The TRA '97's new basis allocation rules for property distributions.

• Author: McCoskey, Melanie G.

In an attempt to prevent basis shifting, Congress, in the Taxpayer Relief Act of 1997, changed the method by which basis is allocated when multiple assets are distributed to partners. This article explains this change in the context of both liquidating and nonliquidating distributions, and offers planning tips.

The Taxpayer Relief Act of 1997 (TRA '97) enacted several provisions affecting entities taxed as partnerships.(1) The most significant change, TRA '97 Section 106, amending Sec. 732(c), effective for tax years beginning after Aug. 5, 1997, relates to the allocation of a partner's basis in property distributed to him by the partnership for which he cannot take a carryover basis. Inability to take a carryover basis in distributed assets occurs in a nonliquidating distribution when the partner has insufficient basis in his partnership interest to allocate to the assets, and in a liquidating distribution when his basis in his partnership interest must be allocated to the assets distributed.(2)

Under pre-TRA '97 Sec. 732(c), when a partner was required to take a basis in property that differed from the partnership's basis, basis allocations were assigned according to each property's adjusted basis to the partnership, a process that sometimes produced results inconsistent with the property's fair market value (FMV).(3) This discrepancy in basis allocation distorted the gain or loss on ultimate disposition of the property, or produced abnormally high depreciation expense when the property was depreciated by the distributee partner. The TRA '97 introduced a different methodology for allocating basis to the distributed assets, although the precise methodology used depends on whether an increase or a decrease to the partnership's basis is required. This article will discuss and illustrate the application of the new basis allocation rules; new and old allocation results will be contrasted and planning opportunities will be explored.

Nonliquidating Distributions

From the distributee partner's perspective, there are two important issues when distributions are received from partnerships. The first is the tax effect of the distribution; the second is the partner's basis in the property received.

Most distributions are tax-free to partners. Generally under Sec. 733, the amount of cash(4) and the adjusted basis of the property distributed to a partner reduce his basis in his partnership interest; the partner usually takes a carryover basis in the distributed property, under Sec. 732(a).

Example 1: J's basis in JKL Partnership is $8,000;JKL distributes $2,000 of cash to her. Because the cash does not exceed J's basis in her JKL interest, she does not recognize gain on the distribution. J's basis in her JKL interest is reduced to $6,000 ($8,000 - $2,000).

Example 2: The facts are the same as in Example 1, except that J also receives property with an adjusted basis to JKL of $1,000. J's basis in her JKL interest is further reduced to $5,000 by JKL's $1,000 basis in the property; J takes a $1,000 carryover basis in the property received.

If the cash received exceeds the partner's basis in his partnership interest, Sec. 731 (a) provides that the distribution in excess of basis is treated as a sale or exchange of the partnership interest. Because partnership interests are usually capital assets to partners under Sec. 741, such gain is capital gain.(5)

Example 3: K's basis in her JKL Partnership interest is $10,000; she receives a $12,000 cash distribution. K has owned her JKL interest for five years. Because the cash distribution exceeds K's basis in her JKL interest, the excess is treated as a sale of such interest. Accordingly, K has a $2,000 long-term capital gain; her basis in her JKL interest is zero.(6)

Insufficient Basis

In a nonliquidating distribution, a partner generally reduces his basis in his partnership interest by the partnership's adjusted basis in the assets distributed and takes a carryover basis in the assets received. If the partnership's basis in cash and property distributed exceeds the partner's basis in his partnership interest, the partner must allocate his basis in his partnership interest to the property received, according to Sec. 732(c).(7)

If the cash distributed is less than the partner's basis in his partnership interest, the partner will have basis remaining to allocate to the distributed property. The distributed property is classified into two groups, according to Sec. 732 (c) (1): (1) unrealized receivables and inventory(8) and (2) all other property. Basis allocations are made first to unrealized receivables and inventory; if basis remains, it is allocated to the other property received.

Under Sec. 732(c)(1) (A) (i), partnership basis is first allocated to inventory and unrealized receivables to the extent of the partnership's adjusted basis in those assets. If insufficient basis exists to allocate carryover basis to these assets, Sec. 732(c)(1)(A)(ii) requires the partner to make a negative adjustment to the partnership's basis in those assets equal to the difference between the partnership's basis in the assets distributed and the partner's basis in his partnership interest. New Sec. 732(c)(3) prescribes a two-step process for allocating the negative adjustment. First, the bases of assets that have declined in value are decreased, but not below FMV. Second, any remaining negative adjustment is allocated to the properties in proportion to their adjusted bases, after any adjustment to FMV.

Example 4: G has a $6,000 basis in his UGA Partnership interest; in a nonliquidating distribution, he receives the following:

Asset UGA's adjusted basis FMV Inventory 1 $14,000 $17,000 Inventory 2 $8,000 $1,000 Equipment $20,000 $25,000 G should allocate his basis to the inventory items to the extent of UGA's basis in those items, but he has insufficient basis; thus, a negative adjustment to the partnership's basis in these items is required. The total adjustment is $16,000, the difference between G's $6,000 basis in his UGA interest and UGA's $22,000 adjusted basis in the inventory. This adjustment is allocated first to assets that have declined in value to reduce their bases to FMV; accordingly, the basis of Inventory 2 is decreased by $7,000 to its $1,000 FMV. The remaining $9,000 ($16,000 - $7,000) negative adjustment is allocated to each inventory item based on its relative adjusted basis after any adjustment to FMV; thus, the remaining $9,000 negative adjustment is applied to Inventory 1 based on its basis of $14,000 and to Inventory 2 based on its new basis of $1,000, as follows:

Inventory 1: [$14,000/($14,000 + $1,000)] x $9,000 = [$14,000/$15,000] x $9,000 = $8,400

Inventory 2: [$1,000/($14,000 + $1,000)] x $9,000 = [$1,000/$15,000] x $9,000 = $600

After these additional negative adjustments, G has a $5,600 basis in Inventory 1 ($14,000 - $8,400) and a $400 basis in Inventory 2 ($8,000 - $7,000 - $600). G will take a zero basis in the Equipment he received) Prior to the TRA '97, G would have allocated $3,818 (($14,000/$22,000) X $6,000) of basis to Inventory 1 and $2,182 (($8,000/$22,000) X $6,000) of...