Treatment of ownership changes for EIPs under Notice 2005-32.

• Author: Velotta, Robert A.
• Position: Electing investment partnerships

Section 833 of the American Jobs Creation Act of 2004 (AJCA) amended Secs. 704(c) (1)(C) and 743 to limit a partnership's ability to duplicate or shift losses between taxpayers with respect to losses on built-in loss (BIL) property held by the partnership. The new law accomplishes this by restricting a partnership's ability to allocate deductions and losses from BIL property and to avoid a stepdown in asset basis under Sec. 754. These provisions are supposed to eliminate loss duplication via use of a partnership and apply to "substantial" BILs on partnership property. Notice 200532 addressed some of these issues.

Example 1: Partners A, B and C form Partnership ABC, each contributing $800,000. ABC uses the $2.4 million to purchase X Corp. stock. In year 2, the shares decrease in value to $1.8 million. C sells his interest to D for a fair market value (FMV) of $600,000. D's inside basis in ABC's assets is $800,000, while his outside basis in ABC is $600,000. C would recognize a $200,000 loss on the sale.

In year 3, ABC sells the X stock for $600,000. It recognizes a $1.8 million loss and allocates $600,000 of it to D, who recognized a true economic loss of only $400,000. The $200,000 remainder was recognized by C on the sale to D. Ultimately, this loss duplication will reverse. In year 4, ABC liquidates; A, B and D each receive $200,000 in liquidation of their ownership interests. Because A and B have $200,000 of outside basis, they recognize no capital gain, but D, whose outside basis is zero, recognizes $200,000 (the $200,000 he received in the liquidation, less his remaining zero basis in his partnership interest).

Under ACJA provisions, ABC has to adjust D's basis in the partnership property under Sec. 754, to the amount that D paid for his ABC interest. Sec. 754 becomes mandatory when there is a "substantial" BIL in the partnership's assets. A BIL exists when a partnership's tax basis in its assets exceeds their FMV by more than $250,000 in aggregate. Because ABC's adjusted basis in its property ($2.4 million) exceeded the property's FMV ($1.8 million) by more than $250,000 at the time of C's sale to D, the Sec. 754 basis adjustment is mandatory.

Interim Guidance

Notice 2005-32 provides interim guidance on the AJCA's provisions for both "regular" partnerships and "electing investment partnerships" (EIPs). Generally, for transfers occurring after Oct. 22, 2004, if there is a substantial basis reduction under Sec. 734(d) at the time of an...