entities and special allocations of foreign tax expenditures.

* Many rulings were issued on TEFRA audits, foreign partnerships, See. 704(e), partnership conversions and other areas.

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, subchapter K elections, statutes of limitations, basis, debt and income allocations, transactions between partners and partnerships and partnership continuation.

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During the period of this update (Nov. 1, 2003-Oct. 31, 2004), the American Jobs Creation Act of 2004 (AJCA) was enacted, which made several changes to subchapter K. In addition, numerous proposed and final partnership regulations were issued, concerning liability allocations, capital account revaluations and the status of tax-exempt-bond partnerships. Various rulings addressed partnership operations and abusive tax situations.

AJCA

Signed by President Bush on Oct. 22, 2004, the AJCA contained several provisions that affect partnerships. Most of these apply to basis adjustments allowed on transfers of partnership interests. For example, according to AJCA Section 834, a partnership cannot step down the basis of stock of a partner (or a related person) when applying Sec. 755 basis allocation rules to a liquidating distribution under Sec. 734. The amount that cannot be allocated to the stock will (1) be allocated to other partnership assets or (2) create gain to the partnership if the step-down exceeds the tax basis of the other assets. With this law change, it becomes even more important for the partnership to be aware of any relationships its partners might have with companies whose stock the partnership owns.

In the past, basis adjustments made under either Sec. 734 or 743 were elective. However, when there is a substantial basis reduction, AJCA Section 833(c) requires an adjustment under Sec. 734(b). A substantial basis reduction is deemed to be a downward adjustment of more than $250,000 that would have been made to the basis of partnership assets if a Sec. 754 election were in effect. Likewise, a basis adjustment under Sec. 743 is required for transfers of partnership interests when there is a substantial built-in-loss (BIL). A substantial BIL exists when the partnership's adjusted basis in its property exceeds the property's fair market value (FMV) by more than $250,000. However, if negative adjustments have to be made, the partnership is not deemed to have made a Sec. 754 election for subsequent transfers.

The AJCA does not require electing investment partnerships to make these basis adjustments. Rather, it imposes special loss-disallowance rules at the partner level. It also does not require securitization partnerships to account for BILs in this way.

Under AJCA Section 833(a), only the contributing partner can recognize BILs under Sec. 704(c). To determine the amount allocated to a noncontributing partner, the Sec. 704(c) property's basis is its FMV at contribution. Thus, any remaining BIL is eliminated if the contributing partner disposes of his or her interest. Consequently, a subsequent purchaser of a contributing partner's interest may not benefit from this loss.

The new law also clarifies that the "stock for debt" exception in Sec. 108 does not exist for partnerships. Thus, when a partnership interest is exchanged for debt, the partnership must recognize cancellation of debt income and allocate it to its historical partners.

Partnership Issues

Entity vs. Aggregate Theory

An issue that often arises in the taxation of partners and partnerships is whether to use the entity theory or the aggregate theory. The entity theory treats the partnership as a separate and distinct entity from its owners; the aggregate theory treats it as an aggregate of its owners. Both of these theories are used in various sections of subchapter K.

This year, Treasury used the entity theory in proposed regulations on gain deferral on a partnership's sale of qualified small business stock (QSB). (1) Sec. 1045 allows noncorporate taxpayers to elect to defer gain on the sale of QSB stock by purchasing other QSB stock within 60 days. The proposed regulations provide that this deferral applies to partners if the partnership buys replacement QSB stock or a partner buys replacement QSB stock directly. A partner who sells an interest in a partnership that owns QSB stock is not eligible for the deferral. Likewise, the purchase of a partnership interest is not the purchase of QSB stock, even if the partnership owns such stock; Sec. 1045 does not take a look-through approach to the sale or acquisition of partnership interests.

Partnership Interests

Another issue is the classification of a partnership interest. For example, in Draper, (2) the taxpayer could not deduct a loss on his investment in a limited partnership as a worthless securities loss under Sec. 165(g). The court ruled that a partnership interest does not qualify as a security, even though a partnership interest is classified as a capital asset under Sec. 1221. This decision illustrates one way the Code treats partnerships differently from corporations.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. A question that continues to arise is whether an item is a partnership item. This dilemma arose in Wiener, (3) in which the taxpayer was a...