Identifying what constitutes partnership liabilities and how they affect the basis of partnership assets: not all partnership debt qualifies as a liability for purposes of sec. 752.

• Author: Ellentuck, Albert B.

Treasury regulations define a partnership liability for purposes of Sec. 752 to be a partnership obligation to the extent that the obligation (1) creates or increases the basis of partnership property, (2) gives rise to an immediate deduction in computing the partnership's taxable income, or (3) gives rise to a nondeductible expenditure not properly chargeable to capital (Regs. Sec. 1.752-1(a)(4)).

Not all partnership debt qualifies as a liability under this definition. The general purpose of Sec. 752 is to match the partnership's basis in its assets as a whole with the partners' aggregate basis in their partnership interests--in other words, to balance the inside partnership basis with the outside basis of the partners. To do this, only partnership debt that has an impact on the partnership's inside basis is a liability. All other debt is excluded from consideration.

Generally, the analysis of whether a debt is a liability under Sec. 752 is the same as that for determining whether a liability creates basis or a deduction under the general Code provisions (Sec. 1012, et seq.). This means there can be legitimate partnership debts that may or may not be treated as liabilities depending on the partnership's accounting method. This can be seen in Owen, 34 F. Supp. 2d 1071 (W.D. Tenn. 1999), in which a district court ruled that a cash-basis taxpayer could not increase his basis in real property that he sold for improvements that were paid for with promissory notes that were not paid until a following year.

Regs. Sec. 1.752-1(a)(4)(ii) defines an "obligation" as any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account under the Code. (However, see below for a discussion about whether contingent liabilities are considered obligations under the rules for allocating recourse debt among partners.) Obligations include debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps. The inclusion of contingent debt in the definition of an obligation is the result of the IRS's aggressively pursuing transactions involving claims that a partnership's assumption of a partner's contingent liabilities does not reduce the basis the partner has in his or her partnership interest.

The typical transaction involves the transfer of cash and other assets to a partnership and the assumption by the partnership of contingent business liabilities, such as potential future asbestos liabilities or health care liabilities. The partner argues that since these liabilities are contingent liabilities, their assumption by the partnership does not reduce the basis of the partner's interest in the partnership. However, the contingent liabilities would reduce the price a buyer would pay for the partnership interest on a subsequent sale. When such a sale occurs, the partner sustains a loss based on the argument that the basis of his or her partnership interest was not reduced by the...